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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
I
11
Two Main Institutional Investor Portfolio
Configurations Emerge
When the massive wave of inflows began in the period
from 2003-2007, most institutional investors still had their
traditional 60% equities/40%bonds portfolio. To change that
approach, they typically worked with an industry consultant
to come up with a new allocation, and then sought approval
on that configuration from their investment committees and
board of directors. Since the alternative alpha streams these
investors were looking to create did not fit into an existing
portfolio category, investors and their advisors came up with
a new bucket for these strategies. The result was two new
portfolio configurations that moved institutional investors
away from their traditional 60/40 mix.
Many investors sought to mimic the leading E and Fs portfolio
approach by asking for a ready pool of cash that they could
deploy as desired to a range of illiquid investments or
investments that did not fit within a traditional asset bucket,
either because of the instruments they traded or their inability
to be benchmarked to a specific index. These investors
approached their boards and investment committees and
got authorization to create a new opportunistic allocation.
This new bucket provided investment teams with ready
capital that they could deploy across a broad range of
potential investments including hedge funds. This portfolio
configuration is illustrated in Chart 4.
For many investors, this configuration was used as a transition
portfolio but for others, their approach to alternative and
hedge fund investing endures via this configuration to the
present day. This is especially true for many E and Fs and
sovereign wealth funds that look for more flexibility with their
portfolios allocations.
Indeed, some participants pursuing this approach have
gotten creative in using the allocation, including remanding
responsibility for portions of the portfolio to external advisors
to invest as those managers deem appropriate within agreed
risk limits.
Yet, as the name implies, many investors also choose to
only utilize the capital in this allocation when a specific
opportunity emerges. Having the ability to allocate to hedge
funds or other investments does not imply a requirement to
allocate in this opportunistic configuration. Several investors
we interviewed have the mandate to invest in hedge funds,
but are under no pressure to deploy capital.
“ Our final bucket is opportunistic. Most of our hedge funds are
in here. We also have a number of external CIOs in this bucket.
We’ve identified 5 managers that can do anything they want
to do with the money we allocate to them. We give each of
these managers $500-$600 million. Their only restriction is
that they can’t exceed our volatility target of 12%. All together,
our opportunistic bucket has beaten the HFRI index by about
200 basis points after fees each year,”
– Sovereign Wealth Fund
“ It was more than a 3-year education process for the board
on hedge funds. Initially we implemented an opportunistic
allocation. Capital preservation and dampening the downside
was part of the story to get the board to approve the allocation:
‘So when you crawl out off the hole it is not as deep as it could
have been.’”
– US Public Pension
Passive
Active
Passive
Active
No Fixed Allocation
Discretionary Investment in
Hedge Funds, Private Equity,
Infrastructure or
Commodities
Chart 12
Opportunistic
Equity
Bonds/
Fixed
Income
Chart 4: Institutional Portfolio Configuration:
Opportunistic
“ We only take money from institutional investors and the
minimum investment levels are high (passive $50 million,
bespoke $500 million). This is due to only wanting “like-
minded” investors to be part of the platform in order to
reduce the risk of excessive withdrawals by less stable/less
long-term investors in case of a market crisis of some sort,”
– Asset Manager With Hedge Fund Offerings
Source: Citi Prime Finance