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  Currency Hedging - impact of FX risk on performance and the investment process

Institutional Investment in Foreign Exchange hedge funds

By Amy Bensted

We surveyed over 50 institutional investors that have some exposure to FX products through their hedge fund holdings - these investors ranged in size from USD 300 million to USD 15 billion in assets under management. We surveyed investors from across the globe representing many different types of institutions including endowments, pension plans and fund of funds.

Using our database of institutional investors we found that most investors were making their first allocations to the FX market at the beginning of 2007. When the majority of non-fund of funds investors made their initial allocation to FX, this was mostly coming via a multi-strategy fund of funds or via a foreign exchange exposure within a global macro mandate. What we are now witnessing is a growth in allocations to niche focused FX vehicles - with institutional investors using direct fund investments to pinpoint exposure to the opportunities that foreign exchange investment has to offer.

Will institutional investors be making investments in foreign exchange hedge funds in 2009?

The first question we posed to foreign exchange hedge fund investors was whether they would be actively looking for new opportunities in this space through 2009.

Figure 1: FX hedge fund investors plans for 2009

68.5% of the institutions that Preqin surveyed had fixed plans to invest more capital in FX hedge funds in 2009, with a further 12.3% actively considering FX as part of their opportunistic approach to hedge fund investments. This shows that there is still a strong appetite for foreign exchange hedge funds. With many investors poised to make their first investments in hedge funds in 2009, we predict that more institutional investors will make their maiden allocation to a FX fund in the next 12 months and inflows of capital into this area will be much higher than has ever been previously witnessed.

Figure 2: How many FX HF will institutions be allocating capital to in 2009

How many FX investments will institutional hedge fund investors be making?

Institutional investors will in the main part be keeping the number of foreign exchange investments they make through their hedge fund portfolios relatively small - with the most common allocation being around one or two new fund investment over the next 12 months. From a previous Preqin survey we found that 56% of institutional investors use hedge funds to diversify their portfolios in order to improve their risk/return profile. In order to achieve appropriate diversification for their volatility appetites institutional investors tend to make a small number of investments in a variety of niche strategies. We found that on average institutional investors are placing between USD 1.2 - 7.5 million per foreign exchange hedge fund.

Methods of Exposure

So how do institutional investors gain access to foreign exchange as a strategy in their hedge fund portfolios? From Fig.3 we can see that most commonly institutions are gaining exposure to foreign exchange strategies through their global macro holdings, with nearly half of all FX investors using these funds to boost their FX allocation. Direct investment in FX funds is now a more popular approach than the use of fund of funds. In the past year several FX focused fund of hedge funds have been launched, which may encourage those institutions which are on the borderline of investment but wary of making direct investments to make their first allocation to the asset class.

Figure 3: How do FX HF investors invest in foreign exchange strategies? Figure 4: Breakdown of instiutional investors in FX hedge funds Figure 5: Geographic breakdown of institutional investors in FX HF

Who is investing in FX hedge funds?

We used the Prequin database of 2200 institutional investors to analyse a breakdown of investors in foreign exchange trading hedge funds. US university endowments are the most common institutional investor active in the FX hedge fund space. Endowments have commonly been investing in hedge funds for upwards of 10 years and in this time have gained the necessary experience and knowledge to invest to meet their main obligation: that is to balance the spending needs of the current generation and that of the future. To meet this end, endowments have a long term investment horizon and as they are less constrained by boards and regulations as compared to say, pension fund, they can also invest in more esoteric and risky strategies. Endowments often show a willingness to invest outside traditional market neutral hedge fund strategies such as long/short equities in order to gain access to the newest sources of alpha. As a result they are often the pioneers of new strategies. Where endowments invest other groups of institutional investors are likely to follow - as FX is now established as a strategy by endowments, with approximately one third of all endowments using foreign exchange as a hedge fund strategy in one form or another, we can see other groups of institutional investors now beginning to use FX as part of their hedge fund portfolios.

Currently pension funds represent only a relatively small proportion of those investors active in hedge funds - however from our conversations with pension funds we have found that foreign exchange as a hedge fund strategy is an area that they are keen to exploit in 2009 and as such we can expect more capital to flow in from other sources in the forthcoming months.

What do institutional investors look for in managers that run FX funds?

Next we asked these institutional investors what they look for in their foreign exchange hedge fund managers (Figure 6.). Most of the investors surveyed (85%) said that they would use "first-time" fund managers if they have demonstrated FX skills previously. Institutional investors recognise that FX is a growth area in hedge funds and that the background skills set of managers working in this space is likely to be different to that of their peers working in other hedge fund strategies. As a result, institutional investors are more likely to commit to FX hedge funds with lower assets under management and a shorter track record than they would for funds in other strategies.

Figure 6. Comparison of track record requirements of institutional investors for FX funds vs. all other hedge fund strategies Figure 7: How do institutional investors find new FX managers?

How are investors looking for new hedge fund managers?

Just over half of all institutional investors surveyed use advisors as part of their search for new foreign exchange hedge fund managers, with 46.5% of investors using just their own research and due diligence when selecting new opportunities. It is clear that in order to get a foreign exchange hedge fund to the attention of the institutional market, managers need to both get their fund listed with advisors and performance tracking databases as well as marketing themselves directly to the institutional arena. From earlier studies conducted by Preqin we have found that a significant proportion of the institutional market are delaying making their next investments in hedge funds until the end of Q2 2009 as they reassess the new financial conditions following this prolonged period of turbulence. It is key that foreign exchange hedge fund managers form early relationships with institutional investors in order to prove their worth through the difficult conditions and to gain a piece of the capital inflows when greater stability returns. To do this, managers need to know both which institutional investors are active in the FX arena as well as who is advising them.

Figure 8: Why are institutions investing in FX hedge funds?

Why are institutions investing in FX hedge funds?

Diversification is the key reason why institutional investors are now allocating capital to foreign exchange as a hedge fund strategy. The poor returns across nearly all hedge fund strategies in 2008 show that there is no "safe" place to put all capital, and that in order to avoid large and potentially devastating losses institutional investors are spreading their capital across a variety of strategies to gain exposure to the potential returns that they all have to offer without over exposing themselves to any one strategy. To a lesser extent institutional investors are using FX hedge funds as part of their general opportunistic allocation to the asset class as well as to specifically boost returns in times of falling assets and bad investments. Institutional investors remain confident that FX as an asset class within the hedge fund industry has the potential to generate good returns over the course of the next 12 months.

Where is the FX HF allocation coming from?

Interestingly, a relatively large proportion of the FX hedge fund investors we surveyed (18%) informed us that their allocation to FX hedge funds came from a foreign exchange specific allocation rather than through their hedge fund allocation. Many investors have set FX specific allocations for investments in all FX products (often at the expense of their equity pool) over the past 12 months in order to capture the potential returns caused by increasing fluctuations in global currencies. Some investors are allocating capital to hedge fund managers through this pool of capital as it allows them to be more flexible in their investment decisions and to gain exposure to FX products even if they are fully allocated to hedge funds elsewhere in their portfolios.

Conclusions

The use of foreign exchange as a hedge fund strategy is an area of rapid growth within the alternatives industry. In 2007 approximately 6% of all institutions stated a strategic preference for foreign exchange hedge funds - today this figure is 15.2% and growing. With new foreign exchange funds and fund of hedge funds being formed all the time, and investors carving out specific allocations to these products we expect this figure to increase to at least 20% by the end of 2009.

Over two thirds of all investors active in the FX hedge fund space will be making new investments over the course of the year and as a result hedge fund managers using foreign exchange approaches can expect strong inflows of capital from institutional means by the end of 2009. To date, the largest investors in FX hedge funds have been US endowments and fund of hedge funds - however increasingly pension funds, family offices and foundations have been adding FX funds to their portfolios in order to add an extra layer of diversification and to try to counteract poor performance elsewhere in their holdings.

Institutional investors recognise that foreign exchange is a newer area within the hedge fund industry and that managers often have less formalised hedge fund experience. As a result investors are less stringent when looking for FX managers. First time or emerging foreign exchange fund managers can expect to receive capital from institutional means - as long as they can prove a strong background elsewhere in the FX industry.

So what is the key message for hedge fund managers using foreign exchange and currency themes that are looking to raise capital in the next 12 months? Well from this study we have found that the appetite for FX as a hedge fund strategy is strong - many institutional investors may be holding off from investment until mid year, however they will be carefully monitoring managers active in this field through these difficult times and it is the managers that can prove their worth now that will receive the institutional capital further down the line. It is vital that hedge fund managers form relationships with the right investors and their advisors today if they are to receive capital tomorrow.