Conference Presentation, Panel
Evolution of Hedge Fund Investing: Institutional Investors Go Direct
- Institutional allocation to hedge funds shifted from approximately 20% of total assets in 2003 to nearly two-thirds by the end of 2011, driven by changes in the underlying investor base.
- AXA Investment Managers (AXI) manages ~$750 billion in assets and has shifted its ~$5.5 billion hedge fund allocation from fund-of-funds to targeted single-strategy programs on its balance sheet.
- The Third Swedish National Pension Fund (AP3), managing $35 billion, maintains a $2 billion hedge fund allocation via direct investments only, starting in 2007.
- CalPERS allocated $5.5 billion to Absolute Return Strategies (ARS) with targets of T-bills + 5% returns, 6-8% volatility, and a beta to global equity of 0.2 or less.
- PGGM, a European pension fund with €140 billion in assets, holds a 4% allocation to hedge funds and transitioned from fund-of-funds to an exclusive managed account platform in Ireland in 2008.
- Key drivers for institutions moving from fund-of-funds to direct/managed accounts include cost reduction, the removal of the "middle layer," and gaining control over portfolio construction and manager selection.
- PGGM cites the 2008 crisis and material operational risks in fund-of-funds structures as the primary catalyst for moving to managed accounts to control fraud and liquidity risk.
- AXA reports that its client base now demands thematic exposure (e.g., alternative credit) rather than simple diversification, reflecting a more sophisticated understanding of hedge fund utility.
- AP3 defines "alpha" strictly as market timing capability; they categorize returns into traditional beta, alternative beta, and manager alpha, often rejecting strategies that simply capture alternative beta premiums.
- CalPERS challenges the strict separation of alpha and beta, acknowledging that security selection and trading strategies involving market dislocations also generate skill-based alpha.
- PGGM has identified 33 distinct alternative risk premiums to systematically analyze and replicate embedded return sources, avoiding payment of management fees for strategies replicable via traditional or alternative beta.
- AP3 operates with a two-person investment team, utilizing external providers only for operational due diligence while retaining full control over investment sourcing and decision-making.
- PGGM employs a 12-person front office team to manage its managed account platform, whereas AXA employs ~40 staff with under 20 dedicated to direct hedge fund investment.
- Institutions are moving toward "fund of one" structures to allow for concentrated positions, customized liquidity terms, and opportunistic capital deployment not available in flagship funds.
- PGGM argues that statistical replication of hedge fund indices is flawed due to backward-looking data; they prefer analyzing individual manager return streams to identify persistent alternative beta sources.
- CalPERS notes that while alternative beta can be captured systematically, direct allocation to active managers offers dynamic capabilities that static replication strategies lack.
- AXA suggests that the industry has not sufficiently addressed fee alignment, noting that despite asset growth to $2.5 trillion, fees remain high relative to declining returns.
- A proposal was made for hedge funds to create a specific "pension fund share class" (e.g., 1 in 10 fees) to address fee compression and underfunding pressures in the pension sector.
- PGGM and AP3 report success in negotiating fee reductions and fee structures for early-stage or medium-sized managers, a leverage point often unavailable to smaller public pension funds.
- Institutions favor managed accounts for their ability to conduct daily stress testing, risk budgeting, and portfolio-level aggregation, though some note that high-frequency strategies may not benefit from this granularity.
- AP3 maintains that the operational risk transfer from manager to investor in managed accounts requires robust internal systems to realize the potential benefits of daily data over monthly reporting.
- AXA emphasizes that while fund-of-funds provide valuable portfolio management services, institutions moving direct must replicate these capabilities through experienced internal teams or trusted advisors.
- Regarding emerging managers, AP3 and CalPERS invest without strict AUM or track record minimums, provided the manager has a pedigree as a Portfolio Manager (distinguished from an analyst).
- PGGM observes a trend since 2008 where emerging managers have adopted more conservative strategies compared to the pre-crisis era.
- Governance structures vary: AP3 uses a risk committee for operational approval with PMs making investment decisions; CalPERS delegates hiring/firing to staff with Board oversight on policy; PGGM uses a tiered approval system based on allocation size.
- CalPERS plans to expand its investment team from six to ten professionals to manage its growing direct hedge fund program.
- AP3 excluded commodity exposure from its hedge fund portfolio due to legal restrictions, necessitating direct customization of global macro strategies.