Institutions still committed to hedge funds despite falling returns, says report

Date: Friday, July 4, 2008
Author: Hedgeweek.com

Last year's downturn in hedge fund performance has not caused institutions to shift their thinking with regard to their hedge fund investments, according to a study by Greenwich Associates and Global Custodian.

The share of hedge fund capital provided by institutions was unchanged from 2006 to 2007 following several years of steady growth, but the results of the 2008 study suggest that pension funds, endowments and foundations remain strongly committed to the asset class.

Pensions, endowments and foundations directly provide 13 per cent of the average hedge fund's assets under management. Institutions also commit assets to hedge funds through their investments in fund of funds, which account for an additional 23 per cent of hedge fund assets.

'High net worth individuals and family offices remain the biggest sources of assets for the average hedge fund, accounting for 37 per cent of the total, which does not include about 10 per cent of assets provided by the funds' employees and general partners,' says Greenwich Associates consultant John Feng.

For the world's biggest hedge funds, however, institutional investors have overtaken high net worth individuals and family offices as a source of assets. Twenty-five percent of these funds' assets come from direct investments by institutions, while high net worth and family office investment account for 22 per cent.

'In terms of importance to funds with more than USD1bn in assets, both of these sources rank behind funds of funds, which provide 27 per cent of total assets, up from 25 per cent a year ago,' says another Greenwich consultant, John Colon.

According to the report, institutions' commitment to hedge funds is due in large part to the key role that hedge funds have taken on in sophisticated portfolio management models that were first developed by endowments and foundations and are now being adopted by pension funds.

These new models were designed to expand the principles of modern portfolio theory to encompass non-traditional assets, an approach characterised by heavy use of hedge funds, private equity funds and, increasingly, other alternative asset classes viewed as having a low level of correlation with traditional fixed income and equity holdings.

In the US, which accounts for the vast majority of institutional hedge fund investment, nearly 45 per cent of institutions invest in hedge funds, which accounted for 2.6 per cent of institutional assets last year, up from 2.2 per cent in 2006 and 1.9 per cent in 2005. Although those percentages seem modest, in dollar terms US institutions' investments in hedge funds amounted to some USD195bn in 2007, up from USD140bn in 2006 and USD113bn in 2005.

When asked about their hedge fund investments by Greenwich in October 2007, 23 per cent of US institutions said they planned to increase their allocations beyond current levels by 2010, and only 2 per cent said they planned to reduce them.

'It is important to keep in mind that average allocations at the country level include many institutions that do not invest in hedge funds at all,' Feng says. 'Many active hedge fund users have devoted much larger shares of their assets. For example, US endowments that describe themselves as active hedge fund investors devote on average 16.5 per cent of their total assets to hedge fund investments.'

Institutional interest in hedge funds has received an additional boost from new hedge fund style investment strategies that have been rolled out by both hedge fund managers and traditional asset management organisations looking to attract institutional dollars. Among the largest hedge funds participating in the Greenwich study, for example, nearly 11 per cent say they are active in 130/30 strategies

'Hedge fund managers are creating new funds in which they dial down leverage and shorting activity to attract institutional investors, and they are also creating funds featuring their best long-only investment ideas,' says Greenwich hedge fund specialist Karan Sampson. 'On the other hand, traditional asset-management organisations are adding hedge-fund like products to get to the same place from the opposite direction.'

Greenwich Associates is an international research-based consulting firm in institutional financial services, specialising in providing benchmark information on best practices and market intelligence on overall trends. Based in Greenwich, Connecticut, with offices in London, Toronto, Tokyo and Singapore, the firm offers more than 100 research-based consulting programmes to more than 250 global financial services clients.