02/03/2011 Author: Shannon Hawthorne

Wealth of nations

The hunt for large-scale institutional investment is changing the way hedge funds operate, and investors don't come much bigger than state-owned sovereign wealth funds. As new countries join the handful of long-time hedge fund investors, HFMWeek looks at where this interest is coming from, and what hedge funds need to do to capitalise on it.

If there was ever a Holy Grail of investors, surely it's the sovereign wealth fund (SWF). Totalling an estimated $4trn in assets under management - a figure that Deutsche Bank predicts will leap to $7trn within the decade - and with the largest, the Abu Dhabi Investment Authority (Adia) weighing in at an impressive (estimated) $625bn, these government investment funds clearly hold a wealth of opportunities for a hedge fund industry still hungry for capital inflows.

And SWFs are no strangers to the hedge fund space; some, particularly those in the Middle East, are long-time allocators to the sector. However, and perhaps more significantly for hedge funds, over the past couple of years, a growing number of SWFs have announced plans to make their first allocations to the space: the $33.6bn Irish National Pensions Reserve Fund, the $37bn Korea Investment Corporation and the $300bn Hong Kong Monetary Authority, to name but a few.

In fact, HFMWeek has identified 23 sovereign wealth funds, with assets under management totalling an estimated $2.28trn, that are either currently investing in hedge funds or planning to do so in the near future.

So far, so good? Perhaps - but any manager expecting a flood of SWF inflows may need to pause for thought, because, much like hedge funds, SWFs are liable to be subjected to intense public scrutiny regarding their investment choices. And it is this need for SWFs to be keenly aware of the potential headline risks of their investments that may put some off investing in hedge funds - it's one thing for a state fund to lose money on a 'traditional' investment, it's quite another to lose it via a fund of hedge funds (FoHFs) in a Madoff-style blow-up - in the eyes of the public at least.

"SWFs are inherently conservative, and are subject to very public oversight - on the front page of newspapers or in debates in parliament," says Andrew Gordon, head of Asia for BNY Mellon's Alternative Investment Services business. "So when it comes to hedge fund investments, they are focused on the managers that have good institutional infrastructure - not only strong investments processes, but also an operations and a risk management infrastructure to match."

That said, post-crisis, hedge funds are ticking said boxes increasingly well, and, as a consequence, a greater number of funds are shrugging off the traits and stereotypes of the past and becoming more palatable to SWFs.

"The more thoughtful hedge funds fully accept investor desire for more transparency than in the past, when a hedge fund was almost a complete 'black box' and sovereign wealth funds who wished to access their returns really had very little information to go on," says John Nugée, senior managing director of State Street Global Advisors. "For the more sophisticated SWFs, hedge funds are becoming more part of the orthodox space; they're viewed as less extreme than they were."

However, from a PR perspective the risks of investing in the hedge fund space remain, and so for many SWFs, the 'bigger is better' mantra remains a firm fixture, with larger, more experienced firms seen as a safer bet. "[Concerns about headline risk] eliminate many start-ups, at least at an early stage, until they have a proven track record of performance at both the investment and operational level," says BNY's Gordon.

The typical size of a SWF allocation also plays a part in this, adds Judy Posnikoff, a managing director and co-founder of $10bn FoHF Paamco. "SWFs tend to make large allocations, say $100m if not more, and if allocating directly, this can make it very difficult to access some of the smaller managers. The fund, or their investment consultant if they are using one, may not have the resources to do the due diligence and monitoring of every fund they have allocated, say, $5m to."

But rare is the rule that has no exception. Last November, the Mubadala Development Company, a $13.3bn United Arabs Emirate (UAE) sovereign fund, indeed announced plans to allocate $100m to a hedge fund - but perhaps surprisingly, that hedge fund was Russian manager Verno Capital, which at the time had $116m under management.

"First and foremost, they were interested in the geography, in putting some money into Russia and with someone local, someone who could help them with local knowledge, understand how long markets work," Verno founder Dimitri Kryukov explains to HFMWeek. "What we offered was expertise - we consider ourselves to be Russia experts because we've been working in this sector for a long time, very successfully."

But Kryokov is wary of proclaiming this as symptomatic of a growing shift by SWFs towards smaller managers. "What we can offer is a lot of flexibility and the attention that we pay to the needs and requests of our clients, which is something some investors find attractive in smaller managers," he says. "But on the other hand, some think that bigger firms are safer. It depends on so many different factors."

Clearly then, it's important to appreciate that SWFs investing in the hedge fund space may not be doing so simply for the sake of investing in a hedge fund, but rather because they are interested in a particular investment approach and it just happens to be a certain hedge fund that meets their needs. "We believe there is a greater emphasis on selecting the strategies that best fit in with the sovereign wealth fund's overall objectives, rather than just allocation to hedge funds per se," says Garry Hawker, a partner at global investment consulting firm Mercer.

What's more, it's vital to have an understanding of the background to a sovereign fund - why it has been set up, how it's funded and the political and regulatory issues surrounding it. "We all lump sovereign wealth funds together, but they are very different, both regionally and within regions. They have different aims and goals; where the money comes from is often quite different and that helps set their investing pattern," says Paamco's Posnikoff.

In turn, SWFs, like many other institutional investor groups, are taking an increasingly nuanced approach to portfolio diversification, with a growing number opting to take a risk-based approach to allocation, and move away from the traditional asset class distinctions that see all hedge fund strategies lumped together in one portfolio.

"If you look at asset classes and at different investment opportunities from the point of view of their risk factor exposures, then in extremis, that should mean that the distinction between so-called 'traditional' and so-called 'alternative' asset classes becomes outdated," says Andrew Rozanov, managing director and head of sovereign advisory at $22bn FoHF Permal, which manages assets for three of the top-ten largest SWFs. "It's similar to the way in which a nutritionist would look at food. It's not a question of how much bread or how many vegetables you eat, but rather, it's a question of how much protein, or how many carbohydrates, you want in your diet. And when viewing it in this manner, the way the nutrients are packaged, be it in 'traditional' or 'exotic' foods, becomes irrelevant."

According to Rozanov, one particular hedge fund strategy that continues to offer significant benefits for SWFs is global macro. "You get access to timely market intelligence and the recent thinking - if you want to position your portfolio to be robust, whether it's inflation or deflation, you probably want to know what the best and the brightest in the industry are thinking about inflation and deflation," he explains.

With 60% of SWFs set up in the last decade, it's clear that the potential for future sovereign inflows is substantial. But in the same way that lumping all hedge fund strategies into one asset class is increasingly viewed as an outdated way of thinking, projecting homogeneity onto SWFs is clearly a flawed approach. Understanding the individual investment needs of these funds is key, and it's those hedge funds that appreciate this that will reap the rewards.

WHO IS INVESTING IN HEDGE FUNDS?
A countdown of 23 of the largest sovereign wealth fund investors by size, along with their current allocation plans
source: HFMWeek

1 Abu Dhabi Investment Authority - $625bn
Allocates to macro, relative-value, event-driven and market-neutral equity strategies, as well as managed futures

2 Singapore Government Investment Corporation - $330bn
Allocated 3% to hedge funds as of March 2010

3 China Investment Corporation - $300bn
Currently invests in hedge funds as part of alternative portfolio

4 Hong Kong Monetary Authority - $273bn
Revealed plans to invest in hedge funds in 2010

5 Kuwait Investment Authority - $250bn
Currently allocating to hedge funds, targeting an excess return of 100 BPS against the HFRT1 Fund of Funds composite Index

6 Temasek Holdings - Singapore - $145bn
Currently allocates to hedge funds, with a focus on Asian economies

7 Australia Future Fund - $71.9bn
Allocating 15.6% to alternatives, including event driven, multi-strategy/relative value and macro directional hedge fund managers. Planning to increase to 20% by June 2011

8 Qatar Investment Authority - $60bn
Currently investing in hedge funds

9 Alaska Permanent Fund Corporation - $39.5bn
Allocating 6% to absolute return as of 2010

10 Korea Investment Corporation - $37bn
Planning to increase alternative allocations, including hedge funds, to 20% of investment portfolio

11 National Pensions Reserve Fund - Ireland - $30.3bn
Preparing to make first allocation to FoHFs (5%)

12 Brunei Investment Agency - $30bn
Currently investing in hedge funds

13 Mubadala Development Company - $23.4bn
Invested in Russian hedge funds Verno Capital in 2010

14 State Oil Fund - $22.8bn
Revealed plans to invest in hedge funds in 2009

15 Alberta Heritage Saving Trust Fund - $14.4bn
Allocated 5.9% to hedge funds as of 30 Sep 2010, with a 10% allocation limit

16 New Mexico State Investment Office Trust - $14bn
Allocates around 10% to FoHFs

17 Mumtalakat Holding Company - Bahrain - $13.8bn
Revealed plans in HFMWeek to invest in hedge funds in 2009

18 New Zealand Superannuation Fund - $13.8bn
Currently invests in five market neutral managers (AQR, Numeric, Bridgewater, Blenheim and Vermillion)

19 Istithmar World - Dubai - $12bn
Currently investing in GLG Partners

20 Permanent Wyoming Mineral Trust Fund - $11.5bn
Currently invests in FoHFs

21 Palestine Investment Fund - $800m
Revealed plans in HFMWeek to invest in hedge funds in 2009

22 State Capital Investment Corporation - $500m
Revealed plans in HFMWeek to invest in hedge funds in 2009

23 Abu Dhabi Investment Council - $unknown
Currently invests in hedge funds, including relative value, macro, event-driven and systematic CTA strategies