Institutional Investment in Hedge Funds:

Transcription

1 June 2012 Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence A Prime Finance Business Advisory Services Publication

2 Methodology

3 Table of Contents Key Findings 4 Methodology 6 Introduction 7 Section I: Hedge Funds Become a Part of Institutional Portfolios 8 Section II: A New Risk-Based Approach to 13 Portfolio Construction Emerges Section III: Forecasts Show Institutions Poised to Allocate a 26 New Wave of Capital to Hedge Funds Section IV: Investment Managers Respond to the Shifting Environment 35 Section V: Asset Managers Face Challenges in Extending Their Product Suite 42 Section VI: Hedge Funds Reposition to Capture New Opportunities 48 Section VII: Accessing Investors Requires More Nuance 59 and Interaction With Intermediaries Conclusion 66 Appendix 67 All quotations contained in this document remain anonymous and are not to be copied or used in any manner. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 3

4 Key Findings Foundational shifts in institutional portfolio theory occurred in the late 1990s and early 2000s; these changes prompted investors to redirect capital out of actively managed long-only funds and channel a record $1 trillion to the hedge fund industry between 2003 and Rather than seeking to capture both alpha and beta returns from a single set of active portfolio managers investing across a broad market exposure, institutional investors began to split their portfolio approach in the late 1990s. These investors sought beta returns via passive investable index and exchange-traded fund (ETF) products built around specific style boxes and looking for alpha returns or positive tracking error from active managers with more discrete mandates which were measurable against clearly defined benchmarks. By 2002, views on how to best ensure alpha returns evolved again 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. To facilitate allocations to hedge funds and these other diversified alpha streams, institutions had to create new portfolio configurations that allowed for investments outside of traditional equities and bonds. One type of portfolio created an opportunistic bucket that set aside cash that could be used flexibly across a number of potential investments including hedge funds; the second type of portfolio created a dedicated allocation for alternatives which allocated a specific carve-out for hedge funds. In both instances, hedge fund allocations were part of a satellite add-on to the investor s portfolio and were not part of their core equity and bond allocations. In the years since the global financial crisis, a new approach to configuring institutional portfolios is emerging that categorizes assets based on their underlying risk exposures. In this risk-aligned approach, hedge funds are positioned in various parts of the portfolio based on their relative degrees of directionality and liquidity, thus becoming a core as opposed to a satellite holding in the portfolio. Directional hedge funds (50%-60% net long or short and above), including the majority of long/short strategies, are being included alongside other products that share a similar exposure to equity risk to help dampen the volatility of these holdings and protect the portfolio against downside risk. Other products in this category include traditional equity and credit allocations, as well as corporate private equity. Macro hedge funds and volatility/tail risk strategies are being included in a stable value/inflation risk category with other rate-related and commodity investments to help create resiliency against broad economic impacts that affect interest and borrowing rates. Absolute return strategies that look at pricing inefficiencies and run at a very low net long or short exposure are being grouped as a separate category designed to provide zero beta and truly uncorrelated returns in line with the classic hedge fund alpha sought by investors in the early 2000s. 4 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

5 The potential for market-leading institutions to divert allocations from their core holdings to hedge funds as they reposition their investments to be better insulated against key risks and the need for the broader set of institutions to ensure diversified portfolios to help cover rising liabilities and reduce the impact of excessive cash balances should both work to keep institutional demand for hedge funds strong. We project that the industry may experience a second wave of institutional allocations over the next 5 years that could result in potential for another $1 trillion increase in industry assets under management (AUM) by Although adoption of the new risk-aligned portfolio approach is at an early stage, the shift in thinking it has triggered has already had significant impact on product creation. This has resulted in the emergence of a convergence zone where both hedge fund managers and traditional asset managers are competing to offer the broad set of equity and credit strategies represented in the equity risk bucket. Asset managers looking to defend their core allocations are moving away from a strict benchmarking approach; they are creating a new set of unconstrained long or alternative beta products that offer some of the same portfolio benefits as directional hedge funds in terms of dampening volatility and limiting downside. They are also looking to incentivize their investment teams, improve their margins, and harness their superior infrastructure by competing head to head in the hedge fund space; however, long-only portfolio managers choosing to go this route may face an uphill battle in convincing institutional investors and their intermediaries about their ability to effectively manage short positions. Large hedge funds that specialize in hard-to-source long/ short strategies, or that have chosen to limit capacity in their core hedge fund offering, are being approached opportunistically by existing and prospective investors to manage additional assets on the long-only side of their books, where they have already proven their ability to generate alpha. Other large hedge funds have made a strategic decision to tap into new audiences and are crossing the line into the regulated fund space, creating alternative UCITS and US Investment Company Act of 1940 (40 Act) products, as well as traditional long-only funds. These products are targeted at liquidity- constrained institutions and retail investors where the sizes of the asset pools are likely to be large enough to offset low fees. Beyond the potential $1 trillion we see for institutional investors to increase their allocation to hedge fund strategies, we estimate that there could be an additional $2 trillion opportunity in these convergence zone products where hedge funds and traditional asset managers will compete head to head. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 5

6 Methodology The 2012 Citi Prime Finance annual research report is the synthesis of views collected across a broad set of industry leaders involved in the hedge fund and traditional long-only asset management space. In-depth interviews were conducted with hedge fund managers, asset managers, consultants, fund of funds, pension funds, sovereign wealth funds, and endowments and foundations. To understand the industry dynamics, we conducted 73 in-depth, one-on-one interviews with an array of institutional investors (chief hedge fund allocator), hedge fund managers (COO/CFO and marketing leads), large asset managers (head of product development and business strategy), consultants (head of the hedge fund or alternatives practice area) and fund of fund managers. Taken all together, our survey participants represented $821 billion in assets either allocated, managed or under advisement in the hedge fund industry. Our survey interviews were not constructed to provide onedimensional responses to multiple choice questionnaires, but were instead free-flowing discussions. We collected more than 80 hours of dialog and used this material to spur internal analysis and create a holistic view of major themes and developments. This type of survey is a point-in-time review of how investor allocation theory is evolving, and how hedge funds and asset managers are in turn looking to advance their product offerings. This report is not intended to be an exact forecast of where the industry will go, but we did construct the paper around the comments and views of the participants, so many of the themes are forward looking. We have also built indicative models based on those views to illustrate how asset flows and opportunity pools may develop in the near future. The structure and presentation of the report is intended to reflect the voice of the client and is our interpretation of their valued feedback. To highlight key points, we have included many quotes from our interviews but have done so on a generic basis, as participation in the survey was done on a strictly confidential basis and we do not identify which firms or individuals contributed to the report. There are a few topics that this survey has touched upon that have been covered in more detail by other recent publications from Citi Prime Finance. In those cases we have referenced the source, and where it touches on broader adjacent trends we have noted it but tried to stay on topic for the subject at hand. The following chart shows the survey participants that we interviewed this year, representing all major global markets. Participant Profile Consultants 14% Investors 15% HF AuM $44,974 Asset Managers 31% Hedge Fund Managers 40% Other AUM $1,538,934 HF AuM $205,275 Survey Participants Investor Participant AuM (Millions of Dollars) Other AUM $3,147,660 HF AuM $187,182 Other AUM $254,582 HF AuM $383,445 Other AUM $1,502,910 Asset Manager Participant AuM (Millions of Dollars) Hedge Fund Participant AuM (Millions of Dollars) Consultant Participant AuA (Millions of Dollars) 6 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

7 Introduction Over the last several years, a paradigm shift has occurred in both the way institutional investors include alternative strategies in their portfolios and in the way hedge fund managers and traditional asset managers position their offerings for this audience. In Part I of the report (Sections I-III), we focus on the investor side of this story. We examine the evolution of portfolio theory and how these doctrines impacted institutional portfolio construction in the late 1990s/early 2000s, setting the stage for these participants to become the predominant investors in the hedge fund industry. We also detail a new risk-aligned approach toward constructing portfolios that has the potential to dramatically increase the use of hedge fund strategies, repositioning them from a satellite to a core holding in institutional portfolios. We conclude this examination by looking at how interest from each of the major institutional investor categories is likely to progress, and what the total impact could mean for overall industry AUM. In Part II (Sections IV-VI), we turn our attention to how both hedge funds and traditional asset managers have evolved their offerings, examining why the gap between product types has narrowed and detailing where these managers are now beginning to offer competing products. We delve into the structural advantages and the perceptional challenges affecting asset managers efforts to expand their product set, and focus on which managers in the hedge fund space are best positioned to expand their core offerings and why. We then look at the range of product innovation occurring across the largest of hedge fund participants, and examine the potential fees and asset pools available in each. Finally, we calculate what the individual and total opportunity may be to add assets in long-only and regulated alternative products. In Part III (Section VII), we bring these arguments together, discussing how hedge fund managers and asset managers looking to offer hedge fund product can best align their marketing efforts to the various portfolio configurations being used by the institutional audience. We also explore the changing role of key intermediaries, and discuss how managers can leverage these relationships to improve their contact and understanding of investors and expand their reach into investor organizations. To me, investing is about going back to the basics. Why do I want to be in this asset class? Why do I want this product? Where does it fit in my portfolio? Once I know the answer to those questions, then I find a manager that fits the mandate. The onus is really on the investor to know why they re creating the portfolio they re creating, European Pension Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 7

8 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 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. 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. 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. Chart 1: Institutional Investor Flows of Money into Hedge Funds (Asset Flows Only Does Not Include Performance) 1200 Please the appendix for a more thorough discussion of these theories and how investor portfolios were configured prior to the time period. This section will now pick up with the impact of those changes. Billions of Dollars $463B $1,028B $179B $248B Source: Citi Prime Finance Analysis based on HFR data ; evestment HFN data I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

9 A massive wave of new capital entered the hedge fund market in the following 5 years. Between 2003 and 2007, more than $1 trillion in new money was channeled to the hedge fund industry from institutional investors. This was more than double the amount of flows noted over the previous 8 years, as shown in Chart 1. Indeed, up until now the flows during these years remain the largest single wave of money the industry has seen. The impact of this move, and the earlier change in allocations from active to passive funds, are clearly evident in Chart 2. In 2003, institutional investors only had 7.0% of their portfolio allocated to passive or beta replication strategies and 2.4% allocated to hedge funds. The remainder of the portfolio (90.6%) was invested with traditional active asset managers. By 2007, a full 10% of the assets for these investors had been allocated away from active managers. Passive mandates received an additional 3% of the allocation to grow to 10% of the total portfolio, while the hedge fund allocation grew by nearly four times, to 9.2% of the total portfolio. Chart 2: Comparison of Institutional AUM Pools By Investment Type December 2003 $8.7 Trillion December 2007 $13.5 Trillion Passive $606B Hedge Funds $211B 2.4% 7.0% Passive $1.37T Hedge Funds $1.24T 9.2% 10.1% 90.6% 80.7% Active 7.8T Active 10.9T Comparison of institutional aum pools by investment type Source: Citi Prime Finance analysis based on evestment HFN & ICI & Sim Fund data Institutionalization started around 2000 when people were watching their long-only equity allocations post down 20% and hedge funds were able to exploit heavy thematic trends in equity markets and alternative forms of beta that clients didn t have anywhere else in their portfolio, Institutional Fund of Fund Clients are selling their long-only equity funds to buy other stuff. Everything from hedge funds to other stuff like real assets everything from commodities to real estate to infrastructure deals. My guess would be that they ve moved 10% out of their equities allocation with 5% going to hedge funds and 5% to real assets, Long-Only & Alternatives Consultant Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 9

10 We are currently in a period of structural change. There was a secular shift from long only to hedge funds in the past few years, <$1 Billion AUM Hedge Fund We re starting to get allocations from what used to be the investor s traditional asset class buckets. To some extent, it depends on who s advising them. We re getting more and more of that active manager bucket and the bucket s getting bigger, >$10 Billion AUM Hedge Fund Institutional Inflows Change the Character of the Hedge Fund Industry From , institutional inflows worked to significantly change the character of the hedge fund industry. Up until the early 2000s, the majority of investors in the hedge fund industry had been high net worth individuals and family offices looking to invest their private wealth. As shown in Chart 3, in 2002 these high net worth and family office investors were seen as the source for 75% of the industry s assets under management. Even though these investors continued to channel assets to the hedge fund industry in the subsequent 5 years, their flows were unable to keep pace with the wall of institutional money entering the market. Chart 3: Sources of Hedge Fund Industry AUM By Investor Type Millions of Dollars 1,800M 1,600M 1,400M 1,200M 1,000M 800M 600M 500M 200M 0 High Net Worth Individuals & Family Offices 25% 43% Institutional Investors including Endowments & Foundations, Pension Funds, Insurance Funds & SWFs 60% Source: Citi Prime Finance analysis based on evestment HFN data By 2007, the share of capital contributed by high net worth and family office investors had fallen nearly 20 percentage points. It was for this reason that many began to talk about the industry as becoming institutionalized. As will be discussed, the drop in high net worth and family office interest can be directly related to this institutionalization. At the outset of this period in 2003, institutional investors only accounted for $211 billion AUM, or 25% of the industry s total assets. Inflows from 2004 to 2007 caused this total to rise sharply, reaching $917 billion, or 43% of total industry assets. Institutional investors entering the market were looking for risk-adjusted returns and an ability to reduce the volatility of their portfolios. This was a very different mandate from the one sought by high net worth and family office investors namely, achieving outperformance and high returns on what they considered to be their risk capital. This difference in their underlying goals helps to explain continued shifts in the industry s capital sources in the period subsequent to While down sharply during the global financial crisis, hedge funds were still able to post better performance than longonly managers held in investors portfolios, and they helped to reduce the portfolio s overall volatility. Institutional investors focused on this outcome and saw hedge funds as having performed as desired. High net worth and family office investors saw this outcome as disappointing. Since that time, many high net worth and family office investors have exited the hedge fund industry to seek better returns in other investment areas such as art or real estate, but institutional investors for the most part maintained and even extended their hedge fund allocations. The result has created a denominator effect. As of the end of 2011, we estimate that institutional investors as a group accounted for 60% of the industry s assets. While this appears to have jumped sharply since 2007, much of the increase is because overall high net worth and family office allocations have gone down. Between 2007 and 2011, we estimate that high net worth and family offices share of hedge fund industry AUM fell from 57% down to only 40% of total assets. All of our capital last year came from US institutional investors. $5-$10 Billion AUM Hedge Fund Private investors just look back 3 years and see how they ve performed and from that perspective, hedge funds have just not been sexy enough. They haven t been able to show consistent performance across 2009, 2010, and 2011 to convince the private audience that they do what they say they do, Asset Manager with Hedge Fund Offerings 10 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

11 We only take money from institutional investors and the minimum investment levels are high (passive $50 million, bespoke $500 million). This is due to only wanting likeminded investors to be part of the platform in order to reduce the risk of excessive withdrawals by less stable/less long-term investors in case of a market crisis of some sort, Asset Manager With Hedge Fund Offerings Chart 4: Institutional Portfolio Configuration: Opportunistic Chart 12 Equity Passive Active Two Main Institutional Investor Portfolio Configurations Emerge Bonds/ Fixed Income Passive Active When the massive wave of inflows began in the period from , most institutional investors still had their traditional 60% equities/40% bonds portfolio. To change that approach, they typically worked with an industry consultant to come up with a new allocation, and then sought approval on that configuration from their investment committees and board of directors. Since the alternative alpha streams these investors were looking to create did not fit into an existing portfolio category, investors and their advisors came up with a new bucket for these strategies. The result was two new portfolio configurations that moved institutional investors away from their traditional 60/40 mix. Many investors sought to mimic the leading E and Fs portfolio approach by asking for a ready pool of cash that they could deploy as desired to a range of illiquid investments or investments that did not fit within a traditional asset bucket, either because of the instruments they traded or their inability to be benchmarked to a specific index. These investors approached their boards and investment committees and got authorization to create a new opportunistic allocation. This new bucket provided investment teams with ready capital that they could deploy across a broad range of potential investments including hedge funds. This portfolio configuration is illustrated in Chart 4. Opportunistic No Fixed Allocation Discretionary Investment in Hedge Funds, Private Equity, Infrastructure or Commodities Source: Citi Prime Finance For many investors, this configuration was used as a transition portfolio but for others, their approach to alternative and hedge fund investing endures via this configuration to the present day. This is especially true for many E and Fs and sovereign wealth funds that look for more flexibility with their portfolios allocations. Indeed, some participants pursuing this approach have gotten creative in using the allocation, including remanding responsibility for portions of the portfolio to external advisors to invest as those managers deem appropriate within agreed risk limits. Yet, as the name implies, many investors also choose to only utilize the capital in this allocation when a specific opportunity emerges. Having the ability to allocate to hedge funds or other investments does not imply a requirement to allocate in this opportunistic configuration. Several investors we interviewed have the mandate to invest in hedge funds, but are under no pressure to deploy capital. Our final bucket is opportunistic. Most of our hedge funds are in here. We also have a number of external CIOs in this bucket. We ve identified 5 managers that can do anything they want to do with the money we allocate to them. We give each of these managers $500-$600 million. Their only restriction is that they can t exceed our volatility target of 12%. All together, our opportunistic bucket has beaten the HFRI index by about 200 basis points after fees each year, Sovereign Wealth Fund It was more than a 3-year education process for the board on hedge funds. Initially we implemented an opportunistic allocation. Capital preservation and dampening the downside was part of the story to get the board to approve the allocation: So when you crawl out off the hole it is not as deep as it could have been. US Public Pension Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 11

12 Family offices can invest in what they want. Sovereign wealth funds also can do what they want. They set up an opportunistic bucket just so that they ll have a place to invest in what they want, >$10 Billion AUM Hedge Fund We have a 0%-8% allocation to an opportunity fund. We can put anything short term in nature here or something that doesn t fit in the portfolio like hedge funds or commodities. There is no pressure to put anything in, though, US Public Pension Other organizations, particularly many public pensions, came up with a different portfolio configuration to enable their hedge fund investing. The boards and investment committees at these organizations wanted to have more oversight and set tighter parameters around how capital was invested. These organizations tended to have a very structured investment process that required extensive oversight and approvals. Moreover, these investors often worked with consultants that required specific mandates around the type of assets permitted in the portfolio and the size of assets they would be advising. These investors and their advisors developed the concept of porting their alternative alpha streams away from the main equity or bond allocation to a new sleeve within their portfolio that became broadly known as the alternatives bucket. This portfolio configuration is illustrated in Chart 5. Chart 5: Institutional Portfolio Configuration: Dedicated Alternatives Each type of investment permitted within the alternatives bucket had a specific allocation and its own set of policy guidelines. In this way, the new investments were set up like an additional asset class in line with the approach used in the traditional equity and bond portions of the portfolio. This accommodation was made because there was not an appetite to have the flexibility of an opportunistic bucket. Most investors using this portfolio configuration acknowledge that they do not truly see hedge funds as an asset class, but they nonetheless count them in this way to satisfy their allocation rules. Because many pensions have adopted this approach and they are by far the largest category of institutional investor, this has since become the dominant portfolio configuration for investors in the hedge fund industry. What is important to note about this configuration and the opportunistic approach is that in both instances the capital allocated to hedge funds is coming from a satellite part of the portfolio that typically only accounts for a small percentage of the institution s overall pool of assets. The core of the portfolio remains in the equity and bond allocations. As will be explored in the next section, there are signs emerging that institutional investors may be in the midst of another foundational shift in how they look to configure their portfolios, the result of which may work to reposition hedge funds from a satellite into the investor s core allocations. Interest has come from the public plans and has been driven by adoption of policy change to allow them to invest in alternative strategies, $1-$5 Billion AUM Hedge Fund Big institutions out there had governors on their long-only buckets that limited their ability to allocate to alternatives. That s why they came up with portable alpha. <$1 Billion AUM Hedge Fund Equity Bonds/ Fixed Income Alternatives Passive Active Passive Active Hedge Funds Private Equity Infrastructure & Real Assets Source: Citi Prime Finance For allocation purposes, we treat hedge funds like a separate asset class even though we realize that they re not, European Public Pension Liquidity issues and impacts of hedge funds that differ from traditional investments drive the thought of putting hedge funds into alternative buckets, US Corporate Pension Plan Most of our clients view hedge funds as a strategy, but bucket it as an asset allocation. Our clients understand that you can t determine whether hedge funds are over- or undervalued. It s a strategy, but they track it as an asset class, - Institutional Fund of Fund 12 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

13 Section II: A New Risk-Based Approach to Portfolio Construction Emerges Maturing experience with the hedge fund product and improved transparency after the GFC Global Financial Crisis are allowing institutional investors to better categorize managers based on their directionality and liquidity. This has facilitated efforts by market leading organizations to re-envision their portfolios based on common risk characteristics rather than asset similarities. The result has been a new portfolio configuration that repositions hedge funds to be a core part of investors allocations. Investors Initially Seek Diversified Hedge Fund Exposure via a Singular Allocation When large institutional flows commenced in the early to mid-2000s, the goal of the investment was to obtain exposure to a diversified hedge fund return stream in order to have an alternate alpha source and to capture an illiquidity premium. The mechanics behind how investors sought that exposure in those early years pre-crisis were extremely different than the model that has emerged in the subsequent period. As discussed in last year s annual survey, Pension Fund & Sovereign Wealth Fund Investments in Hedge Funds: The Growth & Impact of Direct Investing, the majority of institutional investors commenced their hedge fund programs by making a single allocation, typically to a fund of fund, with the goal of obtaining a diversified exposure to a broad set of hedge fund strategies and their associated return streams. Using a fund of fund as an intermediary allowed institutional investors to leverage that team s knowledge of the hedge fund space and their access to managers. Expectations were that the fund of fund manager would move allocations around as needed to ensure the maximum diversification and optimal performance of the portfolio. This was not something most institutional investors were prepared to handle given resource-constrained investment teams that typically had little familiarity with the hedge fund space. As the investor s knowledge of hedge funds increased, and as many investment committees and boards became uncomfortable with the fees they were paying to fund of funds, many institutional investors began making direct allocations to hedge funds. Many of these investors began their direct investing program by again placing a singular allocation with a multi-strategy manager and relying on the CIO of that organization to direct capital across various approaches based on their assessment of market opportunities. In contrast, a set of allocators at some of the leading institutions began to create customized portfolios of hedge funds. Instead of making a single hedge fund allocation, these investors began to think about breaking that allocation out We have many investors that look at hedge funds as a singular portfolio. They focus on an absolute return portfolio as an equity replacement, Alternatives Focused Consultant across a number of managers. To do this effectively, these allocators began to divide the hedge fund space into multiple categories. After the global financial crisis, this tendency to view hedge funds as belonging in multiple buckets accelerated as performance in that time period revealed that hedge funds performed very differently based on their underlying directionality and liquidity. Investors Begin to Categorize Hedge Funds Based on Their Directionality and Liquidity As investors evolved toward direct hedge fund investing programs, they could no longer rely on a fund of fund manager or on a multi-strategy fund CIO to provide a diversity of return streams in their portfolio. It was the investors themselves that needed to ensure their hedge fund portfolio was suitably diverse across investment strategies. In order to manage this challenge, the investors built out their alternatives team, hiring individuals with specialized skills to cover the various strategies. In the majority of cases, the investors also forged relationships with an emerging set of alternatives-focused industry consultants to support their portfolio construction and due diligence efforts. Initially, investors pursuing direct allocations sought diversity by allocating varying amounts of money to a representative set of hedge fund strategies, giving some capital to long/short, some to event driven, some to macro, some to distressed, etc. This was done with little consideration of the underlying liquidity of assets held within each fund and since investors had very little transparency into the holdings of managers in the pre-crisis period, allocations were also done with little consideration of how the hedge fund s positions and exposures aligned to the investor s broader core portfolio. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 13

14 Performance during the global financial crisis revealed two problems with this approach. First, investors could be locked into investments if there was a mismatch between the liquidity of the fund s holdings and the fund s liabilities in terms of needing to cover investor redemptions. Many hedge fund managers threw up gates or created side pockets that excluded investors from redeeming capital at the height of the crisis. This asset-to-liability mismatch prompted investors to put much more focus on the relative liquidity of the hedge fund strategies in their portfolios. The second factor emerging from the crisis was that while many investors thought that they had been pursuing alpha through their hedge fund allocations, they found that in some instances they were instead paying high fees for what many considered to be alternative beta. That is, managers were levering directional bets or taking advantage of carry structures to capture the same type of market returns that active long-only managers were pursuing in the core of the portfolio. Hedge Funds Allocations Begin to Be Broken Out Across Multiple Types of Exposures The result of these realizations was that many institutional investors began to increasingly think about the hedge fund industry not as a singular exposure, but as multiple types of investments with varying degrees of liquidity and directionality. This is illustrated in Chart 6. Chart 6: Emerging View with Multiple Hedge Fund Categories Clients initially start with hedge funds as a stand-alone asset class. But they have slowly been moving hedge funds into other categories. This is a gradual process but they are disaggregating the risk more recently, Alternatives Focused Consultant There are so many of closet beta hedge funds that were long-only biased funds that effectively were levered S&P. Alpha is not simple outperformance; it is uncorrelated outperformance, Alternatives Focused Consultant & Fund of Fund While there is not a single standard approach to how investors are breaking up the hedge fund space, we have tried to represent the three most commonly mentioned categories and show how they differ. Directional hedge funds group those strategies that have an underlying exposure to movements in the equity or credit markets. Of key importance in evaluating this grouping of strategies is understanding the net long or short position of an individual manager. Not all long/short, event-driven, or distressed funds have equal amounts of long and short positions in their portfolio. Managers are typically considered directional if their holdings are more than 60% net long or short. At this level, the manager s holdings are going to be highly influenced by moves in the underlying market. Moreover, as shown in Chart 6, there is a distinct difference in the liquidity profile of long/short and event-driven managers versus distressed managers. This category can thus be subdivided into liquid and illiquid directional hedge funds. LOW DIRECTIONALITY HIGH Long/ Short Macro Event Driven Macro/ CTA Volatility & Tail Risk HIGHLY LIQUID Market Neutral Directional Hedge Funds Arbitrage Absolute Return Absolute Return LIQUIDITY Distressed Relative Value ILLIQUID Source: Citi Prime Finance In contrast, strategies that reside in the absolute return bucket tend to have a much closer balance of long and short positions in their portfolio. For the most part, these managers run a net position of only 0% to 20% net long or short. As such, they are seen as having low directionality, and they generate returns by capturing relative pricing inefficiencies between assets. Based on this profile, they are often discussed as offering zero beta. The strategies in the absolute return category offer a range of liquidity across market neutral, arbitrage, and relative value approaches. A manager that was 50%-60% long would fall between the cracks in our portfolio. That s not really shorting and not really tied to the benchmark. We probably wouldn t take too hard a look at them, Endowment 14 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

15 Strategies that are more than 20% net long or short, but less than 60%, may fall through the cracks in this approach. Indeed, many investors and consultants mentioned that managers in this range are hard for them to consider in compiling a portfolio of single strategies because they do not know how to evaluate their underlying risks and likely performance in different types of market scenarios. The final most frequently mentioned category was macro funds. Strategies in this bucket include global macro, commodity trading advisor (CTA)/macro, volatility, and tail risk strategies. There is some directionality to these strategies, but that directionality can be obtained from both the long and the short side with equal ease based on supply and demand fundamentals as opposed to valuations. Alternatively, these strategies seek to hedge the investor against certain types of macro environmental risks such as inflation or periods of market crisis. Multi-strategy hedge funds often have sleeves in each of these buckets and thus cannot be easily classified by their directionality or neutrality. As such, they tend to not fit cleanly in any one category. Survey participants indicated that multi-strategy funds are most often broken out and placed alongside those strategies they most closely resemble by investors pursuing this approach. This move from having a singular hedge fund exposure to thinking of hedge funds as a varied set of investments has become more common in the years after the global financial crisis. The hallmark of this method is that investors are able to evaluate their portfolios on the underlying risks posed by each category of hedge funds within their portfolio, and they can relate those risks to other parts of their broader portfolio holdings. This has been a critical precursor to broader changes in investors approach. Investors Begin to Group Directional Hedge Funds as Part of a Broad Equity Risk Bucket One of the most commonly discussed changes in many institutional investors portfolio approach, particularly in the years after the global financial crisis, has been the move toward aggregating all those strategies that are subject to a similar underlying exposure to changes in a company s equity or credit position, and then looking at that exposure in its entirety rather than as separate investment pools. The traditional long-only consultants that have moved into the alternatives space are great as a gatekeeper. They can see how they can enhance a portfolio and where a fund can fit. They re helping to drive this trend toward moving long/ short funds into the equities and fixed-income allocations. It s not a massive trend, but an emerging one, particularly since When I think about how to structure the fund, this is definitely something I think about now but it wasn t something I thought about 2 years ago, >$10 Billion Hedge Fund As part of that trend, many institutional investors are beginning to re-categorize their exposure to directional hedge funds and combine these allocations with their broader equity and/or bond allocations. This puts directional hedge funds into a common category with passive index and ETFs, with actively managed long-only equity and credit funds, and in many instances with corporate private equity holdings. Together, this set of strategies is said to reflect the investor s exposure to equity risk. This is illustrated in Chart 7. This shift in investor thinking about how to configure their portfolio is gaining traction and was the most commonly discussed change away from the two main portfolio configurations discussed at the end of Section I. Even if investors are not yet reordering their portfolio to align to this approach, they are considering it as evidenced by the statements below. Things have changed. Most people put us in alternatives and in their hedge fund allocation. More and more you hear people talk about putting us in their equity bucket. Do we see a lot of people doing that? No, but we definitely see people thinking about the core exposure they re taking on, >$10 Billion AUM Hedge Fund We like to understand the exposures we have looking across all our managers. When we add a manager into the portfolio, no matter what part of the portfolio, we want to understand what the impact is on the overall risk. Are we adding more equity risk when we roll up the portfolio? More credit risk? We re moving toward a more risk budget approach, US Public Pension Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 15

16 Chart 7: Grouping of Investment Products By Equity Risk LOW DIRECTIONALITY HIGH Passive Actively Managed Rates Active Equity & Credit Long Only Macro & CTA Long/ Short Macro Event Driven Volatility & Tail Risk Market Neutral Equity Risk Directional Arbitrage Absolute Return Public Markets Stable Value / Inflation Risk Distressed Relative Value Private Markets Corporate Private Equity Commodities Infrastructure Real Estate Timber HIGHLY LIQUID LIQUIDITY ILLIQUID Source: Citi Prime Finance Better Transparency and Investors Desire to See Total Securities Exposure Drives Change A shift in how investors internal teams communicate is helping to drive this change. There is more discussion starting about what assets are being held in traditional equity and/or credit portfolios, and the extent to which those assets overlap with directional hedge fund holdings. For many years, the teams charged with administering these two areas of institutional investor portfolios operated in separate spheres. There was very little communication across groups and for the alternatives focused allocators, there was also very little transparency into hedge fund holdings. This began to change after the global financial crisis. Hedge fund managers have become much more transparent about their positions and exposures, as will be discussed further in Section IV. This has created an improved flow of information, and in many instances hedge funds are now willing to send data on their holdings directly to investors via either reports or risk aggregation engines. This has made it easier for the alternatives team to share information with the broader investment team. As the flow of information about hedge fund holdings has improved, there has also been an emerging sense that administering their hedge fund holdings separately from their core positions is creating exposures that the investor is unaware of and thus not managing properly. This view is being fed by many in the traditional consulting community that have recently expanded their practices to include groups focused on alternative investments. For us, private equity would live within our equity allocation. Long/short strategies would live within equities. It s the driver of returns. What are you buying and how do you crystallize that purchase? We re starting to see our clients come around to this point of view. Long-Only and Alternatives Consultant 16 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

17 When I think of the sovereign wealth funds, they ve been forced to create committees that sit the different investment areas down and say, What do we want to do? We have overlapping exposures and we have to decide how to manage them >$10 Billion AUM Hedge Fund We are seeing more and more that our products are included in the equity bucket of the institutional investor allocation. As we trade listed equities we are a natural part of the beta risk profile for the equity bucket Asset Manager With Hedge Fund Offerings These traditional consultants saw new competitors (alternatives-focused consultants) entering the market and quickly gaining traction across the traditional consultants core client base. In response, long-only consultants began to hire new talent with an understanding of hedge fund strategies. Armed with this new skill set, many traditional consultants saw an opportunity to differentiate themselves from alternatives industry consultants by helping their clients understand how their total book fit together. When I think of pensions, the hedge fund allocator is really good at thinking about hedge funds and the longonly allocators are really good at thinking about long only, but the way that portfolios are changing is forcing communication across the asset class heads which is a great thing because they never had communicated. In some cases, the gap is now not as wide between the traditional and hedge fund side, >$10 Billion AUM Hedge Fund The rationale regarding why directional hedge funds and traditional equity or credit holdings should be viewed in tandem is easy to understand. When the equity or bond markets move substantially in either direction, all the managers in this category would be affected. This dynamic is the fundamental basis for grouping all of these investments together. What is critical to understand is that in this emerging view, the role that directional hedge funds play in the portfolio changes and is no longer seen as primarily providing an alternate stream of alpha. Directional Hedge Funds Gain Traction for Their Ability to Dampen Equity Volatility Another factor encouraging investors to combine their directional hedge funds with their core equity and credit holdings relates to a new understanding of portfolio risk and the role directional hedge funds play in reducing volatility. Articles began to emerge from leading asset managers as early as 2005 arguing that the classic MPT/CAPM approach was too focused on assets and not focused enough on risk. Indeed, they pointed out that while the classic 60% equities/40% bonds portfolio seemed to be balanced from a capital perspective, if that same portfolio were viewed in terms how risk in the portfolio was budgeted, the result was extremely skewed toward equities. Specifically, in the 60/40 portfolio, 90% of the portfolio s overall risk was seen coming from the equity holdings and only 10% of the risk was coming from the bond allocation. These articles were initially viewed as intellectually interesting but not particularly relevant to the majority of investors. The performance of traditional 60/40 portfolios during the financial crisis when major equity indices were down 40% changed investors receptivity to this argument, particularly when it came to light that investors who had reallocated their assets based on a more optimal risk budget outperformed those with traditional portfolios. One repercussion of this has been that many investors that continue to have large equity allocations because of the potential returns they add to the portfolio are looking for ways to reduce their risk exposure in this bucket without having to dramatically reallocate their portfolio. Directional hedge funds are seen as a solution to that challenge. Though many people perceive hedge funds to be riskier than long-only holdings, the opposite is true. Hedge funds offer more controlled risk profiles, and their inclusion in the portfolio typically helps to reduce overall volatility. Again, the financial crisis provides a striking example. While major equity indices were down 40%, the equity-focused hedge indices showed managers down only 20% in the same period. Blending a larger share of their equity allocation with directional hedge fund managers, particularly equity long/ short-focused managers, is seen as offering investors a way to reduce their portfolio volatility while maintaining their returns potential. People are taking more care and due diligence now in using hedge funds more as volatility reduction strategies where in years gone by they were alpha generating concepts, US Corporate Pension Plan Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 17

18 Of those investors moving their long/short equity into their equity bucket, the goal is to dampen the volatility and change the risk profile recast the risk profile. It s coinciding with the whole trend toward risk parity. Even if their equity bucket is only 60% of their allocation, it is much more on a risk budget, Alternatives Focused Consultant Including Directional Hedge Funds in Equity Risk Bucket Helps Limit Downside Exposure There is one final aspect as to why some institutional investors are considering it advantageous to combine directional hedge funds with their traditional equity and credit allocations. This is based on the ability for hedge funds to offer downside protection. While we have focused extensively on how hedge funds initially drew institutional interest because of their ability to add alpha to the portfolio, this argument instead speaks to their role in limiting equity beta and is a corollary to hedge funds having a lower volatility profile. As already discussed, directional hedge funds, most specifically equity long/short managers with a high net long exposure, will move in tandem with the underlying markets, thus producing some degree of equity beta. They will not fully mimic such movements, however, because the short portion of their investment is going to be moving counter to the broad market. This means that in up markets, it is unlikely that the long/ short manager will be able to equal the returns of long-only managers, but when markets are falling, they should be able to limit their downside in relation to those same long-only managers. This was true during the 2008 crisis and many investors now see this as an important role for directional hedge funds. Remember, most institutional investors are focused obsessively on capital protection, as they have limited pools of assets they are managing to meet obligations. For pension funds, these obligations relate to the institution s need to meet liabilities owed to their members. E and Fs need to fund activities over a long-term period. Sovereign wealth funds need to diversify their account balances. In all these instances, there is an extreme aversion to losing money. As the statements below show, many institutional investors would rather engineer their portfolios to have less upside in order to insure that they do not suffer excessive losses that would impact their ability to meet their obligations. Including directional hedge funds alongside their core equity and credit holdings can provide this protection. We re a conservative investor. By conservative, we mean that we d rather protect on the downside and miss a little bit on the upside. That works better for us in the long term. We think about equity beta as covering equity long-only managers, equity long/short managers, and private equity. Credit beta includes investment grade, high-yield, and asset-back securities, Endowment The evolution of institutional investors allocating to long/ short equity from the equity bucket is still really in its early stage. They still remember how bad 2008 was, and still worry about downside volatility so they are interested in what equity long/short can bring to their portfolio $5-$10 Billion AUM Hedge Fund Institutions had alternative funds as a carve-out in a separate bucket but that is changing. Performance has been disappointing and correlated to equities. So now hedge funds are looked at as an alternative to equities with the expectation that they partly participate in the upside of markets with protection to downside markets. European Fund of Fund Investors Allocate Capital to Strategies that Reduce Macroeconomic Impacts Chart 8 shows the emerging second risk-aligned portfolio configuration that combines hedge funds within the macro bucket with other rate-related and commodity investments to create resiliency against a different type of exposure. Namely, investors are looking to group strategies that can help their portfolio capture thematic moves related to supply and demand. In this context, supply and demand cover areas with broad economic impacts such as monetary policy, sovereign debt issuance, and commodity prices all factors that affect interest rates and thus borrowing rates. This contrasts to the supply and demand of specific securities. The goal of combining these investments is to create stable value in the investors portfolio by protecting them against excessive moves in interest rates triggered by economic factors. Because one of the most common outcomes of large interest rate moves is inflation, this group of investments is also sometimes referred to as insuring the portfolio against inflation risk. 18 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

19 Chart 8: Grouping of Investment Products by Stable Value / Inflation Risk LOW DIRECTIONALITY HIGH Passive Actively Managed Rates Active Equity & Credit Long Only Macro & CTA Long/ Short Macro Event Driven Volatility & Tail Risk Market Neutral Equity Risk Directional Arbitrage Absolute Return Public Markets Distressed Stable Value / Inflation Risk Relative Value Private Markets Corporate Private Equity Commodities Infrastructure Real Estate Timber HIGHLY LIQUID LIQUIDITY ILLIQUID Source: Citi Prime Finance The performance of CTA and macro-focused hedge funds during the 2008 crisis was one factor that has helped spur interest in this new portfolio configuration. These managers were able to post uncorrelated returns and generate large profits at a time when equity markets were down sharply. For calendar year 2008, the Morgan Stanley Capital International Indices (MSCI) global equity indices were down -40.3% and the S&P 500 index was down -37.0%, while the Hedge Fund Research, Inc. (HFRI) systematic diversified index was up +17.2% and the Barclay Hedge discretionary traders index was up +12.2%. As highlighted in our recent CTA Survey, Moving Into the Mainstream: Liquid CTA / Macro Strategies and Their Role in Providing Portfolio Diversification, many CTA and liquid macro managers were also able to provide important liquidity to investors in a period when they were unable to pull money out of other investments. These two factors together were coined the 2008 effect and helped create a perception that having an allocation to CTA or macro strategies could work to substantially improve diversification and enhance returns by adding a differing source of beta to the portfolio. The biggest thing I ve seen is pensions and endowments and other allocators now knowing where there betas are and looking at macro and nondirectional hedge funds to add to their portfolios to move them more along the efficient frontier, Endowment People are starting to group macro with long volatility strategies to call them the stable value hedge funds. People have come to believe that market dislocations are accompanied by high periods of volatility and that these strategies generate stress returns, <$1 Billion AUM Hedge Fund Directional hedge funds and stable value hedge funds complement each other. Directional funds establish profits in certain markets and stable value funds provide returns in other markets, <$1 Billion AUM Hedge Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 19

20 Since periods of extreme economic stress also correspond to increased periods of market volatility, managers focused on protecting investors from these types of exposures are also grouped in this risk category. Given the severity of the 2008 move, many investors began to express an interest in one type of volatility protection in particular: tail-risk hedging. Managers pursuing this type of strategy have an unusual profile; during most years they pursue neutral investment programs that result in returns that tend to be close to 0%, but in periods when volatility spikes, their out-of-the-money puts or swaptions will jump in value and offer high returns to offset losses elsewhere in the portfolio. The challenge with tail-risk hedging funds is that they usually end up as a cost to the portfolio and their benefit is evident only in extremely rare instances. For this reason, many investors are either looking at managers that have funds capable of generating returns based on more varied types of market volatility or they are opting to handle tail-risk hedging on their own. People are not looking at tail risk per se as an allocation because of the costs involved. Rather than a dedicated put-buying program which is a losing proposition, they are instead looking to get long volatility. Volatility is the new gold, <$1 Billion AUM Hedge Fund This approach is typically employed by investment teams that have prior sell-side or buy-side trading expertise and are comfortable managing an active book. Some institutional investors are seeking a structured exposure that gives them protection across a large swath of their portfolio. These structured solutions often feature custom swaptions that provide the buyer the right, (but not the obligation) to enter into a swap position that broadly hedges the portfolio. In addition, many investors use collars or other structures to employ protection against large losses while giving up some potential gains. We see real demand for an off-the-shelf tail-risk product with a lower entry point than is currently offered from the very large managers. It will really appeal to the most sophisticated large institutional investors. It was created through reverse inquiries, $5-$10 Billion AUM Hedge Fund Investors do not need to pay the premium for these backward-looking tail-risk funds. The vast majority of tailrisk hedging funds offer a deeply flawed strategy, Long-Only and Alternatives Consultant The way we ve done tail-risk hedging is more subtle. We ve done volatility management by shifting our asset class allocation, Endowment Tail-risk hedging is an important concept to us and we re putting that concept into place in the portfolio in our own way. We re not really looking at the tail-risk funds. We re applying tail risk across the entire portfolio, US Corporate Pension Some Investors Pursue Their Own Tail Risk Hedging or Tactical Asset Allocation (TAA) To avoid the costs associated with tail risk or volatility hedging funds, some investors have built out their own programs to manage these exposures. This is often accomplished through a dedicated put- or swaps-buying regime. Because of the cost of this approach, some investors are instead looking to handle this protection in one of three other ways: tactical asset allocation, portfolio hedging, or the use of custom overlays. Employing a TAA approach requires active management from the investment team; it generally entails moving allocations between equity and fixed-income allocations and using futures contracts to balance the overall portfolio. Trades are placed at somewhat frequent intervals, up to several a week. Finally, there is an emerging group of institutional investors that work with a hedge fund manager to create bespoke overlay strategies. These managers will review the entire portfolio and craft a custom investment product, often using liquid currency and other macro-themed instruments. Many times, pensions have tail risk on their liabilities via rates, so employing an overlay program can provide downside protection. It s important to note that the investment teams employing these approaches tend to be among the most sophisticated institutional investors and have large, dedicated groups looking across both the long-only and hedge fund portfolios. These teams tend to be more experienced and better compensated than the average institutional allocator. The quest for talent to start and grow these programs can be quite challenging. An 20 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

21 Chart 9: Grouping of Investment Products by absolute return and real asset LOW DIRECTIONALITY HIGH Passive Actively Managed Rates Active Equity & Credit Long Only Long/ Short Macro & CTA Event Driven Macro Volatility & Tail Risk Equity Risk Directional Market Arbitrage Neutral Absolute Return Public Markets Distressed Stable Value / Inflation Risk Relative Value Private Markets Corporate Private Equity Commodities Infrastructure Real Estate Timber Real Assets HIGHLY LIQUID LIQUIDITY ILLIQUID adequately structured reward system is an important factor for success, and one that far too many institutional investors are still unable to offer. There has been a lot of emphasis on on-risk, off-risk strategies based on signals. Pensions are approaching stable value from a tactical side. They ll sell S&P futures and buy treasury futures and vice versa, <$1 Billion AUM Hedge Fund We re looking at a number of options or overlay strategies because we also have tail risk on the liability side via rates. If our managers are up 30% on their risk assets and we re up only 15%-17% because we ve applied these overlays, we re okay with that because our target is 8.75%, US Corporate Pension Risk-Based Portfolio Groupings Focus on Low-Directional Products Investors that are moving their entire portfolio to a riskaligned approach note that after they have determined their equity risk and stable value/inflation exposures, they are then left with strategies that offer them little to no beta since they are not aligned with any specific market returns. There are two types of these exposures, as shown in Chart 9. Source: Citi Prime Finance In the public markets, the strategies most able to provide this type of exposure are those absolute return strategies that look at pricing inefficiencies and run at a very low net long or short exposure. These strategies are seen by many as delivering the classic hedge fund alpha sought by investors back when the first wave of massive allocations began in the early 2000s. There are also a group of strategies that are either fully in the private markets or that bridge the private and public markets and base their return stream around real assets, or what some investors refer to as hard assets. This category is growing in popularity across the institutional investor spectrum. These strategies are typically offered by private equity managers Our third bucket is real assets. This includes real estate, infrastructure and this is where physical commodities would go but we don t have a lot of commodities, Sovereign Wealth Fund If people can get the stomach and the resources to really diligence infrastructure in the frontier markets or even Africa, there s a huge opportunity there. Even simple things like toll roads. That s a great investment. You see something like that but it s hard to take advantage of, US Corporate Pension Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 21

22 Right now all of our hedge funds are in our absolute return bucket. This is purely a function of how we defined the absolute return portfolio. We have sold the board on there being zero beta in risk assets zero correlation to anything else in the portfolio, US Corporate Pension that focus on resource-based offerings rather than corporate restructurings, although more hedge fund managers are also beginning to explore this space. Traditional real estate investment structures like real estate investment trusts (REITs) sit in this category. There are also new vehicles emerging to give investors access to a vertically integrated portfolio of companies related to a specific natural resource. The most common of these structures are managed limited partnerships (MLPs) that allow investors to buy into an ownership stake in a set of companies that handle the extraction, processing, and distribution of oil and gas or coal resources. Other emerging funds are not publicly traded but offer investors a similar ability to have an ownership stake in the production, processing and distribution of other natural resources such as timber. Finally, direct infrastructure investment funds are beginning to be launched that offer investors ownership stakes in emerging markets or frontier region projects such as toll roads or power plants. Risk-Aligned Portfolios Reposition Hedge Funds From Satellite to Core Holdings By aligning the strategies in their portfolio around their common risk profiles, institutional investors have begun to create a new portfolio configuration that completely diverges from the traditional 60/40 portfolio and from the two approaches that expanded that traditional portfolio to include either opportunistic or alternative investments that we highlighted at the end of Section I. This new configuration is summarized in Chart 10. People still are not clear on risk allocation versus asset allocation. Starting with an ad hoc traditional allocation of 60% equity / 40% bonds and then trying to somehow risk budget it is very difficult. The way we do it here is we create the asset allocation from the risk allocation after setting risk/return targets, assign correlations, variances, and expectations to various asset classes. Then you come up with optimal asset allocation to serve that risk. Some people have gotten into it but others still don t, Alternatives Focused Consultant and Fund of Fund Chart 10: Institutional Portfolio Configuration: Risk-Aligned Assets Equity Risk Inflation/ Stable Value Absolute Return Real Assets Passive Active Long Only Directional Hedge Funds Corporate Private Equity Macro Funds Volatility & Tail Risk Funds Commodities Market Neutral Funds Arbitrage Related Strategies Relative Value Strategies Infrastructure Real Estate Other (i.e., Timber) Source: Citi Prime Finance We start off with a risk score. How much directional risk do we want to take on and then we think about what investments to take on. We are indifferent as to asset class. We are focused on the risk adjusted returns and we look at that against our top-down views on the macro environment, Long-Only and Alternatives Consultant The thought leaders on the investor side are creating task forces to incubate ideas and then determine the home for their ideas. The hedge fund team is educating the broader investment team and the senior investment staff can think about being more inclusive on the broader buckets, $1-$5 Billion AUM Hedge Fund In this approach, hedge funds have evolved from being a satellite portion of the portfolio to become an essential, core portfolio component. Different types of hedge fund strategies are also included in various parts of the portfolio instead of there being a single hedge fund allocation. If this approach toward portfolio construction takes hold, there is potential for this to spark another period of strong inflows for the hedge fund industry. Indeed, as we will discuss in Section III, while endowments and foundations typically have a fairly substantial portion of their assets allocated to alternative investments and hedge funds, the size of pension funds and sovereign wealth funds core asset pools are multiples of the typical allocations they have carved out for their current alternatives and hedge fund investments. 22 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

23 Thus far, uptake of this new portfolio approach is limited and is estimated to be no more than 10%-20% of the institutional investor universe. Interest is also highly regionally focused, with US investors most receptive to this approach, European investors showing some curiosity and Asian Pacific investors not really showing much movement in this direction. One signal that we may be at just the start of this trend, however, has been the sharp increase in interest in allweather funds that pursue a form of this risk-aligned portfolio construction, known as risk parity. All-Weather Products Create Risk Parity Across Asset Classes to Deliver Returns A form of risk-aligned portfolio that has gotten a lot of press attention recently is an approach called risk parity. When pursuing risk parity, investors divide their risk budget out equally across every asset in their portfolio and then determine how much of each asset type they need to hold in their portfolio to keep that risk allocation in a steady proportion, actively moving their allocations around to maintain this balance. The origins of risk parity go all the way back to the original emergence of Markowitz s MPT. As discussed in Section I, the risk-free assets line (sometimes known at the capital market line) intersects the efficient frontier at the point of the tangency portfolio. This capital line also serves to illustrate another principle. In 1958, James Tobin, another financial markets academic of Markowitz s vintage, drew the line to show the inclusion of cash or an equivalent risk-free asset, such as a 90-day treasury bond, on a potential portfolio. As shown in Chart 11, all of those portfolios that lie along the lower portion of the capital market line (between a 100% riskfree asset portfolio and the tangency portfolio) represent some combination of risky assets and the risk-free asset. When the line reaches the tangency portfolio intersection, this is the point at which the portfolio has all risky assets (ie, equities and bonds) and no cash or risk-free assets. The extension of the capital market line above the tangency portfolio shows the impact of borrowing risk-free assets and applying leverage to a portfolio by using those assets to purchase more of one of the risky assets. In the risk-parity approach, investors take a balanced portfolio that typically works out to be close to the tangency portfolio, but then apply leverage to the lower risk portions of that portfolio using borrowed risk-free assets to lever the tangency portfolio and move up the capital market line. As shown, these portfolios can provide superior risk-adjusted returns versus the traditional 60/40 portfolio because they have a higher Sharpe ratio meaning they deliver better returns for each unit of risk. the idea of using leverage in portfolios has been around for a long time, but institutional investors had an inherent aversion to this proposition and the mechanics of obtaining and managing the borrowing of risk-free assets were difficult in the 1950s through The introduction of treasury futures, however, began to change that paradigm. In 1996, Bridgewater Associates introduced a product called the all-weather fund that was based on risk-parity principles. The lore around the all-weather fund suggests that Bridgewater s founder, Ray Dalio, created the fund to Chart 11: Illustration of Underlying Approach toward Risk Parity Portfolios Return % Tangency Portfolio - All Risk Assets & No Risk Free Assets Leveraged Tangency Portfolio Combinations of Risk Free and Risk Assets Leveraged Portfolios 60/40 Portfolio Risk% (Standard Deviation) Data shown in this chart are for illustrative purposes only. Source: Citi Prime Finance abstracted from work by Tobin, Markowitz, Sharpe & Lintner Pre-2008, one out of every 100 pensions had the risk parity approach. Now you see a lot of people considering it, moving toward it or adapting it outright. Now we re up to about 10 out of 100 having adopted risk parity, but everyone is thinking about it, <$1 Billion AUM Hedge Fund Risk parity is critical to our investment philosophy and to our investors portfolio, Outsourced CIO We ve taken about 6% of the portfolio and dedicated it to opportunistic, because sometimes things don t fit in one of the buckets and we don t want to bucket something just for the sake of bucketing. This opportunistic bucket for us is based on a risk-parity approach. Instead of putting this money in cash, we ve put it in risk parity for the interim 2-3 year investments, US Corporate Pension Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 23

24 mimic the approach he used in managing his own personal wealth. In subsequent years, other market leaders such as AQR followed with similar products. These portfolios were able to significantly outperform traditional 60/40 portfolios in the 2008 crisis and have since gained many proponents. The principles of the All-weather fund are illustrated in Chart 12. The portfolio incorporates all of the assets typically held in the equity risk and stable value/inflation bucket. The portfolio manager then applies an active management overlay to those assets that indicates the optimal mix of assets based on varying economic circumstances related to growth and inflation. More of certain assets and less of others are required to keep the portfolio in parity during each scenario rising growth, falling growth, rising inflation, or falling inflation. The overall portfolio is actively rebalanced in order to hold theassets in parity and to adjust for shifts in view between varying scenarios. The all-weather fund is creating a change in allocation logic whereby an alternative manager can be part of the core of the investors allocation and not a part of the satellite hedge fund allocation, - $1-$5 Billion AUM Hedge Fund We look at Bridgewater and like their approach toward risk parity. It would be a perfect fit with our portfolio, - US Public Pension The Bridgewater all-weather fund is a very diversified portfolio, they actively move assets around based on this idea that they are always adjusting to economic developments. They have frameworks that explain what the asset classes are going to do. They know what their risk boundaries are. There s no question that Bridgewater has an active risk view and that they trade like crazy around those views. AQR too. The reason that people are interested in these all weather fund type products is that you can show a recent back test where this approach worked. - <$1 Billion AUM Hedge Fund Massive amounts of money have reportedly been diverted to these risk-parity funds. One clue of how popular they are can be found in looking at Bridgewater s AUM holdings as shown in Absolute Return s Billion Dollar Club. In 2004, Bridgewater s overall AUM was listed at $10.5 billion, and by the end of 2011 that figure had jumped to $76.6 billion. Allocating to a risk-parity fund is an alternate approach to reordering an institution s entire portfolio configuration into risk-aligned buckets. It can offer institutions an opportunity to get comfortable with the concept of risk budgeting and allows them to monitor how this approach performs relative to their traditional portfolio without being overcommitted to the risk-budget paradigm. In this way, the risk-parity fund provides much the same function that a multi-strategy hedge fund does for investors just beginning their direct investing programs. Chart 12: Illustration of All Weather Fund Overlay to Equity Risk & Stable Value/Inflation Asset Categories Passive Active Equity & Credit Long Only Rising Growth Equity Risk Falling Growth Long/ Short Event Driven All Weather Distressed Corporate Private Equity Macro & CTA Rising Inflation Macro Volatility & Tail Risk Stable Value/ Inflation Risk Falling Inflation Commodities Source: Source: Citi Prime Finance 24 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

25 Changes in Institutional Allocations Confirm Shift in Views About Risk Budgeting The signal that investors are moving toward a risk-aligned portfolio is their willingness to reduce their equity allocations and up their actively managed fixed-income and hedge fund portfolios. Reviewing institutional portfolio allocations over the past 5 years reveals a telling story on how institutional investors are moving toward a more risk-aligned approach and confirm that we may be at the outset of a third major shift in institutional investor portfolio configuration. Chart 13 shows the shift in institutional portfolio holdings between 2007 and As expected, there has been a massive reallocation of money from actively managed equities to actively managed fixed-income funds. The absolute and relative amount of money allocated to active equity strategies fell in the period, dropping from $5.9 trillion in 2007 (43% of total assets) to $4.3 trillion (31%) in The absolute and relative amount of money allocated to active fixed-income and tactical asset allocation strategies rose from $5.1 trillion (38%) in 2007 to $6.1 trillion (44%) in Chart 13: Changes in Institutional Investor Portfolios: 2007 to 2011 Passive $1.4T Active Fixed Income or alanced/taa $5.1T Hedge Funds $1.2T 10.1% December $13.5 Trillion 37.5% 9.2% Active Equities $5.9T 43.2% Passive $2.1T Active Fixed Income or Balanced/TAA $6.1T Hedge Funds $1.5T Hedge fund allocations also posted increases, rising from $1.2 trillion (9.2%) to $1.5 trillion (10.5%) and the trend toward higher passive allocations also continued. This change in allocations is striking. Institutional investors have moved significant amounts of capital out of their actively managed equities into other asset classes and approaches as they diversified their portfolios to lower risk assets. Hedge fund allocations grew in this latest 5-year period even as performance has been difficult. As discussed in this section, part of the reason for this growth has been the change in some leading investors views about where hedge funds fit into the portfolio. 15% December $14 Trillion 10.5% 43.6% Active Equities $4.3T 30.9% Source: Citi Prime Finance Analysis based on evestment HFN data Whereas at the end of 2007, most participants saw hedge funds as a satellite portion of their portfolio, offering the potential for a diversified alpha stream, that view is beginning to change. Increasingly, investors view or are at least are starting to think about hedge funds in a more nuanced manner. The emerging belief is that various types of hedge fund strategies have differing roles in investors core portfolios. Directional hedge funds are seen as providing volatility dampening and downside protection when grouped with other equity risk exposures. Macro strategies are viewed as offering uncorrelated returns and protection against macroeconomic exposures when combined with actively managed rates and physical commodities. Absolute return hedge funds are seen as fulfilling the role of the classic hedge fund allocations that provide pure alpha/zero beta returns. How widespread the adoption of these views become could determine the shape of the hedge fund industry for the foreseeable future. As it stands today, many investors and industry participants feel that the industry is poised for another period of dynamic growth. This will now be discussed in Section III. The risk parity paradigm ideal would say that I want 50% of my risk in equities and 50% of my risk in bonds and I want my overall portfolio to have 8% volatility. To get that, you d have to have a 320% exposure 35% in equities and 285% in bonds. The only way to get that bond exposure is through leverage and the use of swaps and repo, <$1 Billion AUM Hedge Fund People understand that if you did a proper risk balance across all your risks, equity is only one risk factor. You d want to balance across inflation and all the other risks. You can go straight down the list. What this typically means is taking down your equity exposure and taking up your fixed-income exposure, <$1 Billion AUM Hedge Fund There is clearly a sense whereas in the past, a guy had 40% long-only allocated in their portfolio to long-only fixed income, now he ll take 10% of that allocation and give it to an alternatives guy and only run 30% with traditional long-only, $5-$10 Billion AUM Hedge Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 25

26 Section III: Forecasts Show Institutions Poised to Allocate a New Wave of Capital to Hedge Funds Institutional investors showed a net increase in their allocations to alternatives and to hedge funds over the past 5 years ( ) despite issues that arose during the GFC and challenging market conditions in subsequent years. Extrapolating these growth rates indicate that the industry could be headed toward another period of active flows, and these estimates may prove conservative if the new risk-aligned portfolio configuration gains traction and hedge funds start to draw more of investor s core allocations. The majority of interviews conducted for this year s survey exposed three key drivers that are likely to spur increased allocations to hedge funds from the institutional investor world over the coming years. First, institutional market leaders shifting to a risk-aligned portfolio configuration are likely to divert allocations from their core allocation buckets to hedge funds as they reposition their investments to be better insulated against key risk factors. Second, institutions that began with an exploratory stake in hedge funds over the past decade to test their diversification benefit are likely to increase their allocations to address rising liabilities or to reduce the impact of excessive cash balances. Finally, new institutions that had been considering an allocation to hedge funds prior to the GFC and that were sidelined in the turmoil following that period are now positioned to launch their investment programs. Based on these considerations, we created a model showing the impact of industry growth and flows on par with that seen between 2006 and Projections emerging from this model show that the hedge fund industry could be poised to receive a second $1 trillion wave of institutional flows by In compiling our forecast, we decomposed the institutional category and examined trends separately for E and Fs, pension funds, and sovereign wealth funds. Before we detail this forecast, however, we will instead explore concerns expressed by some participants that recent market performance could dampen institutional enthusiasm and cause interest in hedge funds to wane. While this is not a likely scenario, it is still possible and we will thus similarly model the potential impact. To begin that analysis, we will start by profiling the various segments of the institutional investor base and their respective interest in hedge funds. Institutions Enter Hedge Funds at Varying Rates As noted earlier, E and Fs were the original category of institutional investor to focus on alternatives and on hedge funds. Market leaders in this category were already putting substantial sums of money into play in the hedge fund space by the early 1990s. From there, interest in hedge fund investing rippled downstream as smaller E and Fs emulated the model of the early adopters. By the mid-2000s, there was broad participation from E and Fs and approximately 20% of all assets from this category were invested in hedge funds by 2011, as shown in Chart 14. Although the asset size of other institutional investorcategories is much larger than E and Fs holdings, it is important to note that these other segments are not as far along in terms of their overall interest in either alternatives or hedge funds. A limited group of market leaders in the corporate and public pension space began investing in hedge funds in the late 1990s, but the practice did not gain traction until after the technology bubble. Indeed, pensions were the primary drivers of the investment wave in While they accounted for a large part of the allocations in that period, it is important to note that even with these large inflows, the penetration of alternatives and hedge funds has been limited within the pension world and is nowhere near as advanced as in the E and Fs space. According to Towers Watson, alternatives overall were only 14% of global pension holdings in 2006 for the seven largest pension nations that accounted for 97% of total assets. That total rose only modestly to 16% by the end of Hedge funds still accounted for less than 3% of global pension holdings by the end of 2006, and our estimate is that those figures are almost unchanged t to the present day at only 3.6%. 26 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

27 Sovereign wealth funds emerged even later as an institutional category. The majority of these participants began to deploy excessive cash balances to diversify their income streams only in the past decade. Interest in alternatives and hedge funds did not really emerge until the mid-2000s, although these participants were able to gear up their allocations more quickly as they had large, internally directed investment teams. Our estimates show sovereign wealth funds having diverted 7.6% of their total assets to hedge funds by The advent of sovereign wealth funds into the space has been the only really new entrant, Institutional Fund of Funds When I arrived we had one pension and now we have money from 100. We had zero money from sovereign wealth funds and now we have money from 5, >$10 Billion AUM Hedge Fund Chart 14: Growth of Institutional Investor Interest in Hedge Funds by Segment Percent of Total Assets 20% 15% 10% 5% 0% Endowments & Foundations Sovereign Wealth Funds 19.9% 7.6% 3.6% Pension Funds Source: Citi Prime Finance Analysis Endowments are more fully invested. We haven t really seen any who aren t in the hedge fund space, Performance Raises Concerns About Hedge Funds While most survey participants expected interest from these participants to continue higher, some respondents expressed concern about hedge funds relative level of underperformance to the equities markets in the past year. As shown in Chart 15, hedge fund returns protected investors on the downside relative to the broad equity markets in only 3 of the past 15 months between January 2011 and March They were equally flat or down in an additional 3 months, but they significantly underperformed in 9 of the last 15 months, failing to capture even half as much of the upside gains in 6 of those months and were down when the overall markets were up in 2 of those months. Even more worrying was November 2011, when the major hedge fund indices were down more than broad equity market indices were down. This disappointing performance has concerned many market participants and caused some investors to question their core assumptions about the role hedge funds play in their overall portfolios. Some survey participants worried that there could be a loss of confidence in hedge funds and that investors may begin to rethink their level of interest. At a minimum, investors are calling into question how well directional hedge fund strategies will fare in the coming period. Institutional Fund of Funds We can t talk about investors like an investor. Endowments are very different than corporate pensions. Public pensions are very different from family offices. Are there some that act like the other? Sure, but they re just different organizations that make decisions differently and that influences how they allocate, >$10 Billion AUM Hedge Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 27

28 Chart 15: Comparison of Hedge Fund & S&P 500 Monthly Returns: January 2011-March % 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% HFRI Equal Weighted Index We are at a real tipping point. A lot of clients still really believe in risk-adjusted returns, but returns for the past 2 years have pretty much been aligned to long only. This is going to call into question the huge asset flow from long only into hedge funds. The risk is that this trend could reverse or at a minimum pause, Long-Only and Alternatives-Focused Consultant Clients are wondering why hedge funds are not performing and they can t compete in an up market rally E and Fs Trim Hedge Fund Allocations S&P 500 Index Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Fund of Fund Asset allocation trends from the largest E and Fs are adding to the overall level of concern. The National Association of College and University Business Officers (NACUBO) Commonfund Endowment Study that surveys more than 800 US and Canadian endowments found that overall hedge fund allocations from this segment have declined since their peak in These declines were most evident from the largest endowments with more than $1 billion in assets. S&P is the internal yardstick. When individual hedge fund managers are down more than the market, a lot of allocators didn t even think that was possible as a concept in equity long/short. There s more runway for macro and other strategies where there is not as obvious a yardstick, Long-Only and Alternatives-Focused Consultant If hedge funds offer 80% of the performance with 40% of the volatility, that may not be enough. With our client base, the associated operational headaches, the lock-ups, the lack of transparency requires equity-like returns to warrant all the headache. 100% of the returns at 50% of the volatility might be OK, but 80% and 40% won t cut it, Long-Only and Alternatives-Focused Consultant As shown in Chart 16, E and Fs with more than $1 billion in assets had steadily increased their hedge fund allocations between 2002 and 2009, growing from 17.8% to 24.4% of their total assets. This trend reversed in 2010 and continued lower in 2011 as this group s total allocation declined to only 20.4% of assets. Because of the skew these large organizations represent in terms of total E and Fs capital, their shift in course is causing the segment s entire dollar-weighted allocation to hedge funds to dip as well. For many years, E and Fs with more than $1 billion in assets had the highest share of money allocated to hedge funds, and those organizations at lower asset bands had less of their wallet focused on hedge funds. In recent years, however, that pattern has reversed and by 2011, the E and Fs structure had inverted. The largest organizations had the lowest allocation to hedge funds, and the smaller E and Fs had the highest allocation. These large endowments were the market leaders on which other institutional investors modeled their approach of including hedge funds and alternate alpha streams in their portfolio. Seeing a reversal of the more than decade-long trend toward increasing assets from this segment has many investors worried that this may be seen as a signal by other institutional investors. As noted in the following quotes, there were indeed some signs of institutional investors reversing or pausing in their hedge fund investment programs. 28 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

29 Chart 16: U.S. & Canadian Endowments & Foundations Allocation to Hedge Funds Chart 17: Growth in Various Institutional Assets By Type: 2006 to % 22% 20% Over $1B in Assets 24.4% 21.8% 20.4% 19.9% Hedge Fund Assets Total Institutional Alternative Assets 61% 49% 24% Total Assets 18% 16% 17.8% All Institutions Endowments & Foundations 50% 58% 114% 14% 12% 10% 11.3% Sovereign Wealth Funds 67% 108% 151% Source: Citi Prime Finance Analysis from NACUBO Commonfund Endowment Study Global Pension Funds 43% 35% 18% 0% 20% 40% 60% 80% 100% 120% 140% 160% Endowments and foundations have been shrinking since the financial crisis and they are well down from being 1/3 of our asset base, Asset Manager With Hedge Fund Product Future flows from the pension space are really going to be returns dependent. If people don t get the hedge fund return they expect, there may not be much growth in the industry from here. There are a lot of plans thinking about taking that initial step into hedge funds, but the last couple years have dampened their enthusiasm, Institutional Fund of Fund Industry AUM May Be Near Peak if Institutional Interest Stalls In an attempt to quantify how slowing interest in alternatives and hedge funds may impact overall AUM, we dug into the pattern of industry change over the past 5 years. One key point to note is that even with the dramatic events of , our estimates show that the overall level of global institutional assets grew 24.5%, from an estimated $26.5 trillion to $33.0 trillion between 2006 and Gains in overall assets were evident from each major institutional audience, as shown in Chart 17. Source: Citi Prime Finance Analysis based on Towers Watson, SWF Institutte, OECD, NACUBO Commonfund & evestment HFN data According to Towers Watson, pension funds that represent the vast majority of institutional capital increased their global holdings from $23.2 trillion to $27.5 trillion in this 5-year window. Sovereign wealth fund capital increased from $2.9 trillion to $4.8 trillion based on figures emerging from both the Organisation for Economic Co-operation and Development (OECD) and the Sovereign Wealth Fund (SWF) Institute. Finally, according to NACUBO, the total amount of assets held by US and Canadian endowments and foundations grew from $340 billion to $546 billion and since our estimate is that these institutions represent approximately 80% of the global endowment and foundation market, we see overall endowment and foundation capital having increased from $425 billion to $670 billion. The share of that capital being targeted for alternatives also rose across each of these audience segments, as also shown in Chart 17. Within the pension space, detailed asset allocations are provided by Towers Watson for the top seven nations the United States, the United Kingdom, Switzerland, the Netherlands, Japan, Canada, and Australia. These countries represented 97% of global pension assets in 2006 and 89% of assets in Their allocation to alternatives rose from 14% to 16% of total capital in that period. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 29

30 The target we set for our hedge funds influence our allocation. Precrisis, we had 15-16% of the portfolio in hedge funds. Post-crisis we ve taken that down to 10%-11%, European Public Pension Last year, the equity markets collapsed in the summer and the equity long/short funds had a high correlation with the equity markets and we began then to reconsider our equity long/short allocation, Asian Corporate Pension Using those levels as a guide, we have estimated that pension funds total allocation to alternatives rose from $3.25 trillion in 2006 to $4.40 trillion in We also have estimated that the share of alternatives targeted at hedge funds increased from 21% to 22% of alternatives. This implies that pension allocations to hedge funds rose from $683 billion in 2006 to $977 billion in 2011, equating to a jump from 2.9% to 3.6% of total global assets. In the sovereign wealth fund space, there is a less precise breakdown of how assets are allocated, but various industry publications and our own set of interviews have led us to believe that in 2006, these participants collectively had targeted 20% of their total allocations to alternatives and that by 2011, that figure had increased to 25%. Within their alternatives category, we see hedge funds having risen from 25% to 30% of the allocation. The results of these calculations show an estimate on sovereign wealth fund allocations to hedge funds of $145 billion in 2006 and a jump in that figure to $364 billion by Finally, figures provided by NACUBO give us a good guideline to follow in estimating E and Fs allocations to hedge funds. Between 2006 and 2011, these organizations dramatically increased their alternatives allocation from 39% to 53% of total assets, but in part this represented a denominator effect due to sharp losses in the portfolio in Within the alternatives category, there was a decrease in the allocation to hedge funds as discussed in the section above, but this was partially offset by growth in the overall alternatives bucket. Our estimate for this segment is that hedge fund allocations rose from $89 billion to $133 billion between 2006 and The reason we have broken out these changes so precisely is to provide the foundation for a forecast of what might happen to the hedge fund market if interest from institutions stalls. Chart 18 shows the result of that projection. Because trends within the alternatives and hedge fund space do not impact the overall size of assets, we have used the average rate of growth between 2006 and 2011 and come up with a forecast on the size of the total global pool of institutional assets, showing that these holdings will increase from $33.0 trillion to $41.6 trillion by Within each category, we then took down the share of capital being allocated to alternatives back to the levels last seen in We also reduced the share of alternatives being Chart 18: Projected Breakdown of Institutional Assets by 2016 Based on Declining Alternative & Hedge Fund Interest (Billions of Dollars) Pension Funds Sovereign Wealth Funds Endowments & Foundations Total E E E E Total Assets $23,237 $27,510 $32,568 $2,875 $4,794 $7,994 $425 $670 $1,057 $26,537 $32,974 $41,619 Alternative as % of Total Assets 14% 16% 14% 20% 25% 20% 39% 53% 39% 15% 18% 16% Alternative Asset $3,253 $4,402 $4,560 $575 $1,199 $1,599 $166 $355 $412 $3,994 $5,955 $6,571 Hedge Fund as % of Alternatives 21% 22% 21% 25% 30% 25% 53% 37% 37% 23% 25% 23% Hedge Funds Assets $683 $977 $958 $145 $364 $400 $89 $133 $153 $917 $1,474 $1,511 Hedge Fund as % of Total Assets 2.9% 3.6% 2.9% 5.0% 7.6% 5.0% 20.9% 19.9% 14.5% 3.5% 4.5% 3.6% Estimated Breakdown of Institutional Assets: 2006, 2011 & 2016 Estimate Based on Continued Growth in Alternate & Hedge Fund Interest Millions of Dollars Assumptions: 1. Entire Alternatives allocation of global pension fund assets is held by institutional investors 2. Alternatives percent of global pension funds based on top 7 nations share of global assets (97% 2006/89% 2011) 3. Sovereign Wealth Fund allocation to Alternatives & Hedge Funds estimated based on Citi Prime Finance interviews & OECD, SWF Institute Data 4. US & Canadian Endowments & Foundations estimated at 80% of global E&F 5. E&F share of Alternatives & Hedge Funds based on NACUBO Endowment Study US/Canadian Estimates total assets based on average rate of growth by category from 2006 to I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

31 allocated to hedge funds back to the 2006 levels for both pension funds and sovereign wealth funds. Instead of following this same methodology for E and Fs, where we have already seen a decline in the share of alternatives being targeted at hedge funds, we instead opted to hold that allocation at the 2011 level. As shown, if this scenario holds true our forecast is that total institutional assets will flatten out near the industry s current levels, rising only minimally from $1.47 trillion to $1.51 trillion by This forecast is detailed in Chart 19. As shown, overall allocations remain broadly unchanged from each segment in this forecast. While this scenario is certainly possible, the majority of survey participants did not share some participants pessimism about how returns of the past 15 months are likely to affect the industry overall, and instead expressed a much more optimistic view. Most Participants See Institutional Interest Continuing to Rise While a number of interviewees did express concern about institutions continued interest in hedge funds, most participants instead pointed out factors that were likely to drive institutional interest even higher for some time to come. Many of the organizations we interviewed had either recently increased or were newly entering the alternatives and hedge fund space. Foremost among the factors driving a view that institutional interest will continue to grow was the nature of their portfolios. These investors are looking to address long-term obligations or structural cash imbalances. Based on actuarial estimates and funding needs, many of this institutions return goals are 8%-10%. and they wish to achieve these returns without excessive downside risk. Most institutions in Europe are not there yet in terms of hedge funds. We and the Dutch have been moving ahead, but other organizations are still gearing up, - European Public Pension I see hedge funds remaining in some way shape or form in our book for the long run. We ve been in the space much longer than many other pensions and we see our interest continuing. We re now also seeing more and more other pensions getting into the space, - US Public Pension Chart 19: Projected Institutional Hedge Fund Assets: 2016 Based on Declining Alternative & Hedge Fund Interest Billions of Dollars $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 0 $917B $683 74% $89 10% $145 16% Pension Funds SWFs E&Fs $1,474B $133 9% $364 25% $977 66% + $37B $1,511B $153 10% $400 26% $958 63% Estimate Source: Citi Prime Finance Analysis based on Towers Watson, SWF Institutte, OECD, NACUBO Commonfund & evestment HFN data This is not the type of fast money that pursues octanefueled returns, nor is it the type of money that is likely to cause investors to rethink their allocation approach based on 1 or 2 years of market performance. As we explored in depth in last year s survey, these participants take long-term views of their portfolio and are known across the hedge fund community for offering sticky money. For pension funds in particular, rising liability gaps and an aging population are driving participants to remain aggressive in seeking diversification and pursuing strategies that will limit their downside exposure. According to Towers Watson, the US represents 58.5% of global pension assets. The asset-to-liability gap in US state pensions has been estimated at more than $1 trillion according to the latest Pew Center for The States survey, and some academic studies suggest that the figure could actually be as much as $3-$4 trillion. US corporate pension funds recorded their largest deficits ever in 2011, with the gap between assets and liabilities for the 100 biggest portfolios hitting a record $327 billion according to industry specialist consulting firm Milliman, publishers of the Milliman 100 Pension Funding Index. 8 Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 31

32 The timeline of judging performance for public pensions is long term. Yes they look at quarterly results, but they are keenly focused on the long view, - $5-$10 Billion AUM Hedge Fund The biggest growth will be in private alternative products, since developed Asian countries are aging rapidly; their pension systems need to get more aggressive in allocating to hedge funds and other alternatives, - $1-$5 Billion AUM Hedge Fund Another Massive Wave of New Capital Could Be Forthcoming While a minority of participants worried that near-term hedge fund performance could endanger future institutional flows, others pointed toward broader macro trends as driving the opposite a resurgence of active inflows that could rival the wave of money seen in This was based on a belief that we are close to completing the massive deleveraging that began in , and that a renewed focus on risk assets will benefit the hedge fund industry and encourage investors to increase their allocations. Similar pension funding gaps exist in Europe and Asia. Towers Watson notes that Japan is the world s second largest source of pension assets, with 12% of total global holdings. Japan s Ministry of Health, Labor and Welfare announced earlier this year that about 75% of nearly 600 pension funds in Japan set up by small businesses in sectors like transportation, construction, and textiles didn t have enough assets to cover expected payouts. Aviva, the UK s largest insurer and one of Europe s leading providers of life and general insurance, estimated that the European pension gap between assets and liabilities stands at 1.9 trillion across the 27 European Union member states. Meanwhile, there have been 20 new sovereign wealth funds created just since 2005 according to the SWF Institute, with many of these entities looking to diversify state revenues in the wake of surging gas, oil, and other commodity prices. These organizations are looking at broad investment portfolios and are showing an increased interest in both alternatives and hedge funds. These structural issues, along with low global interest rates and low equity market returns in recent years, are likely to drive participants to continue expanding their portfolios into alternatives and hedge funds. As discussed in Section II, the level of interest in hedge funds could even accelerate if investors begin to move toward the risk-aligned allocation approach that places hedge funds in the core as opposed to the satellite portion of the investor s portfolios. We ve been in a massive period of deleveraging since At some point in the coming period call it 20XX we will see risk assets bottom. From there, growth assets will kick in and we ll see risk come back into the system, <$1 Billion AUM Hedge Fund There is still a lot of room for growth in the aggregate demand for hedge funds. The highest allocation of our clients is at 20%, but we have lots of clients that are only at 1%-3% and they could grow to 10%. That s a multibillion opportunity per client, Alternatives-Focused Consultant If we use the actual 5-year growth rates registered by each institutional segment between 2006 and 2011 and extend those forecasts to the next 5-year window, projections about a potential wave of new money can be supported. Chart 20 shows the breakdown of such analysis. The starting point in terms of overall assets is the same as in our earlier projection and is based on the average increase in total assets by segment between 2006 and 2011; but instead of going back and using the 2006 level of interest for alternatives and hedge funds, we will use the change in allocations between 2006 and 2011 and apply that going forward to reflect continued growth. Many of the participants we interviewed, particularly those that have been in the markets for a decade or more, discussed either recently having increased or planning to increase their overall allocations. There were also a number of new institutions that had either just begun or were on the cusp of beginning their hedge fund programs. This was true across the US, Europe, and Asia. 32 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

33 Chart 20: Scenario II: Breakdown of Institutional Assets by 2016 Billions of Dollars $2,500 $2,000 $1,500 $1,000 $500 0 $917B $683 74% $89 10% $145 16% Pension Funds SWFs E&Fs + $996B $1,474B $364 25% $977 66% $133 9% $2,470B $233 9% $839 34% $1,398 57% Estimate Source: Citi Prime Finance Analysis based on Towers Watson, SWF Institutte, OECD, NACUBO Commonfund & evestment HFN data 8 Starting with pension funds, we forecast that the total allocation to alternatives will rise from 16% to 18% of total assets, in line with the gain from 14% to 16% noted between 2006 and Similarly, we project that the share of those alternatives being targeted at hedge funds increases 1%, from 22% to 23%. The result of this analysis shows potential for pension fund allocations to hedge funds to jump from $977 billion to $1.4 trillion, rising from 3.6% to 4.3% of total pension fund assets. For sovereign wealth funds, we project a 5% increase in allocations to alternatives, from 25% to 30% of total assets, and within that alternative category we see interest in hedge funds also rising 5%,from 30% to 35% of total alternatives. The result is a large jump in hedge fund interest from $364 billion to $839 billion, rising from 7.6% to 10.5% of total sovereign wealth fund holdings. These figures seem to be in line with this segment s likely growth, as the profile of sovereign wealth funds is seen as being located somewhere between conservative pension funds and aggressive E and Fs. Survey participants noted that younger sovereign wealth funds are more returns-focused with higher returns targets while more established funds present a more conservative pension fund-like profile. Because E and Fs allocations have already begun to retreat, we had to estimate interest in this scenario. As noted earlier, smaller organizations in this segment are increasing their alternative and hedge fund allocations, even as larger organizations are slowing their allocations. Since these smaller participants do not carry as much influence on a dollarweighted basis, we have forecast only a modest increase in the allocation to both alternatives and hedge funds rather than use the changes noted between 2006 and The result is that we see continued growth in hedge fund interest; however, from a total assets perspective, the impact of that growth is only likely to raise hedge fund allocations from 20% to 22% of total endowment and foundation holdings. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 33

34 We expect to see more allocations from corporate and public pensions and they will account for a greater percentage of our AUM, - $1-$5 Billion AUM Hedge Fund Sovereign wealth funds are at vastly different stages. Some are young and naïve and they have unrealistic expectations about performance. They are targeting 20% across their entire portfolio. That s one extreme, and then you have other more established funds targeting 6% across the portfolio, - $1-$5 Billion AUM Hedge Fund As Chart 21 details, based on the 5-year growth rates noted between 2006 and 2011, the total institutional allocation to alternatives could rise from 25% of total assets in 2011 to 28% in 2016, and the allocation to hedge funds from these participants could rise from 4.5% to 5.9%. From a dollarvalue perspective, this would equate to a jump in hedge fund industry AUM from $1.47 trillion in 2011 to $2.47 trillion by 2016, as detailed in Chart 21. One of the key questions to consider in this scenario is whether these rising allocations will be targeted at today s traditional hedge fund industry participants or whether an emerging class of hedge fund-like strategies and offerings from traditional asset management firms will instead be able to attract an increased share of these assets. Conversely, there are growing signs that hedge funds themselves are cutting into long-only allocations and that they are looking to compete to manage a share of traditional institutional investor assets. Having explored changes in investor portfolios and how their interest may evolve, we will now turn our analysis toward the investment management community, where there is a tremendous amount of product innovation occurring that is narrowing the gap between hedge funds and traditional asset managers. Chart 21: Scenario II: Projected Institutional Hedge Fund Assets by 2016 Rising Share of Alternatives (Billions of Dollars) Pension Funds Sovereign Wealth Funds Endowments & Foundations Total E E E E Total Assets $23,237 $27,510 $32,568 $2,875 $4,794 $7,994 $425 $670 $1,057 $26,537 $32,974 $41,619 Alternative as % of Total Assets 14% 16% 18% 20% 25% 30% 39% 53% 55% 15% 18% 21% Alternative Asset $3,253 $4,402 $5,862 $575 $1,199 $2,398 $166 $355 $581 $3,994 $5,955 $8,842 Hedge Fund as % of Alternatives 21% 22% 23% 25% 30% 35% 53% 37% 40% 23% 25% 28% Hedge Funds Assets $683 $977 $1,398 $145 $364 $839 $89 $133 $233 $917 $1,474 $2,470 Hedge Fund as % of Total Assets 2.9% 3.6% 4.3% 5.0% 7.6% 10.5% 20.9% 19.9% 22.0% 3.5% 4.5% 5.9% Estimated Breakdown of Institutional Assets: 2006, 2011 & 2016 Estimate Based on Continued Growth in Alternate & Hedge Fund Interest Millions of Dollars Assumptions: 1. Entire Alternatives allocation of global pension fund assets is held by institutional investors 2. Alternatives percent of global pension funds based on top 7 nations share of global assets (97% 2006/89% 2011) 3. Sovereign Wealth Fund allocation to Alternatives & Hedge Funds estimated based on Citi Prime Finance interviews & OECD, SWF Institute Data 4. US & Canadian Endowments & Foundations estimated at 80% of global E&F 5. E&F share of Alternatives & Hedge Funds based on NACUBO Endowment Study US/Canadian Estimates total assets based on average rate of growth by category from 2006 to I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

35 1. Section Introduction IV: Investment Managers Respond to the Shifting Environment Initially, the influx of institutional money into hedge funds came via fund of fund intermediaries, and institutional investors did not require much transparency into the holdings of underlying managers. This situation changed significantly post Hedge fund products, particularly in the more liquid directional and macro strategies, now offer a profile that is not as far removed from traditional long-only and regulated products. This has encouraged both asset managers and hedge funds to extend their offerings, the result of which has been the emergence of a convergence zone where these investment managers compete head-to-head. Hedge Funds and Asset Managers End Period at Both Ends of a Barbell A distinct gap existed between hedge funds and asset managers after the wave of inflows in At one end of the market were active and passive long-only managers and managers of long-only separately managed accounts (SMAs) that offered low-fee, transparent, and highly liquid portfolios, primarily in the form of regulated fund structures. At the other end were hedge funds with higher fees, less transparency, and longer lock-ups. The divide between these two offerings was so great that for many years, people referred to the industry as having a barbell configuration. This is illustrated in Chart 22. This period was one of dynamic growth for the hedge fund industry, and managers were clearly in a dominant position. Concerns about capacity were so great that even as the number of hedge funds grew 66% from 4,598 funds at the outset of 2003 to 7,634 funds at the end of 2007 the average fund holdings grew even more quickly, rising 80% from $136 million at the outset of 2003 to $245 million by the end of (Source: HFR) Even more impressive was the growth of fund of fund intermediaries. Growth in the number of fund of hedge funds (FoHFs) was explosive. At the outset of 2003, there were 781 FoHFs, and by the end of 2007 that figure had increased 215% to 2,462 funds. (Source: HFR) Chart 22: Investment Structures in the Public Markets: 2007 LOW LIQUIDITY HIGH Regulated Funds & Long Only SMAs Passive Index & ETF Funds Actively Managed Long Only Funds Traditional Asset Managers Barbell Private Funds Hedge Funds Directional Non-Distressed Macro Absolute Return Distressed HIGH TRANSPARENCY LOW Source: Citi Prime Finance Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 35

36 We had very little in hedge funds a while back. The first step for us was a fund of fund. We viewed this as dipping our toe in the water. Now we re doing things direct, US Corporate Pension When I got here in 2009, our assets were 70% from fund of funds. Now that figure is down to 32%. Of the $5.7 billion we raised last year, 75% was from new investors and only 1% was from fund of funds. We did that by design, >$10 Billion AUM Hedge Fund During those years, FoHFs were the primary conduit through which many institutional investors channeled their money into hedge funds. Institutions would make a single allocation to an FoHF s comingled vehicle and trust that the FoHF team would identify and invest the capital in a suitable and diverse set of hedge fund managers. There was not much demand for transparency into actual hedge fund holdings, and both FoHFs and their underlying investors were caught off guard by the asset-liability mismatch that FoHFs had created in their portfolios by placing managers with illiquid assets into fund structures that typically offered liquidity terms based on managers with more liquid assets. This mismatch was discussed in depth in our 2010 survey. Historical Gap Between Hedge Funds and Asset Managers Narrows After Crisis Coming out of the GFC, there were two major changes that took place in the industry, both of which have served to narrow the gap between hedge funds and more traditional asset managers. The other big change coming out of the GFC was that the hedge fund industry shifted from supply driven to demand driven. The due diligence process became highly extended and managers that had previously been able to raise money quickly began to experience longer selling cycles, as direct investors could often take 6+months to decide on an allocation. As investors forged direct relationships with managers over these extended periods, they built relationships with the managers and were able negotiate more transparency into the hedge fund s holdings and obtain liquidity terms that were better aligned to the type of assets being traded as part of the fund s overall strategy. Managers proved mostly receptive to moving in this direction, partly to diversify their own investor base away from being too concentrated around FoHF exposure and partly to qualify for the larger single tickets of $100-$200 million being written by pension and sovereign wealth funds entering the market. The results of this realignment are striking. By March 2012, 65% of the hedge funds reporting to the evestment HFN database required 30 days or less notice from an investor about their intention to redeem funds, and 72% indicated that they offered monthly or better liquidity terms. Improved transparency and liquidity helped to narrow the gap that had previously existed between hedge funds and traditional asset managers. Those strategies with the most liquid underlying assets (directional and macro hedge funds) were able to move into broad alignment with more traditional investment vehicles. This is illustrated in Chart 24. Chart 23: Share of Industry Assets Held in Fund of Hedge Funds versus Directly Allocated to Single Managers The first change pertains to investors decision to directly allocate their hedge fund capital (with or without the help of an industry consultant) rather than turning over that responsibility to an FoHF intermediary. As discussed at the outset of Section II, this trend had started prior to the GFC but only gained momentum after According to evestment HFN, at the end of 2002 assets invested in FoHFs accounted for 52.8% of the industry s total AUM, but by the end of 2007, that figure had declined 4.6% to 48.2% of the industry s total assets. After the GFC, this trend picked up dramatically. By the end of 2011, FoHF assets had fallen an additional 12% and accounted for only 36.2% of the industry s total AUM. This is illustrated in Chart % 60% 55% 50% 45% 40% 35% % Direct Allocations Fund of Hedge Funds 36.2% Source: evestment HFN 36 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

37 Chart 24: Investment Structures in the Public Markets: 2012 Changes in Hedge Fund Profile LOW LIQUIDITY HIGH Regulated Funds & Long Only SMAs Passive Index & ETF Funds Actively Managed Long Only Funds Traditional Asset Managers UCITS & Regulated Alternative Funds Directional Non-Distressed Hedge Funds Macro Private Funds Absolute Return Distressed HIGH TRANSPARENCY LOW Source: Citi Prime Finance Hedge Funds Cross the Line to Offer a Range of Actively Managed Products Narrowing the gap between hedge funds and traditional asset management products has made it fairly easy for many hedge funds to take that process one step further and move across the line that separates regulated funds and long-only SMAs from private funds. Several factors have driven this move. First, the size of the wallet in the regulated and long-only SMA world is substantially larger than hedge fund AUM; this will be explored further in Transparency from hedge funds is getting better and reporting is improving, Endowment If a hedge fund shows any hesitancy to being transparent, they re off the table in terms of our consideration, US Public Pension In Europe, we still see a near manic focus on liquidity. It s probably the biggest regional differentiation we notice, Section VI. Many managers saw opportunities to diversify their investment base and tap into new retail capital pools with regulated alternative or long-only product. Even if these investments brought with them lower fee structures, sentiment was that managers could raise large enough amounts of AUM to equal or even exceed the higher management and incentive fees they could have obtained on their core hedge fund product. Second, there was rising retail and institutional demand from Europe for regulated UCITS funds. Consequently many of the more liquid hedge fund managers in directional or macro strategies saw opportunities to preserve their asset base by launching such vehicles. In part, this was a response to regulatory uncertainty regarding the Alternative Investment Fund Managers Directive (AIFMD) marketing rules, and a desire from many participants to ensure that they had onshore product to offer their investors. In part, this was also a backlash against the liquidity issues many investors experienced during the GFC. Over the last 2 years, many US and Asian managers have begun to launch, or have considered launching UCITS to tap into European investors. < $1 Billion AUM Hedge Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 37

38 We are getting dragged over the line by the wallet. We are also working on two regulated funds driven by the investor. We would be a sub-advisor to the RIC product, $1-$5 Billion AUM Hedge Fund The great news for us is that instead of getting $20 million to manage at 2&20, you get a $300 million investment for 1&10. Hedge funds have to decide if they want to be an asset a manager and have a lot of product on their platform. Some will do it to get access to pensions and up-sell their traditional hedge fund product, >$10 billion AUM Hedge Fund A third driver of hedge funds moving into regulated funds and long-only SMAs was a growing perception across many in the institutional audience that hedge fund managers had fewer constraints on how they chose to run the long side of their books. Their more flexible approach could generate better returns for their active equity or credit portfolios than those being achieved by traditional managers that had requirements to be fully invested, and that were being evaluated on their ability to outperform a specific benchmark. This was an especially appealing proposition for hedge fund managers that were at or near capacity in their long/short funds. A final driver was the perception that regulated fund structures offered more investor protection when looking at new investment areas such as commodities, emerging, or frontier markets. In our interviews this year, we encountered hedge funds across the US, Europe, and Asia that had all made this move into the regulated funds and long-only SMA space. The result of this product expansion was that many participants now see hedge funds as synonymous with active managers and look at these participants for their ability to pursue both alpha- and beta-type returns. Traditional Asset Managers Loosen Constraints on Their Long-Only Funds Traditional asset managers have not stood by idly as hedge funds crossed the line into the regulated fund space. They themselves followed suit and started offering actively managed long- only product. There has been a significant change in many organizations that reflects a backlash against the rigid restraints that limited how traditional managers were required to invest their long- only funds. This change has led to a shift away from funds tied to benchmarks and a move toward traditional asset managers offering unconstrained, actively managed long funds. Under this new approach, managers are not required to be fully invested, nor are they tied to index weights in making their allocation decisions. They have the option of having a portion of their portfolio in cash, and they are often allowed to use limited amounts of shorting or leverage if they so desire. Limited is, however, the operative word. Typically, these funds are between 90% and 110% net long. Oftentimes they will choose to short an index or ETF to obtain some hedge protection for the portfolio, but rarely do they use singlename shorts designed to generate independent alpha. Many in the asset management industry are calling these types of funds hedge fund lite offerings or alternative beta funds. Many in the institutional audience are looking with favor upon these unconstrained funds. Because the net long on the portfolios remains so high and the amount of shorting allowed in the fund is so limited, they can shift their longonly allocations in this direction and still remain within policy guidelines set by their investment committees. The result has been a split in the actively managed long-only pool, with a majority of new fund launches being targeted for the unconstrained long space. This is illustrated in Chart 25. The long-only world is clearly transforming not necessarily to an absolute return mindset, but away from a benchmark focused approach, European Wealth Manager Client demand is moving away from benchmarks. Absolute return from an asset allocation perspective drove the traditional long-only business into taking a more active approach to management, Asset Manager With Hedge Fund Offerings The intention was to change our book away from index huggers to managers that are benchmark aware but not tied to the benchmark. Part of that is our own familiarity with managers that had long-only products that were only 85% or 90% long. They were completely unconstrained, Endowment We see more allocators move away from benchmark thinking, $1-$5 Billion AUM Hedge Fund 38 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

39 Chart 25: Investment Structures in the Public Markets: 2012 Changes in Traditional Asset Manager Profile LOW LIQUIDITY HIGH Regulated Funds Passive Index & ETF Funds Unconstrained Long Long Only UCITS & Regulated Alternative Funds Convergence Traditional Asset Managers Hedge Funds Directional Non-Distressed Private Funds Macro Absolute Return Distressed HIGH TRANSPARENCY LOW Source: Citi Prime Finance Asset Managers Also Cross the Line Into Alternative Product Just as hedge funds cited several reasons to cross the line into the regulated fund space, many traditional asset managers also brought forward arguments as to why they, too, should cross the line, but in the opposite direction, by beginning to offer hedge funds. Foremost among these reasons was a desire to preserve their asset base as well. As discussed in the investor section of this report, there has been a massive movement out of actively managed long-only funds into hedge funds over the past decade. Many asset managers expressed their belief that they needed to be able to offer a range of products that provided an investor choices about the investment techniques that could be employed to generate returns within their portfolio. Moving into the hedge fund space allowed these managers to offer a product able to employ more aggressive techniques with fewer restraints in order to pursue alpha. Hedge funds are more readily creating UCITS funds, especially in equity long/short strategies. The perceived investor appetite is leading managers to UCITize what is UCITizable. Increased requirement for more transparency and regulation is driving this trend. It is leading to less fees and more compliant products. 50% of equity long/short managers have done it or are thinking about offering these products because they need to attract assets. US hedge funds are also thinking about creating UCITS vehicles if they want to raise money in Europe, European Fund of Funds We re being asked by some clients to find hedge funds to replace managers in their active equity allocation or evaluate them as part of their credit allocation. This is especially true when they are looking to access managers in regions where they can t perform their own due diligence or in strategies that they aren t familiar with, Institutional Fund of Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 39

40 Our expansion in to alternatives has mainly been a clientdriven process. Many of our clients are putting more and more money into alternative products, so it s a question of keeping AUM intact and adding net new sales, Asset Manager With Hedge Fund Offerings We view that we are migrating towards a better business ( 2/20 ) and that our competitors ( regular long/short hedge funds ) are migrating to a worse lower fee business. Because we have the infrastructure established it means we can handle a lower fee model, Asset Manager With Hedge Fund Offerings Second, asset managers cited hedge fund products as offering potential to improve their margins. The fee structure on longonly money has been under pressure from cheaper index and ETF funds for quite some time, and many active managers have seen management fees on their assets decline to well below 1% and often to as low as 50 basis points. Hedge funds, with their 2% management fee and 20% incentive fees, were seen as highly attractive. Third, the mechanics of how a hedge fund worked appealed to traditional asset managers, specifically, the ability of these funds to insist upon a minimal term during which investors had to agree to leave their money in the fund,and the requirement that investors notify the fund manager of their intent to redeem well before they were able to withdraw money. These structural aspects of hedge funds were seen as allowing for more stable portfolios that would enable managers to pursue more strategic bets in the markets. Even redemption notification of 30 days and monthly lock-ups were seen as attractive to these asset managers, as the bulk of their traditional products offered daily liquidity and investors were under no obligation to inform the portfolio manager of their intent to reduce their allocations. Fourth, there was a talent retention aspect to the decision to offer hedge funds. Many organizations felt that they needed to allow senior managers an option to expand their investment portfolios or risk losing these individuals because they could strike out on their own to create hedge funds independently. For many successful long-only portfolio managers, there was a desire to extend their skill set and challenge themselves to find extended ways to express their market convictions. Moreover, the decision was seen as having ripple-through effects by providing a broader career path for analysts and more junior portfolio managers who may have otherwise been drawn over to the hedge fund industry. Finally, traditional asset managers felt that the cost of launching and running these hedge funds in addition to their regulated funds was only incremental, and that they could leverage their existing infrastructure for the majority of functions. Unlike actual hedge fund managers that had to build out their infrastructure while simultaneously looking to raise capital and ensure that they could fund all their operations off their management fees, portfolio managers employed by traditional asset managers had substantial proven resources they could draw upon at limited additional cost, removing one of the major business concerns institutional investors express about independent hedge fund managers. Taken together, these factors have encouraged many traditional asset managers in the Americas, Europe, and the Asia Pacific region to launch hedge funds to supplement their long-only products. Overlap in Convergence Zone Sets Up Competition Between Asset Managers and Hedge Funds The result of these changes has been the emergence of a convergence zone where investors have the option of choosing from either a traditional asset manager or a hedge fund manager to invest their capital. This convergence zone now runs from regulated long-only funds and long-only SMAs through to unconstrained long-only funds to regulated alternative and UCITS funds to directional hedge strategies, as illustrated previously in Chart 25. There is some movement of big long-only managers who are trying to market their long/short products to me and their long-only products to other parts of our investment team, European Public Pension When some of the long-only houses were launching their hedge funds, it was pretty common from the long side to use shorting the index because it was convenient to get the product off the ground and learn how to use shorting. Now we are starting to see their learning curve advance and many of those participants are starting to do shorting on a more selective basis identifying paired shorts or sector shorts, European Insurance Company 40 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

41 This marks a complete reversal of the barbell concept, where managers were positioned prior to the GFC. The blurring of lines between traditional asset managers and hedge funds also reflects the shift in investor portfolio configuration toward risk-aligned allocation buckets that combine allocations to long-only and hedge strategies. Indeed, the convergence zone is an alternate representation of the publicly traded portion of the investors equity risk bucket,as discussed in Section II. The shift in product offerings from both hedge funds and traditional asset managers may say more about where investor portfolios are headed than any comment or observation from participants trying to evaluate the likelihood of a change in portfolio approach. As hedge funds and traditional asset managers compete head-to-head in their offerings, opinions on which type of manager is better suited to handle each type of investment are diverse. In some areas, traditional asset managers are seen as having inherent advantages, and in other areas hedge fund managers are seen as superior. In both instances, there are challenges that the managers would need to overcome in order to most effectively pursue the whole range of products. Core decisions need to be made about how to adjust their organizations and their client strategy in order for managers to effectively compete in this space. The following sections will explore such challenges and delve into the opportunities offered via product innovation in both the asset manager and the hedge fund space. Regarding hedge fund and long-only managers, my belief is that there will be creep but I don t see either encroaching on the other very quickly. And the reason is due to the difference in business models. Investors need to say to themselves, do I want part of my portfolio allocated to the cottage industry of hedge funds or do I want to keep allocations with the big boys in the mutual fund space, Alternatives Consultant and Fund of Fund When you look at how investors are allocating capital, the lines between long-only equity and long/short equity are going to blur and that s going to benefit long/short managers, >$10 Billion AUM Hedge Fund We tend to bump into the long-only guys more when we are pushing our unconstrained global long bond funds because this is a more similar product. We re not seeing them as much on the long/short side. $5-$10 Billion AUM Hedge Fund There will be some convergence, but not as much as people thought a while ago. There are different skill sets, and convergence could be a disguise for mediocrity, >$10 Billion AUM Hedge Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 41

42 Methodology Section V: Asset Managers Face Challenges in Extending Their Product Suite Asset managers were pushed into a defensive posture by institutional investors diverting funds from their actively managed portfolios to hedge fund managers. Many market leaders responded by creating their own hedge fund offerings, leveraging their internal trading talent and superior infrastructure. Some of these efforts have been quite successful, but in many instances institutional investors and their intermediaries have concerns about how well long-only investment teams can handle the challenge of long/short funds. An alternative has been to allow portfolio managers to move away from strict benchmarking and offer more unconstrained long product with hedge fund-like characteristics. Hedge Fund Offerings Represent Only a Small Portion of Traditional Asset Manager Product A select group of asset managers have built substantial hedge fund businesses in recent years. In several instances, their hedge fund AUM exceeds $10 billion, making them peers of the top independent hedge funds managers in the space. Another wave of newer entrants is also quickly moving forward, and several have managed to raise more than $1 billion AUM for their hedge fund products in just the past few years. Relative to the size of the hedge fund industry, these are impressive figures and clearly position these asset manager-backed hedge fund offerings as an alternative to independently managed funds. Yet, it is important to note that relative to the asset manager s total pool of assets; these figures are quite small, representing less than 5% of their holdings in most instances. In part, this is because long-only assets are highly concentrated in the hands of a relatively small number of firms. Looking at just the mutual fund market, a subset of these asset managers overall business, ICI found that the top 25 US firms controlled 73% of the total pool of invested assets and that the US itself accounted for 49% of global holdings. Given total US holdings of $11.6 trillion, these ICI figures imply an average firm size of $339 billion across the top 25 firms. These figures help to clarify how limited hedge fund offerings are from this segment. They also help to illustrate the largest advantage asset managers have when considering an expansion into the hedge fund space. Asset Managers Possess a Structural Advantage When Offering Hedge Fund Product By virtue of their size and tenure, traditional asset management organizations can approach hedge fund product development with a different mindset one that is longer term and less constrained by the daily pressures of managing a small business. This is an important structural advantage that runs across the product lifecycle from the inception of a new fund idea through to the support and maintenance of established hedge fund units. The primary difference between asset managers offering hedge funds and traditional hedge fund managers is the fundcreation process. Rather than striking out on their own and looking to create a new fund offering while establishing their core business infrastructure and ensuring enough day one and early stage investor capital to keep the organization running, portfolio managers emerging from the asset management space have an extremely different path to market. Portfolio managers launching hedge funds from the asset manager side begin by pitching their proposed strategy and approach to peers within the organization, and oftentimes to relationship management or business development teams that have ongoing dialog with key clients about their appetite for new product. If there is interest, the portfolio manager is typically asked to run a paper portfolio and test the strategy to understand its eventual capacity and volatility. This testing can be done on the organization s existing infrastructure, allowing the portfolio manager to have insight into the impact of differing market conditions via their reports and metrics. Successful ideas are then seeded internally, either by the organization or with peer capital. The seeded portfolio can run live for long periods and establish an extensive track record before being offered externally to clients. The time pressure typically experienced by smaller firms looking for fee income is removed, and products can be well defined and matured before moving into the client domain. Chart 26 illustrates an example incubation period for a new hedge fund developed within a traditional asset manager. In some instances the portfolio manager uses this incubation period to transition away from running his long-only portfolio and in other instances, the manager adds the hedge fund to his existing product portfolio, maintaining their long-only fund offering. 42 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

43 New funds also benefit from robust trade, as well as position monitoring and risk oversight. Large asset managers have industrial-strength systems that process hundreds of funds daily and large teams already in place to supervise portfolios. This is very appealing to the eventual external clients, who perceive operational excellence and independent risk oversight as important facets of their investment decision. There is also a cost benefit for the hedge fund as the portfolio manager is typically charged only incremental costs, with support charges dispersed across a much wider set of participants. Hedge funds within asset managers also benefit from research and commission relationships that are core to the long-only businesses. These asset management firms have significant sell-side relationships with access to premiere research ideas, investment insights, and corporate introductions. Asset managers also use the weight of their total wallet across a sellside firm to negotiate the most favorable commission rates. Portfolio managers running hedge funds within asset manager organizations benefit from this broader relationship, allowing them access at a level far superior to most comparably sized hedge funds operating independently. Investors recognize this advantage in reviewing such managers. Finally, the hedge fund benefits from the asset manager s extensive distribution network and partnerships. Such organizations invest vast sums in building out robust relationship management teams that often focus on high net worth and institutional audiences. These relationships provide ready ground for introducing and attracting assets to new funds when they are ready for launch. Although the majority of these organizations focus on longonly sales, they are increasingly creating product specialists that can work with relationship managers to help promote hedge funds. This removes the responsibility for capital raising from the portfolio manager and investment team, allowing that team to focus exclusively on the portfolio. This ability to identify and successfully execute a short trade idea was one of the most debated and discussed points in the survey. Chart 34 Chart 26: Asset Manager Approaches to Developing Hedge Fund Units 6 12 Months 1 3 Years Proposal of Investment Thesis Paper Trading of Strategy at Capacity Establish Live Track Record Approved by Investment Committee Decision to Provide Seed Stake Open Fund to External Investors In Some Cases Give Up Long Only Portfolios Exclusive Focus on Hedge Fund Source: Citi Prime Finance Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 43

44 We like to run a fund on paper at full capacity to understand what the strategy could support in terms of eventual size. When we have that sense, we stake the fund with enough money to prove the strategy out in the actual market and begin to establish the track record. Depending on the strategy, we have sometimes held at this stage for up to 3 years, Asset Manager With Hedge Fund Offerings We launch funds with a very low profile and we tell managers to expect small amounts to begin with. We launch with mostly internal capital, Asset Manager With Hedge Fund Offerings We see some institutional investors that view hedge hfunds within long- only firms as an asset they feel that we are better off from an infrastructure and controls perspective than a stand-alone hedge fund, $1-$5 Billion AUM Hedge Fund Investors want to see that you have all of the benefits of size in terms of corporate access and research breadth, $1-$5 Billion AUM Hedge Fund Investors Challenge Long-Only Portfolio Managers Ability to Add Shorting as a Skill Set Despite these structural advantages, many investor and intermediary participants in the survey had mixed views on the ability of traditional asset managers to successfully offer hedge fund products to the more sophisticated institutional audience, where these managers compete head-to-head with independent hedge funds. Most of these concerns related to the skills required as a portfolio manager moves from having managed primarily a long-only to a long/short fund. This ability to identify and successfully execute a short trade idea was one of the most debated and discussed points in the survey. Some respondents expressed their view that managers emerging from a career spent focused on long-only investing are not suited for shorting. They cited the experience of 130/30 funds as an example of a failed expansion of skills into the long/short arena. These less constrained long strategies emerged in the mid-2000s. They gradually introduced shorting and a minor degree of leverage into the directional long portfolios, but under strict constraints and monitoring. These funds performed poorly during the period and damaged many investors faith in long- only managers expanding their focus. The reason for many participants concern relates to perceived differences in the research process between longonly managers and traditional hedge fund organizations. Most long-only managers rely on their proven fundamental approach that examines a set of securities to establish their relative value. These managers are accustomed to the concept of overweighting and underweighting the mix of securities they own in a given sector or market. Many investors and consultants expressed concern that these managers use their least favorite buy recommendations as a stand-in for their short trades. They note that wanting to own less of something is not the same as wanting to short something. Respondents of this view indicated that they were looking for managers that were able to pursue alpha on the short side. They are looking for managers able to think about portfolio construction as a multidimensional opportunity across the long side, the short side, and potentially even the hedge portion of a trade. In this view, each of the trade elements can be constructed and managed in such a way as to provide independent opportunities to generate alpha. Many feel that making this leap in thinking is highly psychological and that it is a difficult transition for most portfolio managers. There was also concern that the magnitude of mistakes on the short side is greatly exaggerated by the nature of the trading. Investing with inexperienced short managers was thus seen as potentially risky for institutions that are averse to volatility and poor performance in their portfolios. These guys might be great stock pickers, but we want to see an established track record. Shorting is whole different ball game. We saw this with the launch of the 120/20s and 130/30s a few years ago as those funds really got caught in the quant crisis, US Public Pension There is a skill difference that comes into play. In many ways, shorting is a psychological activity. Not every long manager is suited to be a good long/short manager, Asset Manager With Hedge Fund Offerings The whole shorting side is such a difficult skill set. Long only managers have such a tough time moving into that space, Endowment 44 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

45 Being a long-only analyst that will rate something as a sell is different than a long/short analyst putting a short rating on a stock. Selling a long idea is very different to actually shorting, Asset Manager With Hedge Fund Offerings Most people, when they first start shorting learn a lot from their mistakes and I don t want to pay for that. With shorting, your biggest mistakes get magnified and your best ideas get submerged, Outsourced CIO Shorting With ETFs or Indices Is Seen as Unconstrained Long, Not Hedge Fund Product Many portfolio managers moving from a long-only to a long/ short approach decided that rather than picking individual stocks to short, they would take on general protection by shorting relevant indices or ETF products. This was particularly true of many sector-based long-only managers moving into long/short product. Investors and intermediaries comfortable with this approach cited lower fund costs for trading the short ETF and index products as opposed to the borrowing fees of the single stock approach, and also viewed the technique as a learning ground and stepping stone to moving into more specific single stock short trades. It was difficult for many participants, however, to differentiate between the approach of an unconstrained long fund that was breaking from the index in terms of tracking and the approach of a long-only manager using ETFs and indices to express a short idea. These participants felt that any fund using an ETF or index to short was just a rebirth of the 130/30 structure or that this was an investment approach more appropriately targeted at retail type investors, and as such should be bundled under a regulated fund wrapper to correctly characterize the portfolio. Many investors and intermediaries also noted that portfolio managers selecting ETF or index product as their preferred short holdings were not looking to generate alpha on the short side, but were instead insuring the portfolio against excessive downside volatility. They felt that this approach did not warrant the high fee structure hedge fund product demanded and expressed their wariness about paying alpha fees for beta product. If a long-only guy opened up a hedge fund, we wouldn t even look at it. We spend a lot of time with our hedge funds trying to understand how they approach shorts. We don t want to invest in a manager who will use ETFs as shorts. Shorting is a real skill, Endowment Long-only managers typically can t short individual stocks well. 100% long exposure with 40% short exposure via ETFs is not ahedge fund. The alpha short is important to us from a research perspective. We consider shorting ETFs or selling S&P 500 put options as just giving up that responsibility, Long-Only and Alternatives Consultant The hedge funds we have are effectively long-only funds because they are only shorting the index. They definitely came from the long-only side, Insurance Company Asset Managers May Have to Hire New Talent to Attract Hedge Fund Flows The benefit of a long/short mindset is understood at a theoretical level by many in traditional asset management organizations, but there have not been many examples of exceptional managers coming out with product to make an overwhelming case for the overlap of long-only skills into the hedge fund universe. Individual success stories aside, the majority of participants had doubts about hedge funds originating from long only organizations and viewed these products as at best safe. Even those in the asset management community noted that they most frequently targeted a high net worth and family office audience as opposed to an institutional audience in marketing their hedge funds. These investors typically have more familiarity with long only as opposed to hedge fund managers, and place a value on having a known entity from a brand name firm being the one to handle their risk capital. While institutional investors and their intermediaries both noted that they would be willing to look at talent from any source, they clearly had biased views about hedge fund managers originating from the long-only side. For this reason, many of the asset managers interviewed for the survey discussed how they have been bringing in resources from the hedge fund universe to supplement their existing teams or to create their hedge fund offerings. Portfolio managers and research teams with this skill set were seen as having a more solid foundation in pursuing long/short strategies. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 45

46 This is likely to be the path for many asset managers looking to expand or create hedge fund offerings in the future. Proving out their ability to generate alpha in their hedge fund offerings is likely to be a hurdle these asset management firms must pass before the benefit of their infrastructure comes into play for most allocators and their intermediaries in the institutional space. I look across both long-only and independent hedge funds. I try to draw the circle wide. This is a necessity if you want more experienced teams with a track record, Insurance Company We definitely look at managers coming from the long-only side. There are many considerations there you have to weigh. This is a talent business first and foremost so if you don t look, you could be missing a real opportunity, Asset Manager With Hedge Fund Offerings We will also work with skilled long-only managers to create hedge fund products, Long Only and Alternatives-Focused Consultant Hedge funds should and have been successful because they re entrepreneurial and their interests are well aligned. The long-only guys getting into the hedge fund space are typically safe, but not exciting, Alternatives-Focused Consultant More Success May Be Found in Competing for Lower Fee, Unconstrained Long Funds There was less clarity from institutional investors and their intermediaries as to whether long-only or hedge fund managers were better suited to handle unconstrained long products in the convergence zone. There is clearly a demand for more sophisticated and well executed unconstrained long strategies that do not align to a benchmark, but the jury is still out on how best to deliver this type of alternative beta and how best to develop and maintain the right skills to make this a valuable and viable part of Institutional portfolio allocations. Asset managers are the dominant players in this space, and their issuance of these types of hedge fund-lite offerings dwarf the size of their actual hedge fund product. One asset manager interviewed for the survey that ranked among the leading firms in the hedge fund space pointed out that its AUM in these unconstrained long funds was more than five times higher than its firm s hedge fund AUM, and that all of the products emerging from their long-only product structuring team over the past year had hedge-fund like characteristics. Fees for this type of alternative beta product emerging from the asset manager side remain in line with their longonly offerings. This is likely to be seen as an advantage for asset managers, since hedge fund managers often look to charge both a management and an incentive fee on funds they oversee in unconstrained long portfolios, as will be discussed shortly. Asset managers also seem to have a clear distribution advantage in attracting assets for these types of offerings. As noted back in Section II, most institutional investors have separate teams focusing on long-only allocations and on hedge funds, and the majority of consultants advising institutions tend to specialize in either long-only or alternative managers. When the long-only institutional allocator is looking to find new funds, he and the consultants he employs are likely to stick with the set of managers they know best those from traditional asset management organizations. How long this edge may last is unclear, however. As will now be discussed, there are starting to be increased instances of longonly allocators reaching over the divide in their organization to request introductions to hedge fund managers so that they can expand their set of active managers into unconstrained long funds managed by these participants. 46 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

47 An example of the evolution theme is the reshaping of the active fixed-income business that has taken place. It started out as investing in long-only physical assets and has become much more derivatives heavy. This is partly an evolution of the capital markets in combination with client demand moving away from benchmarks. Absolute return from an asset allocation perspective drove the traditional long-only business into taking a more active approach to management, Traditional Asset Manager We see a little bit of the long-only guys trying to get into the long/short credit space, but not as much as you d think. There might be a higher barrier to entry than in the equity space. We tend to bump into the long-only guys more when we are pushing our unconstrained global long bond funds because this is a more similar product. We re not seeing them as much on the long/short side, $5-$10 Billion AUM Hedge Fund My group is not in the alternatives business but our products do have alternative-like characteristics. All the new products that have been launched from my group in the last year and all the funds slated for launch are not traditional long-only or bond product, Asset Manager with Hedge Fund Offerings We used to call these long-only funds being run with a long/ short mindset 130/30 funds these are now dead. Now, we call them long only-enhanced where you re between 90 and 110 or you re going to short some indexes. These strategies are still in the long-only space, European Wealth Manager Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 47

48 Section Methodology VI: Hedge Funds Reposition to Capture New Opportunities The number of large hedge fund managers with $5 billion or more AUM is growing, and as these organizations mature they are exploring expanded product opportunities. For some managers, their ability to continue raising assets in their core hedge fund offerings becomes constrained above a certain level because of short-side capacity concerns. Other managers have extensive sunk infrastructure costs and are looking to enhance their margins and leverage their trading expertise by creating new products that offer investors cash + alpha, or that target new audiences. Determining the right course comes down to a manager s willingness to trade off high fees for larger asset pools. Largest Fund Managers Are Most Active Pursuing New Product Innovation Investors and their intermediaries interviewed for the survey also had concerns about hedge funds moving into the convergence zone and offering long-only, unconstrained long, or regulated alternative products, but these concerns were not tied to their investment skills. Rather, concerns were linked to perceptions that these managers were asset gathering and shifting their focus away from their core hedge fund product. This has to do with the fact that it is often the largest hedge funds with AUM near, at, or above $10 billion that are the most public participants pursuing this product diversification. These largest hedge funds are the ones with the most established infrastructure and developed product teams and, as such, are typically the most active in developing new offerings. These new products can incrementally add to their margins and can oftentimes be created at extremely low cost. Many of these new products are focused in the convergence zone highlighted back in Section IV. As will be discussed, some of the emerging products from these largest hedge funds are also targeting a different convergence zone that overlaps with the private equity space. While these are the most recognized hedge funds offering convergence product, these are, however, another category of managers that are also active in this space but whose participation is not as widely publicized. This is illustrated in Chart 27. Chart 27: Managers Best Positioned to Consider Product Innovation Appetite to Manage Institutional Allocations LOW HIGH Size Concerns Institutional Threshold Direct Allocator Sweet Spot Concern About Managers Limiting Capacity Concern About Ability to Generate Alpha Opportunity Zone <$1 B $1 B-$5 B $5 B-$10 B $10 B+ Hedge Fund Manager Size Source: Citi Prime Finance 48 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

49 As we discussed in last year s hedge fund industry survey, there are a number of managers with assets closer to the $3-$5 billion range and above that have opted to limit their capacity and close to additional investors near and above that AUM band. These managers are concerned about their ability to absorb continued inflows and effectively deploy capital in their core hedge fund product. Yet, these managers are seen as having additional capacity in the long-only side of their portfolio. Increasingly, many of these participants are beginning to manage long only money alongside their hedge fund, but in private structures that have been initiated almost exclusively at the request of existing investors. Hedge funds that have grown are offering follow-on products. They are looking to diversify their product mix to be more profitable, Institutional Fund of Funds You ll often see someone who started a successful long/ short fund and then carved out their long book. Then they might hire a credit group. This product proliferation stage raises more red flags for us than anything. Is it a dilution? Is the goal now about asset raising? Institutional Fund of Funds Both sets of these managers are found in what we showed was the bifurcation zone in last year s hedge fund industry survey. These are the most mature hedge funds, where it is a logical next step to begin thinking about their strategic development. Smaller hedge funds are still growing, and as such risk losing their focus if they look beyond their core product. Our interviews in Asia highlighted a further set of hedge fund managers that were actively looking to diversify their product offerings, namely, much smaller hedge fund firms that needed long-only accounts to keep the lights on. We interviewed several APAC hedge fund firms with significant long-only or other product offerings that were added to their product arsenal over the last few years. In many instances, these products were created at the request of existing investors. The reality for most Asian hedge funds has been that since the Global Financial Crisis it has been difficult to raise hedge fund capital and that in order to afford the steadily growing fixed costs of this business, they had to be flexible and open to reverse inquiries from clients for long-only SMAs, etc. It s only been in the last couple years that we ve started seeing the hedge funds starting to offer long-only product. For one key guy, he s out of capacity in his hedge fund but there s lots of room on the long-only side, Outsourced CIO Few APAC assets managers can survive on hedge funds assets only <$1 Billion Hedge Fund New Products Show Inverse Relationship Between Fees and Potential Asset Pools Chart 28 illustrates the span of product innovation we encountered across this year s hedge fund participants. There are three main considerations managers discussed when determining where they are best suited to create new product offerings. First, managers need to decide whether they will look for extended opportunities in alpha strategies or whether they will look at traditional actively managed product to capture beta returns. Second, managers must determine which audience they wish to pursue the traditional institutional and high net worth hedge fund audience or the broader retail audience. Finally, managers must determine the trade-off they are willing to accept between fees and asset pools, as there is an inverse relationship between these two factors. Strategies likely to draw the highest fee potential are those that have the most limited AUM pools and, conversely, those that have the largest AUM pools are likely to command significantly lower fee structures. Products with the highest fee potential are those being explored by hedge funds in a secondary convergence zone on the opposite end of the investment spectrum. These are typically activist managers looking to identify offerings that blur the lines between hedge funds and private equity offerings, or they are credit managers offering structured illiquid products built around assets with an associated cash flow as well as an alpha opportunity. These products are clearly focused on the traditional hedge fund audience of institutional and qualified high net worth investors. These products require deep investment expertise to structure and hedge and a substantial infrastructure to cover the set-up, administration, and accounting. While fees on these products are high, the lock-up and payout on incentive capital is often long-dated at 3 years or beyond. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 49

50 Chart 28: Hedge Fund Product Development Opportunities & Trade Offs LOW SIZE OF POTENTIAL ASSET POOL HIGH INSTITUTIONAL & HNW AUDIENCE New Cash + Alpha PE Like Products BETA STRATEGIES Custom Long Mandates via SMA Based on Core Strategy Regulated Alternatives: 40 Act & UCITS ALPHA STRATEGIES Unconstrained Long Regulated Funds RETAIL AUDIENCE HIGH FEE POTENTIAL LOW Source: Citi Prime Finance The next highest fee pool is found when a hedge fund manager is approached by an existing or prospective investor to manage long-only money on a private basis. This most typically occurs with managers in the directional category running long/short funds at 50%-60% net long. These managers tend to have a perceived sector or market expertise that is desired for the investor s long- only portfolio where they see the hedge fund manager as being better qualified to pursue that opportunity than a traditional long-only manager. These private funds are set up as custom fund of one vehicles or separately managed accounts. Fees for this long-only product were cited as being lower than the core hedge fund, but still substantially higher than traditional long-only offerings. A 1% management fee and 10% incentive fee were commonly mentioned arrangements for these vehicles. We ve seen quite a few hedge funds interested in long only. Some of them are very well established funds whose AUM is up there and there s not as much opportunity on the short side. They can continue to work and grow the long side of their books, Endowment I think that there are a lot of people on the hedge fund side looking to have more directional, lower fee product. These are people we think highly of. Their flagship funds can t really take on more capacity, US Corporate Pension As hedge fund managers begin to consider regulated product, the trade-off flips with the size of the assets, and not the fees providing the incentive. Regulated alternative funds are unable to charge incentive fees in most instances, but these offerings are attracting substantial flows and managers can still charge a management fee on this money. These products are found across both the UCITS structures and in vehicles that fall under the US Investment Company Act of 1940 and are thus referred to in the vernacular as 40 Act funds. There are both single fund offerings and fund of fund offerings being created in this category. 50 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

51 As shown in Chart 28, the target audience for these regulated alternative funds is typically retail in nature, although some institutional investors with conservative liquidity guidelines, especially in Europe, have also looked at these products to satisfy their investment mandates. There are also several macro- or commodity-focused ETFs in this category that have drawn interest from both a retail and institutional audience. Fees on these vehicles are typically in the 1% range, and there are no incentive fees. There are also a small but growing category of hedge fund managers that are looking further afield from their current investor base to create long-only product exclusively targeted to the retail audience. In many instances, these managers offer these products on a subadvised basis, charging only a management fee and no incentive fee on these funds. Most frequently, they rely on distribution platforms or investment management partners to distribute and administer these funds on their behalf. Only a handful of the largest hedge fund managers create and distribute their own regulated long-only product. In most instances, there is a 1% management fee There are a few hedge funds with long-only versions where they have lower fees than in their co-mingled vehicle. These fees are still a lot higher than what s being charged by the long-only guys, but they re lower than the hedge fund, Alternatives-Focused Consultant We now have 8 SMAs, 5 of which are long only with about $4 billion. All of which has been created in the last 5 years, $5-$10 Billion AUM Hedge Fund We need to be entrepreneurial and open to prospects demands in order to establish ourselves as a viable business; some of the products/structures may not be successful, but it is important to show clients that you are willing to provide them with product they want. < $1 Billion AUM Hedge Fund associated with these offerings, but in certain situations, the manager accepts a lower fee in the basis point range to leave room for their distribution partner to layer on a charge. In order to better understand the potential growth and industry wallet for these offerings, we will now take a closer examination of each, highlighting important nuances in their structures, fee potential, and the size of their potential asset pool. Private Equity-Like and Cash + Alpha Products Focus on Funding Gaps and Infrastructure Due to the recent poor yield environment and the belief by many that yields will remain low in the near term, some investors are taking interest in vehicles and strategies that generate cash flow as part of their investment and return expectations. Though these strategies use the traditional 2&20 fee arrangement, most are less liquid than traditional the managers often agree to wait until the end of the term or for an extended multiyear period before calculating their incentive fee. Most of these strategies emerged to provide alternate funding options in the wake of the 2008 liquidity crisis in response to tight credit markets in key areas. Funds designed to take advantage of the significant yield being offered by bank debt securities in companies were one of the earliest examples in this category. These securities are higher in the corporations capital structure than traditional bonds and thus considered safer. They offer floating rates as opposed to the fixed rates of traditional credit bonds, and thus provide investors an opportunity to capture rising rates if the environment begins to shift. Hedge funds and investors alike saw the opportunity to step into this market and provide necessary capital that was traditionally provided by banks. A primary function of the return for these funds was the coupon (cash flow) provided by the bank debt instruments. Some distressed hedge funds alsosaw the opportunity post-2008, and launched what effectively were short-term private equity funds that offered limited liquidity and had a set maturity date. Both of these product types looked to extract value from the market disruption by offering investors access to corporations and the cash flows their companies generate. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 51

52 Another industry affected by the 2008 market disruption was the insurance business. Hedge funds launched vehicles to invest in and trade catastrophe (CAT) bonds and other insurance-linked securities (ILS) which were negatively affected by the damage to insurance company s balance sheets. Hedge funds entered this market and launched dedicated funds to fill the void left by insurance companies unwilling to structure and issue these bonds. The primary characteristic of these instruments that is attractive to investors is the strong cash flows coming from the premiums paid to the issuers. Retail mortgage-backed security (RMBS) funds were launched opportunistically around the same time and were structured with medium term maturities (redemption dates) to take advantage of the dislocation in the mortgage market. The underlying mortgage bonds, some of which were at the heart of the financial crisis, offer very attractive performance that include a good cash-on-cash return that investors continue to seek in this low-yield environment. Investors looking for strategies that offer current income can also allocate to hard asset funds that straddle the public and private market divide. One such example is the master limited partnership (MLP) fund that trades in the form of an ETF or an exchange-traded note (ETN). As noted in Section II, these funds invest in partnerships that have a vertically integrated portfolio around a specific industry such as oil and gas, coal, or shipping. Because they are structured as limited partnerships, the securities distribute capital back to investors on a quarterly basis. This is particularly attractive to those investors that have operating expenses they need to support with their investment portfolio. These cash flows can become reliable and tend to be consistent while the underlying business (e.g., oil and gas exploration and distribution) are genuinely uncorrelated to the markets. There is a limited pool of assets for each of these products. Hedge fund AUM in bank loan funds is not publicly listed, but S&P cites the mutual fund market in these assets as of February 2012 at $71.7 billion. According to Aon Benfield, CAT bond funds had a record first quarter 2012 with issuance of $1.49 billion with total CAT bond issuance in 2012 expected to be $5- $6 billion. According to the Securities Industry and Financial Markets Association (SIFMA), RMBS debt outstanding at the end of 2011 was $516 billion. No industry-wide data on MLP AUM were available, but the largest funds in the space were in the $3-$4 billion range, and there are perceived to be six or seven major competitors in this space Long/Short Managers Make Inroads Into Actively Managed Long-Only Fund Allocations Directional hedge funds as described in Section II represent the largest category of AUM for the industry, but one that has fallen in terms of importance prior to the global financial crisis. This is illustrated in Chart 29. As shown in Chart 29, these strategies topped $1 billion in 2006, accounting for 48% of the industry s total AUM. Assets continued to rise in 2007 to a record $1.3 billion, but outflows and performance hit this segment hard in Total AUM fell 38.5% in this category versus only 29.3% in other hedge fund strategies during the crisis, resulting in a decline in overall share to only 42% of AUM. While the actual level of assets held in these strategies has stabilized and rebounded to more than $1.1 trillion, the relative share of AUM controlled by directional hedge strategies has not regained its former peak and has been hovering around 44%-45% of total AUM. There is a transformation of the financial system happening with credit at the core and if you can notice the opportunities then it is a great time to be in credit products. The banks are getting out of a lot of stuff and there is a fundamental mismatch between assets and liabilities. Someone has to do what the banks were doing themselves so the pension plans are seeking those cash flow products. Banks are no longer intermediaries, Asset Manager With Hedge Fund Offerings If you re creative enough to create product that generates cash as part of the business, people eat it up. Cash + alpha product is definitely a new phase for the industry, What we re doing with catastrophe bonds is completely different from the reinsurance market. Because of the number of catastrophes that have happened in the last few years, insurers don t have capital. It s becoming more and more of a bond market specifically, a bond that looks like a CDS contract triggered by a catastrophic event. We ll run a pond portfolio dedicated to this space and we ll hedge out risks with the swaps markets, $5-$10 Billion AUM Hedge Fund $5-$10 Billion AUM Hedge Fund 52 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

53 Higher than expected correlations to beta and poor market performance during a period of excessive volatility hurt institutional interest in directional hedge funds, particularly long/short funds that make up the majority of this category. Strongly performing equity markets in the early part of this year also dampened interest in this category, as have shifts discussed in Section II concerning the role these directional hedge funds play in dampening equity risk as opposed to generating outright alpha. Chart 29: Breakout of Hedge Fund Strategies by Major Categories (Billions of Dollars) Directional Hedge Funds $1,026 $1,310 $806 $1,008 $1,172 $1,102 Macro/Volatility Funds $255 $323 $317 $337 $334 $398 Absolute Return Funds $289 $302 $230 $229 $279 $296 Distressed Securities $140 $245 $144 $183 $203 $201 Multi Strategy $235 $365 $253 $245 $267 $277 Emerging Markets $212 $329 $162 $262 $296 $257 Total $2,157 $2,874 $1,912 $2,264 $2,551 $2,531 Directional As Percent 48% 46% 42% 45% 45% 44% Directional hedge funds include Long/Short Equity, Event Driven/Special Situations, Fixed Income Non- Arbitrage, Regulation D, Small/Micro Cap & Value, Macro/Volatility hedge funds include CTA/Managed Futures & Macro. Absolute Return includes Convertible Arbitrage, Fixed Income Arbitrage, Market Neutral Equity, Merger/Risk Arbitrage, Options Strategies & Statistical Arbitrage. Source Citi Prime Finance Analysis based on evestment HFN data Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 53

54 Chart 30: Actively Managed Institutional & Directional Hedge Fund Assets Vs. Directional Hedge Fund Share Actual & Projected 16% Picking Up Active Long Only Flows 15.8% $14,000 14% $12,268 B $11,528B $12,000 12% $9,206 B 10.9% +$450B 11.9% $10,000 $8,000 10% 8% 9.6% Based on Average Directional Hedge Fund Flows $6,000 $4,000 6% 5.9% $2,000 4% F F F F F $0 Yet, for many years these strategies were able to successfully draw away money from actively managed long-only funds as investors competed for access to some of what they perceived to be the best stock pickers in the industry. This is illustrated in Chart 30. Between 2003 and 2007, directional hedge fund managers gained market share at a rapid clip. When compared to the total universe of actively managed institutional AUM (total AUM less allocations to passive index & ETF funds), directional hedge funds share of assets rose from 5.9% to 10.9% in this period. This represented a belief across the institutional audience that these managers offered superior alphagenerating potential compared to those managers overseeing their traditional actively managed portfolios. that they would prefer to have these managers handle their long-only allocations if at all possible; many alternatives consultants and direct hedge fund allocators mentioned that they are being approached by representatives handling the long side of investor portfolios to help them identify directional hedge fund managers for new long only allocations. We have tried to model what the impact of this trend might be in terms of total AUM. If we extrapolate the share that directional hedge fund managers represent across the total actively managed universe using the entire period, which includes the slow growth of recent years, we project a gradual increase in the share from 9.6% at the end of 2011 to a new record of 11.9% by Many institutional investors and their intermediaries continue to view the skill of these managers positively. In contrast to the concerns they cited about long-only portfolio managers trying to shift into the long/short skill set, the majority of survey participants saw these long/short managers as better suited to move in the opposite direction. Managers in the directional hedge fund grouping can show proven track records on the long side of their book, and since they were running fairly substantial net long portfolios many of them were seen as more fundamental in their approach and thus well positioned to identify and capture value on the long side. Indeed, a significant majority of respondents indicated. We moved into the long-only space at the request of one of our hedge fund pension fund investors looking for more of a pure alpha play, $1-$5 Billion AUM Hedge Fund Our entry into the long-only space came via a reverse inquiry from an existing hedge fund client. They wanted us to provide them with a long-only fund investing in convertible bonds which is one of our areas of expertise, $1-$5 Billion AUM Hedge Fund 54 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

55 What that might equate to in total AUM is difficult to project because this would require a point of view on where the size of the total actively managed universe is headed, and there has been too much volatility in this figure over the past 5 years to reliably forecast. At 2011 asset levels, however, a pick-up of 2.3% would equate to an AUM gain of $265 billion over the next 5 years. This figure represents our baseline projection for the directional hedge fund manager category. To determine how much AUM might be available to these managers on the long-only side as opposed to in their directional hedge fund portfolios, we have extrapolated likely shifts in market share based on the faster pace of growth seen prior to Our reasoning is that institutional investors originally diverted funds from their traditional long-only managers to hedge fund managers because they believed that hedge fund managers were more apt to produce alpha. This assessment still seems to hold true, but they are now looking for these managers to handle their allocations via long-only exposures as opposed to hedged exposures. In this scenario, directional hedge fund managers might be projected to increase their market share more substantially, from 9.6% to 15.8% of the total universe. Again using the 2011 level of assets, this 6.2% gain would represent a $715 billion gain in AUM. Regulated Alternative 40 Act and UCITS Funds Show Rapid Growth in AUM Hedge fund managers looking for expanded opportunities in their core alternative strategies and interested in tapping into new investment audiences are watching developments in regulated alternative products and considering opportunities in that sphere. In their report Regulated Alternative Funds: The New Conventional, SEI Knowledge Partnership (SEI) and Strategic Insight note that AUM for these types of products reached $644 billion as of 2011, up 134% since This dynamic growth is illustrated in Chart 31. Chart 31: Assets in Alternative UCITS & Mutual Fund/ETFs % $644 This $450 billion difference between the baseline projection for directional hedge funds and what a renewed acceleration in growth based on performance prior to 2008 would have indicated is the size of the asset pool we project that directional hedge fund managers could pick up in terms of custom long only portfolios from existing and prospective institutional investors $ Many investors feel that it makes sense to have a manager that has gone through multiple cycles showing their ability to create alpha on the short side evolve his approach to run long only as well. This makes much more sense than having a long-only guy change his DNA, < $1 Billion AUM Hedge Fund The director of our long-only program is doing some new sourcing for her portfolio and she s coming to us on the hedge fund side asking which hedge fund manager s process might be well-suited to long only, US Public Pension Alternative UCITS Funds US Alternative Mutual Funds/ETFs Source: SEI Knowledge Partnership, Strategic Insight Simfund GL, MF SEI notes that these offerings represent the ultimate convergence product. They allow retail investors and their advisors access to the greater complexity and diversity of alternative strategies that were previously reserved solely for qualified high net worth and institutional audiences. They also offer institutional and high net worth investors a regulated, transparent, and liquid structure that is usually found only in the retail domain. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 55

56 According to SEI, there were 1,500 alternative UCITS funds and 750 alternative mutual funds & ETFs as of August These numbers can, however, be somewhat misleading. Assets were highly concentrated, with only 41 UCITS funds and 28 mutual funds/etfs running more than $1 billion AUM. Moreover, these offerings only accounted for 4.4% of the total UCITS and US mutual funds/etf market. While this is up from 2.2% in 2007, it is still only a tiny portion of overall assets. Survey respondents for the most part saw these products as offering substantial potential for growth. SEI and Strategic Insight project that assets are likely to hit the $1 trillion AUM mark by This would represent a 50% expansion in industry AUM. Many participants felt, however, that the opportunity will be primarily realized through subadvised products that can be distributed directly to retail clientele or as targeted vehicles for institutional participants facing specific liquidity constraints. They also noted several potential pitfalls with these structures. Several respondents noted that these products were only suitable for strategies using highly liquid products. There were also concerns that these products would not get the same attention and focus from hedge fund managers as their core funds, since the fee potential was not as great. Many worried that managers would just view these products as an opportunity for asset gathering and that their lack of performance could hurt the brand of the hedge fund industry overall. interest in hedge fund products, particularly in Europe, is another factor. Finally, there is a sense that the size of the AUM pool is sufficiently large for retail-focused, long-only funds that a hedge fund manager will still be able to realize substantial profits by offering these funds, even with fees as low as 50 basis points. In Chart 32, we explore that contention, looking at just those funds that may be available from individual investors via their pension fund or retirement fund holdings. As we noted back in Section III, Towers Watson estimated that the global pension market in 2012 was $27.5 trillion, up from $23.2 trillion in Based on the average rate of growth in assets, we had also forecast that the total would rise to $32.6 billion by Chart 32: Global Pension Fund Assets Focus on Equities & Bonds Held in Individual Accounts $35,000 $30,000 $25,000 $20,000 $9,410 $10,586 10% $1.24T $ $14,301 Individual Equities & Bonds Retail Focused Long-Only Funds Offer the Largest Asset Opportunity Hedge fund managers have not traditionally focused on the long-only retail audience because in many markets, including the US they were prohibited from charging an incentive fee to these participants. There are also sometimes rules prohibiting or limiting the use of leverage or shorting for these inexperienced investors. Attitudes about this audience began to change noticeably after the Global Financial Crisis, however, as many hedge fund managers lost substantial portions of their AUM or were finding it difficult to attract flows for their traditional hedge fund product. Several high-profile hedge funds launched regulated, pooled long-only mutual funds or open ended funds in the period since These pioneers have raised billions of dollars in these vehicles. Many of these managers see the addition of this audience base as adding resiliency to their portfolio. They also cite a strong demand from these investors, as disappointing equity markets and falling pension or retirement fund balances have prompted these investors to seek out more active management. Concerns about regulation hurting $15,000 $10,000 $5,000 0 $10,574 $3,253 $12,523 $4,402 $5, Est. Institutional Equities &Bonds Alternatives 2016 total assets based on average growth between 2006 & Breakdown of assets reflects projection for continued growth in institutional interest in both Alternatives & Hedge Funds Source: Citi Prime Finance Analysis based on Towers Watson Global Pension Studies & evestment HFN data. 56 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

57 We developed an alternative mutual fund of fund product that s registered. We re working to get on some 401(k) RIA platforms. We re definitely seeing more interest from alternative managers to create regulated 40 Act structures. We do monitoring of the portfolios in the regulated fund of fund and are a hedge fund sub-advisor. The underlying funds have flat fees from 60 basis points to 100 flat. They can t use more than 1/3 a turn on investments that existed in 1940, but this covers most instruments, Alternatives-Focused Consultant Over the past couple years we have been approached by several institutional investors to create long-only and UCITS product. Over the past 2 years we have been asked probably 5-10 times for RIC product alone, If UCITS doesn t constrain the manager, it s more attractive because of the liquidity and the fact that they re regulated. If they re trying to shoe horn in a strategy and it really doesn t fit well, we d rather go into the offshore fund, Insurance Company We don t see the appeal of the regulated hedge funds. You still pay almost all the fees in the 40 Act product. Total all-in fees are very high and the portfolios that managers are delivering are not the same as in their hedge funds. Instead of a best ideas portfolio, it s almost a worst ideas portfolio. The manager is always going to think of their hedge fund first. The 40 Act funds are just a throwaway, $1-$5 Billion AUM Hedge Fund $5-$10 Billion AUM Hedge Fund These figures represent the total amount of pension fund and retirement fund holdings across equities, bonds, and alternatives, including assets held in institutional portfolios and in individual accounts. Since the vast majority of retail investors are prohibited from holding alternative investments in their pension and retirement plans, we have excluded alternatives from this analysis and assigned that AUM to the institutional audience. evestment HFN has also provided an estimate on the size of institutional holdings in equity and bond funds globally. These totals were $10.6 trillion in 2006 and $12.5 trillion in We have extrapolated those figures as well, based on our view that both alternative and hedge fund assets are set to grow in the coming years, and projected this asset pool at $14.3 trillion by When alternative and institutional allocations are excluded from the total pension fund figures, the remaining assets can be assumed to belong to individual investors. In 2006, that total amounted to $9.4 trillion, and by 2011 the figure had risen to $10.5 trillion, a gain of only 11.7% versus 17.9% growth in institutional assets and 43.0% growth in alternative assets over the corresponding period. These figures confirm hedge fund industry perceptions that individual investors are likely to be looking for more active management product that could offer higher returns. Between now and 2016, our forecast shows that individually held assets in pension or retirement accounts are due to rise to $12.4 trillion. If only 10% of that pool gets diverted to hedge fund managers looking to enter the market with longonly product, that could represent an AUM opportunity of $1.24 trillion. Even at a fee of only 50 basis points, this could represent a management fee opportunity of $6.2 billion for hedge fund managers looking to enter this space. We definitely have a different fee scale for our long only stuff. Our typical fee there is 50 basis points. We re competing in that space with traditional long-only managers, $5-$10 Billion Hedge Fund We are not looking at any registered alternative products, but we have launched a long-only fund. This was investor driven and existing investors told us they liked performance on the long side of the portfolio. This is where you do get into convergence, but this was on the high net worth side. This is a co-mingled product, $1-$5 Billion Hedge Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 57

58 We think that our long-only clients seemed to like the fact that we had started off as a hedge fund firm. We sense that investors felt that our team will be more nimble in their investment/risk management approach, $1-$5 Billion AUM Hedge Fund We see some growth in hedge funds creating long-only funds. In Europe, this is more likely due to a fear of regulation. Managers create long-only products to survive, European Fund of Fund Total Assets for New Product Offerings in the Convergence Zone Could Top $2 Trillion When the analysis of all these asset pools across the products in the long-only and regulated fund space is added together, our forecast shows that hedge fund managers could be looking at an opportunity of more than $2 trillion. This total is comprised of the $450 billion opportunity we see for directional hedge fund managers to extend their offerings into private long-only funds with existing and prospective institutional clients, the $350 billion opportunity in regulated alternative funds put forward by SEI and $1.24 trillion in retail pension and retirement fund assets that could be redirected from traditional long only managers to hedge fund managers with regulated long-only fund offerings. This is a tremendous figure, almost as large as the entire hedge fund industry as it exists today. The draw of these assets is likely to remain a driving factor encouraging hedge funds to continue to innovate their products and expand toward a realm previously owned exclusively by traditional asset management firms. The largest hedge fund managers that will achieve success with their core offerings and been able to build robust organizations and infrastructures will be those best positioned to access these opportunities. For most, moving into this space and expanding their set of product offerings will be seen as a maturation step. The challenge these managers face is determining how to extend their capabilities without being seen as losing their focus or creating second-rate product that offers a lesser standard of management. Having a clearly articulated strategy on why they are making the moves they choose to make will be a critical success factor for these managers. Knowing how to position both their core product and new offerings to their investor and intermediary audience will also be a key requirement. This is the final paradigm we examine in Section VII of this year s survey. 58 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

59 Section VII: Accessing Investors Requires More Nuance and Interaction With Intermediaries Institutions are becoming more experienced hedge fund investors and now use three different portfolio configurations to administer allocations, each of which positions hedge funds somewhat differently in terms of where managers compete for flows and how their strategy is expected to impact the investor s holdings. Knowing how to present their fund to most effectively address each type of portfolio configuration is becoming a key requirement for hedge fund marketing teams. Managers can leverage an expanding set of intermediaries focused on advising investors to help gain a deeper understanding of the investor s goals. These same intermediaries also offer a conduit for hedge funds looking to forge stronger ties to allocators in the long-only space. Leading Hedge Funds Move toward a Know Your Investor Approach to Marketing As has been discussed throughout this paper, the hedge fund landscape and investor base has changed over the past few decades, growing from a cottage industry known primarily to a high net worth and family office audience to an investment option for the largest and most sophisticated institutional allocators globally. Long gone are the days when the primary marketing tool hedge fund managers relied upon to attract new capital was word-of-mouth endorsements at cocktail parties and family gatherings. Hedge funds have improved many aspects of their business to attract institutional investors including their use of technology, the strengthening of their operational infrastructure, and the formalization of their policies and procedures. Being able to articulate these enhancements became a critical part of a manager s presentation to investors post Global Financial Crisis. Discussing your fund s operational excellence is now considered a basic part of every manager s marketing story, right alongside their CIO s and investment team s pedigree, philosophy, and track record. Chart 33: Know Your Investor Aligned-Marketing Messages Equity Passive Equity Passive Equity Risk Passive Active Long Only Directional Hedge Funds Active Active Corporate Private Equity Bonds/ Fixed Income Opportunistic Passive Active No Fixed Allocation Discretionary Investment in Hedge Funds, Private Equity, Infrastructure or Commodities Bonds/ Fixed Income Alternatives Passive Active Hedge Funds Private Equity Infrastructure & Real Assets Inflation/ Stable Value Absolute Return Real Assets Macro Funds Volatility & Tail Risk Funds Commodities Market Neutral Funds Arbitrage Related Strategies Relative Value Strategies Infrastructure Real Estate Other (i.e., Timber) Product Positioning Product Positioning Product Positioning Source: Citi Prime Finance Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 59

60 Continuing to refine that story to be best positioned to win allocations from institutions will be the next challenge that marketing teams address globally. Our projections, discussed back in Section III, show that these institutional investors are likely to increase their allocations substantially over the next 5 years, and that there could be as much as $1 trillion in new capital originating from these participants targeted at managers core hedge fund product. Several of the largest hedge funds have discussed how they are finding success in attracting this money and the gist of their advice is to adopt a know your investor mindset. As the range of institutional portfolio configurations expands and risk-aligned portfolio approaches emerge alongside opportunistic and dedicated alternative portfolios, hedge funds marketers need to know how each institutional investor they are pursuing positions hedge funds within their broader portfolio, and understand what role those hedge fund investments are meant to fulfill. Marketers can then determine the best way to present their own fund to align to that investor s specific goals. This concept is illustrated in Chart 33. The most successful hedge fund marketing teams discussed how they perform a reverse type of due diligence on the investors with whom they meet,either directly or via those investors intermediaries. The purpose of this examination is to understand the investor s specific portfolio configuration and thus be able to better tailor their marketing message to most appeal to the investors needs. Each Institutional Portfolio Configuration Requires Different Selling Points If the investor has an opportunistic allocation against which they have broad freedom to select from a variety of investments, including hedge funds, they are more apt to be looking for something differentiated about the hedge fund manager that would make them an interesting addition to their portfolio. These investors view hedge funds as separate from their core holdings, and they assess the value/benefit they may bring to the portfolio individually and on a stand- The first thing we do is try to understand is what they re looking for in their portfolio, >$10.0 Billion AUM Hedge Fund I tell people all the time, you need to understand the investor s buckets and what they need in their buckets, It almost becomes a semantics issue as to whether they put you in their equities or in their alternatives bucket so long as you know what you do in their portfolio, Outsourced CIO alone basis. Hedge funds in this instance are typically competing not only with their peers, but with a variety of other illiquid and private equity investment managers for a share of the allocation. As such, the hedge fund marketer should stress what is unique about their approach, their investment team, and the landscape their strategy focuses upon. Exceptional returns would be a major selling point for these investors, much more so than for investors utilizing other portfolio configurations. Showing how their strategy is uncorrelated to other investment products outside the hedge fund domain would also be viewed favorably. If the investor is looking to fulfill a specific hedge fund allocation within a defined alternatives bucket, the marketing team may want to alter their messaging and marketing approach slightly. These investors will be looking to create a portfolio of hedge funds, with each manager contributing a unique profile that will add to that portfolio s diversity and stability over a long-term time horizon. These investors will not be as interested in how the fund compares to other investment vehicles such as private equity, but will instead be looking for much more depth on how the manager compares to other hedge funds. To that end, the marketing effort should focus on not only how unique the returns may be, but also on how uncorrelated and how volatile they could be when compared to other managers both in your peer group and to managers in other hedge fund strategies. Investors with this portfolio configuration will want to hear a clearly articulated view on what market conditions your fund is most likely and least likely to perform in, and any actual track record from such periods would be well received. These investors are also likely to be more focused on transparency than an investor with an opportunistic portfolio configuration, so that they are able to gauge whether your fund is performing in line with the promised profile. During periods of market turmoil or when there are dramatic swings in the portfolio, they will also probably require more communication, so that they understand if there are any changes occurring in approach. >$10 Billion AUM Hedge Fund 60 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

61 Finally, when investors have fully or partially shifted to a risk-aligned portfolio configuration, they will be looking to understand additional factors that would enable them to more fully assess their various exposures. The first challenge for the marketing team would be to understand the extent to which they have realigned their portfolio. Since this is a new approach, there is not yet as much uniformity in how investors approach this type of portfolio as yet. Our observation from this year s survey is that investors with this configuration have usually moved to one of two portfolio configurations. In the first instance, they tend to split their consideration of hedge funds in two categories: thinking about how directional strategies fit against their broader set of equity risk exposures and then thinking about a separate set of macro and non-directional hedge fund strategies. In the second instance, they have split their consideration of hedge funds into three categories: comparing directional strategies to other equity risk products, and then separately considering strategies related to the macro environment and to those absolute return strategies that offer no beta. The first challenge for marketers working with these investors is to understand their approach, and then to position their hedge fund appropriately. Key points to bring out up front would be how directional your hedge fund strategy is, and how much that net exposure fluctuates over time. If your fund would be considered part of the equity risk bucket, it will be important to discuss how your individual performance compared to the broader equity or bond market in each corresponding period. Investors will be looking for evidence that your strategy helps to dampen volatility and limit downside losses while not giving up too much of the market s upside potential. Having a ready model showing how a broadly held equity and bond portfolio would have performed, with and without the addition of your fund, can be highly persuasive to these investors. If your strategy fits within the macro category, it will be important to stress how your returns are uncorrelated to equities and bonds and have helped to dampen the impact of excessive swings in those markets. Showing performance against changes in interest rates and broad commodity prices is also important, as managers will be viewed in part on how their performance contributes to the portfolio alongside these other types of investments. It will be critical to demonstrate the role these strategies provide in helping to promote stable value within the portfolio and insulate the investor against inflation. Additionally, these macro and volatility funds are often the approaches where investors have the least understanding of how the manager s investment strategy works. Taking the time to educate the investor will be much appreciated. Historically, many of these managers were resistant to providing detailed insight into their portfolio due to less liquid holdings (global macro), complex and proprietary models (CTAs) or complex derivative strategies (volatility funds). Finally, hedge fund managers are the primary providers of product to satisfy investors absolute return allocation in riskaligned portfolios. Unlike the other sub-allocations, managers in this category are looked at solely in relation to other hedge funds and not for how they impact the performance of parallel holdings. Managers of these strategies should focus investor attention on their experience and expertise in security selection and positioning with the aim of providing the portfolio with lowvolatility, consistent returns. They should also be prepared to discuss their approach to risk controls that ensure the net position remains mostly neutral, and to reassure investors that the fund will not drift into directional territory. If a manager has some of the cash + alpha-type funds discussed in Section VI, they should also press investors on how they are looking to allocate money in their real assets bucket to determine whether there is a potential fit for the hedge fund offering in that category. Our allocation to hedge funds will come from equities because that is where we have the largest risk-factor exposure. But I don t want to get something that will, from a risk profile or return stream, look like equities. Because unless they are going to generate spectacular returns it is awfully hard to overcome the fee differential, US Corporate Pension We think there s real value in big macro-type product that doesn t have a market direction. We think about these investments apart from the broader portfolio. This is important because prior to us taking this approach, the direction that equities went, so went the portfolio, US Corporate Pension Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 61

62 Methodology Role of Intermediaries Evolves and Offers Hedge Funds an Advisory Partner Institutional investors, particularly pension funds, are heavily reliant on intermediaries in determining their hedge fund allocations. The role of these intermediaries has shifted, however, in recent years, and marketing teams are now utilizing these relationships in different ways to promote their fund and raise assets. Chart 34 illustrates the role of intermediaries in the market prior to the 2008 GFC. As shown, there was a clear separation evident between FoHFs and consultants. FoHFs were primarily used to obtain access to hedge fund managers. The quality of their access was based on their ability to perform due diligence and evaluate managers, and they required that investors turn over trading authority of their capital by investing in a comingled fund, where the FoHF manager was able to flexibly shift assets in line with their evolving perception of market opportunity and capacity. Consultants, on the other hand, were almost exclusively focused on providing advice to institutional investors, and though some offered operational due diligence services, this was a little utilized capability. As we have already discussed, there was a decisive shift in institutional behavior with regards to FoHFs post-2008, and a far larger share of these investors began to directly allocate their hedge fund capital rather than turn their money over to a FoHF to invest on their behalf. This change resulted in a substantial realignment of the intermediary space. This change is illustrated in Chart 35. Chart 35: Role of Intermediaries in the Hedge Fund Industry Since 2009 ACCESS Managed Account Platform Consultants Fund of Hedge Funds TRADING AUTHORITY Chart 34: Role of Intermediaries in the Hedge Fund Industry Pre-2008 ACCESS TRADING AUTHORITY DUE DILIGENCE & ADMINISTRATION ADVICE Source: Citi Prime Finance Fund of Hedge Funds Consultants DUE DILIGENCE & ADMINISTRATION ADVICE Source: Citi Prime Finance 62 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

63 The first impact of this change in behavior was that institutional investors became increasingly reliant on consultants. The role of consultant expanded to the point that these resources now act as an extension of the institutional allocators team in many organizations. Not only have consultants maintained their traditional advice-giving role; they are now seen as a critical seal of approval in terms of operational due diligence, and the lists they maintain of approved funds have become an industry norm in terms of access, literally determining in many instances which hedge funds the bulk of the institutional audience is willing to consider for potential allocations. FoHFs have also significantly repositioned. Fewer investors were looking to invest in these managers co-mingled vehicles and as such, leading FoHFs responded by deconstructing their offering. Many chose to leverage the platforms they had originally created to administer their own fund, and instead offer that platform directly to investors to use in order to set up custom funds and administer those funds on their behalf. This administration could be offered either in the form of fund of one vehicles or as SMAs. We had a fund of fund before the Lehman shock but we re shifting to single funds. After the global financial crisis our fund of fund did not work well so we re now seeking single funds, Asian Corporate Pension Fund of funds could be in real trouble. They re not dying. They re just consolidating into consultants, Outsourced CIO More and more we re of the seeing foundations people use and fund endowments of funds as are an advisor moving to and the more integrated and more approach. pensions I wouldn t are going say direct. it s quite We saw up to a 50%, $30 million but it s ticket getting from up a there. client They of one may of not our be former fully fund integrated, of funds. but Having they ve old spread legacy their fund hedge of fund funds relationships out across has 2 or been 3 major very buckets, beneficial for us. We ve raised several million dollars from this channel, Alternatives-Focused Consultant >$10.0 Billion AUM Hedge Fund FoHFs have also maintained their trading authority, but that authority is now more tightly linked to the investor. Leading institutional FoHFs now collaborate more extensively with their clients around their desired investment profile, exploring many of the same parameters around their portfolio configurations discussed in the section above. Rather than offering a single co-mingled fund, the bulk of FoHF participants are now likely to have a series of investor-aligned portfolios where they decide upon allocations jointly with their clients, and different clients are likely to have decisively different managers in their fund. Given these changes, it will now often be the investor s intermediary that the marketing team engages with in the first instance, and this intermediary could be coming from either the consulting or the FoHF space. Yet unlike before the GFC, the majority of these intermediaries do not have the authority to act independently of their underlying client, and instead the marketing relationship becomes layered. Marketing teams often have to maintain both the intermediary and the direct allocator relationship. The final change we will highlight relates to how that layering may grow even more complex in the coming period. Leading FoHF managers have also begun to compete with consultants more directly in the advisory space. These participants have extensive investment teams that are experienced at evaluating hedge fund talent, not only in terms of the safety of those investments but also in terms of their profit-generating potential. This differentiates FoHFs from consultants, since consultants do not have any financial stake in the success or failure of their recommended managers and FoHFs in contrast are looking to be able to participate if their recommendations produce positive returns. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 63

64 Fund of hedge funds as an access vehicle is no longer a valid investment thesis. They are justified when they bring due diligence and other service to the institutional investor. Long-Only and Alternatives-Focused Consultant We are having to change our fees to accommodate institutional investors. If it is an explicit fee paid out-ofpocket for advisory services it may need to be lowered to bps. But they tend to be OK with a 1.5% fee if it is charged with the product, European Fund of Fund Outsourced CIOs Emerge to Help Structure and Run More Risk Aligned Investor Portfolios There is an additional change in the intermediary universe occurring that is important to note. Many former FoHF managers or direct allocators have opted to set up firms that work directly with institutional investors to structure their overall portfolios and manage that capital on their behalf. These participants are being deemed outsourced CIOs because of the function they fulfill. Their emergence is illustrated in Chart 36. Chart 36: Role of Intermediaries in the Hedge Fund Industry: Emergence of Outsourced CIO Our observation from the interviews in this year s survey is that for the time being, the outsourced CIO phenomenon is primarily a US- led innovation. European and some Asian FoHFs and consultants are often given discretion over all or some an investor s capital, but this authority tends to be isolated to just the hedge fund portion of that investor s portfolio. In contrast, the outsourced CIO looks across both the long-only allocations and the alternative bucket, including the hedge fund investments. In some instances, these participants will advise the existing investment team at the investor s organization around portfolio construction and manager selection, working in tandem with these participants in more of an advisory role. In other instances, the outsourced CIO creates an investment fund into which institutional investors channel their capital, to be overseen externally by the outsourced CIO. In both instances, the outsourced CIO is responsible for explaining and justifying the portfolio construction and the manager selection to the investment committee, and to the board at their client organizations. One reason that the outsourced CIO model is taking hold is that the skill set required to shift an investor s portfolio from an opportunistic or dedicated alternatives configuration to a risk-aligned configuration is difficult to obtain for most institutional investors. CIOs and allocators in the risk-aligned model must be highly skilled at risk management and able to measure and reallocate capital actively based on shifting ACCESS TRADING AUTHORITY I definitely see a convergence of fund of funds, consultants, and outsourced CIOs. Fund of funds could evolve into this. Investors need to hire the best skill-based people and they can t access it via the old fund of fund model, >$10 Billion AUM Hedge Fund Managed Account Platform Consultants Outsourced CIOs Fund of Hedge Funds DUE DILIGENCE & ADMINISTRATION ADVICE Source: Citi Prime Finance 64 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

65 market conditions, and their macro view on how the overall investing environment is likely to impact the various risks being tracked in the portfolio. This is especially true of organizations that choose to move beyond risk budgeting to an actual risk parity approach. Paying an external firm to handle that type of active portfolio oversight is seen as more affordable by many in the institutional investing community, since they will be sharing the compensation of their outsourced CIO across many other investors instead of looking to pay an individual or team to perform that function internally. There s been a real trend toward people wanting professional management of their portfolios, particularly after 2008 and the problems people saw with their liquidity that were entirely unexpected, Outsourced CIO We don t consult. We construct a portfolio and our clients allocate their capital to us and we invest it for them. It s about structuring, not advising, Outsourced CIO I really believe in the outsourced CIO trend. It makes enormous sense for a large number of allocators, especially those that don t have the money to build their internal expertise. Groups that choose to go their own route are typically layering in additional fees through consultants or fund of funds and they end up underperforming. With an outsourced CIO, you re sharing your costs with a lot of other investors that are in similar situations. You re syndicating your costs and direct skill-based expertise, >$10 Billion AUM Hedge Fund If you re working only with a client s hedge fund bucket you are working with one eye closed and you re really missing the bigger picture. So when we work with a client s hedge fund allocations we like to model that out against the client s total portfolio. Consultant & Fund of Fund Intermediaries Help Connect Hedge Fund Managers to Long-Only Allocators There is, finally, one other factor to consider in understanding the role of intermediaries and how they can benefit the hedge fund in looking to market their capabilities. This has to do with the ability to leverage these relationships to forge more direct contacts with the long-only allocators at many institutional investor organizations. As noted at the end of Section VI, there is potentially a $2 trillion opportunity for hedge fund managers willing to extend their offerings from their core hedge fund product to vehicles that could qualify for other asset pools in the convergence zone. Asset managers have a natural advantage in positioning for these allocations because of their extensive set of relationships and their broad distribution and marketing teams. Hedge funds have for the most part only opportunistically taken advantage of the space via requests from existing or prospective clients or through one-off introductions from their intermediaries. The appetite exists for better connectivity. As noted several times in this report, there are already many anecdotal instances where a long-only allocator at an institution is looking to expand its knowledge of hedge fund managers. Securing these managers to oversee money shifting from traditional benchmarked to unconstrained long strategies is seen as highly attractive, but there is a definite relationship gap that needs to be filled in order for this to become a more viable outcome. The emergence of outsourced CIOs, the expansion of longonly consultants to include alternative units, and the shift in fund of fund focus toward constructing more customized portfolios all present the hedge fund marketing team with an opportunity to create a proactive plan to build out their network of contacts and begin testing the waters in terms of expanding their product portfolio. Our marketing is focused primarily on hedge fund sales but looks opportunistically at the long-only business, $1-$5 Billion AUM Hedge Fund Sometimes our clients are interested in understanding what we re invested in. For one investor, we do an investment committee meeting every month. He likes to get an overview of the trends of the market and the activity of the underlying managers. They use this information to evaluate their overall portfolio, not just the portion we manage, European Fund of Fund Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 65

66 Conclusion Methodology The emergence of institutional investors as the dominant investor category in hedge funds has transformed the industry. Some of the consequences of these evolutionary changes, such as the requirement for a robust operational infrastructure and strict risk oversight, have been well discussed. Other impacts have been less noticeable. This year s survey is positing that there is a foundational shift occurring in how leading investors are looking to configure their portfolios. This change would help to reposition hedge funds from being a satellite to a core allocation. The potential engendered by this change could result in as much as $1 trillion in new hedge fund capital over the coming 5 years. Another corollary to this change in portfolio approach relates to how different hedge fund strategies are now being viewed in relation to other investment vehicles. Hedge funds with a high net long or short directionality are being evaluated for how their performance impacts traditional long-only allocations, and even to some extent how they act in a portfolio construct with corporate private equity and distressed securities. Macro and volatility strategies are being viewed in parallel to interest rate and commodity investments. This change in perspective is opening up new product opportunities and a new mindset in the investment community about where to source their trading talent. Hedge fund managers have identified an opportunity to extend their product offerings into the long- only and regulated fund space, where their research and trading talents are seen as highly desirable. Asset managers have identified an opportunity to harness their superior infrastructure and excellence in fundamental portfolio management to extend beyond their benchmarked long-only offerings to a new set of unconstrained long and alternative products. The result has been that there is now a substantial set of investment opportunities that exist in a convergence zone, where institutional investors have their choice of sourcing their investment management from either traditional asset managers or from hedge fund managers. Beyond the $1 trillion potential we see for hedge fund strategies, we estimate that there could be an additional $2 trillion opportunity in these other products. Determining the right model to pursue these opportunities is likely to continue to drive change across the industry in coming years. Already, a movement is beginning to hire away talent from successful hedge fund organizations to asset management firms. This trend is likely to accelerate their movement into convergence products. Similarly, large hedge fund managers are branching out and extending their platform to offer a broader product mix that includes longonly funds, new regulated alternative funds, and potentially hybrid cash + alpha products that bridge the private and public markets divide. With the environment becoming so fluid, there has been an increased need for both asset managers and hedge fund managers to understand prospective and existing investors portfolio approach, and to align their product messaging to address how their offering would contribute to a specific as opposed to a broad set of portfolio goals. Intermediaries are becoming more focused on providing the advice that can help facilitate these discussions, and continue to be an important conduit for both the hedge fund and the long-only side of investor portfolios. Some lingering concerns exist about whether recent performance is likely to dampen any of these trends, but our view is that the nature and needs of the institutional investor audience is likely to overshadow any short-term market considerations. We at Citi Prime Finance stand ready to help our clients through these exciting times of change. For more information on this report or for access to any of the other thought leadership mentioned in this survey, please feel free to reach out to us at prime.advisory@citi.com. 66 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

67 1. Appendix: Introduction Institutional Portfolio Theory Pre-2002 Institutional Investors Base Pre-2000 Portfolios on Two Leading Financial Markets Doctrines Before 2000, most institutional investors followed a common approach to portfolio construction, (ie, determining which assets they should hold and the optimal mix of those assets). This approach was based on two important academic doctrines that had emerged in the 1950s/1960s: Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM), which gained widespread acceptance in the industry in subsequent years. MPT was introduced by Harry Markowitz in a 1952 article and 1959 book. The premise of this work was that investors could reduce their exposure to individual asset risk by holding a diversified portfolio of assets. In other words, combining two or more assets within a portfolio could produce a better risk-adjusted return when compared to each individual asset. MPT further went on to posit that all investors are risk averse and that given two portfolios that offered the same expected return, investors would opt for the less risky portfolio. Thus, investors would only take on riskier portfolios if compensated with better returns. CAPM buillt on Markowitz s work and was introduced in the 1960s by William Sharpe and John Lintner. CAPM puts forth the concept that by having a large number of assets in their portfolio, investors can average out unsystematic risk and create a sufficiently diversified portfolio so that the only remaining risks are systematic risks. When this is done successfully, investors can then gauge the required return on an asset based on its riskiness in the portfolio context as opposed to its stand-alone risk. When an asset is successfully added to a portfolio, it will help the investor outperform beta (the general market s return), and when an asset is unsuccessfully added to the portfolio it will cause a portfolio to underperform beta. The portfolio theories of MPT and CAPM are illustrated in Chart 37. When running a simple two-asset portfolio of equities and bonds, an investor can combine those two assets in various allocations between 100% bonds and 100% equities to achieve a range of return outcomes, each of which produces a certain level of risk. The portfolio combinations that deliver the highest level of return at varying degrees of risk end up at the outer bounds of these outcomes. Those portfolios along the outer bounds are said to exist along an efficient frontier. Portfolios that reside inside the efficient frontier are not seen as optimal because investors could achieve higher returns for the same level of risk. Chart 37: Illustration of Modern Portfolio Theory(MPT) & Capital Asset Pricing Model (CAPM) Return % Risk Free Assets or Capital Markets Line Tangency Portfolio- Highest Amount of Return for Least Amount of Risk Lower Risk/ Lower Return Portfolios Efficient Frontier- Set of Optimal Portfolios Higher Risk /Higher Return Portfolios 100% Bonds Risk% (Standard Deviation) 100% Equities Portfolios inside the curve are not efficient, because for the same risk, one could achieve greater return Data shown in this chart are for illustrative purposes only. Source: Citi Prime Finance abstracted from work by Markowitz, Sharpe & Lintner When introducing a risk-free asset to the equation as a starting point for investors, if you draw a straight line from this point on the y-axis (return) it will at some point intersect the efficient frontier. This point of intersection is known as the tangency portfolio. This tangency portfolio is theoretically the ideal portfolio for investors willing to accept some market risk. It generates the optimal amount of return while assuming the least amount of market risk. It should be noted that MPT and CAPM use standard deviation of returns as a proxy for risk. Standard deviation measures both upside and downside risk equally, and assumes returns are normally distributed. When investors began analyzing these portfolios and their various risk/return outcomes, many determined that they were willing to assume more risk than was identified by the tangency portfolio in order to achieve more return. Most investors zeroed in on a target risk level of approximately 10% for the portfolio. The portfolio that demonstrated this 10% risk level with the highest return is higher up on the efficient frontier. Coincidentally, it was also seen as producing approximately 10% expected returns. The asset allocation associated with this profile was split out 60% to equities and 40% to bonds. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 67

68 People are comfortable with a set it and forget it portfolio approach and tend not to be dynamic, US Corporate Pension As shown in Chart 38, this 60% US equities/40% US bonds portfolio has aligned nearly perfectly to the MPT and CAPM expectations. Calculating an efficient frontier using data from 1950 to 2009 for stocks and bonds, the model 60/40 portfolio would have returned slightly under 10% while assuming 10% risk. Obviously to achieve these model risk and return results over the past 60 years investors would have needed to periodically rebalance their portfolios to maintain the 60/40 allocation. Such rebalancing would need to be accomplished even during periods of market correction. This is more easily said than done as investors would have to periodically reallocate capital away from performing assets and allocate to underperforming assets with the hope that the 60/40 model was optimal for them to achieve their long-term return targets. The reality was that what began as a 60/40 allocation would oftentimes drift from that point. Chart 38: Risk-Return profile for 60/40 Vs 100% Equities or Bonds Return % % Bonds 60% Equities / 40% Bonds Risk% (Standard Deviation) 100% Equities 15 Investors Move From a One-Factor to a Three-Factor Portfolio Model In addition to gauging the success of their portfolio and underlying managers by their risk-adjusted returns, investors also compared the performance of their portfolio to the total market return. Mean-variance optimization of managers returns and diversification across managers were major drivers of institutional investors portfolio construction process. Historically, institutional portfolios were administered as a single large pool of money that was divided up across a set of active money managers to achieve diversification. Investors measured a manager s outperformance against the market based on total market returns and broad-based market indices. The market returns portion of the portfolio was considered beta and the excess returns or positive tracking error generated by the manager was considered alpha. This performance analysis was conducted for both equity and bond managers. In the mid-1990s, Eugene Fama from the University of Chicago & Kenneth French from Yale University published a new financial theory that resulted in a major shift in portfolio configurations by the early 2000s. Fama s and French s research noted that a manager s return was only one factor that should be monitored to determine performance. They expanded the factors for consideration to a 3-factor model for equities and a 2-factor model for bonds. For equities, they determined that in addition to risk-adjusted return, if an investor considered the capitalization of the stocks in a portfolio and if the value of the stocks was also considered in terms of whether the stocks traded on a high or a low book to market value, it would result in more discrete portfolio groupings and like-for-like comparisons. This is illustrated in Chart 39. For bonds, they determined that in addition to risk-adjusted returns, an investor also needed to consider the likelihood of the issuer s likely default and the term of the bond itself. Dividing their large pool of equities and bonds up into these discrete groupings (which became known as style boxes over time), investors would be able to determine whether their managers were simply equaling the market performance for the segment of the market they invested in thus only producing beta or whether they were producing excess returns or alpha. 68 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

69 In essence, Fama s and French s work indicated that looking at the market was too broad a benchmark when evaluating a manager s portfolios and performance. By their nature, some combinations (small cap/high book to market value) would naturally have higher returns than other combinations (large cap/low book to market value). The research led to the tendency to compare a manager s performance to a benchmark that more accurately reflected the market segment in which the manager was investing. Chart 39: Relationship Between Risk Factors & Expected Return in the Equity Markets Small Cap Size Increase Expected Returns When managers and their portfolios were broken down to a suitably discrete grouping, Fama and French were able to prove that managers returns actually showed very little room for positive tracking error (or excess performance) and that active long-only managers only rarely beat their benchmark. Low Book to Market Total Market Value High Book to Market As a result, investors no longer compared a manager s performance to a total market index such S&P 500. They began to assess and compare managers performance against the index that was more representative of the market area in which a manager was invested. For example, they began comparing a manager that primarily invests in small and emerging technology companies to a small-cap, growth index. Decrease Expected Returns Large Cap Once Fama s and French s work began to take hold, there was rapid growth in the creation of indices. For equities, indices were originally created to replicate nine major equity style boxes based on two axes. One axis was based on the market capitalization of the companies using three ranges: large, mid, and small. The other axis pivoted on company valuation related to its price, divided into three ranges: value, blended, and growth. Fama s and French s work also applied to the Source: Fama & French as presented by Index Fund Advisors bond markets and led to the breakdown of default likelihood into the categories of investment grade and high yield, and then a breakdown of duration into short-term and long-term bond holdings. Both equity- and credit-oriented indices began to proliferate based on these new categorizations. Chart 40: Percent of Time that Indices Outperformed Active Funds Growth Core Value LARGE CAP December % 80.20% December December % 67.93% December December % 36.71% December MID CAP December % 90.7% December December % 86.87% December December % 75.58% December SMALL CAP December % 85.64% December December % 71.43% December December % 62.65% December % % 33.4% % 66.7% - 100% Source: SPIVA Scorecard, Year End 2011 Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 69

70 The number of indices grew rapidly in the late 1990s and early 2000s. Standard & Poor s (S&P) became a major provider of indices, and they began tracking how well their offerings did relative to active managers in the same style boxes as early as December The 10-year S&P Indices Versus Active (SPIVA) scorecard noted in Chart 40 shows that it was rare for active managers to outperform their relevant indices. In most instances over two 5-year periods going back to 2001, active asset managers underperformed their relevant market index more than 66% of the time. In only a few instances did active money managers outperform their benchmark (33%-66% of the time). At no point did active asset managers outperform their relevant market index more than 33% of the time. These results confirm Fama s and French s findings. As the new theory began to take hold in the early 2000s, the first of two major shifts in investor portfolios took hold. Rather than looking at their set of active managers holistically to both capture market performance and achieve beta and potentially outperform the market and achieve alpha, investors began to split their approach. For the beta component of their returns, investors began to look to emerging index and ETF products. Chart 41: Growth in Passive Index & ETF Funds Index Funds ETFs Long-Only Investable Indices and ETFs Draw Investors Beta Allocations Banks and some traditional asset managers saw an opportunity to take the indices being created in these new style boxes and make them investable in the early 2000s. This touched off a wave of product innovation in the long-only world. This innovation began with index replication funds that offered investors a pooled fund where they could invest capital and get exposure to the entire set of companies being used to generate the relevant index. The fund manager would take responsibility for rebalancing the funds holdings as index components changed, thus maintaining the investor s broad exposure. ETFs were also created around this time. ETFs hold assets such as stocks, bonds, or commodities and trade on exchanges at or near their net asset value (NAV) over the course of the trading day. In contrast, index replication funds are offered in a mutual fund construct that only provide for a daily investment window set at the NAV or closing price for the fund. As Chart 41 illustrates, growth began with index funds in the late 1990s and expanded into ETFs in the early 2000s. AUM in these products have more than doubled every 5 years since In 1998, total AUM in these funds were $281 billion. In 2003, that total had risen to $606 billion. By the end of 2007, that figure had risen to $1.46 trillion and at the end of 2010, index and ETF AUM had topped the $2 trillion mark according to the Investment Company Institute (ICI). 2.1T 1.8T When I got here, the book looked like a lot of index huggers. They had a real style box approach, Endowment Trillions of Dollars 1.5T 1.2T.9T.6T Last year we made significant changes in the portfolio. Our previous CIO had been here 20 years. He had all active managers in the portfolio. I believed there should be a core of passive investments. We added 25% of our portfolio to passive in equities and fixed income and liquidated 7 active managers, US Public Pension.3T Source: ICI 70 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

71 Chart 42: US Endowment >$1bln Asset Allocation in 2002 Other Alternatives 9.9% Cash & Other 2.4% Hedge Funds 17.8% Equity 45.1% Cash.3% Absolute Return 26.5% Private Equity 14.4% Equity 28.2% Real Estate 4.3% Fixed Income 20.5% Real Assets 20.5% Fixed Income 10% Endowments with > $1 Billion in Assets Yale University Sources: NACUBO Commonfund Study of Endowments, 2002 & Yale University These new products provided investors access to desired market beta in a less expensive and more liquid way than the general active long-only managers they had been using previously. Fama s and French s research gave rise to the notion that investors should not overpay for market beta. So investors began to shift assets out of underachieving active long-only managers and allocated these monies to passive index funds or ETFs to get their desired beta returns. The result was that those managers left in the actively managed bucket were expected to show a clear ability to generate alpha. As will now be discussed, much debate arose as to whether this was indeed the best place in the portfolio to seek such alpha. We have been taking on our passive exposure mostly through index funds, but we are exploring using institutional ETFs as part of that mix, Endowment We have indices and ETFs. Tracking error is fairly limited across the whole book, European Public Pension Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 71

72 Leading Endowments & Foundations Demonstrate New Paths to Alpha As these trends were developing within the broad investment community, leading endowments and foundations (E and Fs) took the concept of diversification at the heart of MPT/CAPM into new investment areas beyond the traditional equities and bonds that had been investors primary focus. E and Fs expanded their investable universe away from tradable securities in liquid markets and added diversified alpha streams in less liquid markets. E and Fs began allocating to strategies and structures such as hedge funds and private equity funds that offered less liquidity compared to allocations to long-only active managers and passive beta investments. One feature these strategies provided investors was access to an illiquidity premium. Since these vehicles did not have to offer daily liquidity to investors, they could invest in longerterm strategies and themes such as distressed corporate credit and deep-value or activist equity investing. In essence, these E and Fs invested in what they believed were the best managers available in their respective areas, with limited regard to how it impacted the liquidity or ability to benchmark their overall portfolio. They viewed this introduction of varying alpha streams as an expansion on the concept of diversification as originally posited by MPT/CAPM. The philosophy led the largest, most progressive E and Fs to allocate a significant portion of their portfolios to hedge Chart 43: Relative Portfolio Performance of diversified Endowments versus traditional 60/40 portfolios 60% Equities/ 40% Bonds -7.8% -2.2% 1-Year Returns 3-Year Returns In addition, E and Fs allocated to strategies that were not able to be benchmarked either because of the assets they traded (eg, convertible bonds) or because of the investment techniques the managers were permitted (ie, shorting and leverage). Many of these investors viewed these allocations as a purer form of alpha because the managers were not limited to under- or over-weighting positions around a benchmark. >$1B Endowment Portfolio -3.8% +5.6% Yale University +.7% +17% This diversification of alpha streams into hedge funds and other alternative funds including private equity and real estate was led primarily by the market pioneer David Swensen at Yale University and as such became known as the Yale model. The five principles of this model are: Invest in equities, because it is better to be an owner rather than a lender. Hold a diversified portfolio, avoid market timing, and finetune allocations at extreme valuations. Invest in private markets that have incomplete information and illiquidity to increase long-term incremental returns. Use outside managers except for all but the most routine or indexed investments. Allocate capital to investment firms owned and managed by the people actually doing the investing to reduce conflicts of interest funds. Indeed, as illustrated in Chart 42, the average E and Fs holdings for organizations with more than $1 billion in assets had nearly 18% of their portfolios allocated to hedge funds in June 2002, and Yale University had 26.5% of its assets in absolute return strategies in The portfolios of these large E and Fs demonstrated significant resilience during and in the aftermath of the technology bubble of Yale University s returns and returns on the diversified alpha stream portfolio held by E and Fs investors with more than $1 billion in assets far outperformed the general market and the majority of institutional investor portfolios of the period that remained aligned to the 60% equities /40% bond allocation model. 20 Sources: Yale University; Citi Prime Finance analysis & NACUBO Commonfund Study of Endowments, 2002 This is illustrated in Chart 43. Yale University made money (+0.7%) and large E and Fs portfolios suffered far less severe losses (-3.8%) than the traditional 60/40 portfolio (-7.8%) during the broad equities market correction of I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence

73 The move to hedge funds is to reduce equity beta in the overall portfolio. As part of that, investors say how much alpha have I been able to generate from my long-only and can I get more with less volatility and still capture returns with a hedge fund? Institutional Fund of Fund It was obvious that the diversification benefit of alternatives was so compelling that the big institutions were going to have to increase their exposure to hedge funds, <$1 Billion AUM Hedge Fund We still do not have any hedge fund investments. We are looking at it and have been looking at it for some time now, US Corporate Pension Yale University (+17.0%) and the large E and Fs portfolios (+5.6%) reported positive performance during the 3-year period around the correction. This compared to the negative 3-year performance of the 60/40 portfolio (-2.2%). This outperformance compelled traditional institutional investors to consider looking for alpha outside their active long-only manager buckets by accessing alternative strategies. Investors came to see that adding alternative alpha streams such as hedge funds to their portfolio improved their overall risk/reward profile and offered up a more optimal target portfolio than traditional equity/bonds. Efficient Frontier Becomes More Compelling With Addition of Hedge Funds to the Portfolio Most institutional investors seek to be prudent fiduciaries to the assets they manage, and as such take their time in considering significant changes in their portfolio approach. Moreover, they have strict portfolio allocation limits and policy guidelines regarding what types of investments can reside in each investment category. These guidelines are only reviewed and reassessed periodically by the investment committee and possibly by a consultant hired by the institution to assist in the management of the portfolio. While leading E and Fs were moving toward portfolios with diverse alpha streams, the majority of institutions had boards of directors and investment committees that were unfamiliar with hedge funds and their investment strategies. They were also deeply suspicious of how safe their money would be with these independent investment managers that were offering products that had lower liquidity and higher fees compared to their existing active manager allocations. To help foster a shift in thinking within these traditional institutions, participants went back to the core MPT/CAPM principles and used that framework to demonstrate that portfolios containing hedge funds offered a superior riskadjusted return on the efficient frontier. This is illustrated in Chart 44. Chart 44: Efficient Frontier Chart Comparing Equity and Bond Portfolios to Equity, Bond and HF Portfolios Return 15% 10% 5% 0% 57% HFRI Eq Hdg 43% HFRI Macro 60% HFs 40% US Eqty 5% 10% 18% 20% Risk 33% Agg Trsy 67% US Eqty 100% MSCI Europe Source: Citi Prime Finance analysis As shown, portfolios that included hedge funds offered up higher return potential for investors at a similar risk expectation when compared to the traditional 60/40 portfolio. The uncorrelated nature of hedge funds within the traditional portfolio construction framework of MPT/CAPM helped many organizations visualize the benefit that hedge funds provided to the portfolio, and allowed them to begin authorizing some shifts in their allocations. Many institutions adopted this new way of thinking about their portfolios, and this led to a massive influx of money to the hedge fund industry in the early to mid-2000s. Changing an institution s approach to their portfolio construction is still a very difficult and oftentimes slow process, particularly within the very conservative pension world. While many institutions have moved in the direction of broadening their portfolio to additional alpha streams, there are still significant numbers of investors that continue to have traditional portfolios and that do not have any allocations to alternatives or hedge funds. Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence I 73

74 Notes evestment Alliance (evestment) is a global provider of institutional investment data intelligence and analytic solutions. evestment delivers extensive data through robust, user-friendly products, with an unparalleled commitment to client service. Through its online evestment Global Database, evestment captures the most comprehensive dataset in the industry and distributes all information via its fully Web-based evestment Analytics system, a platform that has set the software standard for online manager comparisons, research and competitive intelligence. evestment was founded in 2000 and is headquartered in Atlanta with offices in New York, London, Sydney and Hong Kong and regional sales offices in Boston, Seattle, Raleigh, Chicago and Toronto. 74 I Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence