The hedge fund conundrum
Many thousands of trees have been felled, many millions of words written on hedge funds and their suitability for Pension Funds but are most of us any wiser? Generally, ‘no’. Unless or until a pension fund actually invests in the sector, most remain woefully ignorant of what exactly hedge funds offer. And even a few of the pension funds that have invested in hedge funds are still not sure exactly what they have bought.
The problem arises for two main reasons. Firstly, the term ‘hedge fund’ encompasses such a variety of different strategies as to make analysis of the sector, if it can be called one, very difficult if not impossible. Secondly, many hedge funds themselves are unregulated and far from transparent. Apparently there are more than 6,000 unregulated funds, many of which are closed. The underlining quality is, to say the least, variable but far too many suffer from poor background information and a total lack of transparency.
The fund of hedge funds industry is a little better but still suffers from variable quality and poor transparency. The whole industry, which is probably a better term than sector, suffers from very high fees and almost overwhelming choice. Apparently there are more than 1,000 unregulated fund of hedge funds.
And then we have the problem of benchmark choice. Just how do you measure performance? Well, if hedge funds really are absolute return strategies then surely it is simply a matter of saying you require x percentage points above the risk free rate on cash. And yet a whole new industry is being created by the big index providers such as FTSE, MSCI and so on, as well as other hedge fund players to give investors benchmarks.
So how do you choose which index to use? According to Carl Beckley, director of markets development at FTSE: “There are so many indices to choose, so many biases to suffer”. Obviously Beckley believes that FTSE has the answer but in reality it not that easy. Almost, no matter how you construct an index it can not be truly representative of the industry and if it were, it would be uninvestable, as so many funds are closed to new money. And then you have the problem of adverse selection, inadequate capacity, how to weight funds and ensure that the benchmark you construct is close to being representative of hedge fund risk and returns.
However, despite all of the problems, the hedge fund industry has shown a remarkable growth record. In 1970, Fortune magazine estimated US hedge fund assets in 1970 at $1bn (E834m). Van Hedge Fund estimates the assets are now closer to $1,400bn.
According to Jamie Murray, head of marketing, HSBC Republic Investments, the core demand is still from family offices and High net worth investors, although they account for a much smaller percentage of hedge funds (42% of total assets invested in 2002 compared to an estimated 80% in 1994). However, with funds of funds now accounting for around 30% of hedge fund assets, the picture has changed quite dramatically, with a growing demand from pension funds and other similar long term institutions. What we have yet to witness, mostly because of regulatory pressure is any sign of demand from ordinary retail investors. Although hedge funds are only ever likely to have limited appeal to the mass affluent investors, who are not to be confused with truly high net worth investors, who, I am sure, will continue for some time to be the leading player in the hedge fund industry.
So what can hedge funds actually offer pension funds? Well it certainly is not a liability matching asset but there are not many, including most bonds, that really are. So hedge funds are sold on other characteristics. Not many commentators claim they will outperform equities over the long term, but the last few years have demonstrated the dangers of relying too much on long term solutions. So what hedge funds can provide is diversification over the long term with fairly good capital protection over the short term. Whilst hedge funds may not outperform absolutely, recent studies have shown that many hedge fund strategies have been providing better risk adjusted returns over quite a long period.
However, what has become increasingly apparent to a number of commentators is that whilst a large number of traditional long only equity managers have become closet indexers, hedge fund managers really are skill based managers and thus capable of real alpha generation. The problem for a lot of pension fund trustees is that they are now finding that to access this skill they have to pay through the nose. A lot of pension funds have to make some very careful calculations to find out if it is really worthwhile paying to access this skill or whether the bulk of the alpha that hedge funds really do generate simply goes to the manager in fees.