The governing bodies of institutional investors have become significantly more comfortable with the idea of investing in hedge funds over the past year, according to the third institutional investor hedge fund study conducted by State Street.

According to State Street, more than half of all survey respondents indicated that their governing bodies were more comfortable investing in hedge funds today than they were 12 months ago, and more than half of boards spend 15 percent or more of their time on the subject.

The survey was conducted late last year in conjunction with the 2006 Global Absolute Return Congress. The investors taking part in the study included representatives of global corporate pension schemes (21 percent), public and government pension schemes (32 percent), and endowments and foundations (44 percent), with investible assets totalling more than USD1trn.

'The findings of our study reinforce the industry trend we've been witnessing among our client base - investment boards are overwhelmingly accepting that hedge funds are a viable option for their investment allocations,' says Gary Enos, executive vice-president and head of State Street's alternative investment servicing business.

'They are also discovering the various ways hedge funds can be incorporated into portfolios based upon investors' risk appetite, return targets and overall investment objectives.'

The survey results indicate that the proportion of institutions investing in alternatives has increased significantly over the past year. In the latest survey, only 4 percent of asset owners said they had no hedge fund investments, down from 16 percent the previous year, while all participants said they allocated assets to private equity.

Half of the institutional investors surveyed said the negative financial effects of recent highly publicised hedge fund manager debacles on institutional portfolios had prompted their boards to call for a more robust risk management programme.

Nearly half cited a need for additional reporting and analysis on the part of hedge fund managers and more rigorous due diligence practices, although less than 5 percent of institutions planned to add staff themselves to address these concerns. A growing number of respondents said they would increase use of third-party resources for due diligence, fund screening and/or investment recommendations.

Nearly half of the institutions surveyed acknowledged that in-house risk management tools and analysis could be more robust. A majority said they found it difficult to gain a portfolio-wide view of risk, and that aggregating risk statistics provided by all hedge funds in their portfolio was problematic. A similar proportion also agreed that obtaining an accurate valuation of hedge fund holdings could be problematic.

'The tools, methods and best practices for managing risk will further develop as hedge funds become a tried and true staple of institutional portfolios,' Enos says. 'Particularly in the light of regulatory pressure and changes in accounting practices, asset owners will continue to push hedge fund managers and third-party service providers, such as administrators, to develop and deliver enhanced risk and transparency solutions.'

The number of hedge fund managers hired directly by a single institution has increased. More than half (56 percent) of the study participants said they invested with more than 10 direct hedge fund managers.

A year earlier, only 48 percent said they invested with more than 10 direct managers. This shift implies that portfolio construction is following current empirical evidence that supports a properly diversified portfolio of hedge funds to mitigate systemic risk.

By contrast, the number of funds of hedge funds used by institutions appears to have declined. In the 2007 study, nearly a third of institutions said they used no fund of funds managers, compared with just over a quarter of institutions in the 2006 study.

Nearly two-thirds (60 percent) said they employed the services of between one and three fund of funds managers and only 8 percent used four or more. This represents a shift from the 2006 study, in which 43 percent of institutions said they used between one and three fund of funds managers and 29 percent used four or more.

Evidence suggests that reduced use of funds of funds is likely due to growing sophistication and familiarity with hedge fund investing, and a cost-benefit analysis in favour of a do-it-yourself approach.

The State Street survey also indicates that institutions are concerned about hedge fund fees. High fees detracting from returns was identified as the greatest threat to hedge fund investing by nearly a third of institutions, closely followed by headline risk (20 percent) and investment loss (20 percent).

'As fees continue to eat away at precious returns, more institutions will balk at paying alpha fees for beta performance,' says Jane Tisdale, senior managing director for absolute return strategies at State Street Global Advisors. 'Asset owners will likely begin to force fee compression for all but the most successful funds.'

Boston-based State Street is a global leader in providing institutional investors with investment servicing, investment management and investment research and trading services, with USD11.9trn in assets under custody and USD1.7trn trillion in assets under management at the end of last year and operations in 26 countries worldwide.


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