SWFs in Latin America and Middle East consider their first hedge fund allocations

For any hedge fund manager, winning a mandate from a sovereign wealth fund (SWF) is the Holy Grail. These are the biggest institutional investors on the planet and also offer, potentially, the stickiest capital given their multi-year investment horizons. 

One should therefore take encouragement from the fact that SWF allocations to hedge funds have steadily risen from 31 per cent in 2013 to 33 per cent today, according to the latest research by Preqin in their Hedge Fund Spotlight June report. But the fact remains that SWFs remain under-allocated to the asset class; 60 per cent do not invest at all. That is quite a contrast to the way they use other alternative assets. 

As Amy Bensted (pictured), Head of Hedge Fund Products at Preqin notes, far greater numbers of sovereign funds are allocating capital to private equity, real estate and infrastructure, and even though private debt is only just emerging as a new alternative asset “already approximately 25 per cent of all SWFs are investing in these products. For sovereign funds the risk/return and liquidity profile of these alternative assets can make more sense; as they are seeking long-term return streams and do not have the immediate liquidity requirements of many other investors,” says Bensted.

That said, for SWFs who are taking a more proactive stance to diversify their portfolios hedge funds are a good option to reduce the volatility of their return stream. Geographically, SWFs located in Asia (28 per cent), North America (24 per cent) and the Middle East (24 per cent) are the most active participants. Perhaps due to the Eurozone crisis in recent years, only 4 per cent of Europe-based SWFs currently allocate to the asset class; that’s half as much as African SWFs (8 per cent). 

To illustrate the appetite among Asian SWFs, Bloomberg reported on 1st July 2015 that Korea Investment Corp., South Korea’s USD84.7 billion SWF, plans to increase its allocation to alternative investments from 8 per cent currently to 15 per cent by the end of the year. Not only that, but its Chairman, Ahn Hongchul aims to increase Korea Investment Corp’s allocation to 50 per cent over the next five years. That’s a significant commitment and should be music to the ears of hedge fund managers. 

If one considers the regional preferences of SWFs, and hypothecates that the same preferences apply to Korea Investment Corp., then North American managers could be well placed to benefit. According to Preqin’s research, 68 per cent of SWFs allocate to North America, although it should be pointed out that from a cultural perspective, Asian investors, including SWFs, do have a preference for investing in local markets. 

As SWFs become more experienced at investing in hedge funds it is likely that direct investment to single managers will become the preferred route. Currently, 76 per cent use a combination of direct investments and FoHF investments, drawing on the expertise of FoHF managers to source, screen and select the most appropriate managers. What is revealing is that only 20 per cent of SWFs use FoHFs only. This is a decrease from 24 per cent in 2014. 

When discussing these figures, Bensted suggests that FoHFs will always play a role in the sector just as they continue to do in the wider hedge fund industry. 

“The FoHF business model continues to evolve, with managers offering bespoke or customized portfolios – the type of product that might be of interest to a large sovereign wealth fund, or by launching niche or emerging manager focused vehicles. This is something that SWFs might not be able to get access to themselves. However, like other investor groups, I think we will see SWFs allocate more capital directly in funds, as they gain experience and shift resource internally to monitor these investments,” says Bensted. 

As mentioned earlier, these investors have multi-year time horizons and are more than happy to lock up capital over the long term with hedge fund managers. As such, this could benefit some strategies more than others, particularly at the less liquid end of the spectrum: distressed debt, private debt, bank loan strategies, convertible bond arbitrage, activism. All of these strategies need time to allow managers to demonstrate their edge. 

“We certainly see a higher proportion of SWFs interested in more illiquid strategies such as event driven and credit strategies than across many other groups of institutional investors,” says Bensted. “However, the SWFs we monitor have quite strategically diverse portfolios and we also see them showing some interest on the liquid end of the scale for macro and CTA strategies. If we see 1) more SWFs begin to allocate to hedge funds and 2) these SWFs increasing their (currently) modest allocations to the asset class, there could be a lot more capital pouring into the asset class in the years to come. This could benefit a wide group of funds.”

To confirm, 76 per cent of SWFs favour event-driven strategies, whilst 64 per cent favour credit strategies. 

If SWFs such as those in South Korea start to ramp up their existing allocations to hedge funds, and we start to see the 33 per cent figure climb to 35 per cent, 40 per cent, it will seriously boost todays USD3 trillion industry. 

Asked where she envisages the future growth of SWF allocations, from a location perspective, Bensted concludes:

“I think we’ll continue to see more SWFs globally begin to invest in hedge funds for the first time. Currently our database shows there are SWFs in Latin America and the Middle East that are actively considering their first investments in hedge funds; so we may see some expansion from those regions.

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