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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
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“ The move to hedge funds is to reduce equity beta in the overall
portfolio. As part of that, investors say how much alpha have I
been able to generate frommy long-only and can I get more with
less volatility and still capture returns with a hedge fund?”
– Institutional Fund of Fund
“ It was obvious that the diversification benefit of alternatives
was so compelling that the big institutions were going to have to
increase their exposure to hedge funds,”
– <$1 Billion AUM Hedge Fund
“ We still do not have any hedge fund investments. We are looking
at it and have been looking at it for some time now,”
– US Corporate Pension
Yale University (+17.0%) and the large E and Fs portfolios
(+5.6%) reported positive performance during the 3-year
period around the correction. This compared to the negative
3-year performance of the 60/40 portfolio (-2.2%).
This outperformance compelled traditional institutional
investors to consider looking for alpha outside their active
long-onlymanager buckets by accessing alternative strategies.
Investors came to see that adding alternative alpha streams
such as hedge funds to their portfolio improved their overall
risk/reward profile and offered up a more optimal target
portfolio than traditional equity/bonds.
Efficient Frontier Becomes More Compelling With
Addition of Hedge Funds to the Portfolio
Most institutional investors seek to be prudent fiduciaries
to the assets they manage, and as such take their time in
considering significant changes in their portfolio approach.
Moreover, they have strict portfolio allocation limits and policy
guidelines regarding what types of investments can reside in
each investment category. These guidelines are only reviewed
and reassessed periodically by the investment committee and
possibly by a consultant hired by the institution to assist in the
management of the portfolio.
While leading E and Fs were moving toward portfolios with
diverse alpha streams, the majority of institutions had boards
of directors and investment committees that were unfamiliar
with hedge funds and their investment strategies. They were
also deeply suspicious of how safe their money would be with
these independent investment managers that were offering
products that had lower liquidity and higher fees compared to
their existing active manager allocations.
To help foster a shift in thinking within these traditional
institutions, participants went back to the core MPT/CAPM
principles and used that framework to demonstrate that
portfolios containing hedge funds offered a superior risk-
adjusted return on the efficient frontier. This is illustrated in
Chart 44.
As shown, portfolios that included hedge funds offered
up higher return potential for investors at a similar risk
expectation when compared to the traditional 60/40 portfolio.
The uncorrelated nature of hedge funds within the traditional
portfolio construction framework of MPT/CAPM helped many
organizations visualize the benefit that hedge funds provided
to the portfolio, and allowed them to begin authorizing some
shifts in their allocations.
Many institutions adopted this new way of thinking about their
portfolios, and this led to a massive influx of money to the
hedge fund industry in the early to mid-2000s. Changing an
institution’s approach to their portfolio construction is still a
very difficult and oftentimes slow process, particularly within
the very conservative pension world. While many institutions
have moved in the direction of broadening their portfolio to
additional alpha streams, there are still significant numbers of
investors that continue to have traditional portfolios and that
do not have any allocations to alternatives or hedge funds.
Chart 8
15%
10%
5%
0%
Risk
Return
5%
10%
18%
20%
100% MSCI Europe
57% HFRI Eq Hdg
43% HFRI Macro
60% HFs
40% US Eqty
33% Agg Trsy
67% US Eqty
Chart 44: Efficient Frontier Chart Comparing
Equity and Bond Portfolios to Equity, Bond and
HF Portfolios
Source: Citi Prime Finance analysis