Hedge Funds Lose Favor Among US Institutional Investors

June 26, 2013

An annual survey of institutional investors and financial advisors conducted by investment research firm Morningstar revealed that the high fee structure of hedge funds and their recent prolonged underperformance are prompting institutional investors to use alternative mutual funds as substitutes for hedge funds. The survey of 235 institutions and 471 financial advisors conducted in March found a sharp decrease in the number of institutional investors using long short hedge funds compared to 2010 and an increase in institutions using long short equity mutual funds during the same period.

Hedge Funds Versus Alternative Mutual Funds

Credit: ETF Trends

According to data compiled by Morningstar, most hedge funds charge 2 percent as management fees but the average hedge fund management fees is around 2.6 percent. In addition, most hedge funds take a 20 percent share of the profits as performance fees. According to Morningstar, the average long short mutual fund charged 1.9 percent in management fees in 2012. Unlike hedge funds, mutual funds don’t have performance fees attached to it.

Nadia Papagiannis, director of alternative funds research at Morningstar says alternative mutual funds have expanded their product offering in recent years to compete more aggressively with hedge funds. Alternative mutual funds now offer hedge fund-like products at lower management fees and without the attachment of performance fees.

The survey found that this year only 26 percent of institutional investors used hedge funds for long short strategies, a sharp decrease from 2010, when 61 percent of institutions allocated money to long short hedge funds. During the same period, institutions using long short equity mutual funds have gone up to 45 percent from 38 percent. The survey revealed that for the second year in a row long-short equity strategies remained the top choice of institutional investors for increased allocation.

Papagiannis says there are factors about hedge funds other than fees such as lack of liquidity as a result of multi-year capital lock-in, shortcomings in transparency, and lack of regulation that cause discomfort to institutional investors.

Hedge Funds Continue To Underperform

Despite a positive year for the hedge funds as measured by the Barclay Hedge Fund Index, the average hedge fund continues to significantly lag the markets.  The Barclay Hedge Fund Index is up a respectable 5.87 percent year to date, but well below the 15 percent gain in the broader Standard & Poors 500 Index.

The appeal of hedge funds among institutional investors has been waning in recent years due to their shocking underperformance compared to the broader stock market index. The shift to alternate mutual funds from hedge funds suggests that institutional investors are losing confidence in hedge funds’ ability to significantly outperform the market. From a job market perspective, this is a long-term negative news for the hedge fund industry. For hedge funds to attract a large portion of institutional money, it will have to generate returns significantly better than the broader market index over a sustained period of time. Given its recent track record, it is unlikely that investors will flock to hedge funds in a hurry in the near term.

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