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18
I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
Including Directional Hedge Funds in Equity Risk
Bucket Helps Limit Downside Exposure
There is one final aspect as to why some institutional investors
are considering it advantageous to combine directional hedge
funds with their traditional equity and credit allocations. This
is based on the ability for hedge funds to offer downside
protection. While we have focused extensively on how hedge
funds initially drew institutional interest because of their
ability to add alpha to the portfolio, this argument instead
speaks to their role in limiting equity beta and is a corollary to
hedge funds having a lower volatility profile.
As already discussed, directional hedge funds, most
specifically equity long/short managers with a high net long
exposure, will move in tandem with the underlying markets,
thus producing some degree of equity beta. They will not fully
mimic such movements, however, because the short portion
of their investment is going to be moving counter to the broad
market.
This means that in up markets, it is unlikely that the long/
short manager will be able to equal the returns of long-only
managers, but when markets are falling, they should be able
to limit their downside in relation to those same long-only
managers. This was true during the 2008 crisis and many
investors now see this as an important role for directional
hedge funds.
Remember, most institutional investors are focused
obsessively on capital protection, as they have limited pools
of assets they are managing to meet obligations. For pension
funds, these obligations relate to the institution’s need to
meet liabilities owed to their members. E and Fs need to fund
activities over a long-term period. Sovereign wealth funds
need to diversify their account balances. In all these instances,
there is an extreme aversion to losing money.
As the statements below show, many institutional investors
would rather engineer their portfolios to have less upside in
order to insure that they do not suffer excessive losses that
would impact their ability to meet their obligations. Including
directional hedge funds alongside their core equity and credit
holdings can provide this protection.
Investors Allocate Capital to Strategies that
Reduce Macroeconomic Impacts
Chart 8 shows the emerging second risk-aligned portfolio
configuration that combines hedge funds within the macro
bucket with other rate-related and commodity investments
to create resiliency against a different type of exposure.
Namely, investors are looking to group strategies that can
help their portfolio capture thematic moves related to supply
and demand.
In this context, supply and demand cover areas with broad
economic impacts such as monetary policy, sovereign debt
issuance, and commodity prices—all factors that affect interest
rates and thus borrowing rates. This contrasts to the supply
and demand of specific securities.
The goal of combining these investments is to create stable
value in the investors’ portfolio by protecting them against
excessive moves in interest rates triggered by economic
factors. Because one of the most common outcomes of large
interest rate moves is inflation, this group of investments is
also sometimes referred to as insuring the portfolio against
inflation risk.
“ Of those investors moving their long/short equity into
their equity bucket, the goal is to dampen the volatility and
change the risk profile—recast the risk profile. It’s coinciding
with the whole trend toward risk parity. Even if their equity
bucket is only 60% of their allocation, it is much more on a
risk budget,”
– Alternatives Focused Consultant
“ We’re a conservative investor. By conservative, we mean
that we’d rather protect on the downside and miss a little
bit on the upside. That works better for us in the long term.
We think about equity beta as covering equity long-only
managers, equity long/short managers, and private equity.
Credit beta includes investment grade, high-yield, and
asset-back securities,”
– Endowment
“ The evolution of institutional investors allocating to long/
short equity from the equity bucket is still really in its early
stage. They still remember how bad 2008 was, and still
worry about downside volatility so they are interested in what
equity long/short can bring to their portfolio”
– $5-$10 Billion AUM Hedge Fund
“ Institutions had alternative funds as a carve-out in a
separate bucket but that is changing. Performance has
been disappointing and correlated to equities. So now
hedge funds are looked at as an alternative to equities with
the expectation that they partly participate in the upside of
markets with protection to downside markets.”
– European Fund of Fund