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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
A third driver of hedge funds moving into regulated funds and
long-only SMAs was a growing perception across many in the
institutional audience that hedge fund managers had fewer
constraints on how they chose to run the long side of their
books. Their more flexible approach could generate better
returns for their active equity or credit portfolios than those
being achieved by traditional managers that had requirements
to be fully invested, and that were being evaluated on their
ability to outperform a specific benchmark. This was an
especially appealing proposition for hedge fund managers
that were at or near capacity in their long/short funds.
A final driver was the perception that regulated fund
structures offered more investor protection when looking
at new investment areas such as commodities, emerging, or
frontier markets.
In our interviews this year, we encountered hedge funds
across the US, Europe, and Asia that had all made this move
into the regulated funds and long-only SMA space. The result
of this product expansion was that many participants now see
hedge funds as synonymous with active managers and look at
these participants for their ability to pursue both alpha- and
beta-type returns.
Traditional Asset Managers Loosen Constraints
on Their Long-Only Funds
Traditional asset managers have not stood by idly as hedge
funds crossed the line into the regulated fund space. They
themselves followed suit and started offering actively
managed long- only product. There has been a significant
change in many organizations that reflects a backlash against
the rigid restraints that limited how traditional managers were
required to invest their long- only funds. This change has led
to a shift away from funds tied to benchmarks and a move
toward traditional asset managers offering unconstrained,
actively managed long funds.
Under this new approach, managers are not required to be
fully invested, nor are they tied to index weights in making
their allocation decisions. They have the option of having a
portion of their portfolio in cash, and they are often allowed to
use limited amounts of shorting or leverage if they so desire.
Limited is, however, the operative word. Typically, these
funds are between 90% and 110% net long. Oftentimes they
will choose to short an index or ETF to obtain some hedge
protection for the portfolio, but rarely do they use single-
name shorts designed to generate independent alpha. Many
in the asset management industry are calling these types of
funds “hedge fund lite” offerings or alternative beta funds.
Many in the institutional audience are looking with favor
upon these unconstrained funds. Because the net long on
the portfolios remains so high and the amount of shorting
allowed in the fund is so limited, they can shift their long-
only allocations in this direction and still remain within policy
guidelines set by their investment committees.
The result has been a split in the actively managed long-only
pool, with a majority of new fund launches being targeted for
the unconstrained long space. This is illustrated in Chart 25.
“ We are getting dragged over the line by the wallet. We are
also working on two regulated funds driven by the investor.
We would be a sub-advisor to the RIC product,”
– $1-$5 Billion AUM Hedge Fund
“ The great news for us is that instead of getting $20 million
to manage at 2&20, you get a $300 million investment for
1&10. Hedge funds have to decide if they want to be an
asset a manager and have a lot of product on their platform.
Some will do it to get access to pensions and up-sell their
traditional hedge fund product,”
– >$10 billion AUM Hedge Fund
“ The long-only world is clearly transforming—not necessarily
to an absolute return mindset, but away from a benchmark
focused approach,”
– European Wealth Manager
“ Client demand is moving away from benchmarks. Absolute
return from an asset allocation perspective drove the
traditional long-only business into taking a more active
approach to management,”
– Asset Manager With Hedge Fund Offerings
“ The intention was to change our book away from index huggers
to managers that are benchmark aware but not tied to the
benchmark. Part of that is our own familiarity with managers
that had long-only products that were only 85% or 90% long.
They were completely unconstrained,”
– Endowment
“ We see more allocators move away from benchmark thinking,”
– $1-$5 Billion AUM Hedge Fund