s institutional investors seek to better manage their
liabilities, diversify their portfolios and generate
alpha, they increasingly are considering hedge
fund strategies. However, the rush of insti-
tutional investors into the space could
potentially create a dearth of opportunities.
Consensus estimates indicate that U.S. institutional investors
will increase hedge fund allocations from about $60 billion
in 2006 to $300 billion within the next five years. As more
managers crowd into similar hedge fund strategies, the market
inefficiencies that initially made those strategies attractive to
investors have begun to disappear and returns have ultimately
started to diminish.
In addition to the potential scarcity of return opportunities,
investors will face the challenge of identifying real manager
skill in generating alpha. “Institutions looking at strategies such
as portable alpha should be careful that what they’re getting is
truly alpha. That is, unsystematic, or idiosyncratic, returns,
rather than systematic returns,” says Ken Stemme, director of
hedge fund investments for Northern Trust.
18 | APRIL 2007 | nor therntrust.com/pointofview
EXPLORING THE HEDGE
FUND UNIVERSE
With an increasingly crowded marketplace, the challenge in hedge
fund investing will be identifying new market inefficiencies.
A
What’s purported to be alpha often results simply from the
fact that it’s difficult, if not impossible, to benchmark hedge
fund managers, Stemme says. “How do you replicate the
universe of the convertible bond arbitrage manager, for
instance? With an irrelevant benchmark, any outperformance
you see may not be true alpha because the strategy is not
trying to manage to that index. Long-short managers are a
good example because they often are gauged against the S&P
500 Index. But the S&P 500 is not a relevant benchmark for
those because it doesn’t take into account shorting strategies.”
In order for investors to unearth the true sources of alpha
in a hedge fund strategy, “you have to do a lot more work
deconstruc