Hedge Funds Prepare for Institution's Second Wind

GREENWICH, Conn. (HedgeWorld.com)--The latest Greenwich Associates research highlights what pension fund trustees could learn from endowment funds that paved the way for institutional hedge fund investing.

These researchers said pension funds won't remain satisfied with their existing fund of hedge fund portfolios for long. They will likely begin to move more into single-strategy and multi-strategy portfolios offered by single managers in the near future.

Endowment funds were undoubtedly at the forefront of hedge fund investing in the United States. Much of that effort began at Harvard University's endowment, which has seen its staff launch hedge fund firms of their own in recent years. Smaller colleges and universities followed Harvard's lead and invested heavily in hedge funds, along with endowments at the University of North Carolina-Chapel Hill, Smith College and others.

These endowments were the first institutional investment wave, and pension funds are going to dominate the second stage of the movement in the coming years, according to the Greenwich Associates researchers.

"Luckily, there is an invaluable source to which they can turn for guidance in this process--the endowment example," said Rodger Smith, a Greenwich Associates consultant, in a statement.

Today, of the $113 billion in hedge fund investments among U.S. institutional investors, $69 billion belongs to endowments, whereas $40 billion comes from U.S. corporate and public pension plans combined.

While the average U.S. pension fund sets aside less than 1% of its assets for hedge fund investments, endowments have generously invested 12.3% of their portfolios on average in order to gain the true benefits of diversification, according to Greenwich officials.

As endowments matured they too adopted funds of funds, according to Greenwich Associates. But as those portfolios grew, more endowments started to diversify their hedge fund holdings and moved toward direct single-strategy investing.

In its survey of 164 endowments, Greenwich Associates found that large endowments invest roughly 18.8% of their investment portfolio in hedge funds. Those endowments under the $1 billion mark still set aside more than 15%, according to the report, Institutional Investments in Hedge Funds: Lessons from the Endowment Experience.

Funds of funds serve as an important gateway for smaller endowment funds, as they currently do for most pension plans. This is due to the significant time and resource requirements for hedge fund due diligence, Greenwich Associates officials wrote. Consultants at the firm are adamant, though, that investors should dedicate 5% or more of their portfolio to hedge funds or not bother investing at all, just because of the resources required.

As endowments reach the double-digit percentage threshold in their hedge fund mandates, more of them are allocating to single-strategy and multi-manager portfolios in order to save on investment fees associated with funds of funds. More than half of all endowment funds surveyed by Greenwich Associates (53%) gave money to single-strategy, single manager funds.

The increasing scale of these new monies is prompting more single hedge fund managers to turn themselves into "institutional" organizations, Greenwich Associates found. Some have theorized that the institutional movement spawned investment adviser registrations in advance of the Securities and Exchange Commission's new hedge fund rule.

Greenwich Associates' William Wechsler said he believes that the new money is part of a transformation in asset management that will mean some of today's hedge fund firms will become the large financial institutions of tomorrow. This would be a cultural shift from the rise of traditional financial firms born in the corporate banking business.

As larger pension plan players begin to augment their fund of hedge funds portfolios with single-strategy funds, as has already been evidenced in other pension consulting research, capacity will undoubtedly become an issue. The only cure for hedge funds, Greenwich Associates says, will be for hedge fund managers to add strategies to their lineups; upgrade technology; improve risk-controls, transparency and compliance measures; and "professionalize" their business overall.

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.

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