Wanted: Alternative investments

Middle East institutional investors are dumping excess cash into hedge funds

The Middle East continues to experience unprecedented interest in alternative investments as regional institutional investment in hedge funds is expected to surge to $140 billion, or 14% of the total $1 trillion forecasted institutional investor capital in hedge funds by 2010, according to a report by the Bank of New York.

The report said global institutional investor capital in hedge funds will increase from around $360 billion today to more than $1 trillion in 2010, and institutional investors will account for more than 50% of the total flows.

On this premise, the Middle Eastern institutional investors will increase their exposure to worldwide hedge funds almost five times from around $29 billion today, mainly because the willingness of regional institutions to invest in hedge funds will outpace the expected near tripling of the industry portfolios.

While noting that the vast majority of institutional investors worldwide – Bank of New York estimates 85% – do not currently invest in hedge funds, the report sees alternative investment tools of the industry move into the mainstream of financial management practices. Institutions using hedge funds are in the large majority satisfied with their performance, and only 3% of surveyed institutions said hedge funds they were invested in had underperformed.

To better understand investment tools used by hedge funds, institutional investors will be pushed towards those comparatively aggressive funds by a growing need to achieve higher returns than those offered by more traditional strategies, such as equity and fixed income investing. The increased demand for hedge funds in the Middle East is the result of investors searching to diversify portfolios into investments that are not linked with volatile equity markets.

The report, based on interviews with 101 senior professionals in the fund management industry and updated from a 2004 study, shows Middle East institutional investors make up around 8% of the global institutional market, while the United States and Europe – including Japan – represent around 40% each.

“Investors are looking at hedge funds as an investment that has a lower correlation with other assets in the portfolio. Diversification is the single most mentioned reason for investing in hedge funds,” the report said.

Leader of the pack

According to David Aldrich, Bank of New York managing director, the GCC, with its serious liquidity and high oil revenues, is expected to take the lead for the bulk of the region’s 14% worldwide institutional hedge fund investments.

“Middle East institutions are adopting a more aggressive approach to investment, and you’ve got big government-backed investors who are not constrained by investment fund trustees,” said Aldrich. He noted that regional investors have been on the lookout for better return on investment for some time, especially after the exceptional performance by the GCC stock markets in 2004 and 2005.

Historically, regional investors have preferred mutual funds and until recently, hedge funds have appealed to those willing to take big risks. But, since governments continue to reap the benefits of high oil prices, the hedge fund market has taken on a new dimension for institutional investors in the Middle East. Coupled with the current downturn or volatility of the region’s stock markets, investors are keen to explore the potentially rewarding investment alternative.

“Bull markets don’t really encourage people to move into alternatives,” Aldrich said. “A lot of institutions have just moved into hedge funds globally and these investment decisions were triggered by the bear market in global equities.”

Many institutions view traditional fixed income as a low return asset class. Low yields across the developed world have created a huge gap between fixed income returns and investors’ needs. The report pointed out that the vast majority of those surveyed, 72%, said their hedge fund program has performed within 1% of their target expectations; 25% said that their hedge fund exceeded their return target by 1% or more.” Only 3% of investors said that their hedge fund program has underperformed versus their expectations.

The UAE, and specifically Dubai, has been aggressively at work to position itself as a one-stop-shop for the hedge fund industry. The UAE recently issued and passed the Collective Investment Law 2006, in the DIFC as part of a strategy to provide solid infrastructure and incentives for fund managers to operate. “Dubai can offer the proper administration and the location for investment advisors. This is a more complete package than the Cayman Islands, which is currently the domicile of choice,” Aldrich explained. “But this will be a slower process than people would like. Returns are more important than infrastructure.”