Hedge funds seem to be afraid of taking risks - What should investors do?

Are hedge funds just not taking enough risk? A new 2020 theme is that investors want hedge funds to take more active bets and generate more alpha. A good hedge fund may have an attractive information ratio but a low volatility and not enough absolute return. That may be fine but if the return is below a pension's discount rate, it may not truly help the portfolio. Of course, there will be diversification benefits, but investors are looking for return. 

A report from Willis Towers Watson "Hedge Funds: A New Way" touches on some of these issues in the more competitive and rapidly changing hedge fund world. Hedge funds have been disappointing investors on a number of fronts. While there are many successful funds, the industry is going through growing pains as it transitions into larger developed firms from smaller craftsman funds.

The hedge fund alpha, on average, has fallen close to zero with limited volatility as measured by Willis Towers Watson. 

There are a number of global hedge fund issues that are affecting performance, investor demand, and industry confidence.

• The firms - As hedge firms have gotten bigger, there is greater emphasis on enterprise value and smoothing management and incentive fees and less focus on high absolute returns. The impact of this business focus is that less risk is being taken. There is a strong desire to hold assets and not swing for the fences and incentive fees. Fund products have been structured to be more diversified and appeal to institutional clients at lower volatility. 
• The macro environment - There has been a significant decline in asset volatility which reduces return dispersion and return potential from trading or making specific active bets. There is more value with just holding market beta in a low dispersion world. 
• Additionally, the hedge fund business has become more competitive with more new firms and traditional money managers moving into the hedge fund space. More capital is chasing what may be limited alpha
• Regulation has also reduced the opportunities for hedge funds to create information advantages.
• Fees - With lower returns, fees have become a larger component of overall return. Investor, of course, want lower fees, and are putting more pressure on managers given there is limited alpha. 
• Financial alternatives - There are more investment alternatives such as alternative risk premia swaps from banks and factor products from traditional managers that have increased the competition and benchmarking of hedge funds. Competition is coming from more than just other hedge funds. 

Are there solutions for investor who do not want to face more low alpha in a changing hedger fund industry?

• The right benchmark - Forming the right benchmark and understanding the risks being taken by hedge funds managers has become a more critical part of the due diligence process for investors. Alpha shrinks when the correct benchmark for a hedge fund is used. If the factor exposures can be measures, the value-added from hedge funds can also be measured.  
• The search for specialists - A big change in the hedge fund industry is the greater desire for specialists or specialty funds especially within larger firms. Investor want to target specific styles and strategies to improve returns from alternatives.
• The fee negotiation - There is greater focus on paying for alpha and not for beta. 
• Alternative risk premia - The development of alternative risk premia swaps have allowed investors to by-pass hedge funds and obtain factor strategy exposures in an efficient manner Investors can get higher leverage and liquidity in the swaps markets. Additionally, the total return swaps based on alternative risk premia are priced at more attractive levels than hedge funds that charge management and incentive fees.  

Investors have to adapt to the changing industry by getting ahead of the structural dynamics. While alpha has been declining, there are simple steps to still gain an investment advantage through adjusting the process of choosing hedge funds, using alternatives to hedge funds, and negotiating for better investment and fee terms.