Institutional investors pour into hedge funds

This year is shaping up to be the strongest for institutional investment in hedge funds since 2007.

Institutional investors, especially U.S. public pension plans, have been pouring new money into hedge funds to the tune of $39.9 billion of net inflows and pending searches year-to-date through Nov. 10, according to Pensions & Investments' analysis of reported hedge fund search and hiring activity.

If the current pace holds for the rest of the year — and consultants and hedge fund marketing executives predict it will — 2011 will be the second biggest year for hedge fund activity since 2004 when P&I began tracking searches, hires, new allocations and increased allocations to existing managers.

The year-to-date figure for 2011 represents a 24% increase from the $32.3 billion of net institutional hedge fund activity in calendar 2010, but trails 2007 — which brought in a record net $66.1 billion — by 40%, according to P&I's analysis.

P&I's estimate of net hedge fund activity likely is low. Amounts are not routinely given when searches are made public, and many searches and hires are never announced publicly.

Institutional hedge fund investors have shown remarkable resilience in the face of extreme market volatility that has whipsawed the returns of many hedge fund managers, not only remaining invested in hedge funds, but also continuing to top up their portfolios.

“I've been pleasantly surprised that there have not been knee-jerk reactions from institutional hedge fund investors. They are hanging in there,” said Jeff Gabrione, senior hedge fund researcher n the Chicago office of Mercer Investment Consulting.

The first six months of 2011 produced flat to moderately positive returns for most multistrategy and single-strategy managers with the HFRI Fund Weighted Composite index returning 0.76% year-to-date through June 30. But third-quarter returns were among the worst on record, as the HFRI index returned -5.5% for the three months.

Consistent with the market's wild gyrations since June, the HFRI Fund Weighted Composite index return was 2.43% in October, positive but badly trailing the 10.77% return of the Standard & Poor's 500 stock index.

Hedge fund investors in aggregate apparently tired of the volatility, and net investor outflows totaled $24.5 billion in the third quarter, according to Peter H. Laurelli, vice president of eVestment Alliance LLC, Marietta, Ga.

Mr. Laurelli added that early estimates indicate that October redemptions likely will outpace inflows for the second month in a row. He said it's impossible to gauge how much of the net outflows came from institutional investors.

But P&I's data showed institutional investors have been steadily moving money into hedge funds throughout 2011, allocating a net $17.4 billion in the first quarter; $5 billion in the second quarter; $8.3 billion in the third quarter; and $9.2 billion in the fourth quarter through Nov. 10.

In aggregate, institutional investors only removed $556 million from hedge funds as of Nov. 10 through reductions of individual manager allocations or terminations, according to P&I's data. The bulk of those redemptions were in the first half of the year, before turmoil and volatility overtook global markets.

Despite the overall net outflows in recent months, hedge fund and hedge funds-of-funds managers are predicting “normal” year-end outflows of about 5% of plan assets, Mercer's Mr. Gabrione said.

Some of this year's largest moves have been by first-time hedge fund investors.

Two — the $119.6 billion New York City Retirement Systems and the $7 billion Rhode Island Employees' Retirement System, Providence — have spent years educating their boards, but will have largely completed the investment of multibillion-dollar hedge fund portfolios in under a year, a feat largely unheard of a few years ago.

Three of the five New York City funds — the $41.4 billion New York City Employees Retirement System, $24.6 billion New York City Police Pension Fund, and $8 billion New York City Fire Department Pension Fund — invested a total of $450 million in hedge funds of funds managed by Permal Group in the first half of the year.

Larry Schloss, chief investment officer of the New York City Retirement Systems, and his staff have begun to invest about $4 billion directly in hedge funds on behalf of the three pension funds, confirmed spokesman Michael Loughran. Mr. Loughran declined to provide a timeframe for the direct investment program or details about the number of managers or hedge fund strategies sought by Mr. Schloss' team.

The Rhode Island State Investment Commission, Providence, which manages the state's public pension plan, likely will complete the investment of a new 15% allocation to hedge funds, about $1.1 billion in current dollars, in less than six months, Kenneth Goodreau, CIO, said in an interview.

Board members had been studying hedge fund investments for three years and “they were really ready when we started to present the hedge fund managers we wanted to hire,” he said.

Mr. Goodreau said the hedge funds are included within existing asset classes, rather than segregated into a hedge fund category. Of the 15% hedge fund allocation, 2% will be included in the fund's fixed-income portfolio, 5% in a real return portfolio and 8% in global equity. The goal for the hedge funds is to be a “diversifying complement” to the rest of the fund's portfolio, Mr. Goodreau said.

The fund plans to hire 18 hedge fund managers in groups of six, Mr. Goodreau said.

The first set of managers, approved at the commission's Sept. 28 meeting, were global equity managers Ascend Capital LLC, Davidson Kempner Capital Management LLC and Elliott Associates LP, which each received $60 million. Real-return managers Brevan Howard Asset Management LLP and Och-Ziff Capital Management Group LLC each received $75 million and D.E. Shaw Group was awarded $50 million.

At the Oct. 26 commission meeting, six more hedge fund managers were selected and likely will receive mandates of similar size to the first six firms, although the final amounts remain to be determined, Mr. Goodreau said. Those managers are credit manager Gracie Credit LP; global equity managers Mason Capital Management LLC, Samlyn Capital LLC and Viking Global Investors LP; and real return managers Winton Capital Management Ltd. and Capula Investment Management LLP.

The final six likely will be hired in December or January.

For more experienced institutional hedge fund investors, 2011 has been a year of “scaling” up their hedge fund portfolios, said Kent Custer, senior investment officer for equities of the $37.4 billion Illinois Teachers' Retirement System, Springfield.

As part of a 2012 tactical plan approved Oct. 28, the board increased direct investments to existing hedge fund managers Claren Road Asset Management LLC, BlueMountain Capital Management LLC and Carlson Capital LP by a total of $450 million, raising each manager's initial $50 million allocation to $200 million.

The New Jersey State Investment Council, Trenton, which manages the state's $66.4 billion in public pension assets, committed $1.6 billion directly in new hedge funds and additional contributions to existing funds this year through Nov. 10, bringing the fund's total hedge fund investments and commitments to about $4.7 billion. The council approved commitments of $785 million in October alone.

Texas County & District Retirement System, Austin, committed $400 million in new or follow-on investments directly in October alone, according to a transaction report on the $18.4 billion fund's website. The fund committed or invested a total of $1.3 billion in hedge funds in 2011 as of Nov. 10. Combined with previous investments in the asset class, that brings the system close to its 20% asset allocation target.