Despite recent high-profile exits from hedge funds and alternative investments, public pension funds are expected to be the main driver of growth in the alternatives space going forward. The combination of high interest and controversy around hedge funds and their managers has fueled the misperception of the role of a hedge fund allocation in an investor's portfolio.
As institutional investors' footprint in hedge funds has grown dramatically over the past several years, many of these investors might need to reassess and educate themselves on how hedge funds as a whole fit into their portfolio vs. their investment goals. We believe the drive into hedge funds by institutions has been prompted by their desire for diversification, bond-like volatility and low correlation to traditional long-only assets. Now, when a majority of institutions are either underfunded or stretching to meet their annual spending needs, the ability to generate bond-like consistent rates of return, lower volatility returns from equities and absolute returns to meet their financial obligations would be optimal.
To accomplish this, investors should seek out those strategies that employ conservative gross and modest net exposures, moderate levels of leverage and have proper diversification in regards to percent of assets within a particular asset class, industry group, and individual positions. Hedge funds that typically have these characteristics are long/short market-neutral equity and multistrategy funds. Institutional investors seeking higher returns, such as competing with and outperforming the Standard & Poor's 500 index, should gravitate toward funds that can run with high gross and net exposures, will take directional positions and can employ various levels of leverage. Strategies fitting this model include long/short equity hedge, distressed/high yield debt and macro/CTA and are described in our strategy universe as return-generating.