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Why are institutions turning to hedge funds, asks Goldman Sachs? ...
Why are institutions turning to hedge funds, asks Goldman Sachs?

Global hedge fund investments are conservatively estimated at between£280bn and£320bn. By 2005 it is estimated the market size will reach£700bn.

An asset class which was traditionally the preserve of ultra high net worth individuals is now being explored by many of the leaders of UK and continental European institutional investors. These investors are following the lead of US institutions such as the endowment funds of Harvard and Yale Universities.

A survey carried out by Goldman Sachs and Frank Russell in 2001 found that the largest endowments held the greatest proportion of alternative investments. On average, 29.6% of all assets held by US endowments with over£750m in their investment pool were categorised as alternative. In contrast, those with less than£75m had an average 3.3%.

Why is sentiment changing after a degree of negative press in recent years? Hedge funds are often misunderstood and misrepresented. The industry is not helped by a name that does a very poor job of describing what the managers who operate in the space actually do.

Hedge funds encompass a broad array of unregistered funds, whose managers can potentially invest in any selection of traded securities following any investment strategy. They are free to trade often, exploiting market anomalies as well as utilising instruments such as derivatives which are not available to conventional funds.

The hedge fund universe can be classed into four broad themes: relative value (arbitrage strategies), event driven (merger arbitrage and distressed securities), equity long/short strategies and tactical trading (managed futures and global macro).

European pension plans have traditionally focused on domestic equity and fixed income products, with some international equity exposure. The performance of equity markets over the past two years has reminded institutions that equities are not a one-way bet and that the risk premium that brought them handsome rewards throughout the 1990s can quickly turn against them.

Fund managers are taking a more sympathetic view of asset classes and investment strategies which, through a low or even negative correlation to equity, have the potential to substantially reduce portfolio risk. In a climate where funds managed relative to a benchmark may make the argument that they lost you less than the next person, investors may take comfort from part of their portfolio working on an absolute basis.

The decision to move into hedge funds is not straightforward. For pension plans, investing in hedge funds means their portfolios will contain investments which are not widely understood and will demand high fees, with no benchmark to blame should performance not live up to expectations. The job of explaining investment decisions to their boards becomes that much more difficult.

The majority of institutional investors are choosing multi-manager strategies to gain initial access to hedge funds. The fund of funds approach offers the potential of greater liquidity for institutional clients and provides access and diversification, as well as a reassurance that the investment decision has been prudently delegated to appropriate experts. The hedge funds themselves also benefit from this approach, because they get experienced investors who will better appreciate the dynamics of the industry.

A hedge fund investment accesses the skill of a particular hedge fund manager. It will typically have few employees, be truly entrepreneurial and express investment views with conviction. Poorly regarded stocks can be shorted rather than simply underweighted in a portfolio. The incentive fee structure means managers can be rewarded many times above what they could receive in traditional money management. Investors benefit from an alignment of their interests with the managers they employ, and for the most part the manager does not get paid until the investor earns a significant return.

Looking at typical long-only portfolios shows that a relatively modest allocation to hedge funds has the potential to enable an investor to benefit both from volatility and returns.

The multi-manager investment can deliver the investor the transparency, market intelligence, capacity and diversification they would not achieve from picking their own individual managers.

Thoughtful portfolio construction is vital as diversification benefits are significantly diluted if managers are following very similar strategies. Risk monitoring is critical and requires a large amount of data which is comprehensively analysed on a regular basis. These functions require the investment of a great deal of time and expertise.

If broad based and unquestioned support for hedge funds is ever achieved, the industry will probably look very different from today. For hedge funds to win the debate, investors will need to trust the skill of the managers they are paying and remove artificial constraints. In the absence of sustained growth in the equity markets, institutions will need to consider how to sweat their portfolios harder.

Today, we argue investors should consider the exploitation of mispricing opportunities and directional views taken by managers which can continue to deliver growth with low correlation to equities.

This argument appeals particularly as equity markets have delivered disappointing returns recently. Such a strategy makes still greater sense in the context of a portfolio which is effectively diversified across multiple asset classes.

European institutional investors remain more cautious towards hedge funds than their US equivalents. However, we believe the potential benefits of hedge fund investments are clear and they will become a standard allocation in institutional allocations in the near future.

We also believe that the access of choice will be through the fund of funds route. This offers diversity, access and transparency, which can give comfort, especially to those entering the universe for the first time. In the post-Myners era the appointment of a manager also answers the need to be seen to delegate to an appropriate investment expert.

We see a typical institutional portfolio having a meaningful exposure to hedge funds which would sit within a structured allocation to the asset class as a whole. In this way, the investor can ensure active managers are assessed to have low correlations to the rest of the portfolio and, importantly, to each other, and be well diversified across sub strategies.

The resulting portfolio will then become less reliant on directional markets while accessing active managers who target different sources of alpha.

Health warning

The material provided is for information purposes only.

Alternative investments such as hedge funds are subject to less regulation than other types of pooled investment vehicles, may be illiquid and can involve a significant use of leverage, making them substantially riskier than other investments.

Investment in an alternative investment fund is suitable only for sophisticated investors for whom investment in such funds does not constitute a complete investment programme. Alternative investments, by their nature, involve a substantial degree of risk, including the risk of total loss of investor's capital.

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