Infovest21 White Paper: Institutional Investors Enter Next Phase in Hedge Fund Investing

Institutions want the highest and most timely disclosure of information from hedge funds as seen by their move toward customized vehicles and managed accounts.

They have raised the bar in areas such as liquidity and transparency. Institutions generally want greater liquidity from their hedge fund managers i.e. funds with shorter lock-up periods. They generally prefer conservative strategies and reduced leverage. As a result, they are searching for hedge funds which can produce lower annualized returns than requested before e.g. 6-7%.

Institutional investors are increasingly differentiating alternative investments by liquidity and risk.

Rather than separating hedge funds out as a separate asset class, some industry experts expect pension funds to use hedge fund managers within their existing equity and fixed income buckets as a best-of-breed solution.

They want fees based on long term rather than short term performance.

Fall-out from 2008 financial crisis
The global financial crisis of 2008 resulted in some institutions putting their hedge fund allocation plans on hold while others re-evaluated their portfolios and asset allocation. Pension & Investments estimated institutional inflows into hedge funds in 2009 were $21.51 billion, down 49% from 2008 and down 68% from 2007. It was not until the fourth quarter of 2009 that inflows started and were estimated at $12.4 billion.

Hedge Fund Asset Flows P&I
($B)
Q1 2009 3.8
Q2 2009 4.5
Q3 2009 0.8
Q4 2009 12.4
Source: Pensions & Investments

Despite disappointing hedge fund performance in 2008, the Madoff Ponzi scheme and other scandals, gates and related illiquidity issues, institutional investors continue to find hedge funds attractive – realizing they performed better than most other investments during 2008.

According to Russell Global Survey, the average institutional allocation to hedge funds was 4.2% in 2009 and is expected to increase to 5.7% by 2012.

Recent activity
In the past year, several institutions made their first foray into hedge funds, such as California State Teachers Retirement, Denver Employees Retirement Fund, Florida State Board of Administration, Kentucky Retirement System, State of Wisconsin Investment Board, Employees’ Retirement System of Texas and Vermont Pensions. In Europe, Ireland’s National Pension Reserve is on brink of making its first allocation.

Other institutions have increased their allocations such as Arizona Public Safety, Chicago Teachers Pension Fund, Illinois Teachers Retirement, Iowa Public Employees, Kern County Employees Retirement, New Hampshire Retirement, New York State Common Retirement Fund, Ohio School Employees Retirement System and West Virginia Investment Board. In Europe and UK, British Telecom, APK, ATP, Clywyd Pension Fund, UK Universities Superannuation Scheme and West Midlands are among those increasing hedge fund allocations.

RFPs and searches are out (or expected soon) for Chicago Policemen’s Annuity & Benefit Fund, Connecticut Investment Council, Los Angeles Police & Fire, Ohio Public Employees Retirement System, San Antonio Fire & Police, San Bernardino County, Santa Barbara County, and Texas Permanent School Fund. In Europe, searches are on for AP1, Fife Council, Lincolnshire Pension and Waltham Forest.

Some institutions, despite filing lawsuits in connection with hedge funds e.g. Amaranth’s collapse, Madoff-related cases or WG-related cases, continue to allocate to hedge funds. Two examples are Iowa Public Employees Retirement System and San Diego County Employees Retirement Association.

Momentum grows toward direct investing
Another trend is institutions allocating directly to hedge funds rather than take the funds of funds route. Relatively poor fund of funds performance in 2008 and 2009, Madoff and other Ponzi schemes, the pressure for lower fees, institutions and their consultants acquiring more knowledge and expertise on hedge funds as well as some hedge funds becoming more institutional in nature have encouraged some institutions to invest directly with hedge funds. Recent examples include Boeing, South Carolina Retirement System and Pensioenfonds Zorg en Welzijn.

Yet some pensions are searching for funds of funds e.g. Ohio Public Employment Retirement System, Croyden and Lincolnshire Pension. Some institutions continue with the core-satellite approach where the core allocation is to a fund of funds supplemented by a number of single strategy funds.

Growth potential
Whereas public pension funds comprise a larger number investing in hedge funds, the largest growth potential is with private corporate plans. The private sector started investing later than public pensions and endowments. Recent activity shows select corporate pensions are starting to make large allocations to hedge funds.

In the endowment space, growth is limited with the larger endowments as they were early and heavy adopters of hedge funds. The main opportunity is a new manager replacing an existing manager or with smaller endowments increasing their allocations. Following the 2008 financial crisis, endowments are no longer copying the Harvard and Yale models but reassessing what is best for their specific needs.

Outside the US
It appears that European institutions have terminated or reduced hedge fund allocations more than their US counterparts. Lack of diversification, lack of transparency during the financial crisis as well as poor performance during 2008 are often-cited reasons. Some institutions in this category are Unipension (Denmark), VER (Finland), Ilmarinen Mutual Insurance (Finland), TNO (The Netherlands), Nedlloyd Pension (The Netherlands), AP2 (Sweden), BLVK (Switzerland), Luzern Pension (Switzerland) and Tate Gallery (UK).

Nevertheless, European pension plans as a whole are still looking to increase their exposure to hedge funds/funds of funds. According to an IPE survey, the average European institution has about 2.3% of its portfolio in hedge funds. Swiss pensions have the highest average allocation at about 6%. While most European institutions have increased their allocations, Italy was the exception and almost halved it.

Japanese pension funds have become more cautious of hedge funds. Estimates are that hedge funds account for 7-9% of Japanese pensions; a 2% reduction occurred in the past year. Hedge funds’ role seems to be changing from a fixed income substitute to a middle-risk type asset. Japanese pension fund preference is for low risk and transparent products.

Other trends
Other interesting trends include more focus on due diligence. While the weighting of the various attributes varies among investors, focus is increased on operational due diligence and risk management policies, notes Don Steinbrugge of Agecroft Partners.

Lois Peltz Lois Peltz, president of Infovest21, observes, “Some institutions are taking a more active role in seeding hedge fund managers because they hope the best hedge fund managers will spin out as bigger independent firms. The rationale is that by getting involved early on with a hedge fund manager, the institutional investor has more control over its assets and can better control its investment cost. It creates the possibility of locking in and aligning interests early on with top teams without paying high compensation costs.”

The above information is an excerpt from Infovest21’s just-released Institutional Interest/Allocation in Hedge Funds, an annual white paper examining trends on a global basis. The white paper looks at recent hedge fund interest and activity by pensions, endowments, sovereign wealth funds. Commentary is also provided on consultants, corporate pensions and insurance companies. For each institution, summary highlights of recent activity are provided as well as plans for moving ahead.

Institutional activity is examined in North America, Europe, UK, Japan and Australia. Special emphasis is place on the largest allocators i.e. those allocating $1 billion or more to hedge funds, as well as the next tier i.e. those allocating between $500 million and $999 million. A survey is also provided of smaller institutions making allocations as well as those issuing RFPs or conducting a search. Those institutions deciding not to allocate or who have reduced their hedge fund allocation are also listed.