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52
I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
“ There is a transformation of the financial system happening
with credit at the core and if you can notice the opportunities
then it is a great time to be in credit products. The banks are
getting out of a lot of stuff and there is a fundamental mismatch
between assets and liabilities. Someone has to do what the
banks were doing themselves so the pension plans are seeking
those cash flow products. Banks are no longer intermediaries,”
– Asset Manager With Hedge Fund Offerings
“ If you’re creative enough to create product that generates
cash as part of the business, people eat it up. ‘Cash + alpha’
product is definitely a new phase for the industry,”
– $5-$10 Billion AUM Hedge Fund
“ What we’re doing with catastrophe bonds is completely
different from the reinsurance market. Because of the number
of catastrophes that have happened in the last few years,
insurers don’t have capital. It’s becoming more and more of a
bond market—specifically, a bond that looks like a CDS contract
triggered by a catastrophic event. We’ll run a pond portfolio
dedicated to this space and we’ll hedge out risks with the
swaps markets,”
– $5-$10 Billion AUM Hedge Fund
Another industry affected by the 2008 market disruption
was the insurance business. Hedge funds launched vehicles
to invest in and trade catastrophe (CAT) bonds and other
insurance-linked securities (ILS) which were negatively
affected by the damage to insurance company’s balance
sheets. Hedge funds entered this market and launched
dedicated funds to fill the void left by insurance companies
unwilling to structure and issue these bonds. The primary
characteristic of these instruments that is attractive to
investors is the strong cash flows coming from the premiums
paid to the issuers.
Retail mortgage-backed security (RMBS) funds were launched
opportunistically around the same time and were structured
with medium term maturities (redemption dates) to take
advantage of the dislocation in the mortgage market. The
underlying mortgage bonds, some of which were at the heart
of the financial crisis, offer very attractive performance that
include a good cash-on-cash return that investors continue to
seek in this low-yield environment.
Investors looking for strategies that offer current income
can also allocate to hard asset funds that straddle the public
and private market divide. One such example is the master
limited partnership (MLP) fund that trades in the form of an
ETF or an exchange-traded note (ETN). As noted in Section
II, these funds invest in partnerships that have a vertically
integrated portfolio around a specific industry such as oil
and gas, coal, or shipping. Because they are structured as
limited partnerships, the securities distribute capital back to
investors on a quarterly basis. This is particularly attractive
to those investors that have operating expenses they need to
support with their investment portfolio. These cash flows can
become reliable and tend to be consistent while the underlying
business (e.g., oil and gas exploration and distribution) are
genuinely uncorrelated to the markets.
There is a limited pool of assets for each of these products.
Hedge fund AUM in bank loan funds is not publicly listed, but
S&P cites themutual fundmarket in these assets as of February
2012 at $71.7 billion. According to Aon Benfield, CAT bond
funds had a record first quarter 2012 with issuance of $1.49
billion with total CAT bond issuance in 2012 expected to be $5-
$6 billion. According to the Securities Industry and Financial
Markets Association (SIFMA), RMBS debt outstanding at the
end of 2011 was $516 billion. No industry-wide data on MLP
AUM were available, but the largest funds in the space were
in the $3-$4 billion range, and there are perceived to be six or
seven major competitors in this space
Long/Short Managers Make Inroads Into Actively
Managed Long-Only Fund Allocations
Directional hedge funds as described in Section II represent
the largest category of AUM for the industry, but one that has
fallen in terms of importance prior to the global financial crisis.
This is illustrated in Chart 29.
As shown in Chart 29, these strategies topped $1 billion in
2006, accounting for 48% of the industry’s total AUM. Assets
continued to rise in 2007 to a record $1.3 billion, but outflows
and performance hit this segment hard in 2008. Total AUM
fell 38.5% in this category versus only 29.3% in other hedge
fund strategies during the crisis, resulting in a decline in overall
share to only 42% of AUM. While the actual level of assets held
in these strategies has stabilized and rebounded to more than
$1.1 trillion, the relative share of AUM controlled by directional
hedge strategies has not regained its former peak and has been
hovering around 44%-45% of total AUM.