Institutional Demand for Hedge Funds: A Global Perspective US$360 Billion Today, US$1 Trillion by 2010?
The Bank of New York
This 2006 survey was conducted through more than 100 in-depth interviews with institutional investors, investment consultants, hedge funds, funds of hedge funds and industry experts worldwide. It follows the similarly successful survey conducted in 2004, both undertaken in conjunction with Casey, Quirk & Associates.
We found that hedge funds are here to stay as a growing component in global institutional portfolios. Institutional investors report widespread satisfaction with their hedge fund and fund of hedge fund programmes to date, with only 3% reporting programmes that underperformed expectations. So far, these programmes are succeeding in meeting the typical institutional objective: a consistent 8-9% net return with “bond-like” volatility. We estimate that global institutional capital in hedge funds will grow from approximately US$360 billion today to more than US$1 trillion in 2010. Retirement plans are now jumping in with both feet and will represent 65% of total institutional flows through 2010.
The Drivers of Institutional Demand
Five years ago, the hedge fund market was dominated by wealthy individuals and a handful of institutions. Today, more than 40% of hedge fund flows are institutional; by 2010, we expect the institutional share of flow to top 60%. We see two major factors driving this shift:
Current low return environment
Growing acceptance of alternative investments
Global Institutional Demand Today
Hedge funds’ role in institutional portfolios
Investors in all countries and across all institutions were consistent in their rationale for hedge fund investing. They are seeking diversification – a low correlation with other portfolio assets – and absolute returns – a yield in the range of 8-10% with volatility comparable to that of bonds.
Key institutional selection criteria
The most important selection criterion identified by institutional hedge fund investors, outranking even the performance record, was understanding and validating the sources and sustainability of an investment manager’s returns. This is critical for investors seeking to implement portable alpha programmes, as they must ensure that the alpha basket has nearly no correlation to the beta in the programme. Performance record ranks as the second most important criterion, followed by quality of personnel.
Current satisfaction levels
To date, global institutional investors report a high level of satisfaction with their hedge fund programs. 72% report performance within 1% of target expectations, and 25% report performance exceeding their return target by 1% or more.
Institutional Hedge Fund Programme Returns Expected vs Actual
Investors are Satisfied with Returns
Within 1% of Target
Exceeded Target by 1% to 5%
Exceeded Target by at least 5%
Source: The Bank of New York and Casey, Quirk & Associates analysis 2006
Looking Ahead: The Industry in 2010
Institutional assets in hedge funds
We estimate that global institutional investment in hedge funds will exceed US$1 trillion by 2010, up from approximately US$360 billion today. Cumulative institutional flow will be about US$510 billion from 2006 through 2010. Institutions will account for more than 40% of hedge fund assets by 2010, up from approximately 30% today. The median allocation of our survey participants currently invested in hedge funds is set to rise from 6% to 10% by 2008.
Projected growth will come from around the globe.
Projected Cumulative Institutional Hedge Fund Flows by Region 2006 – 2010
The role of funds-of-hedge funds: the “dual approach” model emerges
The vast majority of participants in our survey (87%) currently use either funds of hedge funds (FoHF) exclusively or the “dual approach” – a combination of FoHF and direct investments.
The industry in 2010: five forecasts
We expect the industry to reflect five changes by 2010:
Today’s hedge fund techniques will be tomorrow’s mainstream investing. Specifically, absolute returns/alpha delivery will emerge as the primary investing strategy.
Synthetic/passive exposures to hedge fund strategies emerge. Many institutions have remained lukewarm to portable alpha strategies because they balk at the high fee structures.
Fees are more highly correlated to value. We forecast that management fees will settle around 1%, performance fees will be explicitly tied to alpha, and FoHF fees will settle in the flat 50-80 bps range.
Institutional quality competitors dominate. By 2010, we forecast that nimble boutiques will continue to flourish, but the industry will be dominated by a group of leading active/hedge fund investment managers. The same holds true for FoHF.
Customisation proliferates. As institutions’ understanding of specific risks in their overall portfolios increases, the desire for targeted exposures grows.
The Industry’s Biggest Challenge
Factors such as scandal and regulation could slow predicted growth, though we would expect the impact to be marginal. The single factor that would materially change our growth expectations would be sustained, broad underperformance of institutional investors’ net return requirements.
Institutions are rapidly transitioning away from bull market-oriented portfolios and toward portfolios designed to deliver on specific net return requirements with specific risk exposures. The capabilities required to facilitate this transition are just being built today: the competitive landscape remains wide open. The leading investment managers of 2010 will employ bold thinking to create business models that meet the needs of the next generation of institutional investors.
The Bank of New York will host three events across Asia to present the findings of this survey.
Marina W. Lewin, Managing Director, The Bank of New York Alternative Investment Services will provide an insightful review of the results to audiences in:
Singapore - 28 February 2007 Hong Kong - 2 March 2007 Tokyo, Japan - 7 March 2007
For hard copies of the research paper published by The Bank of New York and Casey, Quirk & Associates entitled: “Institutional Demand for Hedge Funds 2: A Global Perspective”, please contact: