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1. Introduction
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
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Institutional Investors Base Pre-2000 Portfolios on
Two Leading Financial Markets Doctrines
Before 2000, most institutional investors followed a common
approach to portfolio construction, (ie, determining which
assets they should hold and the optimal mix of those assets).
This approach was based on two important academic
doctrines that had emerged in the 1950s/1960s: Modern
Portfolio Theory (MPT) and the Capital Asset Pricing Model
(CAPM), which gained widespread acceptance in the industry
in subsequent years.
MPT was introduced by Harry Markowitz in a 1952 article
and 1959 book. The premise of this work was that investors
could reduce their exposure to individual asset risk by holding
a diversified portfolio of assets. In other words, combining
two or more assets within a portfolio could produce a better
risk-adjusted return when compared to each individual asset.
MPT further went on to posit that all investors are risk averse
and that given two portfolios that offered the same expected
return, investors would opt for the less risky portfolio. Thus,
investors would only take on riskier portfolios if compensated
with better returns.
CAPM buillt on Markowitz’s work and was introduced in
the 1960s by William Sharpe and John Lintner. CAPM puts
forth the concept that by having a large number of assets
in their portfolio, investors can average out unsystematic
risk and create a sufficiently diversified portfolio so that the
only remaining risks are systematic risks. When this is done
successfully, investors can then gauge the required return
on an asset based on its riskiness in the portfolio context as
opposed to its stand-alone risk. When an asset is successfully
added to a portfolio, it will help the investor outperform
beta (the general market’s return), and when an asset is
unsuccessfully added to the portfolio it will cause a portfolio
to underperform beta.
The portfolio theories of MPT and CAPM are illustrated
in Chart 37. When running a simple two-asset portfolio of
equities and bonds, an investor can combine those two assets
in various allocations between 100% bonds and 100% equities
to achieve a range of return outcomes, each of which produces
a certain level of risk. The portfolio combinations that deliver
the highest level of return at varying degrees of risk end up at
the outer bounds of these outcomes. Those portfolios along
the outer bounds are said to exist along an efficient frontier.
Portfolios that reside inside the efficient frontier are not seen
as optimal because investors could achieve higher returns for
the same level of risk.
When introducing a risk-free asset to the equation as a starting
point for investors, if you draw a straight line from this point on
the y-axis (return) it will at some point intersect the efficient
frontier. This point of intersection is known as the tangency
portfolio. This tangency portfolio is theoretically the ideal
portfolio for investors willing to accept some market risk. It
generates the optimal amount of return while assuming the
least amount of market risk.
It should be noted that MPT and CAPM use standard deviation
of returns as a proxy for risk. Standard deviation measures
both upside and downside risk equally, and assumes returns
are normally distributed.
When investors began analyzing these portfolios and their
various risk/return outcomes, many determined that they
were willing to assume more risk than was identified by the
tangency portfolio in order to achieve more return. Most
investors zeroed in on a target risk level of approximately
10% for the portfolio. The portfolio that demonstrated this
10% risk level with the highest return is higher up on the
efficient frontier. Coincidentally, it was also seen as producing
approximately 10% expected returns. The asset allocation
associated with this profile was split out 60% to equities and
40% to bonds.
Appen ix: Institutional Portfolio Theory Pre-2002
Risk% (Standard Deviation)
Return %
Portfolios inside the
curve are not efficient,
because for the same
risk, one could achieve
greater return
Higher Risk /Higher
Return Portfolios
Lower Risk/
Lower Return
Portfolios
100% Equities
100% Bonds
Chart 1
Tangency Portfolio-
Highest Amount of
Return for Least
Amount of Risk
Efficient Frontier-
Set of Optimal Portfolios
Risk Free Assets or
Capital Markets Line
Chart 37: Illustration of Modern Portfolio
Theory(MPT) & Capital Asset Pricing Model (CAPM)
Data shown in this chart are for illustrative purposes only.
Source: Citi Prime Finance abstracted from work by Markowitz, Sharpe & Lintner