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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
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The potential for market-leading institutions to divert
allocations from their core holdings to hedge funds as they
reposition their investments to be better insulated against key
risks and the need for the broader set of institutions to ensure
diversified portfolios to help cover rising liabilities and reduce
the impact of excessive cash balances should both work to
keep institutional demand for hedge funds strong.
We project that the industry may experience a second wave of
institutional allocations over the next 5 years that could result
in potential for another $1 trillion increase in industry assets
under management (AUM) by 2016.
Although adoption of the new risk-aligned portfolio approach
is at an early stage, the shift in thinking it has triggered has
already had significant impact on product creation. This has
resulted in the emergence of a convergence zone where
both hedge fund managers and traditional asset managers
are competing to offer the broad set of equity and credit
strategies represented in the equity risk bucket.
• Asset managers looking to defend their core allocations
are moving away from a strict benchmarking approach;
they are creating a new set of unconstrained long or
“alternative beta” products that offer some of the same
portfolio benefits as directional hedge funds in terms of
dampening volatility and limiting downside. They are also
looking to incentivize their investment teams, improve
their margins, and harness their superior infrastructure by
competing head to head in the hedge fund space; however,
long-only portfolio managers choosing to go this route may
face an uphill battle in convincing institutional investors
and their intermediaries about their ability to effectively
manage short positions.
• Large hedge funds that specialize in hard-to-source long/
short strategies, or that have chosen to limit capacity in
their core hedge fund offering, are being approached
opportunistically by existing and prospective investors to
manage additional assets on the long-only side of their
books, where they have already proven their ability to
generate alpha.
• Other large hedge funds have made a strategic decision to
tap into new audiences and are crossing the line into the
regulated fund space, creating alternative UCITS and US
Investment Company Act of 1940 (40 Act) products, as well
as traditional long-only funds. These products are targeted
at liquidity- constrained institutions and retail investors
where the sizes of the asset pools are likely to be large
enough to offset low fees.
Beyond the potential $1 trillion we see for institutional
investors to increase their allocation to hedge fund strategies,
we estimate that there could be an additional $2 trillion
opportunity in these convergence zone products where
hedge funds and traditional asset managers will compete
head to head.