Institutional Investors Continuing to Shift Portfolio Allocations to Hedge Funds

Terry Flanagan

Institutional investors are continuing to pile into the hedge fund space as they increasingly embrace the risk management and diversification that hedge funds offer.

With institutional investors taking a more risk-based approach to hedge funds—whereby hedge funds can fit into different investment styles and strategy buckets—they are no longer being classed as an alternative allocation and can now compete for a place in the whole portfolio of an institutional investor rather than inside just a narrow category.

“Institutional investors are investing more and more into hedge funds and will continue to actively allocate capital to hedge funds due to their strong outperformance on a risk-adjusted basis,” said Najy Nasser, chief investment officer of Headstart Advisers, a London-based hedge fund.

However, it is the larger hedge fund managers with long track records who appear to be benefiting most from this development.

“The vast majority of the institutional capital flows have tended to go to a small number of very large managers where the ability to generate excess returns on both an absolute and risk-adjusted basis is significantly more challenging,” said Nasser. “We expect this to be the major area of evolution as institutions become increasingly sophisticated.”

The hedge fund industry has been riled by claims of underperformance in recent years with many funds failing to beat the S&P 500, the leading benchmark for the large-cap U.S. equities market, in the past couple of years. Although many hedge funds look to deliver long-term stable returns by being disciplined at managing risk and hedging their portfolios and they claim it is hard to match the S&P 500 when it is on a significant bull run.

“We feel that equity market returns are a poor comparison for a true hedge fund; having said that, on a risk-adjusted basis, a significant number of hedge funds have outperformed the S&P 500 in both recent years and on a longer time horizon,” said Nasser.

“Hedge funds should not be considered as a replacement for equities, but as a diversifier to a portfolio. Going forward, especially considering where equities trade today, we expect many hedge funds to continue to outperform on a risk-adjusted basis.”

A recent study by Deutsche Bank found that institutional investors are set to allocate 11% more to hedge funds this year and more are beginning to view hedge funds as a core part of their portfolio with a quarter of those surveyed saying they are adopting a risk-based approach.

“Investors are increasingly looking for steady and consistent returns as they balance portfolios according to a risk based rather than asset class approach,” said Anita Nemes, global head of capital introduction at Deutsche Bank. “Top performing managers continue to dominate, but besides performance, aligning interests with those of the investor is also critical in order to win attention from an increasingly institutional investor base.”

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