In recent weeks, following the U.S. presidential election, market volatility has been continuing to increase. Hedge funds typically relish periods of heightened volatility, as they tend to expose additional investment opportunities for savvy finance professionals. However, at this time some funds are finding that they are unable to make the investment decisions they want to make. What is holding them back? Ties to institutional investors, many of which are unhappy with what they see as overly risky bets.

Institutional Investors Tend to Be Risk-Averse

A number of the top hedge funds across the country have become increasingly focused on a small number of institutional investor clients. These investors are able to offer huge asset pools for hedge funds to utilize, but they tend to be more conservative in their approaches to investing, which perhaps comes as no surprise as these investors tend to be pension funds, university endowments, and similar pools of money.

To understand just how much more weight the opinions and preferences of institutional investors hold for money managers across the industry, it is helpful to see the growing importance of these investors' assets to hedge funds. In 2002, institutional investor assets constituted 20% of all hedge fund assets, according to a report by Citigroup Inc., based on information from Hedge Fund Research and eVestment and reported by the Wall Street Journal. Today, by contrast, these investors represent a whopping 71% of hedge fund assets.

Will Institutional Investors Change the Way Hedge Funds Invest?

Hedge funds developed the reputations that they have by taking big risks and, in some cases, earning major payoffs. As institutional investor clients push funds to avoid highly risky wagers, some analysts feel that hedge funds will no longer be capable of making the attention-grabbing headlines and returns they once brought in. On the one hand, hedge funds may be less likely to suffer cataclysmic losses. But, on the other hand, they also will bring in much more ordinary and less impressive return levels.

As hedge fund returns dip, many investors, including the large institutions that may have helped to push for safer bets in the first place, have questioned the usefulness of hedge fund investments in the first place. After all, hedge funds still typically charge relatively high fees for their services. The result is that many pension funds and endowments have reconsidered their positions in hedge funds entirely, pulling their assets and driving hedge funds to desperation. Some managers and analysts see this as a dangerous cycle for hedge funds, as smaller asset pools limit the investment opportunities these funds have available to them and, in turn, make it more difficult to make riskier and potentially more rewarding investments, even if they want to.