Hedge funds have provided their best downside protection in the ongoing bear market, as a proportion of broader market falls, since the dotcom crash at the turn of the 21st century.

According to new research from leading investment solution provider, WTW (formerly Willis Towers Watson), hedge funds have delivered downside protection with returns of -5.6% between January and June 2022 (on the HFRI Fund Weighted Composite index) compared to broader equity market declines of -20.5% on the MSCI World index.

This means that hedge funds have tracked just over one quarter (27% proportion) of broader market declines over this period. This compares favourably to the initial pandemic panic seen in markets in early 2020, when a -11.6% drop from hedge funds matched more than half of the -21.1% drop in equities over the same bear market period (January – March 2020).

Today’s downside protection is not as strong as was seen in the Dotcom crash when hedge funds almost avoided a negative return while markets fell by nearly half. However, the current performance offers a striking parallel to the downside protection seen from hedge funds during the early 1990s, when the invasion of Kuwait caused an oil shock, recession in many economies and associated bear market.

This serves as a reminder of the potentially powerful role of hedge funds in portfolios, particularly in today’s market conditions of high inflation, a challenged macroeconomic outlook and the ongoing war in Ukraine.

Today’s newly released research paper from WTW highlights positive changes to the hedge fund industry in recent years. These trends include technological and investment innovation, momentum in sustainable investing best-practices and delivering better value for money.

Chris Redmond, Head of Manager Research at WTW, says: “Sustained change will be essential for hedge funds to stay relevant. A hedge fund industry offering a strong client value proposition can thrive in these uncertain times.

“Our mission to change the investment industry for the benefit of the end saver has driven us to create a new way for hedge funds. We are encouraged by the value added by those hedge funds which have embraced this and by the emerging positive trends we have examined in our recent papers.”

“We believe that in the current environment, hedge funds are well positioned to contribute strongly to institutional investors’ portfolios, as evidenced by their recent robust performance. We are convinced that by embracing innovation and sustainable investing best-practices, the hedge fund industry can take a leap forward in its client value proposition, establishing a sector that will better reflect our society and deliver better performance outcomes for savers.”

“However, there is a risk that the recent improvements in performance outcomes and renewed interest catalyses a backward step to some of the ugly behaviours of the past; we hope this will not be the case.”

Hedge Funds: The industry strikes back  leverages the data insights obtained over the last three years to demonstrate that the portfolios of hedge funds constructed using “a new way” have consistently added value. Not only have hedge funds generated stronger absolute returns than WTW had seen over the past two decades, but they have also offered significant protection at times of volatility.

This year’s downside protection from hedge funds has beaten the industry’s performance during the financial crisis of 2007-2009, when hedge funds (down -21.4% between November 2007 and February 2009) tracked two fifths of the drop in equity markets (down -54.0% in the same financial crisis bear market).

A newer industry evolution is the growth in multi-manager platform hedge funds (“platforms”), a hedge fund product type that employs multiple portfolio managers under the same hedge fund roof with all costs passed-through to the underlying investors. Due to relatively robust performance and consistent marketing efforts, many of the industry’s hedge fund platform solutions are seeing significant growth in assets under management. This success is enticing more hedge funds to switch to this business model which, WTW warns, would denote a backward step for the industry and risks disenfranchising the end saver, representing a departure from a value for money mindset. 

To prevent this, WTW highlights the areas where more remains to be done to encourage more asset owners to tap into hedge funds’ full potential and generate better returns. In order to firmly set the wider hedge fund industry on a positive trajectory, WTW suggests:

  1. That hedge funds make Inclusion and Diversity an urgent priority in order to attract and retain talent, while keeping the industry relevant and at its best for investors
  2. That investors allocating to hedge funds using the expense pass-through model should check whether they are getting value for money and protecting the longer-term stability of this model
  3. The hedge fund industry should prioritise providing better alignment of fees, expenses and terms with investors and seek to improve their client value proposition.

Today’s paper follows WTW’s prior 2019 research entitled Hedge funds: A new way, which took a contrarian stance during the peak of hedge fund unpopularity by calling attention to the benefits of investing in hedge funds, if approached correctly.  

Chris Redmond concludes: “We have been encouraged by the progress made by the hedge fund industry in recent years, including the strong performance contributions to institutional investors’ portfolios and downside protection provided in periods of falling equity markets. There is a fantastic opportunity for hedge funds to continue recent positive momentum and remain highly relevant to investors.  However, there is a risk that the recent success catalyses a backward step, with expense pass-through models employed by platforms a potential example.  We question whether clients are getting value for money from this platform model and worry about the misalignment of interest with the end saver.”