In today's environment pension funds ought to seek absolute returns, write Jeroen Tielman and Hamlin Lovell. And if you are after absolute returns, it pays to go with smaller, younger managers

Alpha, more than ever, must be the guiding star for investors in 2012. The investment
world has been transformed beyond recognition in 2011.

Volatility rewards those with a flexible and dynamic approach to risk taking, and punishes those investors trapped in a straitjacket of traditional investing. Equities, commodities and currencies have displayed extreme volatility and governments are interfering with these markets in many ways, such as actively intervening in currency markets. Long-only investors can only profit from half of the opportunities in any market, since they cannot profit from lower prices.

Skilled macro traders have had a good 2011 from timing their positioning and from taking relative value positions, such as owning German or Dutch government debt and shorting that of Portugal, Italy, Ireland, Greece and Spain. China's widely followed renminbi currency has moved in both directions - upwards in the first half of 2011, and downwards in the second half. Skilful currency traders have been able to profit from these reversals.

Similarly, equity long-short managers who can profit from lower share prices have, in some cases, generated strong returns in 2011, even though no major equity index ended significantly up on the year. Equity-relative value managers are far more interested in the dispersion of returns among sectors and stocks than in the general direction of markets.
Commodity index products in 2011 have not turned out to be a hedge against accelerating inflation in some countries. Skilful commodity traders, able to go short as well as long, and trade calendar spreads rather than just direction, have profited in 2011.

Inflation-linked government debt is showing negative nominal yields, while normal government debt yields or interest on cash cannot even keep pace with inflation in many countries. It is not clear to what extent central bank buying of government debt is shoring up the market, or how long quantitative easing might continue. When and if QE is unwound, it is possible that higher interest rates could cause holders of government bonds to incur large capital losses, as happened in the 1970s.

Some pension funds might take the view that the interest rate at which they discount their liabilities would correspondingly increase, leaving their solvency position stable. But the reality is that the actual pensions that need to be paid out have to be funded. Since interest rates cannot go below zero, any further upside from owning government debt must be very limited and the potential downside is many multiples of the potential upside.

In spite of all these concerns about conventional investing, most pension funds remain overwhelmingly invested in traditional assets. A 2011 survey from JP Morgan showed that there was some 80% of assets in equities and bonds, with 5% in real estate and just 14% in alternatives.

The long-only bias of most institutional investors is ill-equipped to meet liabilities that keep on growing - with inflation, life expectancy, and other demands - whatever happens to equities and bonds. Only absolute returns, ahead of zero, can hope to meet these liabilities, which have no real link to conventional asset classes.

Against this challenging landscape, skill-based, absolute-return, investing is a pre-requisite. More and more pension funds are of the opinion that alternatives are the assets of the future: allocations to alternatives are growing by between 1% and 2% of assets per year, according to a survey by Cliffwater, the specialist alternatives advisory consultant to institutional investors.

Emerging hedge fund managers deserve to form a core element of any alpha generation strategy. Time and time again, academic studies confirm the outperformance of newer and smaller hedge funds as the entrepreneurial spirit shines through bull and bear markets. We have found plenty of studies over the past two decades re-affirming the superior performance of smaller managers. This is true in Asia, the US and Europe. Some of the most successful endowment managers, like David Swenson of Yale, have built their reputations - and performance - on seeking out small, hungry and entrepreneurial managers.

The latest update to PerTrac's yearly study ‘The Impact of Fund Size and Age on Hedge Fund Performance' showed a persistent return premium in 2010.

The outperformance compounded up over time, with smaller funds cumulatively beating larger ones by 200 percentage points over 15 years.

Yet these studies focusing on fund performance nearly always ignore several other performance engines enjoyed by seeders - discounted fees, seeding economics and acceleration economics. In some cases, these might only be the icing on the cake; in other instances, these additional return sources can eclipse even the premium investment performance produced by emerging managers.

Discounted fees can result in funds of funds investing in emerging managers having lower overall fees than many single hedge funds that do not offer the diversification or additional monitoring of a fund of funds. Taking stakes in the management companies of hedge funds can be another source of returns that taps into the growth of a business.
Seeding can also provide an opportune time to draw up a good governance structure, that aligns the interests of fund managers with those of investors.

For instance, a seeder may place caps on the pay of fund managers so that they can only accumulate significant capital from positive performance. Seeders also tend to get more portfolio transparency that allows for closer monitoring and risk management.
Now seeding is gathering momentum and moving towards the mainstream menu for institutions. The percentage of institutional investors which will seed has doubled to 21% from 11% since 2009, according to the 2011 Prequin Global Hedge Fund Investor report. Pension funds globally are embracing the early-stage hedge fund movement. Pension funds from Australia, the US, Sweden and Finland are all active in the space. Family offices, high-net-worth individuals, sovereign-wealth funds and insurance companies are also anxious not to miss out on the opportunities.

Early allocators may be in a strong position to dictate favourable terms. If inflows in 2010 and 2011 have been biased towards giant bulge bracket hedge funds, then 2012 may be the year to redress the balance. Trading volumes across all asset classes have been thin, and liquidity has been impaired.

In a climate where banks are de-leveraging and exiting proprietary trading, it is quite
likely that volumes and liquidity continue to decline. That could be a significant headwind for multi-billion funds but may have only marginal, if any, impact on smaller and nimbler funds. So 2012 could be the year to make allocations to more agile funds with multiple return drivers, and potentially better transparency and governance.

Jeroen Tielman is CEO and Hamlin Lovell is portfolio manager and assistant CIO at IMQubator