Institutional Investors and Hedge Fund Structural Preferences – July 2014

by Michael Haimson

  • 10 Jul 2014
  • HF

The hedge fund structural preference of an institutional investor is one of the primary criteria used when determining the selection of managers and funds. Traditionally, investors allocate directly to single-manager hedge funds, invest through funds of hedge funds, or use a combination of the two methods. As hedge funds continue to underperform equities in the post-financial crisis era, funds of hedge funds are coming under pressure due to the extra layer of fees associated with the structure.

According to Preqin’s Hedge Fund Investor Profiles, investors that only allocate directly to hedge funds have a mean of $14.5bn in total assets under management (AUM), while those investing solely through funds of hedge funds have an average of $5.4bn in AUM. This can be attributed to smaller investors with limited capital choosing multi-manager structures to diversify their hedge fund exposure, as this requires fewer resources than creating a diversified portfolio of single manager hedge funds. Likewise, investors employing both single-manager funds and funds of hedge funds have an average of $25.7bn in AUM, as larger investors tend to employ more structures in order to gain access to the best strategies and talent, as well as to manage risk.

Of all investors globally with stated structural preferences (excluding fund of hedge funds managers), 35% allocate to both structures, 35% invest directly and 30% allocate to hedge funds solely through funds of hedge funds. North America-based investors are slightly more likely to invest through funds of hedge funds (31%) and less likely to invest directly (34%), while Europe-based investors have a greater preference for investing solely through single-manager funds (40%). Asia-Pacific-based investors are the least likely to invest solely through funds of hedge funds (17%), with 44% investing solely through direct investments and 39% using a combination of the two methods.

Comparing investors in each of the three regions by AUM reveals that the more small investors there are in a region, the more likely funds of hedge funds will be employed. The average North America-based investor has $8bn in AUM, with their Europe- and Asia-Pacific-based counterparts boasting average assets of $31.6bn and $50.7bn respectively. Therefore the demand for funds of hedge funds is inversely correlated to the average size of the investor. This argument is further supported by the average current and target allocations of fund of hedge funds investors (9.7% and 10.9%) being lower than that of both direct investors (17.3% and 17.0%) and those investors employing both structures (15.5% and 14.5%). Not only are investors allocating solely through funds of hedge funds smaller on average, they also allocate less of their portfolios to the asset class.

As the demand for traditional multi-manager vehicles declines in favour of listed vehicles and direct funds, which offer diversified exposure, the pressure on funds of hedge funds will only intensify. With 52% of public pension funds investing solely through funds of hedge funds, there should be plenty of opportunities for single-manager funds to gain inflows from this area. However, larger investors, such as sovereign wealth funds and banks, tend to employ both structures more often than not (67% and 53% respectively). As a result, funds of hedge funds will remain important to small and large investors alike, allowing an entry point for new and small investors in the asset class, while offering more choice and flexibility to larger investors.

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