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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
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These traditional consultants saw new competitors
(alternatives-focused consultants) entering the market and
quickly gaining traction across the traditional consultants’
core client base. In response, long-only consultants began
to hire new talent with an understanding of hedge fund
strategies. Armed with this new skill set, many traditional
consultants saw an opportunity to differentiate themselves
from alternatives industry consultants by helping their clients
understand how their total book fit together.
The rationale regarding why directional hedge funds and
traditional equityor credit holdings shouldbeviewed in tandem
is easy to understand. When the equity or bond markets
move substantially in either direction, all the managers in this
category would be affected. This dynamic is the fundamental
basis for grouping all of these investments together. What is
critical to understand is that in this emerging view, the role
that directional hedge funds play in the portfolio changes and
is no longer seen as primarily providing an alternate stream
of alpha.
Directional Hedge Funds Gain Traction for Their
Ability to Dampen Equity Volatility
Another factor encouraging investors to combine their
directional hedge funds with their core equity and credit
holdings relates to a new understanding of portfolio risk and
the role directional hedge funds play in reducing volatility.
Articles began to emerge from leading asset managers as
early as 2005 arguing that the classic MPT/CAPM approach
was too focused on assets and not focused enough on
risk. Indeed, they pointed out that while the classic 60%
equities/40% bonds portfolio seemed to be balanced from
a capital perspective, if that same portfolio were viewed in
terms how risk in the portfolio was budgeted, the result was
extremely skewed toward equities. Specifically, in the 60/40
portfolio, 90% of the portfolio’s overall risk was seen coming
from the equity holdings and only 10% of the risk was coming
from the bond allocation.
These articles were initially viewed as intellectually interesting
but not particularly relevant to the majority of investors.
The performance of traditional 60/40 portfolios during the
financial crisis when major equity indices were down 40%
changed investors’ receptivity to this argument, particularly
when it came to light that investors who had reallocated their
assets based on a more optimal risk budget outperformed
those with traditional portfolios.
One repercussion of this has been that many investors that
continue to have large equity allocations because of the
potential returns they add to the portfolio are looking for
ways to reduce their risk exposure in this bucket without
having to dramatically reallocate their portfolio. Directional
hedge funds are seen as a solution to that challenge.
Though many people perceive hedge funds to be riskier
than long-only holdings, the opposite is true. Hedge funds
offer more controlled risk profiles, and their inclusion in the
portfolio typically helps to reduce overall volatility. Again,
the financial crisis provides a striking example. While major
equity indices were down 40%, the equity-focused hedge
indices showed managers down only 20% in the same
period. Blending a larger share of their equity allocation with
directional hedge fund managers, particularly equity long/
short-focused managers, is seen as offering investors a way
to reduce their portfolio volatility while maintaining their
returns potential.
“ When I think of pensions, the hedge fund allocator is
really good at thinking about hedge funds and the long-
only allocators are really good at thinking about long only,
but the way that portfolios are changing is forcing
communication across the asset class heads which is a
great thing because they never had communicated. In some
cases, the gap is now not as wide between the traditional
and hedge fund side,”
– >$10 Billion AUM Hedge Fund
“ When I think of the sovereign wealth funds, they’ve been
forced to create committees that sit the different investment
areas down and say, ‘What do we want to do? We have
overlapping exposures and we have to decide how to
manage them’”
– >$10 Billion AUM Hedge Fund
“ We are seeing more and more that our products are included
in the equity bucket of the institutional investor allocation.
As we trade listed equities we are a natural part of the beta
risk profile for the equity bucket”
– Asset Manager With Hedge Fund Offerings
“ People are taking more care and due diligence now in using
hedge funds more as volatility reduction strategies where in
years gone by they were alpha generating concepts,”
– US Corporate Pension Plan