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I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
The majority of interviews conducted for this year’s survey
exposed three key drivers that are likely to spur increased
allocations to hedge funds from the institutional investor
world over the coming years.
First, institutional market leaders shifting to a risk-aligned
portfolio configuration are likely to divert allocations
from their core allocation buckets to hedge funds as they
reposition their investments to be better insulated against
key risk factors.
Second, institutions that began with an exploratory stake in
hedge funds over the past decade to test their diversification
benefit are likely to increase their allocations to address rising
liabilities or to reduce the impact of excessive cash balances.
Finally, new institutions that hadbeen consideringanallocation
to hedge funds prior to the GFC and that were sidelined in
the turmoil following that period are now positioned to launch
their investment programs.
Based on these considerations, we created a model showing
the impact of industry growth and flows on par with that
seen between 2006 and 2011. Projections emerging from this
model show that the hedge fund industry could be poised to
receive a second $1 trillion wave of institutional flows by 2016.
In compiling our forecast, we decomposed the institutional
category and examined trends separately for E and Fs, pension
funds, and sovereign wealth funds.
Before we detail this forecast, however, we will instead explore
concerns expressed by some participants that recent market
performance could dampen institutional enthusiasm and
cause interest in hedge funds to wane. While this is not a likely
scenario, it is still possible and we will thus similarly model
the potential impact. To begin that analysis, we will start by
profiling the various segments of the institutional investor
base and their respective interest in hedge funds.
Institutions Enter Hedge Funds at Varying Rates
As noted earlier, E and Fs were the original category of
institutional investor to focus on alternatives and on hedge
funds. Market leaders in this category were already putting
substantial sums of money into play in the hedge fund space
by the early 1990s. From there, interest in hedge fund
investing rippled downstream as smaller E and Fs emulated
the model of the early adopters.
By the mid-2000s, there was broad participation from E and
Fs and approximately 20% of all assets from this category
were invested in hedge funds by 2011, as shown in Chart 14.
Althoughtheasset sizeofother institutional investorcategories
is much larger than E and Fs holdings, it is important to note
that these other segments are not as far along in terms of
their overall interest in either alternatives or hedge funds.
A limited group of market leaders in the corporate and public
pension space began investing in hedge funds in the late
1990s, but the practice did not gain traction until after the
technology bubble. Indeed, pensions were the primary drivers
of the investment wave in 2003-2007.
While they accounted for a large part of the allocations in
that period, it is important to note that even with these large
inflows, the penetration of alternatives and hedge funds has
been limited within the pension world and is nowhere near as
advanced as in the E and Fs space.
According to Towers Watson, alternatives overall were
only 14% of global pension holdings in 2006 for the seven
largest pension nations that accounted for 97% of total
assets. That total rose only modestly to 16% by the end of
2011. Hedge funds still accounted for less than 3% of global
pension holdings by the end of 2006, and our estimate
is that those figures are almost unchanged t to the present
day at only 3.6%.
Section III: Forecasts Show Institutions Poised to Allocate a
New Wave of Capital to Hedge Funds
Institutional investors showed a net increase in their allocations to alternatives and to hedge funds over the past
5 years (2006-2011) despite issues that arose during the GFC and challenging market conditions in subsequent
years. Extrapolating these growth rates indicate that the industry could be headed toward another period of
active flows, and these estimates may prove conservative if the new risk-aligned portfolio configuration gains
traction and hedge funds start to draw more of investor’s core allocations.