Hedge funds head south

Hedge fund investors had better temper their expectations for 2014. In the past two years, hedge funds have posted double-digit returns, according to alternatives investment data provider Preqin. But this year, Preqin’s all hedge fund benchmark is up just 3.7% year-to-date, way short of the double-digit returns expected for 2014 by family office investors.

Trouble is not apparent on the surface of it. Three of the 27 strategies tracked by HFR, the hedge fund tracking firm, have beaten the S&P’s 5.6% return; six did better than the 4% of the Barclays U.S. Capital Government/Credit Bond index. None of that sounds too bad. But here’s another truth: One-quarter of the 16,500 funds tracked by Preqin are either flat or in the red in 2014.

Perhaps Preqin’s most important survey finding: More than half of fund managers and institutional investors now believe 2014 hedge fund returns will fall between 4% and 6%, net of fees, suggesting investors shouldn’t expect too much more from their hedge fund investments this year.

Sentiment is important. After heady gains of 11.7% last year, most investors came into 2014 with rosy expectations. By June of 2014, however, 57% of the 150 fund managers surveyed were positive about the second half of the year, already down significantly from the 73% scored just six months earlier. Conversely, the ranks of those in the bear camp jumped from 26% at the end of last year to 39% in June.

But Preqin’s data suggests there was an even bigger mismatch between the expectations of family offices versus pension funds, foundations and endowments. At the end of last year, family offices were targeting 10% returns from hedge funds in 2014, while everyone else was shooting much lower. Fund-of-fund managers were seeking returns of 8.6%; insurance companies, pensions, endowments and foundations, were looking for 5.7% to 6.7%. The lower expectations of this institutional money have been far more realistic.

Why is there a disparity between the expected returns of family offices and institutional investors? Good question. Preqin’s head of hedge fund research, Amy Bensted, says 92% of family offices invest directly in hedge funds, versus 71% of institutional investors, who use fund of hedge funds or other intermediaries to pick their hedge fund investments. “Family offices tend to have more appetite for risk and volatility, and look at more niche-type categories that can outperform. This year, those products happen to be underwater,” she says.

The silver lining in all this? Bensted claims the industry’s poor performance is creating a tough environment for managers to raise money. “Hedge fund investors could be able to negotiate significantly lower fees this year,” she says.

This downward pressure on hedge fund fees has been building for a while, with the historic 2% management fee and 20% of performance no longer the norm. A Deutsche Bank survey of 400 hedge fund investors shows that, on average, wealthy folks now pay 1.7% in hedge fund management fees and 18.2% on profits. Bensted expects management fees will be negotiated as low as 1.5% in the near future, and many investors are making inroads to push for performance fees that kick in only when hedge funds hit certain profit thresholds. Lower fees mean, of course, higher take-home returns.

Our reading: lower performance expectations for 2014, while perhaps adding hedge fund exposure with fees negotiated sharply lower.

Also see Tom Elliott's article, Are hedge funds right for you?

This article was first published in Barron’s, and is reproduced with permission.