Hedge funds to see strong institutional inflows, good for ILS funds

Institutional investors perception of hedge funds appears to be maturing, according to research from investment bank Deutsche Bank, with investors increasingly appreciating hedge funds as just one piece of a portfolio approach to asset management.

Hedge funds have historically been seen as an almost separate asset class by mainstream institutional investors, who have often found it hard to come to terms with alternative investment strategies and how they fit within a broader portfolio. Of course insurance-linked securities funds, including catastrophe bond funds and reinsurance-linked strategies, fit squarely within this segment of the asset management space.

The results of a survey published by Deutsche Bank today suggest that institutional investors view of hedge funds is maturing and that increasingly investors are getting to grips with including allocations to hedge funds and other alternative investment funds within their broader portfolio strategy.

Deutsche Bank’s twelfth annual Alternative Investment Survey saw over 400 investor entities participating, representing more than $1.8 trillion of hedge fund assets and over two-thirds of the entire market in terms of assets under management.

Strong growth for the hedge fund sector is expected through 2014, with institutional investors expected to increase their allocations to hedge funds as they find better ways to slot alternative investments into their broader portfolios.

Hedge funds are forecast to grow the assets of the sector to $3 trillion by the end of 2014, up from the $2.6 trillion they ended 2013 with. This is a combination of $171 billion net inflows and performance-related gains of 7.3% (representing $191 billion), according to investors forecasts for the year.

A slice of this growth in hedge fund AuM will be destined for the ILS and reinsurance linked investments sector. Growth in hedge fund allocations can only help the growing ILS, catastrophe bond and reinsurance investments space to increase its profile among the wider institutional market, as they come under the scrutiny of an ever broader set of potential investors.

Deutsche Bank’s survey results showed that institutional investors have been increasing their allocations to hedge funds steadily, with over half of investors polled increasing allocations in 2013 and 57% saying that they intend to up their allocations to hedge funds in 2014.

That also bodes well for ILS funds and reinsurance linked investments as these investors will be looking for diversification within their allocations to hedge funds and ILS certainly stacks up on that measure. In fact, as institutional investors increase their focus on hedge funds ILS and reinsurance may stand out due to the low correlation with broader financial markets and indicators. The diversification that an allocation to ILS and reinsurance can offer within the hedge fund component of a large institutional portfolio is likely to stand out to these investors and their advisors.

Institutional investors now make up two-thirds of the hedge fund industries assets, compared to around one-third before the financial market crisis. This shows that institutional investors are not just more comfortable with allocating to alternative asset classes and hedge funds they are happy with the returns and performance provided as well.

Barry Bausano, Co-head of Global Prime Finance at Deutsche Bank, commented; “Hedge funds continue to establish their growing position within the broader asset management industry, alongside some of the more mainstream asset managers. The hedge fund industry is predicted to reach a record $3 trillion by 2014 year end driven by significant inflows, most notably from institutional investors.”

Anita Nemes, Global Head of the Hedge Fund Capital Group at Deutsche Bank, added; “With the majority of investors happy with hedge fund performance, we expect institutional investors to further strengthen their commitment to hedge funds. Last year’s respondents targeted 9.2% for their hedge fund portfolios, and hedge funds delivered – the weighted average return for respondents’ hedge fund portfolios this year was 9.3%. Looking forward, respondents are targeting 9.4% for 2014.”

The survey shows that 80% of respondents felt that hedge funds performed as expected or better in 2013. Interestingly, the return targets of these investors fit well for the ILS and reinsurance asset class, with 63% of respondents, and 79% of institutional investors, saying that they are targeting returns of less than 10% for their hedge fund portfolios in 2014.

The issue of how hedge funds, or alternative investments, are classified within an institutional investment strategy came up in the survey, with hedge funds able to command greater allocations now investors are increasingly adopting a risk-based approach to investment. Prior to that investors had allocation limits on fixed income absolute return funds, the risk based approach means hedge funds can break out of this bucket to attract larger commitments.

Management and performance fees were also highlighted within the survey, with the concept of 2% management, 20% performance fee no longer the norm, as it hasn’t been in ILS for some time. The average from the survey respondents was 1.7% and 18.2%, although almost half of investors polled said they would allocate to hedge fund managers charging more where they can prove consistent strong performance in absolute terms.

Alternative hedge fund managers, a group that ILS and reinsurance linked investments fits squarely into, are forecast to see growing allocations as investors increasingly see hedge funds as diversified asset managers. Deutsche Bank said that non-traditional hedge fund products have seen exceptionally strong growth since 2008 and this is expected to continue. 43% of respondents to a November survey by Deutsche Bank said that they would grow their allocations to non-traditional hedge fund products in 2014.

Growth in non-traditional hedge fund products is set to grow in 2014, with 42% of surveyed hedge fund managers saying they intended to launch a non-traditional product in 2014. That could increase competition for asset allocations for ILS and reinsurance linked investment managers.

We’d expect that the diversification and low-correlation selling points of ILS and reinsurance as an asset class will mean that new opportunities from the growing pool of assets devoted to hedge fund investments will outweigh any growth in competition. The promise of greater interest in hedge funds from institutional investors and more allocations will be promising news for many ILS managers.

Of course the key issue that may face the ILS and reinsurance linked investment sector in 2014 may not be raising investor interest to attract allocations. Rather it may be in acquiring the capacity to absorb the interested capital, so putting the capital to work, an issue that the market may find an ongoing conundrum driving more managers to collateralized reinsurance through 2014.