Despite Relative Outperformance, Alternative Investments Have Room to Grow

Some have suggested that the strong performance of hedge funds relative to equities over the past 12 months could come back to haunt it in a rather circuitous manner. The theory goes that institutional investors with fixed target allocations to different asset classes might decide that alternative investments now represent too large a portion of their holdings - simply because alternatives depreciated much less than equities over the past year.

That was the theory. But a report from consultancy Casey Quirk and institutional investment database eVestment Alliance says that hedge funds represent the same portion of institutional portfolio allocations now as they have over the past few years. In fact, institutional allocations to alternative investments (of all sorts) have remained pretty stable at around 3.5% since way back in 2004.

The report also contains some other interesting observations about the greater asset management industry. For example, check out the chart below showing the average allocations to equities, fixed income and alternatives by type of institution (click to enlarge).

Notice the whopping, what, 3% allocated to alternative investments by endowments and foundations. Defined contribution pension plans also have a statistically significant allocation to alternative investments. But almost across the board, you can see that there is significant growing space for alternatives - particularly if, as one commentator has recently predicted, “equities are dead as a long-term asset.“

And here’s a curious observation. While new asset flows into all funds tracked by eVestment Alliance was around US$600 billion/year until Q4 ‘07 (chart not shown here), annual asset flows from institutional investors turned negative at least a year earlier (Q4 ‘06 or before, it’s impossible to tell from that chart - click to enlarge).

This means that institutional investors were decidedly counter-cyclical. As retail investors piled into funds in 2007, institutions were apparently stampeding for the exits already (to be joined by retail investors at the end of 2008 - just as the institutions started getting back in the game again).

This quarterly update on the state of the asset management industry is pretty interesting. We’d recommend it for anyone who makes it their business to keep tabs on the waxing and waning of the investment management sector.

Comments

[Mark Bern:]

The quarterly updates are certainly an interesting recommendation. Knowing where the institutional money is flowing is very important. It is, taken in aggregate, usually more telling of future market direction than the retail investing crowd. That may be true simply because Institutional money has the wherewithall to move the market and set trends. However, I believe that the institutional money flows are early in going long now just as they were early in getting out in 2006.

Only time will tell for sure, but I would guess that the market will lag by closer to a year in finding a true bottom from the Qtr 3 2008 turn to positive in institutional interest in equities. That would mean that we should find the final cycle bottom sometime around the end of Qtr 2 or the beginning of Qtr 3 2009. Just a guess, like everything else is in times like these.

Apr 02 02:00 AM

[Mutual Fund...:]

Good article. Investing as we know it could change dramatically if global markets switch to a new world monetary system or gold standard.

Doug T....The mutual fund guy

Apr 02 01:24 PM

[Mad Hedge F...:]

Perhaps. After last year’s carnage, you can expect the remnants of the hedge fund industry to split in two. One group will inherit large, illiquid fixed income positions, like convertible bonds and subprime CDO’s, and evolve into private equity funds, which they should have been all along. The rest will retreat to trading large liquid global positions that did well during the nineties, offering investors quarterly redemptions they now demand. Fees will fall across the board. This is how hedge funds will cope with a new world that is transitioning from excess capital to a capital shortage.

Apr 02 03:16 PM

[Mad Hedge F...:]

Nice work. After last year’s carnage, you can expect the remnants of the hedge fund industry to split in two. One group will inherit large, illiquid fixed income positions, like convertible bonds and subprime CDO’s, and evolve into private equity funds, which they should have been all along. The rest will retreat to trading large liquid global positions that did well during the nineties, offering investors quarterly redemptions they now demand. Fees will fall across the board. This is how hedge funds will cope with a new world that is transitioning from excess capital to a capital shortage.

Apr 03 10:15 AM

[Franklin Bird:]

"Some have suggested that the strong performance of hedge funds relative to equities over the past 12 months..."

Mmmm, down 18% AFTER the results of many losing funds are stripped out (survivor bias). I thought hedge funds were absolute return vehicles? I did better in a 60/40 balanced fund.

Apr 04 10:26 AM