Hedge funds are more and more relevant in the asset allocation of institutional portfolios and this is becoming very clear to traditional asset managers in search of better risk-return profiles for their customers. The hedge fund industry is now more sophisticated and regulated after the well-documented episodes of 1998.
Hedge funds were, for a long time, the preserve of high net worth individuals only, but now they are meeting the needs of institutions.
First of all we have to segment the hedge fund world. There are more than 3,000 hedge funds managing about $400bn (E444bn). Not all are interesting for institutional portfolios and many of them are simply unsuitable. What’s crucial are the legal and regulatory frameworks in which both investors and funds are located.
Hedge funds are – by definition – loosely regulated, based mostly in offshore financial centres and without any link to central monetary and supervisory authorities in the developed countries. Nevertheless, institutional investors are predominantly very risk adverse and have to comply to a number of regulatory dictates as far as investment strategies and type of funds are concerned. So, the opportunity for a hedge fund to be of some interest to an institution is limited.
Among the biggest hedge funds buyers are banks and insurance companies. The medium-sized institutions are those most interested, given their less developed investment banking divisions (sometimes non-existent) and the simpler decision-making process. For these it is sensible to allocate a certain amount of risk to a well-structured hedge fund or fund of hedge funds. They can replicate a proprietary trading activity without any significant investment in human resources and technology, their only cost being fees for the hedge fund manager.
In doing so, regional banks expose themselves to a number of strategies with a predetermined level of risk and cost. The complexity of managing a variety of financial instrument is minimised by just keeping of a group of ‘net asset values’, on their books.
But which hedge funds are suitable for institutional clients? We can
summarise the required features in three categories: transparency, risk management and low correlation.
Transparency
One of the necessary conditions for an institution to invest is transparency, so hedge funds need to conform to a standard level of data information required by institutional customers. This information should be constantly available and almost in real time. To appeal to an institution a hedge fund has to overcome its natural tendency to secrecy and the investment team should be open to regular conference calls and meetings with customers.
Risk management
Excellent risk management techniques are equally necessary to attract institutional clients. Not only should risk management be an intrinsic part of hedge fund investing, but it has to be included in the information regularly transmitted to customers so that they can ascertain their investment’s level of risk. Risk management should be monitored by an external, independent entity to ensure that proper methodology is being used. Risk management methodology also needs to be consistent with what institutions are familiar with, so a value-at-risk based system and regular stress testing of portfolios are essential in approching the institutional market.
Low correlation
What institutions really look for in hedge fund investing is not simply a decent absolute return for their money but more importantly a low correlated return to their existing investments. One important point in presenting hedge funds to this type of customer is to make them aware of the extraordinary value of hedge funds as a means of diversifying a complex portfolio. In recent years, because of stock markets rallies in the US and Europe, the low correlation feature of hedge funds (in particular of long/short equity hedge fund) has been a bit diluted and large institutions tended to forget about this, sufficiently satisfied by the spectacular returns.
But a hedge fund should be considered a powerful tool to reduce overall portfolio risk at any given return target or to enhance the overall portfolio return. A hedge fund is interesting to long-only investment portfolios primarily when it offers valid protection against market setbacks.
It is clear that institutions not only have to segment the hedge fund ventures into different groups according to a number of criteria (type of investment strategies, risk management capabilities, shareholder structures, transparency and availability to disclosure, etc), but also they need to maintain a high degree of control on their hedge fund managers.
This means institutions should dedicate a group of senior officers to research and monitor non traditional investments.
Hedge fund managers need to brace themselves if they target institutions’ money as due diligence is usually very restrictive, deep and demanding. One way to meet this need is the creation of a dedicated team of people in charge of business/product development for institutional clients. The person leading the team should come from an institution already familiar with hedge fund investing, so they can produce solutions when problems arise on the buyer side.
The need to segment the institutional market is important for hedge fund managers as well. First of all, a hedge fund firm has to position itself very precisely on the market, according to its own competitive advantages and specialist areas. Then it should dedicate time and resources to find out what type of client is best for itself. This marketing and strategic search is vital to the success of long term commercial relations.
Institutional investors are set to look more and more at hedge fund investments, in particular at low correlated and market neutral strategies; at well structured and well positioned hedge fund firm in terms of talented portfolio managers, risk management capabilities, information technology framework, transparency and customer relation department.
Hedge fund managers that want to benefit from this trend should prepare themselves to adopt a new structure and abandon some features of the typical non-regulated offshore hedge fund, as they are unsuitable for institutional clients.
Alberto La Rocca is amministratore delegato of EuroPlus Alternative Investments, in Dublin

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