Lyxor expects more hedge funds in institutional portfolios

As hedge funds offer greater transparency via bespoke structures, institutional clients can more readily model risk and reward to the sector that they have previously shunned, allowing hedge funds to play a greater role in their portfolios, according to Lyxor.

Some practitioners have feared that the risk-weighting rules of Solvency II, as applied to insurers – and possibly soon also Europe’s pensions – could force ‘risky’ hedge funds to be an insignificant part of these institutional investors’ portfolios.

A similar argument could be put for other alternative investments, and trade body the European Venture Capital Association recently argued forcefully against applying Solvency II to Europe’s pensions.

But Lyxor said in a recent research paper that “it is now possible to perform a reliable risk/return analysis on hedge fund strategies, similar to that carried out on traditional asset classes”.

Mathieu Vaissie, the author, pointed to new forms of investment vehicles such as separate or managed accounts, which he said give insurance companies enough transparency and liquidity to perform a reliable risk/return analysis on their allocations.

“The Solvency Capital Requirement of the different hedge fund strategies can be easily factored into the portfolio construction process, and a solution may be designed that is optimal from both a risk-adjusted performance [standpoint], and a capital efficiency standpoint.”

The paper argued that, as a result, there is now “no reason why hedge fund strategies should be placed in the ‘other equities’ category, next to ‘emerging equities’, ‘private equity’ or ‘commodities’, and suffer such poor treatment as in the standard approach.

“A Solvency Capital Requirement of 49% then would clearly not be representative of the risks embedded in hedge fund strategies. A capital charge of no more than 25% would deem to be appropriate for a well-diversified hedge fund allocation.

“Hedge fund strategies not only appear to provide insurance companies with an appealing solution from an investment perspective, but they also look to be efficient from a capital efficiency standpoint. Against all expectations, hedge fund strategies could end up playing a greater role in the future investment policy of insurers.”

A recent hedge fund industry survey by Credit Suisse found eight methods of greater transparency were regarded by investors in hedge funds as “very important”.

These are gross and net exposure; proportionate exposure of largest holdings; P&L attribution by sub-strategy; a breakdown of the portfolio by liquidity and industry sector exposure; the largest positions by name, and the disclosure of weekly NAV estimates.

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