Institutional investors continue to value hedge funds for their diversification benefits and low correlation to other asset classes, but they are exercising caution in their allocations, with many deferring decisions until 2025, according to Preqin’s latest investor outlook report.
The June survey, which included responses from 185 institutions, highlights a nuanced perspective among investors. Despite their enduring appeal, hedge funds are facing a more reserved attitude from institutional investors this year. Notably, 7 percent of public pension assets and 18 percent of large endowment assets remain invested in hedge funds, underscoring the strategy’s role in diversification and risk-adjusted returns.
Diversification: A Primary Driver
Diversification emerged as the top reason for investing in hedge funds, with 68 percent of institutions citing it as their primary motivation. This preference for diversification was stronger than that for other alternative asset classes, including private equity (60 percent), venture capital (59 percent), and private debt (57 percent). Additionally, nearly half of the institutions noted that hedge funds’ low correlation to other asset classes was a key factor in their investment decisions, a higher percentage than for other asset classes.
Inflation Protection Not a Major Concern
Interestingly, hedge funds are not being viewed as a primary tool for inflation protection. Only 7 percent of institutions considered hedge funds as an effective hedge against inflation, a sentiment echoed by similar low percentages for private equity (6 percent) and venture capital (4 percent). This suggests that inflation concerns, while significant, are not driving current hedge fund investments.
Decreased Allocations and a “Wait-and-See” Approach
Despite the recognized benefits of hedge funds, institutional investors are scaling back their allocations this year. The Preqin report notes that 35 percent of institutions plan to decrease their hedge fund allocations, a notable increase from 25 percent last year. While 47 percent intend to maintain their current allocations, only 18 percent plan to increase their exposure to hedge funds.
This cautious stance is reflected in asset flows, with hedge funds experiencing $25.2 billion in net redemptions between March 2023 and March 2024. Moreover, 68 percent of the institutions planning to allocate more to hedge funds are postponing these decisions until next year, and 40 percent do not expect to commit new funds until the second half of 2025 or later.
Flawed Data Concerns
Critics argue that institutional investors may be making allocation decisions based on incomplete or flawed data. Many hedge funds with over $1 billion in assets do not share their performance data with commercial databases. When these funds are included in performance calculations, the average hedge fund performance increases by more than two percentage points, suggesting that the perceived underperformance of hedge funds may be overstated.
Outlook for Hedge Funds
As institutional investors continue to adopt a “wait-and-see” approach, the hedge fund industry faces a period of uncertainty. The Preqin report suggests that while hedge funds remain a valuable tool for diversification and risk management, investor confidence in these strategies is currently wavering. The broader economic environment, particularly any changes in interest rates, may play a critical role in shaping the future of hedge fund allocations.
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