Big investors keep faith with hedge funds

Large investors with more than $1 billion allocated to hedge funds plan to maintain or increase their exposure in 2012, a Preqin study has found.

Despite many investors being disappointed with the performance of hedge funds in 2011, Preqin’s latest survey of what it calls the “$1 billion club” reveals these investors are looking past the current market uncertainty and keeping faith with the asset class.

Preqin researcher Amy Bensted finds that 91 per cent of this small but influential group of institutional investors intend to at least maintain their hedge fund exposure, or increase it to meet pre-determined allocation targets.

“Investors see opportunity in the current market environment and are continuing to allocate to hedge funds in order to tap into an alternative source of alpha within their holdings,” Bensted says in her paper, The $1 billion Club.

This long-term outlook and desire to continue building a strong stable of funds comes against a backdrop of disappointing returns for hedge funds in 2011.

In recent research Preqin found that 40 per cent of investors were disappointed in the returns hedge funds achieved last year.

Bensted says this $1 billion club represents 150 investors and more than $430 billion in invested assets, and it is shaping the way the hedge fund industry evolves towards an institutional quality market, demanding greater transparency and accountability.

Out of this group, 33 are public pension funds, the majority of which are based in the US, with a significant number also in Europe.

A number of prominent US public pension funds last year announced they would increase their allocation to alternatives, and in particular to hedge funds.

Florida’s State Board of Administration announced it would boost its allocation to alternatives by $6 billion. Hedge funds are included in its alternatives asset category.

Teacher Retirement System of Texas (TRS) also received approval from its legislature to increase its allowable allocation to hedge funds from 5 per cent to 10 per cent.

Further afield, Australia’s Melbourne-based sovereign wealth fund, Future Fund, invests more than 20 per cent of its total assets in hedge funds.

Bensted finds that the large hedge fund investors are typically experienced investors, with more than 10 years’ experience investing in hedge funds, compared with six years for all other investors on the Preqin database.

They have a mean allocation of $3.1 billion to hedge funds and on average have between 30 and 35 funds in their portfolio, compared to just 8 to 10 for all other investors.

Bensted also found that 86 per cent of this group invested directly in hedge funds to some extent, with 60 per cent also having some exposure to fund-of-funds.

When it came to strategies, long/short strategies were the most sought after, with 50 per cent of these large investors saying they would invest in this strategy.

The next most popular strategies were macro and event-driven.

Alex Jones, a senior analyst at Preqin says that the difficult fundraising environment and overcrowded manager space has led to a “buyers’ market” for institutional investors.

Investors are enjoying a strong bargaining position on fund terms and fees and are becoming more sophisticated in their dealings with hedge fund managers.

“Gone are the days of the black-box opaque investment vehicles, as general investors now understand the asset class much better and now expect high levels of transparency, disclosure and liquidity,” Jones says.

This can be seen in fees, where Preqin finds that just 29 per cent of single-manager hedge funds adopt the traditional “2/20” fee structure.

The mean management fee now stands at 1.6 per cent, while the mean performance fee is 19.2 per cent.

Jones says that hedge fund managers are balancing this reduction in fees with more manager-friendly terms, such as longer lock-up periods.

But despite these improvements, Preqin has found that investors are still unhappy about performance fees, especially in light of recent poor performance, with 48 per cent of investors saying this is an area that needs improvement.

While established fund managers are in a position to bargain hard, emerging managers are not in such a strong position.

With greater experience in the industry, members of this so-called $1 billion club are also more prepared to make a bet on emerging managers.

While 70 per cent of these large investors say they are considering investing in an emerging hedge fund manager, just half of all other investors were prepared to make such an investment.

Bensted found this difference even more marked when it came to seeding arrangements.

While just 19 per cent of all other investors would consider seed investment, almost half of these large investors were prepared to consider this sort of arrangement.

Jones says the rapidly maturing Asia-based hedge fund investor is proving to have a much higher appetite for first-time funds, with 58 per cent of investors from this region prepared to invest in emerging-manager hedge funds.

This compares to 39 per cent of European investors and 48 per cent of those in North America.