Institutions are the biggest hedge fund investors

Preqin’s The Real Value of Hedge Fund Investment report states that 65% of hedge fund investors are institutions. These investors are mostly located in the United States and Europe. More than 4,600 entities use hedge funds as part of their portfolio and 87% look to maintain or increase their portfolio’s share of hedge fund investments over the next 12 months. Most institutional investors have increased their investment in hedge funds over the last 3 years. Family offices have increased their hedge fund allocation by 3.7%, the largest increase in 3 years among institutions.

Institutions industry capital

Source: Preqin investor survey, June 2014

Instituions Hedge Fund allocation

Source: Preqin investor survey, June 2014

Institutions use hedge funds to diversify

Although institutions state a variety of goals for hedge funds in their portfolios, four goals stand out as the most frequently mentioned:

  1. Provide returns uncorrelated with stock price movements
  2. Provide absolute returns regardless of market direction
  3. Improve risk-return profile of portfolio
  4. Reduce fluctuations

Institutional investors hedge funds

Source: Preqin investor survey, June 2014

Institutions are using hedge funds primarily as a diversifier and they expect returns of 4%-6% per year. High returns are not a primary goal of institutions, as only 6% of investors expect returns of 10% per year on average. Institutions also expect hedge funds to fluctuate less than equities. Mitigating downside in downward trending equity markets is paramount to institutions and they see hedge funds as an important vehicle to achieve this goal.

Hedge fund portfolio volatility

Source: Preqin investor survey, June 2014

Given that institutions see hedge funds as a risk-return enhancer for their portfolios, they commit their capital to hedge funds for the long term. Choosing the right group of hedge funds for a portfolio is a time consuming process that includes doing research to determine if the hedge funds are sound investments and evaluating how several hedge funds impact the portfolio’s return and volatility. Monitoring and managing hedge fund exposures involves evaluating performance over time and gathering information from several hedge fund managers regarding fund’s outlook. Both of these tasks are resource intensive. Hedge funds’ performance reporting at quarter end is often preliminary as illiquid investments within the fund may not be valued. Return revisions are required mid quarter to account for changes in hedge fund returns due to illiquid valuations.

Most institutions think three to five years is a reasonable period to evaluate hedge fund performance. Only 19% of survey respondents thought that 10 years or longer is an adequate performance measurement period.

Institutional investors success

Source: Preqin investor survey, June 2014

Institutions are satisfied with hedge funds’ performance

Institutions believe that hedge funds are meeting return targets, assuming proper levels of risk and dampening equity market volatility within portfolios. Over the past 12 months, 84% of investors surveyed by Preqin believe performance is satisfactory. Over 3 and 5 year periods, satisfaction among institutions remains above 60%. Hedge funds had difficulty achieving absolute returns in 2011, which dampened institutional investor enthusiasm.

One area of concern for hedge funds is achieving uncorrelated returns. Hedge funds as a whole are positively correlated to the S&P 500 (INDEXSP:.INX), according to Preqin. In upward trending markets, the correlation of hedge funds versus the S&P 500 is 0.69 and in down markets this correlation increases to 0.72. This relationship may expose portfolios to more downside when equity markets fall.

Hedge fund returns

Source: Preqin investor survey, June 2014