Few institutions are considering abandoning their
commitment to a broad diversification of assets as
the best way to manage their funds.
procedures. In addition, many of the biggest pension funds in the
United States are presenting their managers with take-it-or-leave-it
demands for separately managed accounts over which they can
exert greater risk control.
than abandoning their overall investment approaches, institutions
told Greenwich Associates that they would continue to stick with
strategies they were in the process of implementing prior to the crisis.
Among the institutions that reported they were making significant
changes to their asset mixes last year, 28% were reducing allocations
to active U.S. equities, 30% were increasing allocations to private
equity, a quarter were upping their allocation to hedge funds and
20% were boosting allocations to real estate. These numbers are
consistent with recent years’ trends. Only 3-4% of institutions were
reducing allocations to any of these alternative asset classes and only
4% were increasing allocations to active U.S. equities.
As is so often the case, however, the broader story behind these
headlines is less dramatic. While the vast majority of hedge funds
fell short when it came to their implied mandate of protecting capital
in 2008, as a whole, they outperformed long-only indices by a
wide margin. More specifically, research by Greenwich Associates
reveals that the typical institutional investment manager experienced
a 31% reduction in portfolio asset values in 2008. By comparison,
the Credit Suisse/Tremont Hedge Fund Index was down 19.07% in
2008—a result in line with other estimates of overall industry performance for the year. Meanwhile, the S&P 500 Index ended down
more than 38% on the year and financials in that group ended 2008
down a staggering 58%.
Nowhere is the demand for greater transparency higher than with
respect to hedge funds, which are also coming under fee pressure,
particularly fund-of-fund structures. Providers of these investments
claim to deliver superior manager selection, risk management, and
ongoing due diligence/monitoring, as well as the ability to access
best-in-class managers. However, the performance of some funds-of-funds in 2008 has called into question whether the actual benefits
delivered on these counts warrant the significant layer of additional
fees imposed. Indeed, some investors have concluded that the
structure erects an additional curtain hiding risks they only learned
about the hard way.
Few institutions are considering abandoning their commitment to
a broad diversification of assets as the best way to manage their
funds. There appears to be little desire—at least in the current
environment—to rein in risk by retreating wholesale to government
bonds with the lower returns that would imply. Institutions are keeping
their prior strategies in place and—after accounting for market effect
and portfolio rebalancing—institutional asset allocations in 2009
should be driven by many of the same trends seen in recent years,
namely, the desire to reduce exposure to domestic equities and
diversify assets into international investments and alternatives.
Perhaps as a result, three quarters of the institutional investors
participating in a Greenwich Associates survey in November said
they had not altered their hedge fund investments as a result of the
crisis and 85% said they planned to maintain or increase their hedge
fund allocation targets. Discussions with investment consultants and
other market participants confirm that this level of commitment has
not wavered in 2009.
Institutions are reassessing the value of liquidity. Prior to
last year’s market collapse, most institutional investors viewed
cash holdings as a drag on long-term performance that should be
minimized to the greatest possible extent. Historically, money market
funds and other “cash” investments have made up a tiny portion
of institutional portfolios, averaging in the neighborhood of 0.5%
of assets. Look for those allocations to increase substantially after
a year in which a severe plunge in asset values demonstrated the
importance of liquidity in preventing institutions from having to sell
undervalued assets into falling markets.
Of course, some institutional investment practices will change. Two
important shifts are under way:
Institutions are not giving up on hedge funds.
2008 was a punishing year for hedge fund managers, and the
resulting shakeout has shrunk the industry by at least 35% in terms
of assets under management and at least 8% so far in terms of
number of active funds, according to one industry report. For more
than six months, hedge fund troubles have been front-page news,
featuring stories of investment losses, redemptions, suspensions,
liquidation, and, of course, Mr. Madoff. More recently, The New York
Times and other national publications have turned their attention to
allegations of a pay-to-play scandal connected to state pension fund
investments in hedge funds.
Institutions are pressing for greater transparency. Across
the board, institutions are demanding increased transparency in
connection with intense focus on their own internal risk management
So, the permanent changes we expect to emerge from the crisis
of 2008 are greater appreciation for liquidity, increased demand
for transparency, and keener attention to risk in all its forms. We
also anticipate lower fees for hedge funds, particularly in fund-of-funds structures. Yet, the most interesting legacy of this historic
crisis might not be the changes that unfold in institutional investing
practices, but how much stays the same. n
Christopher McNickle, CFA, Greenwich Associates managing director, consults with investment
management clients in the United States and Europe. Chris rejoined Greenwich Associates in 2002 after
having worked at the firm from 1989 to 1994. In the interim, he was a vice president at J.P. Morgan and
a senior vice president at Prudential Retirement Services. Chris received his BA magna cum laude in
economics from the University of Pennsylvania and a PhD in U.S. history from the University of Chicago.
He is a member of the CFA Institute and the New York Society of Security Analysts.