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Hedge Fund Investors Catch Equity Fever, Triggering Big Inflows

Institutions such as pension funds that have seen their funding status improving are looking to reduce their equity risk. Enter hedge funds.

The movement by hedge fund investors back into equities is turning into a stampede.

Except for a tiny reprieve in 2010 and 2011, investors had been cutting back allocations to hedge fund equity strategies since 2008. This trend began to turn around in the second quarter of 2013, and the pace of net inflows into equity strategies has been accelerating since then, according to eVestment, an investment data firm based in Marietta, Georgia.

In the first four months of 2014, investors provided net inflows of $48.3 billion into hedge fund equity strategies, the firm says. The recent pattern builds on the 2013 turnaround, which saw equity strategies go from net outflows of $13.8 billion in the first half of the year to net inflows of $29.3 billion in the second half. Total equity strategy assets in hedge funds reached an estimated $949 billion by the end of April, according to eVestment.

Publicly available data do not identify how much of net inflows are coming from institutional investors, but those players most likely represent the key driver behind the turnaround, according to Peter Laurelli, a vice president in the research group at eVestment. Institutions are the largest direct investment grouping in hedge funds, he says, and “they dominate and influence where hedge funds are going.”

HFR, a Chicago–based hedge fund data firm, has reported a similar shift in flows. The firm, which uses a different classification system for hedge fund categories, says equity strategies had net inflows of $16.35 billion in the first quarter. In 2013, by comparison, hedge fund equity strategies had $1.32 billion in net outflows in the first half of the year and $19.23 billion of net inflows in the second half, it said. HFR estimates total hedge fund equity assets of $761 billion at the end of March.

Institutional investors — including government funds, endowments, pensions and foundations — “represent about 40 to 50 percent of all investor capital in hedge funds,” and that share “has grown in the past five years,” says Kenneth Heinz, president of HFR.

When you combine both net inflows and performance gains, equity hedge funds also beat other broad hedge fund categories. Net inflows of $16.35 billion in the first quarter combined with $10.7 billion in gains on investments to push the total quarterly increase in assets managed by equity hedge funds to $27.1 billion, according to HFR. By comparison, relative value hedge funds, in second place, registered net inflows of $11.2 billion and performance gains of $15.3 billion for an overall asset increase of $26.8 billion in the quarter.

The big irony of the sudden fashion for equity hedge funds is that it appears to be driven by a reduced appetite for equities in the conventional side of investor portfolios. Institutions “are diversifying away from equity risk into other risk-reward dividers, including skill,” explains Mark Ruloff, director of asset allocation at Towers Watson in Arlington, Virginia.

Ruloff points out that institutions that allocated significant sums to what he calls the “equity risk premium sector” did very well last year. The S&P 500 index rose 26.39 percent during 2013.

Because of these extraordinary equity gains, many institutional investors have had to rebalance their portfolios. Many have chosen to apply incoming funds to alternative investments that can diversify and reduce their overall risk. “For corporate pension plans that have a derisking glide path, their funding status has improved; therefore they want to be taking the risk level down,” Ruloff says. “Now, generally, that would mean you are moving into liability hedge assets. But it can also mean that you want to reduce your equity risk and move into other things, like hedge funds.”

With the equity rally improving their funding status, many closed and frozen pension plans are thinking about changing their target allocations “to reduce the risk they are taking,” says Ruloff. Corporate pension plans may first consider whether or not to shift funds out of equities into bonds. Given the very low returns available from fixed-income investments, however, “while that might be a low-risk strategy, it might not be attractive,” Ruloff says. That can then lead a pension fund manager to choose instead the option of investing in a hedge fund. He adds, “Generally, you want to have higher risk-adjusted returns and higher long-term risk-adjusted returns, so that’s why you want to be diversifying away from the equity beta in any one particular year like 2013, when equity could be the big winner.”

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