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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
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Investors Initially Seek Diversified Hedge Fund
Exposure via a Singular Allocation
When large institutional flows commenced in the early to
mid-2000s, the goal of the investment was to obtain exposure
to a diversified hedge fund return stream in order to have an
alternate alpha source and to capture an illiquidity premium.
The mechanics behind how investors sought that exposure in
those early years pre-crisis were extremely different than the
model that has emerged in the subsequent period.
As discussed in last year’s annual survey,
Pension Fund
& Sovereign Wealth Fund Investments in Hedge Funds:
The Growth & Impact of Direct Investing,
the majority of
institutional investors commenced their hedge fund programs
by making a single allocation, typically to a fund of fund, with
the goal of obtaining a diversified exposure to a broad set of
hedge fund strategies and their associated return streams.
Using a fund of fund as an intermediary allowed institutional
investors to leverage that team’s knowledge of the hedge
fund space and their access to managers. Expectations
were that the fund of fund manager would move allocations
around as needed to ensure the maximum diversification and
optimal performance of the portfolio. This was not something
most institutional investors were prepared to handle given
resource-constrained investment teams that typically had
little familiarity with the hedge fund space.
As the investor’s knowledge of hedge funds increased,
and as many investment committees and boards became
uncomfortable with the fees they were paying to fund of funds,
many institutional investors began making direct allocations
to hedge funds. Many of these investors began their direct
investing program by again placing a singular allocation
with a multi-strategy manager and relying on the CIO of that
organization to direct capital across various approaches
based on their assessment of market opportunities.
In contrast, a set of allocators at some of the leading
institutions began to create customized portfolios of hedge
funds. Instead of making a single hedge fund allocation, these
investors began to think about breaking that allocation out
across a number of managers. To do this effectively, these
allocators began to divide the hedge fund space into multiple
categories. After the global financial crisis, this tendency to
view hedge funds as belonging in multiple buckets accelerated
as performance in that time period revealed that hedge
funds performed very differently based on their underlying
directionality and liquidity.
Investors Begin to Categorize Hedge Funds Based
on Their Directionality and Liquidity
As investors evolved toward direct hedge fund investing
programs, they could no longer rely on a fund of fund manager
or on a multi-strategy fund CIO to provide a diversity of return
streams in their portfolio. It was the investors themselves
that needed to ensure their hedge fund portfolio was suitably
diverse across investment strategies. In order to manage
this challenge, the investors built out their alternatives team,
hiring individuals with specialized skills to cover the various
strategies. In the majority of cases, the investors also forged
relationships with an emerging set of alternatives-focused
industry consultants to support their portfolio construction
and due diligence efforts.
Initially, investors pursuing direct allocations sought diversity
by allocating varying amounts of money to a representative
set of hedge fund strategies, giving some capital to long/short,
some to event driven, some to macro, some to distressed,
etc. This was done with little consideration of the underlying
liquidity of assets held within each fund and since investors
had very little transparency into the holdings of managers
in the pre-crisis period, allocations were also done with little
consideration of how the hedge fund’s positions and exposures
aligned to the investor’s broader core portfolio.
Section II: A New Risk-Based Approach to
Portfolio Construction Emerges
Maturing experience with the hedge fund product and improved transparency after the GFC Global Financial
Crisis are allowing institutional investors to better categorize managers based on their directionality and
liquidity. This has facilitated efforts by market leading organizations to re-envision their portfolios based on
common risk characteristics rather than asset similarities. The result has been a new portfolio configuration
that repositions hedge funds to be a core part of investors’ allocations.
“ We have many investors that look at hedge funds as a
singular portfolio. They focus on an absolute return portfolio
as an equity replacement,”
– Alternatives Focused Consultant