Hedge Funds see a Return of the Institutional Investor

Hedge funds have seen a significant change in their investor base in the last year as wealthy individual investors exit the asset class, according to a recent Reuters article, no longer seeing the same return potential in the lower risk strategies being executed by hedge funds today. The industry is beginning a transition back to its roots in many ways, focusing on providing an alternative asset class that provides consistent returns but is not linked to equity or fixed income indexes. Who is the big buyer of these kinds of investments? Institutional investors such as pension plans and endowment funds that are seeking out higher returns than fixed income can currently offer, while still providing a low beta to traditional equity indexes.

For many hedge funds, the big investments sizes and longer term commitments of institutional investors are hard to pass up. Overhead and transaction costs are lower as well when dealing with large investment block sizes, which reduces costs for the fund, often pocketing some of the savings.

Growth of the Industry Driven by Institutional Demand

The hedge fund industry has grown rapidly in the past two decades, from a mere $200 billion in the mid-nineties to the $2 trillion industry that exists today. This massive growth required significant institutional money, and the industry will require continuing support of big pension funds to maintain their current assets under management.

Initially, hedge funds were largely an asset class used by institutional investors to diversify their holdings and earn consistent returns using sometimes unconventional strategies. During the several year run up in equity markets, leading to the 2007 pullback, hedge funds began taking larger risks to ensure their returns were competitive with highly attractive equity indexes. Funds did this through the addition of leverage, through either traditional margin transactions or through the use of derivatives to enhance returns. Institutional investors enjoyed the higher returns, but were sharply bitten when markets retreated and hedge funds were hit hard. At that point, there was somewhat of a retraction of some institutional money from the hedge fund space. The industry focused on high return strategies for the following years as they attempted to beat the equity indexes for the redemption needed to retain their clients. Some funds were successful, but many funds continued to lag indexes or experienced undesirably high volatility. A change in focus was required.

The institutional investor’s reluctance to invest in hedge following the crash began to wane along with the decline in fixed income yields. Bonds provided an important diversification tool for portfolio managers, but historically low yields made it difficult for fund managers to meet performance benchmarks. Some institutional fund managers began to look to the hedge fund industry to provide products that offered consistent returns, without being overly correlated with equity indexes. This was really a call to return to the roots of hedge fund investing.

Does This Have Implications for Job Seekers?

The hedge fund industry has been surprisingly resilient over what is turning out to be a tumultuous decade. While hedge funds are currently looking to reduce costs where possible through eliminating overhead and some trading activities, the industry does remain more steady than, for example, IPO investment banking. The hedge fund industry’s shift back to its roots does demand a different skill set than the high risk trades that we saw in the years following the turn of the millennium. The industry now is focusing more on traditional portfolio and risk management techniques, rather than elaborate trading strategies. This certainly opens a door for individuals with experience in these areas, as many funds don’t have great bench strength in what were under-utilized niches of the investment profession.

The outlook in the industry remains mixed. If historically low bond prices remain, hedge funds are likely to see increased investment from institutional investors desperate to squeeze additional return from their portfolios. At the same time, regulation and overall concerns about the economy weigh on funds. Those seeking employment in the sector should have a high level of relevant experience, and they will need to be extremely opportunistic to seize the more desirable opportunities.

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