The results of a new survey show that a majority of institutional investors intend to add to their hedge fund holdings over the next three years.
The move into hedge funds is being driven by their need for better risk-adjusted returns and broader diversification. However, institutional investors differ greatly on the preferred way to invest in this asset class.
Gary Enos, executive vice president and head of alternative investment services for State Street, said: "This research clearly disproves all the recent publicity given to the so called 'bursting of the hedge fund bubble'. Given the uncertainty of the world's financial markets, it's no surprise that institutional investors are looking to hedge fund strategies to maximize their portfolios' risk-adjusted performance."
"The findings of our survey supports the trend that we have seen in which new entrants to the asset class choose the fund of funds approach, while those with more experience in this asset class continue to favour direct investing."
Enos points to three distinct trends seen by Street Street:
* The growing interest from US and European institutional investors in hedge funds, and the need for hedge funds to gear up and service this interest
* The growing pressure on managers to perform, and the corresponding pressure on service providers to cope with new products and strategies being developed by managers
* Changes in the regulatory environment and the growing burden of compliance for both managers and service providers.
He said: "At State Street we have been gearing up for over the past two years to address these issues and we have developed the competence and comprehensive skills to deal with them, at both the manager and investor interfaces."
Enos noted: "We currently service USD 100 billion of assets in alternative fund strategies. Funds of funds account for 20% of this, with the majority being single strategy managers. Around one third of the managers we service are non-US."
State Street, in conjunction with the Global Absolute Return Congress (ARC), conducted this study of institutional investors at the 2004 Global ARC conference in Boston on October 18 and 19, 2004.
The study results reflect the role of hedge funds in institutional investors' portfolios and general views on the asset class among these investors.
Institutional investors are represented by a cross section of conference attendees, including global corporations, public and government pension plans, endowments and foundations. According to Global ARC, the participating institutions collectively manage more than USD 1.2 trillion total assets in both hedge and non-hedge investment portfolios. Other conference attendees, including hedge fund managers, fund of hedge fund managers, consultants and service providers, were not eligible to participate in the study.
The information contained in this report was derived from a web-based study conducted during the conference. One delegate from each of the participating organizations anonymously and confidentially recorded his or her organization's views on hedge funds and the role of the asset class in that institution's current investment portfolio.
Results for each question reflect the views of the entire pool of respondents, helping to set a baseline for trend analysis and further research.
1 Approximately one-third of investors report portfolio allocations of 10% or more to hedge funds today (October 2004) and a full half anticipate allocations of 10% or more by 2007.
Thirty-five percent of respondents reported a current allocation to hedge funds of 10% or more. Forty-two percent of respondents expected to have a 10% or greater allocation to hedge funds within one year, with 50% anticipating reaching that level within three years. It is also important to note that 16% of respondents had not yet invested in the asset class.
After analyzing this data by organization type, we expect that the largest expected percentage increase in hedge fund investing will come from public and government pension plans.
2 The primary reasons investors use hedge funds are to improve returns on a risk-adjusted basis and to increase portfolio diversification.
Forty-two percent of respondents said they invested in hedge funds to improve returns on a risk adjusted basis, whereas 37% cited portfolio diversification as their chief motivation. Additionally, more respondents saw hedge funds as a tool to maximize profit (32%) than to mitigate risk (25%) — although 43% of respondents had no opinion either way.
3 Hedge fund allocations will likely occur at the expense of equity allocations.
Thirty-seven percent of respondents indicated that increased allocations to hedge funds would be sourced from existing active equity allocations. Twenty-one percent reported that they would divert monies from passive equities. This suggests a desire to decrease the risks associated with equity market exposure, namely the volatility of returns characteristic of traditional long-only programs.
4 More than half of respondents showed a preference for direct investment over fund of hedge fund or hedge fund index investing.
Fifty-four percent of respondents agreed or strongly agreed that direct investing in hedge funds was preferable to investing in funds of hedge funds or investable hedge fund indices. Twenty-seven percent of respondents were neutral in their preference.
5 Investment method preferences appear to be governed by experience level: New entrants to hedge fund investing unanimously chose funds of hedge funds over other investment methods, while more experienced investors preferred direct investing (52%).
Among investors whose entrance into hedge funds began within the past 12 months (7% of respondents), funds of hedge funds were the sole investment method used. For investors with greater than 12 months experience investing in hedge funds (77% of respondents), only 15% used funds of hedge funds exclusively.
The report concludes: "We believe preferences toward direct investing will continue to be strongest among investors with existing experience in the asset class. Similarly, it is likely that funds of hedge funds will remain a preferred vehicle for (a) new entrants to the asset class, and (b) investors with significant fiduciary obligations, namely pension plans."