Sponsored statement: SEI Investment Manager Services

Shifting hedge fund landscape: Where institutions put fund managers to the test

SEI logo

Ross EllisView the article as a PDF.

Hedge funds in flux
Sweeping changes in the global environment and heightened market uncertainty are challenging hedge fund investors – including seasoned and sophisticated institutions – as never before. Some long-held assumptions, like hedge funds’ non-correlation with other asset types, have been shaken. Familiar paradigms are being questioned while new ones are still taking shape. Hard experience is also leading investors to broaden their definitions of risk and sharpen their methods of managing it. 

Still, institutional investors are putting their money into hedge funds in the quest for returns, continuing to deepen their commitment and increase allocations. At the same time, institutions keep ratcheting up the challenges and requirements they pose to hedge fund managers. In this new landscape, investors are pushing the industry to de-risk, to improve operations and governance, to enhance liquidity and to provide more windows into investment processes and decision-making. 

The year 2011 was an uncommonly rough one for hedge funds, and yet they have continued to grow with institutional assets as their mainstay. The fifth annual global survey of institutional hedge fund investors, conducted by the SEI Knowledge Partnership and Greenwich Associates, focuses on current trends affecting the hedge fund industry. 

Key findings
Institutional allocations are continuing to rise, although more slowly than in the past

Nearly 38% of investors said they plan to increase their allocations to hedge funds over the next 12 months (compared to 54% in last year’s survey), while 15% expect to lower them (compared to 11% one year ago). As of October 2011, respondents’ hedge fund allocations represented an average of 16.7% of their portfolios, up from 12% during the 2008 financial crisis. 

Absolute return has emerged as the top goal of hedge fund investing
In a year of record volatility and lower returns in many asset classes, absolute return was named the number one objective by nearly one-third of respondents – up from about 21% last year, when “non-correlated investment strategies” were the primary goal. 

Investors’ goals also reflect a strong concern with risk management
Three of the top-four goals named by respondents – accessing non-correlated strategies, diversification and lowering volatility – address investment risks. This suggests that institutions today use hedge funds to help them lower portfolio risks as well as to boost returns. 

Direct investing continues to gain momentum
Four out of 10 institutions surveyed said they invest solely via single-manager funds, up from 24% one year earlier and about double the percentage that responded in the same way in 2008. Not surprisingly, reliance on direct investing is greatest among large investors and 56% of respondents with more than $5 billion in assets said they use single-manager funds exclusively. 

Long/short equity strategies are most in favour
Nearly 82% of respondents name long/short equity among the top-three strategies they presently employ, followed by event driven and credit, 53% and 42%, respectively. 

Institutions show limited interest in shifting hedge fund assets to registered products
Only 15% said they plan to divert some share of hedge fund allocations to mutual funds or Ucits in the coming year, although this may reflect obstacles to exiting existing hedge fund investments as much as it does attitudes toward registered products. 

The difficulty of meeting performance expectations now overshadows all other challenges
Twenty-six per cent of investors this year named performance as their top challenge in hedge fund investing, more than double the percentage than in 2009. The issue of transparency headed the list of top challenges in 2009 and 2010, but, this year, performance outranked it by a wide margin. 

Returns are down, and investors register varying degrees of satisfaction with their results

Based on returns in the first half of 2011, respondents reported earning an average annualised return of 6.2% compared to 9.2% in 2010, and a median annualised return of 5.0% compared to 8.1% in the previous year. More than six out of 10 said they were satisfied with their returns in the first six months of 2011; only about 7% reported any level of dissatisfaction. But, hinting at growing performance concerns, the percentage of respondents that are noncommittal rose from 22% in 2010 to nearly one-third in 2011.

Takeaways for hedge fund managers
Keep articulating and reinforcing the value proposition

While those surveyed generally show a strong, ongoing commitment to hedge funds, responses reveal heightened concern over hedge funds’ ability to deliver the kind of performance investors are seeking. Investors were also split, by a 41%-to-25% margin, on the question of whether they would be able to meet return objectives without having hedge funds in their toolkits. In a challenging climate with rising competition for investor allocations, it behoves hedge funds to demonstrate exactly how their strategies and methods are enhancing their clients’ risk-adjusted portfolio returns. 

Continue investing to improve risk management methods and infrastructure
All four of investors’ top-ranked objectives for hedge fund investing speak to their desire to avoid losses and manage risk. Respondents also named “understanding risk” among the top challenges of hedge fund investing. 

Go the extra mile to make strategies understandable
While strategies fall in and out of favour, it may be no coincidence that, in this time of heightened market uncertainty, investors favour three relatively straightforward strategies – long/short equity, event-driven and credit – rather than complex strategies that may pose hidden risks. Investors’ heightened concern with performance gives fund managers a compelling reason to thoroughly explain the strategies and processes they are using to generate returns. 

Clarify performance expectations
Survey respondents said they now seek absolute return above all. But does this mean they will not tolerate investment losses, or simply that they expect hedge funds overall to lose less than long-only managers in downturns? With institutions more focused on performance than they have been since 2008, fund managers need to probe for a deep understanding of clients’ true return objectives and tolerance for risk. They should also work to help clients understand the trade-offs between risk and reward, and how strategies can be expected to perform under varying market conditions.

Over the past few years, the hedge fund industry has been busy reshaping itself in the image of the institutional investors that have become its dominant constituents. Evolving from a performance-focused culture that thrived on secrecy, unique strategies and huge rewards for stellar returns, the industry has itself become more institutionalised. As hedge funds have responded to investor demands for better risk management, more transparency, greater liquidity and higher-quality operations, institutions have rewarded them with a deepening commitment and steadily rising allocations. 

Now the industry finds itself at an interesting juncture – a point at which institutional investors appear to be somewhat conflicted. As evidenced by their stated objectives, investors have come to view hedge funds more as a vehicle for managing portfolio risks than as a way to earn outsized returns. Yet, in a climate in which investment returns are harder to come by, institutions now exhibit growing unease with hedge fund performance levels. By a wide margin, those surveyed this year named “meeting performance expectations” as the greatest challenge of hedge fund investing, a marked shift from their prior focus on transparency. With their reported portfolio returns down by about 50% from the previous year’s levels, respondents have also become more ambivalent about their levels of satisfaction with hedge fund returns, with nearly one-third saying they are “on the fence”. 

In short, institutional investors are seeking the best of all worlds – better returns, as well as lower correlations, more diversification and better overall management of risk. This thrust is not confined to hedge funds; it was also a prominent finding of SEI’s 2011 series on institutional private equity investing. But, with their promise of outperformance, their disparate risk exposures and some high-profile blow-ups in recent memory, hedge funds have become a lightning rod for investors’ hopes and fears. 

The industry will need to work closely with investors in finding ways to keep advancing towards institutional standards of risk management and operational quality while also preserving the industry’s enterprising and creative spirit. This may spur a collaborative process of clarifying, fine-tuning and perhaps even recalibrating the balance of risk and reward being sought. Herein lie both the challenges and the opportunities ahead for the hedge fund industry and institutional investors alike.

Request the full research paper, The Shifting Hedge Fund Fandscape

View the article as a PDF.

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here