SWFs’ Hedge Fund Portfolios Top Peers — With Room to Grow

March 10, 2015 by Loch Adamson

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Sovereign wealth funds allocate just a sliver of their assets to hedge funds, according to a major new survey. That’s still enough make them big-time industry investors.

State-owned investors are stingy when doling out money to hedge funds, allocating far less on a percentage basis than public or private pensions. Even so, given their vast scale, the amount they do invest is sufficient to make their hedge fund portfolios bigger than those of any of their institutional peers on an absolute basis.

That seeming curiosity is one finding from Deutsche Bank’s Thirteenth Annual Alternative Investment Survey. The bank in December canvassed 435 global hedge fund allocators who together manage or advise $28.2 trillion in assets and $1.8 trillion in hedge fund assets.

According to the survey — which covers a range of investors from wealth managers to insurers to endowments — sovereign wealth funds allocate just 4 percent of their assets to hedge funds, a small part of the 17 percent of their portfolios earmarked for alternative investments in total. Public and private pensions, by contrast, each allocated nearly twice as much to hedge funds, 7 percent, and 26 and 14 percent, respectively, to the alternatives category overall.

That may have to do with their mandates and enduring bad publicity over both legal issues and recent lackluster absolute performance, according to Hossein Kazemi, a senior advisor to the Chartered Alternative Investment Analyst Association (CAIA Association), a non-profit educational group based in Amherst, Massachusetts and professor of finance at the Isenberg School of Management at the University of Massachusetts, Amherst. “Hedge funds still carry some negative associations,” he says.

“Scrambling”

Indeed, the survey reported that overall, 66 percent of respondents did not meet their targeted returns for 2014. Only 27 percent did so, while 7 percent exceeded them. The average performance target for the year was 8.1 percent and investors surveyed reported returns of just 5.3 percent. In 2013, respondents said their hedge funds bested their average performance target of 9.2 percent, albeit by a handful of basis points.

Still, sovereign wealth funds on average sink a huge amount into hedge funds on an absolute basis, more than any other class of institutional investor — fully $9.5 billion on average. That’s a function of the enormous scale of many state-owned investors. By contrast, the average institutional investor’s hedge fund portfolio was just $2.7 billion.

Hedge fund portfolios of endowments and foundations totalled just $1.3 billion on average. For private and public pensions the figures were $2.2 billion and $4.0 billion, respectively. Hedge fund portfolios of private banks and wealth managers averaged $4.2 billion and those of funds of funds and other asset managers totalled $4.4 billion on average.

Sovereign wealth funds lead their peers on another benchmark: They have the highest minimum assets under management (AUM) threshold for the hedge fund firms they invest in — $750 million, versus $525 million in last year’s survey. The average institutional investor’s minimum assets under management was $416 million, up sharply from $260 million last year.

“Only the largest funds have the platforms and back offices that the big institutions like sovereign wealth funds require,” says CAIA Association’s Kazemi. “The bulk of the money going into hedge funds is going to the top 10 to 15 funds. Everybody else is scrambling for the remainder.”

Higher Minimums

That said, the survey reports that a growing number of investors are abolishing minimum AUM requirements. “In our conversations with institutional investors, it appears that some of those with mature hedge fund portfolios are gradually loosening their minimum AUM requirements as they look to make smaller, satellite investments as a complement to their core managers,” the survey reports. “Often, these opportunistic investments are a way to access emerging managers or to capitalize on a particular theme.” Sovereign wealth funds have shown interest in a variety of investment trends, be it the growth of global luxury goods or clean energy.

Despite their big absolute investments in hedge funds, the average number of single managers hired by state-owned investors is just average for institutional investors, at 23. The average number of managers in a fund of funds portfolio, by contrast, is 43. Private pensions hire the fewest, at 19.

Not surprisingly given their size, state-owned investor make the largest initial investments in hedge funds, at $96 million. “That’s fairly high,” says Kazemi. “The bigger funds have higher minimums.” Indeed the $96 million figure is more than twice the initial investment of the average institutional investor, at $47 million. The investor class with the smallest initial investment are private banks and wealth managers, with tickets of just $15 million on average.

Sovereign wealth funds also had the highest target size for their hedge fund investments, at $175 million. The average institutional investor target was just $85 million.

Smart enough?

Overall, institutional investors have been seeking to put larger wads of money to work when they make a hedge fund investment. “The typical initial and target ticket size for a hedge fund investment continues to trend upward, largely driven by the continued influx of institutional capital and the move towards greater portfolio concentration,” the survey says. Initial investments grew to $47 million in 2015 for institutional investors from $37 million in 2013. Targets grew to $85 million from $62 million.

State-owned investors are invested in the biggest hedge fund firms of any investor class — the average for 2014 was $6.3 billion in assets versus $4.2 billion for the average institutional investor. The trend may be going in the other direction, however. Sovereign wealth funds expect the average size of the hedge fund firms they invest in to decline to $4 billion in 2015. The average institutional investor expects the average size of the hedge fund firms they invest in to fall to $2.3 billion. “Investors indicated that they would like to commit more capital to small- and mid-sized managers over the coming 12 months,” the survey noted.

When it comes to fees, sovereign wealth funds don’t seem to be making much progress keeping costs down, though penny pinching has become more prevalent in private equity. The state-owned investors’ average management fee for hedge funds was 1.61 percent and the average performance fee, 18.39. That compares to an institutional investor average of 1.57 percent for management fees and 17.71 percent for the performance fee, also known as carried interest.

That raises questions, given the size of state-owned investors. “You’d expect them to ask for lower fees in exchange for longer lock-ups,” says Kazemi. “Maybe they are not smart enough to ask. They may also be getting access to the better managers who won’t negotiate lower fees.”

Public pensions funds, perhaps, have had more success on that front. Their average management fee was just 1.45 percent and the carried interest 17.50 percent. The $299.6 billion California Public Employees’ Retirement System announced in September that it would stop investing in hedge funds because of their cost and complexity. Calpers had $4 billion invested in 30 hedge funds and funds of funds.

It may be time for sovereign wealth funds to put some of their own heft to work.


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