Institutions trim hedge fund allocations: State Street

Date: Friday, March 27, 2009
Author: Megan Harman, Investment Executive

Turbulent financial markets have caused institutional investors to reduce hedge fund exposure temporarily, but not permanently, according to State Street Corp.’s fifth institutional investor hedge fund study.

The study, conducted late last year in conjunction with the 2008 Global Absolute Return Congress, polled representatives from public and government pensions, corporate pensions, endowments and foundations and insurance companies with an estimated $1 trillion in total investable assets.

It found a moderate decline in overall portfolio allocations to hedge funds, but revealed that nearly 90% of institutions intend to increase or maintain current hedge fund allocations over the next 12 months.

“Hedge funds have not been immune to the extremely volatile market environment,” said Gary Enos, executive vice-president and head of relationship management and client strategy for State Street’s alternative investment solutions team. “While alternative investments, including hedge funds, largely outperformed traditional investments in 2008, negative returns understandably disappointed. Although hedge fund allocations declined slightly over the past year, we anticipate growth will resume later in 2009, as institutional investors continue to focus on diversification and risk management.”

The hedge fund study shows that the proportion of institutions allocating more than 5% of their portfolio to hedge funds fell from 68% in 2007 to 51% in 2008.

But 49% of institutions said they would increase their allocation to hedge funds in the next year, and 39% will maintain their current allocation. Of the funding for new hedge fund positions, 80% is expected to come from equity allocations.

The study also found increased institutional interest in private equity funds. More than half of institutions have allocated more than 5% of their portfolio to private equity funds, and half intend to increase their allocation to private equity over the next 12 months.

Among the challenges arising from the recent market volatility has been the growing difficulty in accurately valuing derivatives and other complex financial instruments. As a result, 77% of institutions reported that accurately valuing hedge fund holdings can be problematic, up from 55% last year.

The study participants expressed a need for more transparency. Of the institutions, 84% expect more disclosure of hedge fund positions and 49% anticipate more frequent reporting from hedge fund managers. Only 19% said they currently receive some level of consistent transparency across hedge fund holdings.

To gain a more meaningful assessment of risk across their portfolio, nearly two-thirds of institutional investors either intend to, or already are, aggregating alternative investment risk exposures with other portfolio exposures.

“The recent unprecedented market volatility has prompted institutions to increase their focus on risk management,” said Enos. “To address these concerns and the increasingly difficult challenges inherent in the financial markets, the hedge fund community and allied third-party providers and administrators are stepping up efforts to develop and expand risk management solutions for institutional investors.”