A match made in heaven
In the aftermath of the bursting of the internet bubble, pension funds were forced to cope with an extremely unfavourable environment. Stock markets were plunging and interest rates were falling to historically low levels. Pension funds in general, and European pension funds in particular, have therefore seen the gap between their assets and liabilities widen significantly. Indeed, according to a recent study by JP Morgan Fleming AM, the average funding ratio of European pension funds is currently 70% and can be as low as 56% in the case of German pension funds. In an attempt to stop the haemorrhaging, pension funds have therefore looked for alternative sources of diversification. They thus started to introduce ‘traditional’ alternative investments (eg, property, private equity) and more recently ‘alternative’ alternative investments (eg hedge funds) into their asset-liability management in order to reduce their sensitivity to stock markets and/or interest rates.
Within the scope of its ‘Asset Allocation and Alternative Diversification’ research programme, the Edhec Risk and Asset Management Research Centre has carried out a survey in conjunction with IPE to obtain a better understanding of pension funds’ approaches to alternative diversification. The questionnaire was sent out to the top 1,000 pension funds in Europe. The preliminary results that will be presented in the remainder of this article rely on answers given by 96 pension funds. In the first section, we will review pension fund opinions on the pros and cons of hedge funds. In the second section we will define the position that is reserved for hedge funds in pension funds’ global asset allocation. In the third section we will examine the way in which pension funds practically implement the integration of hedge funds in their portfolio.
In order to have a better understanding of pension fund managers’ expectations, we simply asked them what, in their view, the pros and cons of hedge funds were. As expected, answers given by pension fund managers clearly indicate that they are interested in hedge funds primarily because of their risk profile. As a matter of fact, 49% of them emphasise the de-correlation between hedge fund returns and traditional assets’ returns (36% refer to de-correlation between hedge fund returns and economic cycles). In the same spirit, 48% of pension fund managers are interested in hedge funds because their returns are less volatile than those of traditional assets and 25% because they allow the extreme risks of the portfolio’s overall allocation to be reduced. Nevertheless, even though the risk dimension appears to draw most of the attention of pension fund managers, the return dimension is not completely left aside. Some 28% of pension funds appear to invest in hedge funds because of their ability to generate more alpha. In the same vein, 14% invest in hedge funds because their gross performance is better on average than that of traditional assets. Interestingly, only 4% of pension funds are considering hedge fund investing because of the absolute nature of their returns.
These results undeniably indicate that the absolute return paradigm that was dominating the alternative arena in its infancy is progressively fading away and is being replaced by a logic centred on the risk dimension. For institutional investors, diversification clearly appears to be the rationale behind hedge fund investing, hence the focus on the risk profile of hedge funds.
However, even though hedge funds appear to respond to pension fund managers’ considerable need for alternative sources of diversification, they are not a panacea. Hedge funds are privately pooled investment vehicles that are poorly regulated. They therefore do not abide by the same rules as traditional funds, which poses certain problems for institutional investors. Pension fund managers appear to be particularly concerned by the low level of transparency of hedge funds and more generally by the low level of regulation in the alternative arena (45%). Operational risks, which are particularly important in the alternative industry, also appear to worry a significant proportion of pension fund managers (26%).
Interestingly, the pension fund managers’ answers reveal that the lack of expertise of internal teams (18%), the complexity of the sales offering (16%), or simply the reluctance of the fund’s administrators to gain exposure to hedge fund strategies (11%) are further obstacles for the development of the alternative arena. Not surprisingly, the high level of fees also appears to be a problem for a majority of pension fund managers (59%).
According to our study, 47% of European pension funds are already investing on average 8.97% of their total assets in hedge funds. This confirms that hedge funds are becoming part of mainstream investment. The consequence is that pension fund managers are now more familiar with hedge fund strategies. In this respect, 60% of the respondents to our survey declared that they are well-informed about the risk of hedge funds, and 37% even consider that they are capable of integrating hedge fund risks into a global analysis of the risks of their assets. However, it is worth stressing that only 23% (respectively 22%) of them rely on internal expertise for direct investments in single hedge funds (respectively funds of hedge funds or hedge fund indices). This discrepancy might be explained by the so-called career risk ie, some pension fund managers, though disposing of the appropriate expertise, prefer to pay for the services of a third party (eg consultant) rather than putting their career at risk in the case of failure.
In line with what was found in the previous section, the majority of pension funds, namely 63%, considers hedge funds as diversification providers and as such are exposed to risks that are different from those of traditional assets and which allow the overall diversification of the assets to be improved. 8% of the respondents even consider that hedge funds are essential elements of a well-diversified core portfolio. Conversely, only 19% of pension fund managers consider hedge funds as standalone investment vehicles generating absolute returns, though 9% of them still regard hedge funds as natural candidates for the satellite part of their allocation.
These results confirm that most pension fund managers are considering hedge funds as risk reducers rather than return enhancers. This point is essential as it suggests that they should not assess hedge funds in light of their short-term over/under-performance relative to traditional asset classes but rather upon their long-term diversification properties. In other words, their investment decisions should be driven by hedge fund betas and not hedge fund returns. Unfortunately, as we will see in the next section, this is rarely the case.
As mentioned earlier, the explicit objective of pension fund managers when investing in hedge funds is to improve their diversification. To this end, the best solution is to integrate hedge fund strategies in the core portfolio so that an optimal mix of strategies can be selected. However, only 36% of the respondents have already integrated both hedge funds and traditional asset classes into their global asset allocation process. 19% of pension fund managers continue to consider hedge funds as a homogenous asset class. This lack of understanding of the return generating processes of hedge fund strategies clearly prevents them from tapping into the extensive diversity of diversification profiles offered by hedge funds.
Furthermore, while 22% of the respondents declare that they favour an approach that blends qualitative (e.g. scenarios, tests) and quantitative (e.g. optimisation) approaches when composing their fund of hedge fund allocation, 16% still have no allocation approach as their portfolio is the result of their fund selection process. The direct consequence of such an (uncontrolled) investment process is that pension fund managers do not control the risk profile of their investments in hedge funds properly. Maximising diversification benefits involves (i) identifying the investor’s current risk profile and (ii) constructing an investment vehicle that matches the investor’s specific needs. This cannot be done by focusing on fund picking, nor can it be done if a strategy benchmark is not clearly defined. Since hedge fund strategies are exposed to different sources of risk, they present diverse diversification properties with respect to stocks and bonds. As a result, it is essential to select the strategies that offer the best fit with investors’ initial allocation and to determine the optimal mix in order to maximise the diversification benefits. Nevertheless, 41% of pension fund managers implement an absolute value allocation that has no reference to a strategy benchmark.
Furthermore, the strategy benchmark can only remain optimal if it is allocated dynamically. This last point highlights one further difficulty that investors have to deal with in the alternative arena. Hedge funds, and to a certain extent funds of hedge funds, only provide investors with limited liquidity. It is therefore technically difficult for investors to adjust their exposure to hedge fund strategies dynamically. In this respect, it is worth stressing that investors can now invest in investable hedge fund indices or index-linked products.
This new breed of investment vehicles provides investors with a passive alternative to actively managed funds, thereby giving access to purer betas. Moreover, most of these products are based on managed account platforms. This allows them to offer up to weekly liquidity; it is consequently much easier for investors to construct portfolios that offer appealing diversification properties. In sum, investable hedge fund indices offer the possibility for all pension funds (i.e. even those lacking expertise in the alternative arena) to take advantage of the diversification potential of hedge funds. Many institutional investors should therefore be gaining exposure to hedge fund strategies through investable hedge fund indices in the near future.
According to our survey, 29% of European pension funds declare that they are fully satisfied with the diversification properties of hedge funds and 19% of them are satisfied with their level of performance. Furthermore, 35% of the European pension fund managers who have already invested in hedge funds consider that their exposure to hedge fund strategies should be increased in the future. As a result, we argue that in spite of the recent disappointing returns posted by hedge funds, the future of the alternative industry should be rosy.
However, there is a caveat emptor. The answers that we have received reveal a certain lack of expertise on the part of European pension fund managers with regard to hedge fund strategies and there appears to be a significant gap between the stated objective of pension funds, namely diversification, and the managers’ investment practices. As a matter of fact, a significant proportion of European pension funds still consider hedge funds to be a homogenous class and follow a best-of-breed strategy to construct their funds of hedge funds. More generally, they implement inappropriate investment processes. Consequently, a majority of European pension funds tap into the diversification potential of hedge funds in a sub-optimal way.
Most European pension funds appear to gain exposure to hedge fund strategies through either hedge funds or funds of hedge funds. However, this is not the best way to benefit from hedge funds’ diversification properties. Firstly, hedge funds and funds of hedge funds are actively managed and offer limited transparency; their betas are therefore not pure and are difficult to monitor. Secondly, they offer limited liquidity, which prevent investors from adjusting their exposure to hedge fund strategies dynamically.
Finally it is extremely costly as it requires extensive resources for initial/on-going due diligence and implies particularly high fees. Investable hedge fund indices, on the other hand, are passively managed, charge lower fees, offer greater transparency, and provide investors with increased liquidity. They also reduce operational risks significantly since funds represented on the platform have been thoroughly selected by the managed account platform manager’s teams.
As a consequence, they allow for better control of betas and in turn for greater diversification benefits. There is therefore no doubt that an increasing proportion of European pension managers will shortly begin to gain exposure to hedge fund strategies through investable hedge fund indices.
Mathieu Vaissié is research engineer with the Edhec Risk and Asset Management Research Centre in France