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I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
During those years, FoHFs were the primary conduit through
which many institutional investors channeled their money
into hedge funds. Institutions would make a single allocation
to an FoHF’s comingled vehicle and trust that the FoHF team
would identify and invest the capital in a suitable and diverse
set of hedge fund managers.
There was not much demand for transparency into actual
hedge fund holdings, and both FoHFs and their underlying
investors were caught off guard by the asset-liability mismatch
that FoHFs had created in their portfolios by placing managers
with illiquid assets into fund structures that typically offered
liquidity terms based on managers with more liquid assets.
This mismatch was discussed in depth in our 2010 survey.
Historical Gap Between Hedge Funds and Asset
Managers Narrows After Crisis
Coming out of the GFC, there were two major changes that
took place in the industry, both of which have served to
narrow the gap between hedge funds and more traditional
asset managers.
The first change pertains to investors’ decision to directly
allocate their hedge fund capital (with or without the help
of an industry consultant) rather than turning over that
responsibility to an FoHF intermediary. As discussed at the
outset of Section II, this trend had started prior to the GFC but
only gained momentum after 2008. According to eVestment
HFN, at the end of 2002 assets invested in FoHFs accounted
for 52.8% of the industry’s total AUM, but by the end of 2007,
that figure had declined 4.6% to 48.2% of the industry’s total
assets. After the GFC, this trend picked up dramatically. By
the end of 2011, FoHF assets had fallen an additional 12%
and accounted for only 36.2% of the industry’s total AUM.
This is illustrated in Chart 23.
The other big change coming out of the GFC was that the
hedge fund industry shifted from supply driven to demand
driven. The due diligence process became highly extended
and managers that had previously been able to raise money
quickly began to experience longer selling cycles, as direct
investors could often take 6+months to decide on an allocation.
As investors forged direct relationships with managers over
these extended periods, they built relationships with the
managers and were able negotiate more transparency into
the hedge fund’s holdings and obtain liquidity terms that were
better aligned to the type of assets being traded as part of the
fund’s overall strategy.
Managers proved mostly receptive to moving in this direction,
partly to diversify their own investor base away from being
too concentrated around FoHF exposure and partly to qualify
for the larger single tickets of $100-$200 million being written
by pension and sovereign wealth funds entering the market.
The results of this realignment are striking. By March 2012,
65% of the hedge funds reporting to the eVestment HFN
database required 30 days or less notice from an investor
about their intention to redeem funds, and 72% indicated that
they offered monthly or better liquidity terms.
Improved transparency and liquidity helped to narrow the
gap that had previously existed between hedge funds and
traditional asset managers. Those strategies with the most
liquid underlying assets (directional and macro hedge funds)
were able to move into broad alignment with more traditional
investment vehicles. This is illustrated in Chart 24.
“ We had very little in hedge funds a while back. The first step
for us was a fund of fund. We viewed this as dipping our toe
in the water. Now we’re doing things direct,”
– US Corporate Pension
“ When I got here in 2009, our assets were 70% from fund
of funds. Now that figure is down to 32%. Of the $5.7
billion we raised last year, 75% was from new investors and
only 1% was from fund of funds. We did that by design,”
– >$10 Billion AUM Hedge Fund
35%
40%
45%
50%
55%
60%
65%
2003 2004 2005 2006 2007 2008 2009 2010 2011
Fund of
Hedge
Funds
Direct
Allocations
36.2%
63.8%
Chart 31
Chart 23: Share of Industry Assets Held in Fund
of Hedge Funds versus Directly Allocated to
Single Managers
Source: eVestment HFN