A rising number of institutional investors, including public and private pensions, universityendowments and philanthropic foundations, are devoting larger shares of their portfolios tohedge funds.Once considered an elite investment for wealthy individuals, a majority of hedge funds assets –by one independent measure 65 percent – are now owned by institutional rather than privateinvestors. Thus, the role of hedge funds in the economy is changing as new classes ofinvestors come to embrace them.This research explains the objectives of hedge funds, estimates their potential value toinstitutional portfolios and examines some of the basic public policy concerns surroundingthe role of hedge funds in the financial markets.
When compared to a ―standard‖ portfolio without hedge funds, adding hedge funds to an investment portfolioincreases the probability of achieving positive returns and lowers volatility. A modest allocation to hedge funds would improve returns to U.S. public pension plans by approximately$13.67 billion annually. Similarly, hedge funds have the potential to add $1.73 billion in expected annual returns to U.S. college anduniversity endowments and their affiliated foundations. Hedge funds as an asset class display many of the characteristics we would find desirable in an investment.Hedge fund managers’ incentives are closely aligned to the interests of their investors; they are generally toosmall to affect the integrity of financial markets and therefore, systemic risk in the economy.
The objective of hedge funds is to offer investors an absolute, positive return regardless of marketconditions. Hedge funds offer investors a rich variety of strategies to pursue this objective. The defining characteristic of hedge funds is their focus on managing risk. A hedge fund manager’s pay is directly correlated to his fund’s performance, aligning the interestsof the manager and the investor.
• The hedge fund industry has grown significantly from $38.9 billion in assets undermanagement in 1990 to $2.25 trillion in the fourth quarter of 2012• Over the last 20 years, 40 percent of the growth in hedge fund assets has come from newcapital given to funds by their clients – the rest, or 60 percent, comes from the returnsearned by funds and then reinvested.$0$500,000$1,000,000$1,500,000$2,000,000$2,500,000199019941998200220062010Estimated Growth in Hedge FundAssets 1990-2012 (source, Hedge FundResearch)Assets (In $Millions)Q4 2012$2.375 Trillion
◦ Hedge funds have evolved from an eliteinvestment to a tool used by pensionfunds, colleges and universities, and otherinstitutions to diversify investments,manage risk, and deliver reliable returns.◦ Sixty-five percent of hedge fund assets areheld by institutional investors – pensions,endowments, foundations, and others.◦ These investments help provide criticalresources to fund retirement benefits,scholarships, philanthropic grants andother services.
◦ By understanding the statistical distribution ofreturns earned by each asset class (averagereturns and the risk entailed) and the correlationbetween asset classes, models can calculatereturns and risk for investment portfolios.o By simulating the risk and returns of a portfoliotwice — once with hedge funds among the assetclasses and then once without hedge funds — itis possible to estimate the contribution thathedge funds make to this representativeportfolio.
◦ Compared to a ―standard‖ portfolio, hedge fund investments can help increase the probability ofachieving positive returns.
◦ Adding hedge funds to a diverse portfolioreduces the probability of negative returns.◦ Annually, hedge fund investments decreasethe likelihood of negative investment returnsby approximately 10 percent.
◦ Adding hedge funds to a portfolio improves the probability of achieving positive returns.◦ A modest allocation to hedge funds would improve returns to U.S. public pension plans byapproximately $13.67 billion annually.◦ Similarly, hedge funds have potential to add approximately $1.73 billion in annual returnsto U.S. college and university endowments.
◦ Hedge funds offer investors superior risk management techniques.◦ A recent study performed by economists at Columbia University and the National Bureau ofEconomic Research concluded that ―hedge fund leverage is fairly modest, especially compared withthe listed average of broker/ dealers and investment banks.‖
Given the relatively low level of hedge fund holdings among pensions, the pressures to improve returns,and the modeling results provided in this research, we should expect greater hedge fund holding bythese institutions in the future.
Dr. Everett E. Ehrlich is former Undersecretary of Commerce in the Clinton Administration and nowPresident of ESC Company, an economics consulting firm in Washington, D.C.The full study can be downloaded at http://bit.ly/pmVkxM
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