Bloomberg

(Bloomberg) -- Now is the time to pile more money into hedge funds, Swiss bank UBS is telling its clients.

Hedge funds have had a bad rap of late with some investors questioning why they're paying high fees for mediocre performance in recent years.

UBS's recommended allocation

20%

But UBS upped the share of hedge funds in its global model portfolio to as much as 20 percent from 15 percent less than two years ago, according to Bloomberg News's Klaus Wille. It's worth listening -- if only because UBS is the world's biggest wealth manager with more than $2 trillion in assets.

The move might seem counter-intuitive. Investors yanked $15 billion from the funds in the first three months of this year, the most since the second quarter of 2009, Hedge Fund Research Inc. said on Wednesday.

As a whole, hedge funds had a poor start to the year before a muted recovery in March. The HFRX Index, which aims to replicate the funds' performance, slipped to its lowest level in more than four years in February. It has picked up lately, but is still down about 8 percent over the past year. Preqin, a research firm, also says performance picked up in March -- but the industry still generated a loss of almost 0.3 percent in the first quarter.

So why might UBS recommend clients allocate a third more of their money to hedge funds than it did a short while ago?

Well, other asset classes hardly looked any prettier in the first quarter either. Debt and equity markets fell sharply in January and February before recovering lost ground in March. Longer term, sustained low interest rates and flat bond yields in much of the world mean that picking good hedge funds may be investors' best shot at getting more than anemic returns.

Also, while indices and average data provide some indication of the direction of travel, there are problems with a broad take on performance. Critics of hedge fund indices note that they typically don't reflect a sector where most of the best funds don't provide daily pricing or daily liquidity, for instance. This potential omission means they could understate how the industry as a whole has performed. Also, there are thousands of hedge funds so the mean performance is only a limited piece of data.

Still, there ought to be some concern about the money that's poured into the industry: firms now oversee about $3 trillion, more than twice the figure for 2008. Most of that money sits with a relatively small number of fund managers. Data from Hedge Fund Research show that more than two-thirds of the industry's assets are concentrated in 6 percent of all hedge funds. A few hundred firms (out of about 10,000) control more than $2 trillion.

There are risks here. Research from the Cass Business School in London last year found that size does matter -- performance gets worse as a hedge fund gets bigger, so that a $200 million fund would expect to outperform a $5 billion fund by about 1.25 percent.

There could be several explanations. There is concentration risk: a small number of successful funds could chase the same trades, diluting their effectiveness or exaggerating broad losses. Also, if performance essentially boils down to the number of ideas in a fund multiplied by how good those ideas are, there's the risk that returns dwindle as an individual fund stretches further into ideas that are less good.

A further risk is that huge funds have less incentive to strive for better performance than smaller ones. Hedge funds typically charge an annual fee of 2 percent of assets plus 20 percent of any profit. This is meant to reward those funds that deliver the best results. But as funds get bigger, that 2 percent management fee gets fatter and the fee for chasing outperformance gets proportionately less relevant. That's a problem for investors.

Chasing upside through hedge fund investments makes some sense, but if everyone is at it, picking the right funds may be getting harder. Potential hedge fund investors need to tread carefully before following UBS's recommendation.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story: Duncan Mavin in London at dmavin@bloomberg.net.

To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net.

©2016 Bloomberg L.P.

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