Preqin estimates that institutional investors allocate $2tn in hedge funds, approximately 58% of all capital invested in the industry today. In capital terms, this is the highest level Preqin has recorded; however, the level has fallen proportionally in recent years as institutional inflows have slowed in a period of growing appetite from private sources of wealth and retail clients. Nevertheless, gaining interest from institutional investors, with their long-term investment horizons and “sticky” capital, can be vital to the long-term development of a hedge fund business. However, under the umbrella of “institutional investor” falls many different types of institutions with different sets of challenges and portfolio needs that hedge funds help to solve. Therefore, gaining insight into the differences between types of investor – both on a macro level and an individual basis – is an important step towards securing capital from these investors. In this article we examine these allocators in more detail, based on data taken from Preqin’s online database, to help you understand the needs of institutions in 2018 and really “Know Your Investor”.
Public Pension Funds
473 public pension funds invest in hedge funds globally. 51% of public pension funds actively invest in hedge funds.
Public pension funds have become prominent investors in hedge funds over the past decade and their actions and activity in the asset class has shaped the industry we see today. There has been much focus on these investors in recent years following the cuts made to hedge fund investments by CalPERS and a handful of other high-profile pension funds. However, the “will they – won’t they?” debate around the wider mass exit of public retirement funds from investment in hedge funds is landing firmly on the side of public pension funds remaining committed to hedge fund investment long-term. Today we see more public pension funds investing in hedge funds than ever before, collectively investing the largest sum of capital recorded by Preqin from this group. Much of the increase in capital coming from public pension funds continues to be driven by new funds making their first investments in the asset class, particularly as new regions open up to the possibility of hedge fund investment. Recent relaxation of regulations in South Korea, for instance, has led to investors such as National Pension Service making their first investments; others in the country, such as Yellow Umbrella Mutual Aid Fund, have also begun to consider investment for the first time.
Although the average allocation to hedge funds by public pension funds has remained stable since 2016 (at 7.9%, Fig. 4), we have noted broader changes to their investment portfolios. Public pension funds continue to move away from a complete fund of hedge funds approach to a combined direct and multi-manager portfolio. In 2016, 49% of public pension funds invested solely in funds of hedge funds, and 28% in both funds of hedge funds and directly; in 2017 this changed to 47% and 31% respectively (Fig. 5).
Private Sector Pension Funds
766 private sector pension funds invest in hedge funds globally. 50% of private sector pension funds actively invest in hedge funds.
Private sector pension funds account for 18% of all capital invested in hedge funds by institutional investors, making them the second leading institutional capital source next to their public sector equivalents (Fig. 2). However, unlike public pension funds, their average allocation to hedge funds has fallen over the past 12 months. As at December 2017, private sector pension funds invest an average of 11.0% of their portfolios in hedge funds, compared to 11.3% in December 2016. In fact, this is the first time that Preqin has noted a decrease in the average allocation of private sector pension funds since we began tracking this data in 2007.
Although there has been a slight reduction in the average allocation of private sector pension funds, we have not seen any changes to the average make-up of their portfolios in relation to the types of products they use. The largest proportion (38%) of private sector pension funds allocate to hedge funds via both direct investment and funds of hedge funds (Fig. 5). The remaining private sector pension funds are split almost evenly in their approach to hedge fund investment between funds of hedge funds only (32%) and solely direct investment (30%). In comparison to public pension funds, private sector pension funds invest more capital directly in hedge funds; correspondingly, they also seek higher returns. On average, a private sector pension fund seeks returns of 6.5%; in contrast, public pension funds look for hedge funds to return 5.6% on an annualized basis per annum.
Sovereign Wealth Funds
25 sovereign wealth funds invest in hedge funds globally. 34% of sovereign wealth funds actively invest in hedge funds.
Small in number, but mighty in influence, sovereign wealth funds are a vital part of the institutional investor landscape in the hedge fund industry. This group of 25 represents 10% of all institutional capital invested in hedge funds, an amount equal to endowment plans, of which there are over 30x more in number investing in hedge funds.
Investment in hedge funds among sovereign wealth funds is relatively uncommon, with just over one-third allocating capital to the asset class. In comparison, 63% of sovereign wealth funds invest in infrastructure and real estate. Given the size of the sovereign wealth fund sector, even a small number of these making their first investments in or increasing their allocations to hedge funds would amount to a notable increase in capital available to fund
Sovereign wealth funds have, on average, increased their portfolio exposure over the course of 2017. As at December 2017, the average sovereign wealth fund invests 8.2% of its assets in hedge funds compared to 7.0% at the same time in 2016.
The average sovereign wealth fund has been investing in the asset class for 13 years; however, given the size of sovereign wealth funds and the complexity of their portfolios, the majority of this group prefer to outsource at least some of the fund selection duties to funds of hedge funds. Sixty-five percent will consider both funds of funds and direct investments, while 10% invest solely in funds of hedge funds. However, we have seen a growing number of sovereign wealth funds access the asset class solely through direct investment: in 2016, 19% of sovereign funds allocated solely through single-manager funds. In 2017, this fell to 25%.
599 endowment plans invest in hedge funds globally. 83% of sovereign wealth funds actively invest in hedge funds.
Endowment plans were among the earliest adopters of hedge funds as part of a diversified portfolio, and have led the way in multi-asset-class investing. Today, 83% of endowment plans tracked by Preqin allocate capital to hedge funds; this group accounts for 10% of the institutional capital invested in hedge funds. It is largely schemes linked to US institutions that make-up the endowment universe today: 93% of active endowment plans are based in the US. It is these US schemes – notably institutions like Harvard and Yale – that have paved the way through their large-scale use of alternative assets for other institutional investors to begin allocating capital to hedge funds.
Endowment plans have amassed a sizeable exposure to hedge funds, with an average of 19.2% of total assets invested in hedge funds as at December 2017, a small increase from 19.0% at the same time in 2016. In fact, this group has typically invested between 18.5% and 20.0% of their portfolios in hedge funds since 2008, and have therefore rebalanced their portfolios over 2017, on average, in favour of a higher preferred exposure. As seasoned investors in the hedge fund space, with larger portions of their portfolios dedicated to investment in the asset class, a larger proportion of this group favour direct investment in funds compared to other types of institutional investors (Fig. 5).
955 foundations invest in hedge funds globally. 66% of foundations actively invest in hedge funds.
Nearly two-thirds of foundations allocate capital to the hedge fund space. This group accounts for 18% of investors in hedge funds by number (Fig. 1); however, in comparison, they represent only 10% of the institutional capital invested in the asset class (Fig. 2). Although their relative contribution in monetary terms is smaller than their prominence in number, foundations have been growing their average exposure to hedge funds over the last several years, from 15.6% of total assets in 2013 to 18.9% in 2017, an allocation lower only than endowment plans’ (Fig. 4).
Foundations represent a variety of institutions that use hedge funds to help protect assets for many different pursuits, including funding scientific research, providing health services or funding religious or charitable endeavours. Each foundation will have its own needs from hedge funds driven by their own particular aims and requirements for their portfolio. As a result, foundations are split in their approach to investment in hedge funds. The most favoured (by 40% of investors) route to hedge fund exposure is through a combination of funds of hedge funds and direct investments (Fig. 5). However, 35% and 25% will invest just directly in hedge funds or solely in funds of hedge funds respectively.
185 insurance companies invest in hedge funds globally. 29% of insurance companies actively invest in hedge funds.
Insurance companies allocate the smallest proportion of their portfolios to hedge funds of all institutional investor groups discussed in this article. However, this has increased significantly over 2017: as at December 2016, the average insurance company invested 3.0% of its assets in hedge funds – this has grown to 3.6% as at December 2017. This is the greatest exposure we have recorded since 2011, when insurance companies invested an average of 3.8% of their AUM in the asset class. In addition to being relatively smaller investors, insurance companies also have a lower rate of participation in hedge funds compared to many other groups of institutional investors: just 29% of insurance companies tracked by Preqin have current investments in hedge funds.
Even though insurance companies have relatively small allocations to hedge funds, in terms of the proportion of total assets invested in the sector, this can translate to relatively large amounts in capital terms. Insurance companies represent 4% of all institutional investors active in hedge funds by number (Fig. 1), and 7% by capital (Fig. 2).
Hedge funds have become an important part of the portfolio for many institutional investors. Currently, more than 5,200 institutions allocate capital to the asset class, a number we have seen grow significantly over the past decade, as investors sought out hedge funds following the GFC in an extended low interest rate environment. Today, the hedge fund industry has more than $3.5tn in AUM, and allocations from institutional investors combined represent 58% of these assets. Therefore, the influx of capital from institutions – such as pension funds, sovereign wealth funds, endowment plans, foundations and insurance companies – has been instrumental in shaping the industry we see today. And the industry will continue to evolve as this influential group of institutions grows, both in terms of the size of their portfolios as well as in investment sophistication. For instance, we see the increasing appetite for new strategies and changing needs leading to innovations in the hedge fund space, resulting in products such as alternative risk premia gaining attention.
There are clear differences in the appetite for hedge funds between the groups of investors tracked by Preqin – as our analysis shows. In addition to this, each of the investors tracked by Preqin will have its own individual needs and requirements. Therefore. with institutions’ needs continuing to change and appetite for the asset class returning, it is more important than ever for fund managers to truly know their investors.