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8
I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
Modern Portfolio Theory (MPT) and the Capital Asset Pricing
Model (CAPM) prompted institutional investors to pursue both
alpha and beta returns from a single set of active portfolio
managers investing across a broad market exposure from
the 1960s through to the mid-1990s. Eugene Fama from
the University of Chicago and Kenneth French from Yale
University published new financial theory that resulted in a
major shift in portfolio configuration by the early 2000s. This
new multi-factor model transformed institutional portfolio
leading investors to split their portfolio into distinct sections
– one portion seeking beta returns via passive investable
index and ETF products built around specific style boxes, and
another looking for alpha returns or positive tracking error
from active managers with more discrete mandates that could
be measure against clearly defined benchmarks.
Views on how to best ensure alpha returns evolved again by
2002 after Yale University and other leading endowments
were able to significantly outperform traditional 60%
equity/40% bond portfolios during the Technology Bubble
by incorporating hedge funds and other diversified alpha
streams into their portfolios, thus benefiting from an illiquidity
premium and improving their overall risk-adjusted returns.
Please the appendix for a more thorough discussion of these
theories and how investor portfolios were configured prior to
the 2000-2003 time period. This section will now pick up with
the impact of those changes.
Institutional Investors Shift Assets Into
Hedge Fund Investments
The market correction in 2002 and the outperformance of
more progressive E and Fs in that period can be viewed as
a tipping point for the hedge fund industry. A second shift
in beliefs about their core portfolio theory occurred across
many leading institutions.
Just as they did when Fama’s and French’s theory caused
them to divert a portion of their actively managed long
funds to passive investments, new allocation concepts
about diversifying alpha streams caused many institutional
investors to shift additional capital away from actively
managed long-only funds and significantly increase their
flows to hedge funds.
Section I: Hedge Funds Become a Part of Institutional Portfolios
Institutional interest in hedge fund investing is a relatively new occurrence, with the majority of flows from this
audience entering the industry only since 2003. The impetus for these institutions to include hedge funds in
their portfolios was two-fold. Views on how to optimally obtain beta exposure in their portfolio shifted, causing
institutions to separate their alpha and beta investments, and market leaders demonstrated the value of having
diversified alpha streams outside of traditional equity and bond portfolios.
-400
-200
0
200
400
600
800
1000
1200
Billions of Dollars
2004-2007
$1,028B
2008-2009
-$248B
2010-2011
$179B
1995-2003
$463B
Chart 9
Chart 1: Institutional Investor Flows of Money
into Hedge Funds (Asset Flows Only—Does Not
Include Performance)
Source: Citi Prime Finance Analysis based on HFR data 1995-2003;
eVestment HFN data 2003-2012