Julia Verlaine

Welcome to the first episode of our Capital Advisory Group’s podcast series, What is the role of Hedge Funds today?

Following the results of our 2019 Institutional Investor Survey, Kenny King, Head of J.P. Morgan’s Americas Capital Advisory Group, dives deeper into the findings and discusses the trends we expect to see for Hedge Funds this year.

Kenny

Hello, listeners. My name is Kenny King. I'm the Americas head of the capital advisory group. I'm thrilled to be with two of my good friends, Paul Zummo, chief investment officer, JP Morgan, alternative asset management, and Michael Gubenko, global head of hedge fund due diligence for JP Morgan, global wealth management. Thank you both for being here for our inaugural podcast episode.

Michael

Thanks for having us, Kenny.

Paul

Thanks, Kenny. Great to be here.

Kenny

We recently released our annual investor survey, and even after a challenging 2018, investors remain committed to hedge funds. On the other hand, there's definitely frustration. Hedge funds had struggled to produce alpha, alpha being defined as beating a benchmark. Investors continue to believe that they're getting more beta, beta being defined as just getting the benchmark rather than getting a true source of alpha and a differentiated experience with their managers.

Seventy percent of investors did not meet their target return, which has me, uh, scratching my head. What is the role of hedge funds today? Paul, Michael, how are your businesses thinking about the role of hedge funds in your portfolio?

Michael

you want me to kick off?

Paul

Sure. Why don't you start it off.

Michael

Alrighty. Look, I think that undoubtedly most investors who have been investing in hedge funds have been frustrated with the level of returns they've witnessed out of their portfolio for the past, you know, call it five to seven years as a whole. And I think some are starting to alter what their expectations are for it, and I think that's the exact, like, the wrong place to start here.

And so, here's how we think about it within, uh, within wealth management. We use hedge funds as part of a multi asset class portfolio. We are responsible for managing people's wealth, uh, across generations, and so most of the money that we manage is in multi asset class solutions. And if you think about that, it's really we break it down into the basic building blocks, which are equities provide growth, fixed income provides stability, and then we've used hedge funds for diversification benefits.

So, you know, one of the objectives that we always set for ourselves is, well, um, what is the beta that we expect to come from our hedge fund allocation? We manage our, our, our allocations to be anywhere between a 0.2 and a 0.3 beta to equity markets as a function of where we are, um, in a cycle, today being later cycle.

And so, um, we look for a minimum of 200 basis points of alpha on top of that.

Paul

Yeah, I'd say that the vast majority of our clients are looking , uh, at hedge funds for a source of, of diversification to their other asset classes, but I'd say that, you know, that's not necessarily the case across the board. And maybe more broadly, the way we work with clients has become increasingly, and the solutions in which we provide, has become increasingly customized, increasingly bespoke, um, over the years as well.Kennywith the industry close to $3 trillion in assets, are you finding sourcing managers more challenging today than five years ago?

MichaelI would think for, I would think for both of us, right, you think about this industry, reached an all-time peak last year despite the way that you commenced this conversation about frustration, so clearly there's still money flowing into it. Um, and, you know, how many participants are there? North of 8,000, maybe even, like, 10,000, especially as, um, um, as you've seen growth outside of the core market of the US and even traditional Europe, right, into more emerging economies of the world.

And so, both of us I think view this as we've got to find the best in breed that there is, and so, you know, the number of managers that we cover is well less than 1 percent cover, meaning, uh, invest in well less than 1 percent of that, that, that total universe.

Paul

Well, there's no, no shortage of, of managers. You know, there's always, uh, there's the difficulty of finding good managers, definitely you've seen alpha come down structurally over, you know, 10, 20 years, and especially in certain strategies.

So, maybe just take, you know, a couple different areas. Um, like, fixed income replacement. So, as the prospect for rising rates was really on the mind of many investors, I think people were often turning toward hedge funds as a fixed income replacement, more kind of multi-strategy-oriented portfolio.And, you know, private credit would be another one. Uh, there's obviously many different forms of private credit. Um, on one hand the, you know, direct lending space is, is much more commoditized, but there's a lot of different, you know, substrategies within private credit that are less trafficked and, again, offer both higher rates of return and higher alpha potential.

Um, volatility. So, uh, volatility obviously increased in the fourth quarter, but I think there was concern, just given the level of equity market valuations and a prospect for higher volatility, and that led toward, um, many more conversation around quantitative investments, specifically statistical arbitrage and specifically on the shorter term oftentimes machine learning-oriented statistical arbitrage, which is a beneficiary of a heightened volatility environment.

Kenny

We're definitely seeing, seeing an increased focus on quantitative strategies. Maybe you can define or tell us what are the key drivers because you've definitely been a big proponent of quantitative strategy.

Paul

Right. Yeah, I mean, you know, it's, it's, it's funny, depending on your experience in quant, you could kind of come away with very different conclusions. Or if you're reading the newspapers, you'd see, you know—I don't know, you'd open it up on Monday and it, it, it says quant did, did terribly. You know, Tuesday it's done great. You know, Thursday someone's going out of business.

So, it, it, it's too large, you know, just to say quant, it's just too large of an area. you could really slice that quant world into a lot of different substrategies. I mean, commodity trading advisors on one hand, CTAs, risk, you know, risk-parity based things on, on another.

Um, and they've performed quite differently, and even, you know, taking a space like statistical arbitrage, if you look at machine learning focused managers, they have actually performed, at least recently performed, much different than the traditional methodologies as well.So, growth in data is obviously enormous, both structured and unstructured data. The cost of computing power has obviously come down. That plays into the hands of new managers that are starting up, helping them compete. Um, obviously new techniques. You know, natural language processing, machine learning, all that is really, really important to generate new alpha signals and to be best of breed and to try to, you know, compete for a small manager and startup manager with some of the larger players.

So, you know, we think it is definitely going to be increasing impactful on the hedge fund industry, and that's really exciting, um, but it's obviously affecting wider investment management world as well. And, you know, I'm sure we'll talk about long-short equities, but, you know, if you're a fundamental long-short equity manager and you're not evolving, and, you know, you really have to say how much alpha potential will be left, you know, looking out three, five, 10 years, given the competition that is, that is emerging in the machine learning space.

Kenny

Paul, you make a great point, though. Looking at our survey, quant is definitely the place people are looking to add where fundamental long-short definitely did not have its finest moment in the fourth quarter. Definitely feel like investors are definitely churning their portfolio in the fundamental long-short space. Michael, what are you seeing and doing?

Michael

Um, so, let's talk fundamental long-short for a minute. Um, where I started here is, is a function of where we are in the cycle, which we think is late cycle. We have been de-emphasizing, um, our strategies that contribute to that beta target that, uh, that we run. And so, that inevitably means that we've been, um, shrinking our exposure to both fundamental long-short and [venture], which a good percentage of the [venture] universe, given where they are today, um, given the lack of real distressed opportunities or dislocated credit is largely if you have the ability to invest across the capital structure, invested, uh, invested in equities.And so, um, you know, I, We think that there is, um—there are pockets of really high-caliber people who have the ability to be generalist investors wherever they go, and then there's investors within long-short that also bring that specialization to bear. And there are sectors that, um—where you have a wider universe of stocks, more dispersion. Take tech and health care, to be exact. So, either that sector focus or regional focus we think is one that could lend itself to, uh, alpha potentialKennyPaul, it feels like [indiscernible] for alpha and long-short, people are looking east, you know, from the—looking to go to Asia. It feels like that's where—you know, I've been traveling the last two weeks, and it feels like every conversation I have with an allocator for pension, a family office, it feels like everyone wants to increase their Asia exposure.

Paul

Right.

Kenny

Do you think there's probably more inefficiencies in Asia which may allow for alpha?

Paul

Yeah, look, there's a number of things. Um, I mean, many of the Asian markets were even—sold off even more and obviously more bought quickly, so I think that's caught people's attention. Opened up China is, is, uh, is another one. The quality of—well, the quality of managers, though, is, is probably the most dominant one.

You know, the quality of managers today versus five or 10 or 15 years ago has risen dramatically, and ultimately, you know, at the end of the day, you're going to take strategy views and market views to some degree, but it's really all about manager selection. So, I think people can get much more comfortable with the manager, uh, manager selection side.And then, yeah, you know, alpha should be higher there. Inefficiencies are higher. You don't get—arguably you don't get as much of the crowding as, as you do in, in other places, although, you know, it certainly exists there as well.So, for all those reasons, we've, you know, pretty consistently—and again, not that it's, it's a dominant piece of what we're doing in long-short. US is still the largest. But we've definitely incrementally done more and more in Asia.

Michael

I would say the only thing about that, like, if we're just focusing on the equity side of the equation, what we've generally seen—and no doubt that that market's become more institutionalized, but it also tends to run at—with higher nets than we see elsewhere throughout the world, right? Like, there's less discipline on the short side. It's been a market that trying to capture the beta, maybe not always structurally positioned that way but try and time it as well.

And so, I think there's, there's, there's aspects of investing there that you'd have to be conscious of as you step into that market, too, which is it tends to be a higher beta market. They tend to lean longer. And so, to that—it contributes to that beta profile.

Kenny

We've talked about investing in APAC. How are you thinking about your exposure to European managers?KennyI mean, Europe seems to have a lot of different, uh, issues. You're constantly hearing about Brexit and different, uh, nations, but it seems like that could be a potential source of opportunity.

PaulI, I know Michael has the answer on Brexit. He knows exactly what's going to happen.MichaelSo, so Europe, um, let's start with it on the, on the equity side of the equation. Um, the number—we talked about the number of managers earlier on in this conversation. Number of managers in Europe structured as hedge funds has gone down meaningfully as a function of the fact that that region mostly catered historically to European LPs and European LPs have just sought greater liquidity, and that's been achieved through UCITS structures.

Paul

Sure.

Michael

So, I think that there's just not as deep of a pond to fish in over there on the equity side. And then what else does that leave in Europe? It's, right—obviously there's a credit market. It's smaller than it is here. Um, but comes with certain inefficiencies, especially because on a regional basis, right, like, sourcing of paper could be done at a very localized level.

But I, I, I, I mean, I think, you know, principally the way that I see European exposure sort of manifesting itself through portfolios is, is more from the macro side today in terms of people trading either sterling or, or, or rates. And, I mean, that is, that is not—those are not structural allocations, and Brexit has played a large component of that and what the ECB's, you know, monetary policy is.But Europe is, is frankly just in summarizing, I think it's just a smaller pond to fish in from a management perspective.

Paul

Yeah, we would agree. I mean, on a traditional hedge fund side, we would definitely agree. I mean, where we're—so we're not doing, you know, we're not really bringing on any new allocations on a traditional hedge fund side in our focus on Europe. Happy with kind of what we have.I'd say it is different on a private credit side. So, you know, obviously there continues to be a lot of pressure on, um, you know, on weaker banks in, in Europe to, uh, you know—there's increased capital charge. There's increased regulatory pressure to, uh, to push out non-performing loans. And obviously there's, uh, a tremendous amount of new and existing managers that are, you know, private credit in between hedge funds and private equity to kind of capitalize on that.So, we've built up a lot of allocations, uh, in both kind of dedicated pockets as, as well as kind of hybrid, um, client portfolios that have capitalized on that. So, you know, non-performing loan focus or reg cap focused or other lending oriented strategies.KennyIn our, in our most recent survey, we asked a question, uh, for the second time on ESG, so environmental, social and governance. What's interesting, though, is the term "impact" has come up. Paul and Michael, what is your view on ESG.

Paul

I'd say the quality of the products, uh, on the hedge fund side is a little spotty, uh, which is why, you know, again, there are some good ones, but it's, it's, it's not a, you know, it's not a tremendously deep,But, look, the, the challenge of the ESG space is that a lot of people want a lot of different things. It's hard to meet the marketplace demand, and, and thinking about how does is that best implemented on the hedge fund side, right? Like, for just on an exclusionary stock basis is, is generally considered kind of not enough and, you know, something of kind of yesteryear.

On the other hand, if you kind of go to the other extreme and, and focus much more on impact, I think investors' reaction is going to be I, I want alpha first and foremost. So, you kind of have to have something in between, and that's kind of where we landed, which is let's focus on alpha first and foremost but let's focus on managers, um, that oftentimes are thinking about ESG from the standpoint of, of capitalizing on the structural growth and change that ESG is creating, and trying to identify companies that are increasingly becoming more ESG focused and are going to benefit and perhaps get higher, you know, higher valuations and multiple because of that.

Michael

Yeah, what I would say, um, to address your question, Kenny, on that front is I think part of it is why is—yes, why hedge funds have lagged the rest of the marketplace in ESG adoption. I think part of it is the fact that they run unconstrained strategies by their very nature that tend to be concentrated in, in what they do.So, this concept of looking for best ideas is purely focused on, right, like, where can I achieve the greatest risk-reward nature of things?

So, um, you know, I think it is going to be hard. I think you do have to—it is, it is different for everybody, and I think what you're doing is, is the right thing. We've, you know, just within wealth management it's been much easier to tackle from a traditional perspective. And so, we've been really focused on it. We hired someone to lead our sustainable investing efforts, and what we're focused on is, uh, delivering multi asset class solutions, um, in an ESG framework.KennyYeah. Paul and Michael, I want to ask you about new launches. So, in, in our survey, 43 percent of investors recently mentioned they allocated to a new launch in 2018. We've seen a growing interest in new launches. Paul, how does the asset management think about new launches?

Paul

Sure. Um, so historically we've always been extremely dedicated to the space, so, you know, 65 percent of managers with whom we've invested on Day 1 have been emergent.

So, I mean, the first question is, like, what are you exactly looking for with emerging managers? And, like, for us oftentimes what we're looking for is access to a manager and a strategy that doesn't exist at a larger size, so it's not scalable. So, you know, on, on the quant machine learning side, you know, maybe it's a manager that can only—only has capacity of $500 million and it pays to get in early. Um, because, you know, over and above that, they're going to change what they're doing in terms of the time horizon's going to go out and it's not going to become interesting, so you have to get in early. There's value in getting in early.Um, or, you know, the fees and kind of the deal that you're getting is sufficiently attractive that you're compelled to kind of invest in it at an early stage.

But more broadly, I'd say our efforts have been focused mostly on the quant space, and strangely in long-short equities, we're actually finding—because you have to say, like, where does the inefficiency exist? Oftentimes in emerging, we would actually say there's an inefficiency that exists for managers that have been around a while that have been forgotten about in, in a marketplace.

Kenny

That's interesting.Paulwe found $2, $3 billion managers that we don't normally invest with in Years 3 or 4, but, you know, that are still offering attractive terms that we felt, everything else equal, was a much better, um, opportunity than necessarily getting excited about, you know, the new manager that's launching in long-short.

Kenny

That's great. Michael, as you sort of think about, uh, the year ahead, how are you thinking about the managers in your platform? Are you thinking, expecting, lower turnover or higher turnover? Neutral?

Paul

Hopefully not too high, right?

Michael

Yeah. Definitely don't want it to be like in years past. I, I, I think, um, just like if you were to ask any hedge fund manager, "How do you feel about your book today?" right, they, they love their book.

Paul

Talk to me at the end of the year.MichaelLook, I, I would say I think it's important for us to reflect on this. We were disappointed in last year, but the setup was really good. Rising rate environment. We think that, that QE had naturally suppressed, um, the alpha proposition for a host of different reasons. And, you know, you asked about targets beforehand. I think one of the other things that hedge funds have to do is they have to provide natural diversification to a portfolio. And sometimes we're so in our hedge fund world that we talk about beta and alpha and this and that. I think part of it is as simple as what's the return relatively to a 60/40 portfolio, right?

Kenny

That's a great point.MichaelUm, we don't only manage portfolios of hedge funds, so we have a, a bit of a wider toolkit, and one of the things that we're doing is how do we use hedge fund structures or vehicles to create, um, a, a risk profile and something that has a more attractive fee associated with it. So, an example might be, um, high-yield munis, right? We have a big US taxable client base, um, and that market is one where you need specialization, and so we could create a structure around that.And that, that's a little bit unique, but we're thinking about how do we complement what we do on the traditional hedge fund side by using the vehicle to offer what we believe are attractive solutions to our clients.

Paul

Yeah, I mean, you need to innovate, right? And, and we're doing, you know, we're doing the same thing. So, kind of working with managers to structure solutions that work better for us. Part of it is getting fee savings, but part of it is maybe carving out a small piece of what they're doing and, you know, making that a, a, you know, making that a much broader opportunity. Uh, co-investments would be another one. Um, and it brings down fees, higher, uh, return potential. So, it's evolving.

Kenny

That's great. Last question. If you had a crystal ball, what do you think's a surprise we can expect in the industry in the next 12 to 24 months?

Paul

Well, if we had a crystal ball, it wouldn't be a surprise.

Paul

Yeah. Yeah, yeah, yeah. Well, yeah, I mean, look, on ESG, going back to ESG, I, I, I think the impact of ESG in terms of how, you know, the growth of ESG on a worldwide basis, on what it's going to mean for the hedge fund industry, is certainly being underestimated. And similarly, you know, on, on the, uh, on the quantitative side, machine learning side, you know, like, when you're sitting down and, and talking to these managers and really kind of getting into the weeds of what machine learning is, natural language processing, and understanding obviously the impact not only in the wider world but the impact, you know, on the investment management industry, like, and, and, and obviously the growth in data and everything associated with it, like, people get it. It's not a, you know, it's not a surprise in, in one hand.

But I still think it's vastly underestimated. I mean, it's just, it's just such shocking the, the, the impact and the power of it. And, yeah, I, I still just think it's, it's dramatically underestimated and if people are not paying attention, they're going to get run over

Michael

I think you started this by saying that 70 percent of, uh, the, the survey, uh, respondents were frustrated with performance. I think the surprise is going to be the inverse of that.

Kenny

Yeah. That's great.

Michael

That, that performance is going to, uh, outperform expectations. And so, I look forward to the conversation that we have on the back of that.

Kenny

There you go.

Paul

Yeah.

Kenny

It's great to end on a positive note. Well, that's it for today's podcast. Paul, Mike, uh, thank you for both providing valuable insights, and thank you to our listeners for tuning in. Any questions in the meantime, feel free to reach out to a JP Morgan representative. Thanks, guys.

Michael

Thanks very much, Kenny.

Paul

Thank you. Yeah, appreciate it.