European institutions — led by the U.K. — are expected to raise or change their hedge fund allocations in a bid to improve funding levels while better controlling portfolio volatility, industry observers say.
Hedge fund allocations among pension funds in the U.K. — Europe's largest pension market by the amount of defined benefit assets and its largest hedge fund market by investment assets — could as much as double in the next several years, sources said. In 2011 alone, the average pension fund allocation to hedge funds jumped to 4.1% — or about £33 billion ($52 billion) — from 2.6%, according to data from the National Association of Pension Funds.
Consultants such as Aon Hewitt are recommending that some pension funds could make an allocation to hedge funds of 30% or more within the return-seeking portfolio, depending on the risk/return target of the fund, said Guy Saintfiet, U.K. head of liquid alternatives at Aon Hewitt, based in London.
Estimates are not available for the overall expected growth rate of hedge fund investment flows for Europe.
Furthermore, institutions are also altering hedge fund strategies to reduce correlation, illiquidity and beta exposures.
The e246 billion ($322 billion) Stichting Pensioenfonds ABP, Heerlen, Netherlands, reshaped its hedge fund portfolio in 2011 to target more precise alpha. APG Asset Management, which is the fiduciary manager for ABP, added opportunistic hedge fund strategies “in the distressed area and certain types of arbitrage in the insurance sector” in the past year, said Ronald Wuijster, Amsterdam-based chief client officer and managing director of strategic portfolio advice for the firm, which has about e275 billion in total assets under management.
Others strategies, including some in market-neutral that contained too much beta exposures, were dropped by APG. Hedge funds should be “only aiming for alpha,” Mr. Wuijster said. “We have almost no beta exposure in there.”
In 2011, ABP's hedge fund portfolio returned 6.1%, compared to -5.13% for the HFRI Fund Weighted Composite index. ABP allocated about 4.4% of the total portfolio to hedge funds during the same period.
In the Netherlands, U.K. and elsewhere in Europe, regulatory pressures on solvency levels are pushing institutional investors to seek hedge fund strategies that target more consistent “bond-like” returns, rather than high-octane alpha, sources said.
“Investors are attracted to hedged strategies, and part of that is using hedge funds to reduce risk,” said Stephen Oxley, London-based partner and managing director at Pacific Alternative Asset Management Co., which managed $8.2 billion in global hedge fund assets.
Because of the historic low interest-rate environment, more investors are seeking to add “hedge funds that have similar volatility to bonds with less interest rate risk,” Mr. Oxley said. Others are using highly liquid, less directional hedge fund strategies within a liability-driven investing framework so that “if bond yields move in either direction, you have some protection.”
While the majority of institutions still place all hedge fund assets into one bucket within the alternatives portfolio, some are beginning to view allocations differently as a way to improve performance and lower volatility, said Mr. Saintfiet of Aon Hewitt, whose firm advises on about $30 billion in hedge fund assets globally. “Certain investors no longer see hedge funds as a separate asset class, but as a way of managing risk within asset classes,” he said.
For example, they might add credit hedge fund managers to the credit portfolio, move hedge funds that invest in high-yield debt into the fixed-income category and shift a portion of the equity portfolio into a long/short strategy or even a global macro hedge fund to diversify risk, several sources said.
“Investors are using hedge funds in a more pointed way than ever before,” said Morten Spenner, CEO of International Asset Management, a hedge-fund-of-funds firm based in London. “They're more specific in terms of the exposure they want and how it will fit into the overall portfolio.”