Hedge funds are losing to private equity in a tug-of-war over investors' portfolios, and experts say it's only going to get worse

• Hedge fund performance has bounced back this year after a disastrous end to 2018, but institutional investors are still dropping them from their portfolios in favor of private equity, according to a study by EY.
• The "lackluster demand" for hedge funds is tied to performance troubles and high fees - two longtime pain points for investors - as well as competition from other products in the alternatives space.
• The EY study found a disconnect between hedge fund managers' priorities and their investors. For example, growing assets was the top priority for a majority of hedge fund managers surveyed while investors' top priority was cost rationalization.
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Hedge funds are in danger of playing second fiddle to private equity in their biggest investors' portfolios.

A new study from EY released today surveyed 62 institutional investors with $1.8 trillion in combined assets and found they are replacing their hedge funds - and don't plan on stopping soon.

After making up 40% of these investors' alternatives allocation in 2018, hedge funds now make up only 33%. Private equity meanwhile has grown its share of the pie to 25% this year from 18%.

"Investors do not expect this trend to change over the next two to three years, having reported that they anticipate their allocation to private equity and real estate products to continue to grow," the report reads.

EY notes that performance troubles and high fees have led to less investor interest in hedge funds. Additional factors are competition from other alternative investment options like real estate and private credit. So far this year, the $3.2 trillion hedge fund industry has seen a net loss of $77 billion, according to eVestment.

But a disconnect from investors, as shown by EY's report, may also be costing hedge funds assets. The top priority for a majority of the 102 hedge fund managers surveyed is asset growth and fundraising, while investors say cost rationalization is the top priority they want their managers to have.

And four out of every 10 investors said succession planning should be a top-three priority, while only 13% of hedge-fund managers said the same.

Investors are "increasingly desiring long-term partnerships with their managers," said Ryan Munson, a partner in EY's wealth and asset management division and one of the authors of the report. Hedge funds' current slump has many managers focused on just getting through the short-term and "not thinking five to 10 years down the road" like many pensions are.

More than a decade removed from the financial crisis, investors are looking for "complex, illiquid strategies" that private equity firms provide, Munson said, as liquidity has become less of a concern.

At the Greenwich Economic Forum last week, Paul Colonna, who runs Lockheed Martin's $80 billion pension plan, told attendees that while 60% of his portfolio could be traded in a single day, he's not thinking about liquidity when he's making an investment.

"Of all the things I'm worried and concerned about, liquidity is not one of them," he said.

The EY report also found that private equity's internal policies are more in-line with investors' values. Nearly two-thirds of investors that invest in sustainable products said a manager's internal ESG policy on everything from hiring to investment decisions is "critically important."

On the manager side, firm-wide diversity is lacking at hedge funds more so than private equity, EY found. Roughly half of private equity managers have set diversity targets, while only 15% of hedge funds have. Women make up less than 10% of hedge funds' front offices - where investment decisions are made - from a majority of the survey's participants.

Still, neither private equity nor hedge funds have what would be a considered a diverse industry. Only one in every 10 firms, including both hedge funds and private equity, reported that women make up more than 30% of their front office.

"There is quite a ways to go for the entire industry," Munson said.