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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
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Changes in Institutional Allocations Confirm Shift
in Views About Risk Budgeting
The signal that investors are moving toward a risk-aligned
portfolio is their willingness to reduce their equity allocations
and up their actively managed fixed-income and hedge fund
portfolios. Reviewing institutional portfolio allocations over
the past 5 years reveals a telling story on how institutional
investors are moving toward a more risk-aligned approach and
confirm that we may be at the outset of a third major shift in
institutional investor portfolio configuration.
Chart 13 shows the shift in institutional portfolio holdings
between 2007 and 2011. As expected, there has been a
massive reallocation of money from actively managed equities
to actively managed fixed-income funds. The absolute and
relative amount of money allocated to active equity strategies
fell in the period, dropping from $5.9 trillion in 2007 (43% of
total assets) to $4.3 trillion (31%) in 2011. The absolute and
relative amount of money allocated to active fixed-income
and tactical asset allocation strategies rose from $5.1 trillion
(38%) in 2007 to $6.1 trillion (44%) in 2011.
Hedge fund allocations also posted increases, rising from
$1.2 trillion (9.2%) to $1.5 trillion (10.5%) and the trend toward
higher passive allocations also continued.
This change in allocations is striking. Institutional investors
have moved significant amounts of capital out of their actively
managed equities into other asset classes and approaches as
they diversified their portfolios to lower risk assets. Hedge
fund allocations grew in this latest 5-year period even as
performance has been difficult. As discussed in this section,
part of the reason for this growth has been the change in
some leading investors’ views about where hedge funds fit
into the portfolio.
Whereas at the end of 2007, most participants saw hedge
funds as a satellite portion of their portfolio, offering the
potential for a diversified alpha stream, that view is beginning
to change. Increasingly, investors view or are at least are
starting to think about hedge funds in a more nuanced manner.
The emerging belief is that various types of hedge fund
strategies have differing roles in investors’ core portfolios.
Directional hedge funds are seen as providing volatility
dampening and downside protection when grouped with other
equity risk exposures. Macro strategies are viewed as offering
uncorrelated returns and protection against macroeconomic
exposures when combined with actively managed rates and
physical commodities. Absolute return hedge funds are seen
as fulfilling the role of the classic hedge fund allocations that
provide pure alpha/zero beta returns.
How widespread the adoption of these views become could
determine the shape of the hedge fund industry for the
foreseeable future. As it stands today, many investors and
industry participants feel that the industry is poised for
another period of dynamic growth. This will now be discussed
in Section III.
“ The risk parity paradigm ideal would say that I want 50% of
my risk in equities and 50% of my risk in bonds and I want
my overall portfolio to have 8% volatility. To get that, you’d
have to have a 320% exposure—35% in equities and 285%
in bonds. The only way to get that bond exposure is through
leverage and the use of swaps and repo,”
– <$1 Billion AUM Hedge Fund
“ People understand that if you did a proper risk balance
across all your risks, equity is only one risk factor. You’d
want to balance across inflation and all the other risks. You
can go straight down the list. What this typically means is
taking down your equity exposure and taking up your
fixed-income exposure,”
– <$1 Billion AUM Hedge Fund
“ There is clearly a sense whereas in the past, a guy had
40% long-only allocated in their portfolio to long-only
fixed income, now he’ll take 10% of that allocation and give
it to an alternatives guy and only run 30% with traditional
long-only,”
– $5-$10 Billion AUM Hedge Fund
43.2%
37.5%
9.2%
Passive
$1.4T
Hedge Funds
$1.2T
10.1%
Chart 21
30.9%
43.6%
10.5%
Passive
$2.1T
Hedge Funds
$1.5T
15%
Active Equities
$4.3T
Active Fixed
Income or
Balanced/TAA
$6.1T
Active Fixed
Income or
Balanced/TAA
$5.1T
Active Equities
$5.9T
December 2007 - $13.5 Trillion
December 2011 - $14 Trillion
Chart 13: Changes in Institutional Investor
Portfolios: 2007 to 2011
Source: Citi Prime Finance Analysis based on eVestment HFN data