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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
• Rather than seeking to capture both alpha and beta returns
from a single set of active portfolio managers investing
across a broad market exposure, institutional investors
began to split their portfolio approach in the late 1990s.
These investors sought beta returns via passive investable
index and exchange-traded fund (ETF) products built
around specific style boxes and looking for alpha returns
or positive tracking error from active managers with more
discrete mandates which were measurable against clearly
defined benchmarks.
• By 2002, views on how to best ensure alpha returns
evolved again after Yale University and other leading
endowments were able to significantly outperform
traditional 60% equity/40% bond portfolios during the
technology bubble by incorporating hedge funds and
other diversified alpha streams into their portfolios, thus
benefiting from an illiquidity premium and improving their
overall risk-adjusted returns.
• To facilitate allocations to hedge funds and these other
diversified alpha streams, institutions had to create new
portfolio configurations that allowed for investments
outside of traditional equities and bonds. One type of
portfolio created an opportunistic bucket that set aside
cash that could be used flexibly across a number of
potential investments including hedge funds; the second
type of portfolio created a dedicated allocation for
alternatives which allocated a specific carve-out for hedge
funds. In both instances, hedge fund allocations were part
of a satellite add-on to the investor’s portfolio and were not
part of their core equity and bond allocations.
In the years since the global financial crisis, a new approach
to configuring institutional portfolios is emerging that
categorizes assets based on their underlying risk exposures.
In this risk-aligned approach, hedge funds are positioned in
various parts of the portfolio based on their relative degrees
of directionality and liquidity, thus becoming a core as opposed
to a satellite holding in the portfolio.
• Directional hedge funds (50%-60% net long or short and
above), including the majority of long/short strategies,
are being included alongside other products that share a
similar exposure to equity risk to help dampen the
volatility of these holdings and protect the portfolio
against downside risk. Other products in this category
include traditional equity and credit allocations, as well as
corporate private equity.
• Macro hedge funds and volatility/tail risk strategies are
being included in a stable value/inflation risk category
with other rate-related and commodity investments to
help create resiliency against broad economic impacts that
affect interest and borrowing rates.
• Absolute return strategies that look at pricing inefficiencies
and run at a very low net long or short exposure are being
grouped as a separate category designed to provide zero
beta and truly uncorrelated returns in line with the classic
hedge fund alpha sought by investors in the early 2000s.
Key Findings
Foundational shifts in institutional portfolio theory occurred in the late 1990s and early 2000s; these changes
prompted investors to redirect capital out of actively managed long-only funds and channel a record $1 trillion
to the hedge fund industry between 2003 and 2007.