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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
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“ Our allocation to hedge funds will come from equities
because that is where we have the largest risk-factor
exposure. But I don’t want to get something that will, from
a risk profile or return stream, look like equities. Because
unless they are going to generate spectacular returns it is
awfully hard to overcome the fee differential,”
– US Corporate Pension
“ We think there’s real value in big macro-type product that
doesn’t have a market direction. We think about these
investments apart from the broader portfolio. This is
important because prior to us taking this approach, the
direction that equities went, so went the portfolio,”
– US Corporate Pension
Finally, when investors have fully or partially shifted to a
risk-aligned portfolio configuration, they will be looking to
understand additional factors that would enable them to
more fully assess their various exposures. The first challenge
for the marketing team would be to understand the extent to
which they have realigned their portfolio. Since this is a new
approach, there is not yet as much uniformity in how investors
approach this type of portfolio as yet.
Our observation from this year’s survey is that investors with
this configuration have usually moved to one of two portfolio
configurations. In the first instance, they tend to split their
consideration of hedge funds in two categories: thinking
about how directional strategies fit against their broader set
of equity risk exposures and then thinking about a separate
set of macro and non-directional hedge fund strategies. In the
second instance, they have split their consideration of hedge
funds into three categories: comparing directional strategies
to other equity risk products, and then separately considering
strategies related to the macro environment and to those
absolute return strategies that offer no beta.
The first challenge for marketers working with these investors
is to understand their approach, and then to position their
hedge fund appropriately. Key points to bring out up front
would be how directional your hedge fund strategy is, and
how much that net exposure fluctuates over time.
If your fund would be considered part of the equity risk
bucket, it will be important to discuss how your individual
performance compared to the broader equity or bond market
in each corresponding period. Investors will be looking for
evidence that your strategy helps to dampen volatility and limit
downside losses while not giving up too much of the market’s
upside potential. Having a ready model showing how a broadly
held equity and bond portfolio would have performed, with and
without the addition of your fund, can be highly persuasive to
these investors.
If your strategy fits within the macro category, it will be
important to stress how your returns are uncorrelated to
equities and bonds and have helped to dampen the impact
of excessive swings in those markets. Showing performance
against changes in interest rates and broad commodity prices
is also important, as managers will be viewed in part on how
their performance contributes to the portfolio alongside these
other types of investments. It will be critical to demonstrate the
role these strategies provide in helping to promote stable value
within the portfolio and insulate the investor against inflation.
Additionally, these macro and volatility funds are often the
approaches where investors have the least understanding of
how the manager’s investment strategy works. Taking the time
to educate the investor will be much appreciated. Historically,
many of these managers were resistant to providing detailed
insight into their portfolio due to less liquid holdings (global
macro), complex and proprietary models (CTAs) or complex
derivative strategies (volatility funds).
Finally, hedge fund managers are the primary providers of
product to satisfy investors’ absolute return allocation in risk-
aligned portfolios. Unlike the other sub-allocations, managers
in this category are looked at solely in relation to other hedge
funds and not for how they impact the performance of parallel
holdings. Managers of these strategies should focus investor
attention on their experience and expertise in security selection
and positioning with the aim of providing the portfolio with low-
volatility, consistent returns. They should also be prepared
to discuss their approach to risk controls that ensure the net
position remains mostly neutral, and to reassure investors that
the fund will not drift into directional territory.
If a manager has some of the cash + alpha-type funds discussed
in Section VI, they should also press investors on how they
are looking to allocate money in their real assets bucket to
determine whether there is a potential fit for the hedge fund
offering in that category.