Some large institutional investors want to allocate more money to hedge funds in the coming years and even expect hedge fund managers to do better than the markets, according to a new study. That’s in spite of underwhelming performance by hedge funds in recent years.
But these investors aren’t banking on hedge funds to deliver double-digit returns, according to the study, which will be released Thursday by the Alternative Investment Management Association, an industry group based in London. Rather, they look to these funds as a way to tweak their overall portfolio exposures.
“What our paper shows is hedge funds are increasingly regarded as tools that enable investors to customize their portfolios and achieve individual objectives in terms of risk-adjusted returns, lower correlations, lower volatility, greater diversification and more downside protection,” says Michelle McGregor-Smith, CEO of British Airways Pension Investment Management and a member of the AIMA Investor Steering Committee in an introduction to the study findings. AIMA set out to ask investors why they’ve invested in hedge funds, especially at a time when returns have been modest on average.
“Many of them have either invested in hedge funds since the crisis for the first time, or have increased their allocations. Many spoke of their desire to apportion more of their overall portfolios to hedge funds in the coming years,” says McGregor-Smith. For the survey, titled “Beyond 60-40: The Evolving Role of Hedge Funds in Institutional Investor Portfolios,” AIMA sought lengthy written responses from a small group of investors — 13 altogether — rather than trying to amass quantitative data from a large number of investors. The participants included pension funds, endowments, foundations and family offices around the world, with combined assets of more than $400 billion.
Some respondents to the AIMA survey said they had doubled their investment allocation to hedge funds over the past five years. The average allocation to hedge funds from pension fund respondents was approximately 8 percent of their total portfolio, while endowment and foundation investors had allocations closer to 25 percent.
There is further evidence that investors are boosting their allocations in data compiled by Hedge Fund Research in Chicago. HFR found that investors allocated $15.2 billion of net new capital to hedge funds in the first quarter of 2013, the highest inflow since the first quarter of 2012. Hedge funds have experienced capital inflows in 14 of the last 15 quarters, according to HFR.
Mustafa Jama, head and CIO of the hedge fund investment division at Morgan Stanley Alternative Investment Partners in West Conshohocken, Pennsylvania , says he is also seeing increased investor interest in hedge funds. A lot of the interest has to do with fixed income rates hovering close to zero. “Institutional investors have high single-digit return expectations, not double-digit return expectations,” he says. But more than that, they’re looking for attractive risk-adjusted returns and capital preservation. “In the current environment, that compares favorably to the opportunity set in the fixed income market,” says Jama.
In the AIMA survey, a number of participants expressed a view that they invest in hedge funds for their distinct advantages over long-only managers. “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, trade derivatives, and build more concentrated positions),” wrote a manager at one large U.S. private pension fund.
The authors of the AIMA study say that many pension fund portfolio managers mentioned investing in equity long-short funds primarily to reduce volatility within their equity allocation, not to generate excess returns. This is a turnaround from pre-2008, when wealthy individuals accounted for the majority of capital invested in hedge funds and invested with the goal of achieving high returns.
But investors circa 2013 said outperformance based on a manager’s skill was very important. “In our absolute return portfolio we look for hedge funds to generate high absolute returns with a low correlation to equity and credit markets.” said another AIMA survey participant, a manager of a U.S. pension fund that holds about 15 percent of its assets in hedge fund strategies. “We accomplish this by identifying managers we believe execute a strategy that is diversifying against our existing portfolio of risks and can be executed with consistency going forward.”
The biggest constraint was, not surprisingly, fees. “We do not have a formal constraint to investing in alternatives,” wrote a European investor participating in the AIMA survey. “However, in practice, the constraint is fees, which is why we are limiting the allocation to 15 percent. To obviate the above constraint, we have selected a number of alternative managers who are running traditional strategies with the same risk management as their alternative funds. Costs tend to be much lower.”
