The evolving role of hedge funds in institutional investor portfolios

Institutional investors face an almost unprecedented set of challenges. The post-crisis period has been one of slow economic growth, low or even negative real interest rates, volatile markets and increasing geo-political pressures. This set of conditions is threatening to undermine the viability of the traditional Markowitz portfolio model – the “60/40” model of a 60 percent allocation to domestic equities and 40 percent to high-grade corporate or government bonds.

Equities may have been performing well recently, but investors have not forgotten the stock market falls of 40 percent in 2008, while some sovereign bonds are not yielding anything in real terms – indeed many investors in effect are paying governments for the privilege of lending them money. Put another way, assets that were once regarded as “risk-free” are now characterized in some quarters as “return-free.”
 

Institutional investors have been compelled to move away from the 60/40 structure and to consider instead non-traditional approaches to investing. Faced with managing investment portfolio risk while at the same time identifying solutions that will generate sufficient portfolio returns to support their future liabilities, the need to employ diverse investment strategies is more important than ever.

The hedge fund industry, meanwhile, has recovered fairly well from the financial crisis. Total assets under management reached $2.41 trillion, a record level, by the end of the second quarter of 2013, according to Hedge Fund Research. Institutional investors have been the main source of the industry’s asset growth since the crisis, as a paper we produced with KPMG last year showed. 

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Moreover, recent research by Preqin has found that 88 percent of existing institutional investors in hedge funds intend to maintain or increase their allocations to hedge funds in the coming year. Put another way, the main customers of hedge funds continue to buy the product.

And yet, the “average” hedge fund, as measured by hedge fund indices, has generated relatively modest returns since 2009. It may not be appropriate to compare a hedge fund industry index with, say, the S&P 500, since hedge funds are not an asset class, they are not homogenous and by definition they are likely to be more hedged and diversified than a basket of equities. Nevertheless, many people have questioned why investors have continued to allocate to hedge funds and asked what value hedge funds can provide.

We explored this question further by inviting a group of leading institutional hedge fund investors to describe the different roles that hedge funds play in their particular portfolios. The result was a survey by the AIMA Investor Steering Committee (ISC), a committee of institutional investors that undertakes educational initiatives and provides practical guidance within AIMA, of North American, Asian and European pension funds, endowments, foundations and family offices. The paper that came out of that survey, ‘Beyond 60/40: The evolving role of hedge funds in institutional investor portfolios’, set out to explain why traditional portfolio construction techniques have been revisited by many investors since the crisis and what some of the new thinking in that space involves. The main findings include:

  • Institutional investors are moving away from the traditional 60 percent equities/40 percent bonds portfolio structure and increasingly using alternative investments in general and hedge funds in particular as tools to customize their portfolios.
  • Investors are using hedge funds to enable them to meet individual objectives in terms of risk-adjusted returns, diversification, lower correlations, lower volatility and downside protection.
  • Hedge funds are increasingly regarded as a means to access investment opportunities and to tailor portfolios, rather than as a separate asset class.
  • Most investor-respondents have increased their allocations to hedge funds since the financial crisis, with most planning to continue to increase the size of their investments in the next few years.
  • Hedge fund due diligence is taking longer, with investors saying it can take up to two years to complete prior to investment.
  • The increasing emphasis placed by hedge funds on transparency since the crisis is generally welcomed, but some investors cautioned that they did not want to be swamped with unnecessary data.
  • Many investors welcomed the increased regulation of the hedge fund industry, but some expressed concern that the reforms could be onerous or restrict choice by impacting their ability to allocate to managers in certain jurisdictions.
  • The respondents said they would like hedge funds to take fewer investors and build stronger strategic partnerships with them in future.
  • Asked what steps the hedge fund industry could take to attract new or increased investments, the investors cited lower fees, further transparency, additional improvements to governance and further improvements to operational infrastructure.

To be clear, superior risk-adjusted returns are still, and always will be, essential. But the investors who responded to the survey explained that they also regarded hedge funds as tools that enable them to customize their portfolios and achieve additional objectives in terms of lower correlations, lower volatility, greater diversification and more downside protection.

As one investor, a U.S.-based private pension fund, put it when asked to explain why it continued to invest in hedge funds:

“Hedge funds benefit from more flexible mandates and less constrained use of financial instruments to execute their strategies, e.g. managers have the ability to short, use leverage, use derivatives and build more concentrated positions. Strategies have greater breadth and, therefore, are less dependent on market directionality (which improves risk-adjusted returns). Performance for absolute return strategies is driven more by active risk (as opposed to passive beta replication) whereas long-only managers’ portfolios and risk profiles are often heavily constrained by the need to closely track an index. Performance fees incentivize managers to focus their attention on absolute returns. And meaningful coinvestment, GP ownership stakes and high water marks encourage disciplined downside risk management.”

The lengths that institutional investors such as pension funds methodically take in reaching their investment decisions are also acknowledged in the ‘Beyond 60/40’ paper. Institutional investors routinely undertake significant due diligence before they allocate and the paper underlines the fact that these are sophisticated institutions whose investment decisions are not taken lightly. “Our due diligence process for new instruments typically takes six to 24 months,” said a large university endowment. “Being able to complete a ‘deep dive’ on a manager is time-intensive and requires an experienced and dedicated team.”

Significant due diligence is a measure of the evolving hedge fund investor base, which has brought profound changes to the hedge fund industry. At one time, investors in hedge funds were predominately high net-worth individuals, but today about two-thirds of the global industry’s assets under management come from institutional investors like pension funds, university endowments, charitable foundations and insurers. A significant but sometimes overlooked implication of this is that hedge funds are performing an increasingly important social role by managing investments for socially-important institutional investors.

Another consequence of the changing hedge fund investor base has been a marked increase in the global industry’s operational sophistication and transparency to investors since the crisis. This was one of the themes that we explored in a report we produced with KPMG last year. The report, titled ‘The evolution of an industry’, was based on a survey of hedge fund managers and found that managers have increased their operational infrastructure since the onset of the financial crisis in areas like investor transparency and regulatory compliance as allocations from institutional investors have increased.

Seventy-six percent of the survey’s respondents observed an increase in investment by pension funds since 2008, while institutional investors as a whole, including funds of funds, accounted for a clear majority (57 percent) of assets under management. The report found that the increase in institutional investment has led to more thorough due diligence and greater demands for transparency.
 

It also found that hedge fund management firms had almost universally increased investment in regulatory compliance since 2008, with 98 percent of firms hiring additional staff in this area.
Institutionalization has been described as the continuing inflow of new institutional capital into the industry, but it is also about the increasing sophistication of operational infrastructure with respect to transparency, compliance and due diligence. As the industry continues to draw in ever greater allocations from institutional investors, so it will continue to mature and grow.
 

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Michael Klein Editor Pinnacle Media Group Ltd. PO Box 1365, Grand Cayman, KY1-1108, Cayman Islands T: 345-326-1720C: 345-815-0064 E: mklein@pinnaclemedialtd.com Michael is a financial journalist and copywriter.  In the past he has been responsible for the Risk Management and Corporate Finance sections of a British monthly Corporate Treasury publication.  He has written various financial handbooks, notably on European Banking and Cash Management and the Debt Capital Markets.   In addition he has worked as a copywriter for banks and investment funds and served as corporate communications consultant to US and European blue chip companies.   Michael holds an MA in Political Science and International Law from the University of Bonn in Germany. 

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