By Laurence Fletcher and Tommy Wilkes
LONDON (Reuters) - Hedge funds may be making their clients less money than mainstream financial markets, but with their portfolios increasingly seen as a safer, low-volatility option in a tough investment landscape they have more cash to manage than ever.
The industry's coffers hit a record $2.4 trillion globally in 2013, swollen by money from U.S. and European pension funds seeking help to find returns in the face of low interest rates and unpredictable markets post-financial crisis.
"At times when equities rally, trustees will ask 'Why did we have those hedge funds again?' But it's big volatility events in markets and big selloffs that make people remember, 'Oh yes, that is why we have that hedge fund'," said Aon Hewitt's Guy Sainfiet, who advises pension funds on their investments.
Market meltdowns have ravaged investors' portfolios in the past five years. In 2008, at the height of the financial crisis, the MSCI World Index dropped by more than 40 percent. Over the same period global hedge funds fell less than 20 percent, according to industry data firm Hedge Fund Research.
As a result investors have thrown cash at the industry, which now manages nearly 30 percent more money than in 2007, Hedge Fund Research data shows. An August survey by research group Preqin, covering 450 investors running $11.7 billion, showed 29 percent planned to raise hedge fund allocations over the next 12 months, while only 12 percent expected to cut them.
A closer look at the numbers shows however that the money hedge funds have made - beyond what their clients could have earned from investments tracking the main asset classes - has plunged since the financial crisis.
This return, known in the industry as 'alpha', even turned negative in 2011, according to a recent research paper based on the returns of more than 31,000 funds.
"Total returns have recovered since the financial crisis but average hedge funds' risk-adjusted performance appears to have fallen in the last few years," said Robert Kosowski, associate professor at Imperial College London and co-author of the study with fellow finance academics Juha Joenvaara and Pekka Tolonen.
Their research found the average fund made 5.32 percent more than the so-called 'beta' return delivered by a basket of the major bond, stock, commodity and currency indexes between 1994 and February 2012.
But that headline number hides significant variations in hedge fund returns over time.
Over 36 months, hedge fund 'alpha' - or above market - returns reached almost 10 percent in 2001 but by early 2012, investors were worse off by between one and two percentage points than if they had invested in the basket of major asset class indexes.
"There could not have been more perfect conditions for passive beta (market) investing over recent years," said Arie Assayag, chief executive at UBP Alternative Investments.
Indeed, a simple tracker fund such as the SPDR S&P 500 Exchange Traded Fund, one of the most common so-called "passive funds", is up 16 percent this year, against a 3.9 percent rise in the average hedge fund.
SAFE HANDS, HIGH FEES
Increasingly, then, investors are turning to hedge funds to help them manage volatility and ensure steady - if low - returns, rather than hoping for one-off bumper returns.
From 2007 to 2012, average annual hedge fund volatility was 9.8 percent according to the HFRI index - a widely-used benchmark of hedge fund returns - while the MSCI Global Equity Index was almost twice as volatile at 18.2 percent. Volatility in the S&P 500 was 16.6 percent.
"Many investors are looking for Libor plus 300-500 basis points, while others want returns similar to equity markets but with lower volatility," said Morten Spenner, CEO of International Asset Management.
This is particularly true for pension funds. Steady returns help them to map out how much they need to pay out to retirees - against new money coming in - with greater confidence and consistency.
The price for avoiding volatility? Higher fees. Annual hedge fund management fees can be as high as 2 percent of assets and 20 percent of all profits. By contrast, funds which passively track a basket of stocks or bonds charge around 0.5 percent.
Critics say pension trustees are paying too high a price for safety when the hedge funds' gains have declined so much.
The hedge funds themselves, capitalising on investors' concern, now present their fees as the price of peace of mind.
In a far cry from the industry's early days, when hedge fund managers built their reputations on high-risk, contrarian bets backed by lots of debt, many are now recasting themselves in a more conservative mould, using less leverage and taking fewer risks.
(Additional reporting by Sinead Cruise; Editing by Sophie Walker)