According to a study by State Street Corporation, a provider of financial services to institutional investors, more than half of respondents indicated that their governing bodies are more comfortable investing in hedge funds today than they were 12 months ago. Reinforcing this interest, more than half of boards also spend 15 percent or more of their time on the subject.
Results also show that the percentage of asset owners investing in alternatives increased significantly over last year. This year, only 4 percent of asset owners indicated they have no hedge fund investments, down from 16 percent last year. All of the study participants said they allocate assets to private equity.
This is the third institutional investor hedge fund study, conducted late last year in conjunction with the 2006 Global Absolute Return Congress (Global ARC). Asset owners participating in the study included representatives from global corporate pensions (21 percent), public and government pensions (32 percent), and endowments and foundations (44 percent), with investable assets totaling more than $1 trillion.
“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,” remarks 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.”
Half of institutional investors said the negative financial effects of recent highly publicised hedge fund manager debacles on institutional portfolios have prompted their boards to call for a more robust risk management program. Nearly half cited a need for additional reporting and analysis on the part of hedge fund managers and more rigorous due diligence practices. Less than 5 percent of institutions plan to add to their staff to address these concerns. More participants will also increase use of third-party resources for due diligence, fund screening and/or investment recommendations.
In addition, nearly half of institutions acknowledge that in-house risk management tools and analysis could be more robust. A majority of institutions said they find 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. The same number also agreed that obtaining an accurate valuation of hedge fund holdings can 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,” says Enos. “Particularly in 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 invest with more than 10 direct hedge fund managers. The previous year, only 48 percent said they invested with more than 10 direct managers, a shift implying that portfolio construction is following current empirical evidence supporting 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 indicated they used no fund-of-funds managers, as compared with just over a quarter of institutions in the 2006 study. Nearly two-thirds (60 percent) said they employ 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 fund-of-funds is likely due to two factors: growing sophistication and familiarity with hedge fund investing, and a cost-benefit analysis in favor of a “do-it-yourself” approach.
The results of State Street’s study also show that institutions are concerned about hedge fund fees. High fees offsetting returns was identified as the greatest threat to hedge fund investing by nearly a third of institutions. That concern was 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,” said Jane Tisdale, senior managing director of absolute return strategies at State Street Global Advisors. “Asset owners will likely begin to force fee compression for all but the most successful funds.”