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Pension funds and hedge fund investing - a global paradigm shift by 2010

David Aldrich and Marina Lewin

Bank of New York

Q2 2007

 

Hedge funds are here to stay as a growing component in global institutional portfolios according to recent research by The Bank of New York, in conjunction with, Casey Quirk & Associates – but the investor dynamic is changing.

Five years ago, the hedge fund market was dominated by wealthy individuals and a handful of institutions. Today however, more than 40 percent of hedge fund flows are institutional. This is expected to increase 60 percent from today’s $360 million to exceed $1 trillion by 2010. Pension schemes are now jumping in and it is estimated that they will represent 65 percent of total institutional flows through 2010.

Institutional investors are reporting satisfaction with their hedge fund and fund of hedge fund programmes, with just three percent reporting underperformance expectations. It seems these programmes are meeting the typical objective; a consistent eight to nine per- cent net return with bond-like volatility. Investors across the globe and in all institutions are consistent in their rationale for hedge fund investing; they seek diversification and absolute returns.

Two major factors are driving this shift for institutions; the current low return environment and growing acceptance of alternative investments. In the bull market of the 1980s and 1990s, it was relatively easy for pension funds and endowments to meet their return targets portfolio by dividing it 60/40 between long-only and fixed income but those days are gone. Furthermore, to meet the demand for yield, investors are turning to alpha/beta separation as a framework for portfolio construction and are likely to pay more than previously for alpha while paying less for beta.

The most important selection criteria identified by institutional hedge fund investors - outranking even the performance record - was an understanding and validation of the sources and sustainability of an investment manager’s returns. This is critical for investors seeking to implement portable alpha programmes. Performance record ranks as the second most important criterion, followed by quality of personnel.

Despite the plethora of media coverage surrounding Amaranth’s current difficulties, global institutional investors are reporting a high level of satisfaction with their hedge fund programmes. Seventy-two percent report performance within one percent of target expectations and 25 percent report performance exceeding their return target by one per- cent or more.

The industry in 2010

Cumulative, global institutional flow into the sector is estimated at $510 billion in the four years until 2010 and institutions will account for more than 40 percent of hedge fund in this time, an increase from approximately 30 percent today.

 

Figure 1: Projected cumulative institutional hedge fund flows by region 2006-2010

Pension Funds and Hedge Fund Investing - Figure 1 

 

According to the bank’s research, the vast majority of participants - 87 percent - currently use either FoHF exclusively or the dual approach, a combination of FoHF and direct investments. FoHF will remain the starting point of hedge fund programmes for most institutional investors. In addition to specialised skills, established due diligence procedures, insulation from headline risk and the ability to navigate the complex and dynamic landscape, FoFH managers play a critical advisory/educational role for programmes.

As 2010 draws closer, we believe that today’s hedge fund techniques will be tomorrow’s mainstream investing with absolute returns emerging as the primary investment strategy. We will also begin to see the emergence of synthetic/passive exposures to hedge fund strategies.

Fees have always been a contentious issue in the hedge fund industry but we feel that fees will be more highly correlated to value with management fees settling at around one per- cent, that performance fees will be tied to alpha and FoHF fees settling flat in the 50-80 basis point range.

Although nimble boutiques will continue to flourish, the industry will be dominated by a group of leading active/hedge fund investment managers. The same holds true for FoHF.

The single factor that could materially change growth expectations would be sustained, broad underperformance of institutional investors’ net return requirements.

Institutions are rapidly transitioning away from bull-market oriented portfolios and toward portfolios designed to deliver on specific net return requirements with specific risk exposures. The capabilities required to facilitate this transition are just being built today - the competitive landscape remains wide open. The leading investment managers of 2010 will employ bold thinking to create business models that meet the needs of the next generation of institutional investors.

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