SEI, in association with Greenwich Associates, is publishing the results of its fifth annual global survey of institutional hedge fund investors. Part I of II of its report on “The Shifting Hedge Fund Landscape” is now available.

Part I focuses on current trends in the hedge fund industry, whereas a forthcoming Part II will look at the “continuing evolution of institutional standards for hedge fund evaluation, selection and monitoring.”

The bottom line is that investors want it all, “better returns, as well as lower correlations, more diversification, and better overall management of risk.” Hedge fund managers have to make their “value proposition,” i.e. they have to present their view of what they can do, without over-selling, for their might become “a lightning rod for investors’ hopes and fears.”

Who Responded

Geographically: about 85 percent of the respondents are based in the U.S. The remaining 15 percent are split among the United Kingdom, Canada, and Scandinavia.

Looking at the database by asset size: the largest portion of the respondents (42.2 percent of the whole) is from the smaller institutions, those with assets under management of less than $500 million.  Institutions with AUM above $5 billion represent only 16.9 percent of respondent.

Considered by the type of institution: endowments represent more than a third of respondents, and foundations another 17 percent.

Endowments are the most committed of these institutions to increasing the allocation. Their average is at 21.6 percent and they expect to take it to 25.1 percent. Corporate investors plan to cut back, though not drastically (from 15.9 percent to 14.3).

Recent Performance and Investor Goals

Hedge fund performance in recent years stands in sharp contrast to the broad equity markets, which helps explain their appeal. By the third quarter of 2011, the S&P 500 Total Return since January 1, 200 was, essentially, unchanged (very slightly down). At the same time, the HFRI Fund Weighted Composite Index was at 200 percent of its turn-of-millennium value. Further, as SEI notes: “Since the financial crisis, hedge funds have also experienced considerably less volatility than the S&P – an important factor for hedge fund investors who are seeking to reduce portfolio risk.”

There are several reasons why an institution might want to invest in a hedge fund: absolute return; non-correlated strategy; diversification; decreased volatility; the exploitation of market opportunities; alpha generation. SEI asked survey participants which of these goals was the most important to their institutions. Absolute return was the most popular answer. It was the primary object of nearly a third of the respondents.

But the plurality who answered “absolute investment” shouldn’t necessarily have the last word here. For as you may have noticed in my listing of the choices above, there is a lot of overlap. If you combine the numbers of each of the three answers that involves limiting portfolio’s downside (non-correlated strategies, diversification, and risk management), then the percentage of respondents who gave some risk-management focused answer is 56 percent.

As SEI says, this is “a marked cultural shift from the early days of hedge funds, when many investors focused on their potential to produce outsized returns.”

Strategy

The strategy most in favor just now is long/short equity. Respondent institutions were asked to name the top three strategies in which they invest, by asset level. The most frequently named strategy was long/short equity. Event-driven funds placed second.

SEI interprets these responses not just as a matter of fickle fashion but as a reaction against the overly opaque and complex nature of these strategies. Long/short equity is familiar, and easy to understand.

The take-a-ways for hedge fund managers are as follows:

• It is important to keep selling your value proposition, “[I]t behooves hedge funds to demonstrate exactly how their strategies and methods are enhancing their clients’ risk-adjusted portfolio returns.”
• Continue improving your risk-management methods and infrastructure
• Work hard (“go the extra mile”) to help investors understand your strategies, and
• Clarify performance expectations. For instance, the fact that an investor said he is in it for “absolute returns” does not close the subject. Are you sure that you and he mean the same thing by the phrase?

Part I concludes by listing the issues that should keep us eagerly awaiting Part II: What worries institutional investors most about hedge fund investing? What are their top criteria for hedge fund evaluation and selection? How receptive are institutions to new and emerging managers? How important are consultants?