Sovereign wealth funds are ramping up their hedge fund allocations, but successfully navigating the manager selection process requires more than good investment performance, says Sameer Shalaby, president of Paladyne Systems, a Broadridge Company.
Sovereign wealth fund allocations to alternative investments continue to rise. For hedge funds and investment managers with the right profile, the trend brings enormous opportunities, as well as significant challenges.
Sovereign wealth funds (SWFs) are an increasingly powerful force in the investment world. Total SWF assets topped the $5 trillion mark for the first time at the end of April, with at least 20 funds created since 2005, and several more planned (for example, in Panama and Kenya).
Alongside this asset expansion, consulting firm Preqin notes that SWF exposure to hedge funds rose from 36% in 2011 to 38% in 2012. Preqin also predicts more SWFs which tend to have longer investment horizons and different liability demands to other investor types will expand into alternatives over the longer term.
Meanwhile, at a recent Opalesque Roundtable, it was suggested sovereign wealth funds in the Gulf region which hold more than $1.7 trillion in assets will increasingly target the alternative investment sector, drawn by the funds need for diversification, the search for yield, their growing sophistication and ability to deploy long-term capital.
Sovereign wealth funds financial clout and their desire to source attractive risk-adjusted returns represent a huge opportunity for hedge funds. Nevertheless, there are significant conditions attached.
Reputational risk in particular is a major issue for SWFs. Therefore, hedge funds need to go the extra mile to assure a sovereign wealth fund that investing with them is the right thing to do.
According to the Sovereign Wealth Fund Institute, a solid and consistent performance track record will be of paramount importance. By itself, however, outperformance is not enough. Effective risk management is also crucial, as is quality client service and communication.
For example, the Abu Dhabi Investment Authority (ADIA), the worlds largest SWF with $627 billion in assets, typically invests 5% to 10% of its total assets in hedge funds, according to the Preqin review. To receive an allocation from ADIA, a manager needs a minimum two-year track record and $200 million in assets under management. Historically, ADIA has also focused on funds transparency, fee structures and liquidity provisions when making allocation decisions.
As the SWF Institute points out, a fund managers convictions, investment processes, adherence to the mandate and technology will be key areas of attention for sovereign investors.
For hedge fund and investment managers seeking to attract SWF allocations, a robust operational infrastructure is essential. With a sophisticated and integrated front-to-back office technology solution, managers can:
- Make more informed and faster investment decisions, supported by efficient order generation and routing, helping to boost investment performance.
- Automate all areas of the trade lifecycle to maximize internal and external straight-through processing levels, thereby reducing operating costs and improving management of trading and operational risks.
- Leverage pre- and post-trade compliance tools to enhance firm-wide compliance management.
- Improve client service with the aid of automated and customizable reporting capabilities.
Meeting sovereign wealth funds due diligence demands will require nothing less.