Press Release

Willis Towers Watson calls for change in hedge fund industry

February 1, 2019

LONDON, 1 February 2019 – Investors must change their approach to hedge funds amid structural headwinds facing the industry, according to a new research paper by Willis Towers Watson.

In its paper, ‘The New Way’, Willis Towers Watson argues that the competitive advantage delivered by hedge funds is being eroded by structural, rather than just macroeconomic, constraints; principally the industry’s focus on “enterprise risk” rather than investment risk.

The sustained equity bull market and muted volatility have contributed to lower alpha in recent years, yet data suggests that hedge funds are not assuming sufficient risk to deliver attractive performance in any environment:

Hedge Fund Alpha is reducing on an absolute and risk adjusted basis

Graph showing that Hedge Fund Alpha is reducing on an absolute and risk adjusted basis

The monthly alpha is the residual of a rolling regression where the 36 month beta of the HFRI index to the S&P is the beta of the regression. Sources: HFR® and Bloomberg LLP, 30 June 2018.

As such, investors should not wait for a change in market conditions and should instead adopt three principles when incorporating hedge fund solutions in institutional portfolios:

  1. Specialise and isolate - Managers are rarely best-in-class across multiple disciplines, so fund selectors should avoid over-diversified funds and instead identify managers that possess a unique competitive advantage in a precise area and isolate this specialist skill to create a solution. This might involve carving out the best elements from flagship/multi-strategy vehicles, free from the lower-conviction ‘risk management padding’ that can suppress returns.
  2. Proactively design - Investors should not simply accept the available products and should instead influence managers to create innovative new mandates, designed in the context of wider portfolios. By collaborating with hedge fund managers, investors can shift the managers’ focus from ‘enterprise risk’ (focus on the stability of base management revenues) back to investment risk, allowing an appropriate level of risk to be targeted.
  3. Deliver better value for money - Fee structures, expenses and all costs should be transparent and ensure alignment between the hedge fund manager and the end client. Managers should be paid for alpha, but fees should reflect the manager’s cost structure, the underlying strategy and the risk level.

Sara Rejal, Global Head of Liquid Diversifying Strategies, commented: “We firmly believe that hedge funds continue to have a distinct competitive advantage and a clear role to play in institutional portfolios, largely due to their unconstrained investment mandate.

“However, in recent years, hedge funds have become too focused on issues that are tangential to investment performance. Simply assuming that the macroeconomic situation will improve and boost returns is a strategy of hope, and we’re urging investors to adopt a new approach to ensure they’re selecting the right manager, mandate and fee structure for their hedge fund portfolios.”

Looking ahead: a more favourable environment

The macroeconomic environment should become better-suited to hedge funds in the medium term. With the potential for slower and regionally divergent global growth, there are signs of market volatility with potential for greater downside risks, making equity and credit markets vulnerable to price falls. Indeed, central bank policy divergence has already commenced, and the correlation between stocks is not at historically low levels, implying a greater level of dispersion and a richer opportunity set.

It is also the type of environment where hedge funds can improve the downside protection characteristics of a total portfolio.

About Willis Towers Watson Investments

Willis Towers Watson’s Investments business is focused on creating financial value for institutional investors through its expertise in risk assessment, strategic asset allocation, fiduciary management and investment manager selection. It has over 900 colleagues worldwide, assets under advisory of over US$2.3 trillion and over US$87 billion of assets under management.

About Willis Towers Watson

Willis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has over 40,000 employees serving more than 140 countries. We design and deliver solutions that manage risk, optimize benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas — the dynamic formula that drives business performance. Together, we unlock potential.

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