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I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
that focus on resource-based offerings rather than corporate
restructurings, although more hedge fund managers are also
beginning to explore this space.
Traditional real estate investment structures like real estate
investment trusts (REITs) sit in this category. There are also
new vehicles emerging to give investors access to a vertically
integrated portfolio of companies related to a specific natural
resource. The most common of these structures are managed
limited partnerships (MLPs) that allow investors to buy into
an ownership stake in a set of companies that handle the
extraction, processing, and distribution of oil and gas or coal
resources. Other emerging funds are not publicly traded
but offer investors a similar ability to have an ownership
stake in the production, processing and distribution of other
natural resources such as timber. Finally, direct infrastructure
investment funds are beginning to be launched that offer
investors ownership stakes in emerging markets or frontier
region projects such as toll roads or power plants.
Risk-Aligned Portfolios Reposition Hedge Funds
From Satellite to Core Holdings
By aligning the strategies in their portfolio around their
common risk profiles, institutional investors have begun
to create a new portfolio configuration that completely
diverges from the traditional 60/40 portfolio and from the
two approaches that expanded that traditional portfolio to
include either opportunistic or alternative investments that
we highlighted at the end of Section I. This new configuration
is summarized in Chart 10.
In this approach, hedge funds have evolved from being a
satellite portion of the portfolio to become an essential, core
portfolio component. Different types of hedge fund strategies
are also included in various parts of the portfolio instead of
there being a single hedge fund allocation. If this approach
toward portfolio construction takes hold, there is potential for
this to spark another period of strong inflows for the hedge
fund industry.
Indeed, as we will discuss in Section III, while endowments
and foundations typically have a fairly substantial portion of
their assets allocated to alternative investments and hedge
funds, the size of pension funds’ and sovereign wealth funds’
core asset pools are multiples of the typical allocations
they have carved out for their current alternatives and hedge
fund investments.
“ We start off with a risk score. Howmuch directional risk do we
want to take on and then we think about what investments to
take on. We are indifferent as to asset class. We are focused
on the risk adjusted returns and we look at that against our
top-down views on the macro environment,”
– Long-Only and Alternatives Consultant
“ The thought leaders on the investor side are creating task
forces to incubate ideas and then determine the home for
their ideas. The hedge fund team is educating the broader
investment team and the senior investment staff can think
about being more inclusive on the broader buckets,”
– $1-$5 Billion AUM Hedge Fund
“ People still are not clear on risk allocation versus asset
allocation. Starting with an ad hoc traditional allocation
of 60% equity / 40% bonds and then trying to somehow
risk budget it is very difficult. The way we do it here is we
create the asset allocation from the risk allocation after
setting risk/return targets, assign correlations, variances,
and expectations to various asset classes. Then you come
up with optimal asset allocation to serve that risk. Some
people have gotten into it but others still don’t,”
– Alternatives Focused Consultant and Fund of Fund
Chart 18
Passive
Active Long Only
Directional Hedge Funds
Corporate Private Equity
Macro Funds
Commodities
Volatility & Tail Risk Funds
Absolute
Return
Market Neutral Funds
Arbitrage Related Strategies
Relative Value Strategies
Real Assets
Infrastructure
Real Estate
Other (i.e., Timber)
Inflation/
Stable Value
Equity
Risk
Chart 10: Institutional Portfolio Configuration:
Risk-Aligned Assets
Source: Citi Prime Finance
“ Right now all of our hedge funds are in our absolute return
bucket. This is purely a function of how we defined the
absolute return portfolio. We have sold the board on there
being zero beta in risk assets—zero correlation to anything
else in the portfolio,”
– US Corporate Pension