After several studies and industry discussions pointed to the benefit of a nimble hedge fund to invest in niche markets and move the needle, it seems institutional managers are getting the message.

According to J.P. Morgan’s Capital Introduction annual Investor Survey, institutional money managers “have moved down the assets under management (“AUM”) spectrum,” as a wide majority, 75 percent, expressed a willingness to invest in a hedge fund with $100 million or less.  But it wasn’t just crossing the magic $100 million line in assets under management that occurred. Institutional managers in the study expressed a willingness to consider managers with under one year in experience.

Although there has been some dispute over the issue, several studies over the past 5 years have advocated the prime spot for investing in hedge funds being under $1 billion. Institutional allocators were anecdotally reported to have increased interest in Hedge Funds from $100 million in assets under management to $1 billion most recently. The $100 million in assets under management line was considered by some as a key business threshold to invest in hedge funds. Hedge funds with under $100 million, on a statistical basis, often have difficulty generating enough fee revenue to cover the costs associated with operating and marketing a growing hedge fund. Thus, institutional managers investing in such funds was considered in some circles as excessive exposure to business risk – nothing to do with market-based risk, the typical primary focus of much investment decision.

Hedge funds: Lockups are gaining in acceptance

The study of 386 institutional investors who represented $800 million in assets under management, or 30 percent of total hedge fund assets, showed other significant shifts in topical issues.

The industry focus on liquidity continued, but now an overwhelming majority of institutional managers are willing to accept a lock-up period of one year or more and are open to co-investment opportunities.

Separate analysis indicates that some portfolios are built based on diversification of time frame liquidity because a pension fund or family office typically does not require 100 percent liquidity on their portfolio at any single moment in time. Sometimes institutional investors, when allocating capital to smaller hedge funds, negotiate terms from the fund manager that are unachievable with larger funds. Some of the smaller funds have been willing to give up business ownership in the fund itself along with a significant institutional allocation.

Study points to new hedge fund trends, expects hedge fund asset fund flows to slow

While further growth is anticipated, the study said that in 2015 fund flows could slow.  New capital allocations for 2015 are already down slightly compared to 2014, the report noted.  Fundamental Long Short Equity funds continue to be the most popular institutional strategy, with 90 percent of respondents are invested in, up 6 percent from last year.  Fixed Income Arbitrage saw the greatest growth year-over-year, the report noted, with 46 percent of respondents allocated towards the space in 2014, up 19 percent.

Where the money has been and where it is going appear to be different places.  The report noted that CTA/Managed Futures strategies “grabbed more and more attention in the fourth quarter, producing some of the highest returns in the industry in December, as well as for the year. Clear movement in oil prices and government bond yields, increasing natural gas prices, and a rising US Dollar proved beneficial to macro funds in the fourth quarter.” The report did not mention the Fed predicted return of volatility in its CTA analysis, but did note that “several (institutional investors) indicated plans for small increases to CTA/Managed Futures and Emerging Markets strategies entering 2015.”

JPMorgan Addresses Underperformance

The topic of hedge fund underperformance has been a significant issue, the one Goldman Sachs raised in a its recent hedge fund review. J.P. Morgan answers this question. Most respondents to the survey indicated the underperformance stemmed from too many hedge funds chasing limited opportunities to generate alpha as well as the inability to generate alpha on the short side of stocks were also contributing factors mentioned.  Separate analysis indicates that long / short strategies typically have a short ratio that is many times ¼ of the portfolio exposure relative to ¾ long exposure. Thus, in a bull market the ¼ short exposure can be significantly impaired by the stock positive beta market environment.

Other study points included the fact that most institutional managers (80 percent) are not allocating towards “smart beta” investment products and fewer plan on doing so. When the do invest in the products, banks and consultants are leaders at such allocations.