While most institutions globally remain firmly committed to hedge funds, some non-U.S. institutions are raising sharp questions about their approaches to active hedge funds.
The Abu Dhabi Investment Authority, the world's largest sovereign wealth fund with an estimated $900 billion in total assets, slashed its universe of approved hedge funds by half because executives felt the strategies were too correlated with traditional long-only equity mandates, according to sources close to the fund who asked not to be named. Information about which funds were dropped from the approved list was not available. Officials of the fund, based in Abu Dhabi, United Arab Emirates, declined to comment.
Investment executives at ADIA, which has 5% to 10% of its total assets in hedge funds, separately reviewed the fee structure linked to all active managers and determined that some of those strategies generally did not outperform their respective indexes over time. As a result, the fund shifted a larger proportion of its assets into passive portfolios, according to sources close to the fund. The exact proportion affected was not available.
Beta concerns
Higher-than-expected embedded beta exposure within hedge funds is increasingly a concern, said Keith Black, associate and senior member of the opportunistic strategies investment management research group at Ennis Knupp + Associates Inc., based in Chicago.
Several European pension funds have decided to dump active hedge fund strategies entirely. AP Fonden 7, with total assets of about 80 billion Swedish kroner ($12.7 billion), decided earlier this year to liquidate hedge fund-of-funds portfolios managed by K2 Advisors LLC, Stamford, Conn., and EIM SA, Zurich.
Assets from the active mandates, which accounted for about 3.2 billion kroner, will be equally split between the private equity portfolio and a new hedge fund cloning strategy, said Richard Folcker, acting head of fund administration at AP7, Stockholm.
AP7 had been exposed to the Bear Stearns High-Grade Structured Credit Strategies Fund, one of two hedge funds managed by Bear Stearns Asset Management that imploded in 2007. The headline risk coupled with high management fees relative to excess returns led AP7 officials to terminate its active hedge fund-of-funds strategy. “We were paying management fees at two levels, and that got to be too expensive,” Mr. Folcker added.
Some smaller pension funds without hefty in-house resources to monitor their hedge fund strategies are following suit. Fredrik Holst, head of finance at the pension fund for Landstinget Vastmanland, Vasteras, Sweden, said officials decided earlier this year to liquidate its entire hedge fund holding.
The fund had about 8% of its 1.3 billion Swedish kroner portfolio invested in the Victory Absolute Return Fund, a hedge fund of funds managed by Victory Funds Ltd., a firm registered in the British Virgin Islands, Mr. Holst said. But following a bout of performance pangs that began late last year when problems in the U.S. subprime market emerged, fund executives discovered they had unexpected exposures to relatively risky securities.
In the three months ended Sept. 30, 2007, alone, the pension fund lost 19% of its investment value in the fund-of-funds strategy, according to Mr. Holst. Along with heavy losses in the strategy, a separate strategic review concluded it was “difficult to know exactly what's in an underlying hedge fund,” he said.
The majority of the assets from the hedge fund portfolio, or about 65 million Swedish kroner, will be shifted into long-only equities, with the remainder — or about 40 million Swedish kroner — going to fixed income.
“We thought that by investing in a hedge fund of funds, the risk would be spread out. But that didn't happen, and the impact has been quite bad,” Mr. Holst said. “In the end, we don't believe that we have the competence to analyze (hedge funds) properly.”
But despite these exits from hedge funds, many other institutions globally see hedge funds as a crucial element in their investment strategy, both as a way to diversify and stabilize sources of returns, consultants said. Hedge fund strategies continue to gain institutional assets and generally have beaten popular equity indexes, including the Standard & Poor's 500, in the past year (Pensions & Investments, July 21).
“From our perspective, clients are still very interested in the use of hedge funds, particularly for its diversification benefits,” said Paul Trickett, European head of investment consulting at Watson Wyatt Worldwide, Reigate, England. “Clearly there are some concerns over recent performance, but I don't think that has put clients off of the concept. They're just much more cautious.”
Large U.S. endowments — which were among some of the earliest adopters of hedge funds — have trimmed their allocations, albeit from a high base. Endowments with more than $1 billion in assets reported a 20.5% allocation to hedge funds in 2007, down from 22.4% a year earlier, according to data published earlier this year by the National Association of College and University Business Officers. NACUBO, based in Washington, tracks 785 U.S. and Canadian university and college endowments with a total of about $411 billion in total assets.
Steady decline
New inflows into hedge funds have steadily declined in the first half of 2008, performance in some tried-and-tested strategies is faltering and cheap debt that helped boost returns in recent years has all but dried up, consultants said.
David Bauer, a partner at Casey Quirk & Associates LLC, Darien, Conn., a consultant to money managers, said, “There are certain areas in the hedge fund space, in which there's only so many ways to play the game and the opportunities for returns are being squeezed out over time.”
A greater concentration in the hedge fund business has also put pressure on returns, said Mr. Black of Ennis Knupp, referring to a consolidation resulting in fewer hedge funds controlling larger pools of assets. According to data from McKinsey & Co., New York, the largest 100 hedge funds managed 71% of about $1.9 trillion in total hedge fund assets under management at the end of 2007, up from 68% the previous year and less than 50% at the end of 2003.
“The larger a hedge fund gets relative to its objective, the harder it is for that fund to earn excess returns,” he added.
Average hedge fund returns were negative for the first half of 2008 — not what hedge funds are expected to provide, several sponsors said. Weak performance and investor nervousness contributed to a slower rate of growth, according to a July report by the McKinsey Global Institute, McKinsey's economics research arm. In the next five years, MGI estimates that new inflows into hedge fund strategies will be about 5% annually, a quarter of the level of growth between 2000 and 2007.
Contact Thao Hua at thua@pionline.com