Alternative Investments
Ebb and Flow of the Hedge Fund Industry

It would be easy to view 2015 as a forgettable year for the hedge fund industry. Uncertainty in China, dramatic downward pressure on commodity prices, shifts in federal policy, and other factors rolled the capital markets during the second half of the year. Such instability seemingly should have been to the benefit to hedge funds given their supposed idiosyncratic approaches and their ability to capture return while others are suffering losses. So, on the surface, it was somewhat surprising that the year ended on an uninspiring note for hedge funds as a whole, with the average portfolio declining slightly. Year-end 2015 also marked the first quarterly outflows from hedge funds since the fourth quarter of 2011 — and the largest number of fund closures in any year since the financial crisis. As a result, we believe it is appropriate to address many of these concerns specifically.

Attention-grabbing headlines and actions of a few prominent investors proclaimed the decline of the hedge fund industry. Fact is that the absolute performance of hedge funds was disappointing in 2015 and continued to lag in the first quarter 2016. However, hedge funds continued to post favorable risk-adjusted results during difficult months for the equity markets and added value over a traditional 60/40 mix for the year. In other words, hedge funds actually delivered as an accretive alternative to stocks and bonds, which is the ultimate objective. This degree of downside protection illustrates a key tenet of a hedge fund portfolio approach, and from this perspective the average hedge fund investor’s experience in 2015 should be viewed as being in line with expectations.

At Mercer we do not believe that the hedge fund industry is fundamentally changing. In our opinion, a historical perspective diminishes many of these concerns. Given the size of the hedge fund universe and the degree to which manager selection influences results, the experience of any one investor is not indicative of the opportunity within the industry as a whole.

Properly constructed hedge fund portfolios have continued to deliver attractive, risk-adjusted returns while providing diversification and defensiveness during challenging environments for risk assets. Given the importance of manager selection in achieving this objective, our aim at Mercer continues to be focused on finding the best talent in the space.

The primary objective of this paper is to reaffirm our believes that hedge funds offer a very attractive value proposition, particularly since strong equity and bond returns since 2008 have left few traditional markets in “cheap” territory, while offering a historical perspective on the hedge fund industry of the past 25 years.

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