US pension funds are increasingly committing to hedge fund investments, following a decision last year by the $160bn (E bn) California Public Employees’ Retirement System to forge a hybrid investment program. Furthermore, many pension funds have entered into hedge funds after concluding that the performance of non-US investments and US investments are more closely correlated than previously thought. This correlation of performance means that pension funds are seeking new asset classes to help diversify their portfolios, pension consultants say. The pension funds view hedge funds as programmes that have low correlations to other assets classes and therefore can help further diversify their portfolios to reduce volatility, the consultants add.
Another reason pension funds are interested in hedge funds is due to the strong performance of equity investments causing pension funds to re-balance their asset allocations. In doing so, pension funds typically examine additional asset classes, such as hedge fund investments.
Hedge funds typically take long and short positions on securities, currencies and commodities. They frequently use futures and leverage to enhance returns.
Last August, the CalPERS investment committee modified its investment policy, identifying hedge funds and other investments, such as derivative-based strategies as acceptable for the retirement program, according to a CalPERS spokesperson. The decision earmarked up to $11bn for the hybrid investment programme. The CalPERS spokesman adds that the pension fund has yet to commit to such investments but will continue evaluating hedge funds on an opportunistic basis.
A CalPERS spokesperson explains that the hybrid programme expands upon the retirement plan’s alternative investment programme. Prior to the decision last year, the pension fund’s alternative investment programme was limited to private equity and corporate governance programmes, the spokesperson adds. Corporate governance funds take large ownership stakes in companies. So far, CalPERS has invested $900m in such funds, according to the same spokesperson.
“Regarding hedge funds, plans are becoming more interested in the products”, says Barry Colvin, director of research at Tremont Advisers of Rye, NY, which specializes in hedge funds.
“Over the past year, our clients have placed $500m in hedge funds. The funding is typically coming from clients cutting back on their equity allocations, to make new allocations to hedge funds,” Colvin explains. “In most years, the firm helps clients place $250 to $300m into hedge funds. The firm’s clients have placed a total of $.5bn in such products.”
Colvin says the increased interest is driven, in part, by the CalPERS decision, along with a previous decision by the Virginia State Retirement System (VRS) to invest in market neutral funds. A market neutral strategy uses long and short equity positions, similar to hedge funds, but uses no leverage. Such strategies typically seek investment performance that track specific indexes with incrementally enhanced returns. VRS entered into market neutral funds in 1990, according Nancy Everett, chief investment officer. Currently, it has US$11.25bn committed to such funds. Everett adds that even though the market neutral strategies use short and long positions, they do not use leverage, so although they are similar to hedge funds, they don’t fit the popular definition of such funds.
“No pension fund wants to be the first to make a move into a new investment strategy,” says Colvin. “Many pension board members were looking for hedge funds to receive credibility among other retirement programmes. The announcement by CalPERS and the VRS programme at least allowed board members to discuss hedge funds at meetings with confidence.”
“Strong stock market performance has also contributed to the increased interest in hedge funds.
“Equity allocations have had runaway performances, so pension funds need to rebalance their allocations. They still want equity like performance with the assets that they take out of stock investments, but they want something with performance that is not correlated to stocks,” he explains.
While hedge fund investing can help plan sponsors diversify their assets, retirement programmes face certain issues upon making such commitments. “Many pension plan investment guidelines prohibit retirement programmes from using short sales, so they have to make amendments before they can enter into such arrangements,” says Everett. Additionally, hedge fund strategies require portfolio managers to make quick changes among equities, fixed-income securities, short sales and futures.
“By receiving large allocations from pension funds, some hedge funds may lose the ability to be quick and nimble that often comes with being small. We typically recommend that pension plans divide their assets up among a variety of hedge funds to avoid making a single fund too large,” says Colvin. Tom Leswing