In a recent report, “Institutional Investment in Hedge Funds,” Citi Prime Finance makes the case that the hedge fund industry experienced what was but a first wave of new institutional allocation in the period 2003 to 2007, when institutions redirected their capital out of actively managed long-only funds and into hedge funds with a variety of strategies. Citi expects the second wave shortly.
The second wave, as Citi foresees it, could result in another $1 trillion entering industry coffers, more than doubling assets under management. Further, there might be “an additional $2 trillion opportunity in these convergence zone products where hedge funds and traditional asset managers will compete head to head” such as UCITS products.
Interviews and History
In preparing this report, Citi Prime Finance conducted 73 in-depth interviews with an array of leaders in the industries involved: the allocating institutions, the managers of hedge funds, the managers of funds of funds, consultants and so forth. The authors describe these as free-flowing discussions rather than the acquisition of “one-dimensional responses to multiple choice questionnaires.”
In the introduction to their report, the authors quote one of those interviewees, a leader at a European pension fund, who says: “To me, investing is about going back to the basics. Why do I want to be in this asset class? Why do I want this product? Where does it fit in my portfolio?”
That comment sets up the historical discussion nicely, because the first wave of asset allocations to hedge funds came about precisely when institutional investors started giving new answers to those old queries. For decades prior to the turn of the millennium, modern portfolio theory and the capital asset pricing model had led to a certain conception of a proper institutional portfolio. It should include traditional long-only investments, and (under a separate folder so to speak) passive investable indexes and exchange traded funds, as well as (under a third folder) positions looking for alpha returns from discretionary managers.
But by 2002 there was change in the air. It was clear that certain foundations and endowments, notably Yale University, had outperformed others. They had done so by making use of a liquidity premium their long decision horizon allowed, and by diversifying the alpha-seeking portion of their portfolio. This discovery, along with the market correction of 2002, set the stage for the first wave.
Between 2003 and 2007, the new money more than doubled the inflow of the preceding eight years, and it reshaped the asset-management industry. In 2003, institutional investors had more than 90 percent of their portfolios in the hands of traditional long-only discretionary managers. Another seven percent went to passive or beta-replication strategies. Hedge funds received only the sliver that was left.
By December 2007, the traditionally allocated share of these portfolios was down to 80 percent. Passive investments and hedge funds split the remainder almost evenly, with hedge funds getting 9.2 percent of the pie.
Another Shift in Thinking is Underway
As the above graph indicates, the years 2008-09 saw not only the breaking of this wave, but an undertow pulling the swimmers back out to sea.
Now, though, in 2012, “there are signs emerging that institutional investors may be in the midst of another foundational shift in how they look to configure their portfolios.” Specifically, institutions are less inclined to leave the decision making about the hedge fund portion of their portfolio up to funds of funds, or the managers of a multi-strategy fund. The allocating institutions are building their in-house alternatives team to make the decisions that they would formerly have contracted out.
These in-house teams are considering hedge fund investments along two dimensions: liquidity and directionality.
In a related development, the boundaries between the “alternatives” part of the portfolio on the one hand and the traditional portion on the other are fading. Institutional funds are sufficiently sophisticated to know that a directional and illiquid hedge fund shares a lot in common with directional and illiquid investments of other sorts, such as private equity holdings, and should be considered in the same breath in any over-all consideration of their portfolio.
A second wave may be driven largely by the realization that directional hedge funds can dampen an institution’s exposure to equity market volatility. One of their interviewees, a leader in a US corporate pension plan, said: “People are taking more care and due diligence now in using hedge funds more as volatility reduction strategies where in years gone by they were alpha generating concepts.”