Over the last decade increasing interest from institutional investors in hedge funds has resulted in the asset class becoming an important component in their investment portfolios. More significantly, as more institutional assets continue moving into hedge funds, the shape of this industry as a whole is changing.
Traditionally, hedge funds have been one of the preferred choices for private investors willing to take higher risk, and somehow less transparency, in return for absolute performance. Today, institutional investors faced with increasing liabilities and the need for boosting investment returns look at hedge funds as one of the possible solutions for their investment portfolios, but they also want to keep risk under control and have more transparency in the vehicles they are investing in.
 Justin Dew, Standard & Poor’s | Justin Dew, director and senior hedge fund specialist for the portfolio services group at Standard & Poor’s, says the goals of private and institutional investors are substantially different. “The high net worth group seeks to achieve absolute returns regardless of strategy or transparency. They are interested in achieving this performance and they don’t care how they get there.” He adds: “Institutional investors are rather looking to fill correlation buckets or return characteristics of their portfolios. They are the ones who would build a portfolio in a way that achieves the returns they want to get, as opposed to the private investor who is simply going to a hedge fund manager and saying ‘I know you are a smart person and I want you achieve a return regardless what the market is doing’. |
Funds of hedge funds
Because institutional investors are less willing to incur risk and also require more transparency, they are prepared to give up a bit on the performance side. The lack of in-house capabilities for selecting hedge fund managers or to carry out due diligence tasks, means funds of hedge funds (FoHFs) are their vehicle of choice.
However, FoHFs carry some problems. First, they are not particularly transparent and second, a double layer of fees make them quite expensive investment vehicles.
According to a recent report by the Edhec Risk and Asset Management Research Centre, despite the growing interest in FoHFs from institutional investors, so far little attention has been paid to their added value.
Giving and taking away
Edhec found that FoHFs tend to add value through strategic style asset allocation, but destroy value through active asset management, which increases volatility significantly – the volatility of FoHFs is on average 24 per cent higher than that of benchmarks.
Those behind the study, which will be presented in London in February, believe that even though is difficult to select single hedge funds, picking the right FoFHs is not much easier but the demand for these products from institutional investors is set to continue.
“The super-sophisticated institutions - the CalPERS of the world - without question can do it on their own. But in the short term, in the next five years, you will still see a heavy allocation to fund of funds and indices, where the due diligence, the manager selection and the portfolio construction is done by someone other than the institutional investors themselves,” Mr Dew comments.
However, he believes that over the longer term, investors will start doing some of the work themselves selecting specific strategies as opposed to particular hedge fund managers.
“I think that level of ability is something that we’ll see much sooner than the actual ability to select specific managers,” he says. “But funds of funds are still in their growth stages. The rate at which they grow may start to slow down but they are certainly not going out of business any time soon.”
Indeed it seems investors looking at hedge funds are starting to pay more attention to which strategies within the hedge fund universe can better suit the nature of their investment portfolios, although as Jane Tisdale, managing director, hedge fund strategies, at State Street Global Advisors, explains, multi-strategy products are in increasing demand.
“I think institutional investors are going to be interested in multi-strategy products that are diversified across the whole spectrum. Also from a fee perspective I think multi-strategy products relative to funds of funds are a cost effective way of getting broad exposure to hedge funds,” she says.
Market neutrality
In terms of specific underlying strategies, the increase in interest rates in the US and higher volatility expectations are likely to benefit market neutral strategies, something that hasn’t been the case over the last couple of years where volatility levels stayed low.
“In addition, I think this environment is going to be helpful for arbitrage managers. Also the wave of mergers and acquisitions is increasing and I think that will obviously benefit merger arbitrage managers,” she adds. “This will be something to watch out for in 2006.”
Ms Tisdale expects institutional assets to continue to move into hedge funds, especially coming from investors faced with concerns about their growing liabilities. “In Europe, in particular the UK and the Dutch market, some liability matching is now required and investors also want to have some alpha source to help make up for whatever shortfalls they might have in their funding status. Also in the US a huge percentage of S&P500 companies are underfunded in their pensions and for these reasons these two regions are more interested in absolute return strategies.”
Mr Dew agrees but adds that in terms of the number of investors investing in hedge funds Europe is moving faster than the US, although the US is catching up from an asset size perspective.
“The reason for this is that the idea of a family office for a super accredited individual or family first developed in Europe, and some of the oldest and wealthiest families in the world are based in Europe. That type of money, which is not looking at short-term performance and is not as sensitive to less liquid strategies, is more likely to consider hedge funds as a potential investment. ”
“That mentality is crossing the Atlantic now and it’s certainly getting into the minds of institutional investors in large part because their dependency in equities to achieve returns to fund pension liabilities is not there,” he explains.
Efficiency first
The question now would be to assess whether those investors in need of matching their liabilities are using hedge funds in the most efficient way. According to another study by Edhec the use of hedge funds in asset-liability management requires precautions.
The absence of sufficiently long historical records together with the lack of transparency in the sector, makes it difficult to forecast any long-term risk and return parameters. For this reason, the study suggests integrating hedge funds into the portfolio as a complement and not as a strategic asset class. Academic research also shows that the diversification properties of hedge funds – risk reduction benefits- are more robust from a statistical point of view than their capacity to provide absolute returns.
So whether investors are approaching hedge funds in search of absolute performance or as a tool to reduce risk by introducing greater diversification in their portfolios, the reality is that new money will continue to go into the asset class. This means we are likely to witness more and more fund launches in different regions across the world.
What Mr Dew describes as the “Goldman’s effect” is locations with a strong of the investment banking sector - such as New York and London which continue being the centre of gravity for hedge fund managers. “Interestingly I think the derivative market in the UK in particular is substantially better at launching that type of talent that what we have seen in the US,” he says.
Asia is now witnessing an explosion in the hedge fund industry in terms of assets, and even countries like Argentina are now home to hedge fund managers. “It is tough to know more about Microsoft than the guy down the street, but it is less difficult to know more about a mid-cap company trading in Argentina or Brazil,” he explains, adding that the trend will be to see more hedge funds operating in less efficient markets than the US or the UK, or to a lesser extent Asia.
Hedge fund boutiques will continue to have a role in the market but as institutional interest increases, large asset management organisations are likely to attract assets from investors who have fresh in their minds recent scandals such as the Refco or the Bayou Capital collapses.
Worries and fears
# Barthelemy: institutional investors worried about lack of transparen | According to Francois Barthelemy, senior partner and investment manager at F&C Asset Management, institutional investors still have three main concerns when it comes to investing in hedge funds. First, they want the cost structure to be justified by performance. Second, they are worried about the lack of transparency of boutique arrangements, and thirdly they are concerned about the shortage high quality capacity. |
“Clients recognise that capacity is a constraint. For instance, a large hedge fund or fund of hedge funds is unlikely to have sustainable good performance,” Mr Barthelemy says. “Asset gatherers are at disadvantage.”
Ms Tisdale at SSgA agrees: “Investors may tend to move towards investment managers who have a more solid background, who are operational strong and have the tools in terms of reporting mechanisms that institutional investors are more used to.”
