What Institutions Really Want From Hedge Funds and Funds of Funds

Date: Sunday, April 8, 2007
Author: Lois Peltz

Institutional assets have been flowing into the hedge fund community for the past several years, having vast repercussions for all participants. The general expectation is that these flows will continue and increase.

Looking to better understand these ramifications, Infovest21 completed the recently released survey, “What Institutions Really Want From Hedge Funds/Funds of Funds”. Sponsored by SEI, the goal in conducting the survey was to offer a general understanding of what institutions are looking for when they allocate to single-manager hedge funds or funds of hedge funds.

Some of the areas focused on included: what their return/risk objectives are; the ways they make decisions; how long decision-making takes; the factors considered in manager selection; the functions of the infrastructure; what constitutes an “institutional quality” manager; as well as the roles of transparency, product structure, and major concerns in the use of hedge funds.

"As institutional investors have become more comfortable with hedge funds and other alternative investments, they have also become clearer and more focused in their demands," said Ross Ellis, vice president of SEI's Investment Manager Services unit. "As this survey shows, those institutional demands now extend beyond performance and transparency to encompass a much broader set of structural, operating, and administrative requirements. Hedge funds that want to succeed in the institutional arena need to be aware of emerging best practices in all these areas," he concluded.

Infovest21 randomly interviewed 108 institutions on a global basis during the first quarter of 2007. Surveys were conducted entirely by telephone. Of those interviewed, approximately 53% had not yet allocated to hedge funds.

Of the institutions that allocate to hedge funds, hedge funds represent an average of 24% of their total investment portfolio.

Hedge fund allocations are increasing among institutions allocating to hedge funds. Over half say their allocations have increased over the past several years while 40% say their hedge fund allocations have been flat over the same time period. The remainder cite a decrease in hedge fund allocations.

Pensions comprise approximately 44% of the respondents, while endowments/foundations and consultants make up another 40% and 16% respectively.

One of the main differences was that the experiences, needs and investing patterns of endowments and pensions differ considerably. For example:

Endowments have been allocating to hedge funds longer

Endowments have larger hedge fund allocations in percentage terms

Endowments expect higher returns and lower standard deviation.

Endowment allocations to hedge funds have been largely flat over the past few years, while those from pension funds have been increasing at a faster rate.

Endowments have a shorter-term time horizon for hedge fund allocations than do pension investors.

Endowments have many concerns about hedge funds while pension investors are largely concerned with headline risk.

Endowments are more flexible with respect to managers who conduct their own administration in-house than are pension investors.

Endowments are similarly more flexible on the issue of managers who do not have a “big name” prime broker.

Consolidating responses from all institutions, other major themes highlighted in the survey are:

Once institutions have decided to allocate to hedge funds, the approach they take is a very conservative one.

Headline risk is the major concern.
Most (81%) make their decisions by committee. The committee often makes decisions in accordance with the recommendations of the investment consultant.
The average due diligence period is seven months, with another 12 weeks for the approval process.
The average institution plans to hold their hedge funds in for about 7.1 years.

Infrastructure/people at the firm is a key factor in manager selection

“Institutional quality” is defined most frequently as a manager having critical support and staff. Manager pedigree comes in second.
Of the non-investment professional positions, risk manager and investor relations are the two that institutions most often want to see filled.
Institutions feel it more unacceptable than acceptable for a prospective manager to have his own administration work done internally.
A “big name” prime broker is generally required more often than not.
Transparency of process and transparency of sector are viewed as most important, followed by transparency of industry, and positions.

Almost all institutional investors feel it is critical that a manager stay focused on the original strategy.