Crunch year for pension funds
It would be wrong to make hasty conclusions about the value added by alternative investment strategies. Hedge funds should be allowed to show their worth over time. Nonetheless, this year could prove to be a turning point.
Consultants Wilshire Associates managing director Howard Yata has suggested that it is too early to tell whether pension funds have been successful in their early experiments with hedge funds: “but by the end of 2005, we will have a much better idea how they have fared”.
In the first quarter, the jury is definitely still out. March proved another difficult month, due to, among others things, low volatility and a difficult environment for merger and convertible arbitrage managers. In view of these problems, which have resulted in many funds suffering six down months in the last 12, investors could be forgiven for wondering whether hedge fund managers are able to deliver on their promises.
William Bijesse, CIO of EIM USA is convinced that hedge funds can add value: “Clearly due to the broad spectrum of strategies that hedge funds invest across, they are a strong diversifier for sources of alpha. But investors need to grasp firmly the role of hedge funds in their allocation from the start of their investment in hedge funds, have reasonable expectations for performance and volatility, review quarterly numbers, and evaluate their objectives and performance carefully at least twice a year.”
Relative to individual investors, institutions have much firmer return expectations. A recent report on the institutional demand for hedge funds, by Casey, Quirk & Acito and Bank of New York, implies that return expectations need to be revised downward. Thirty-seven percent of surveyed investors believe that increased capital flows will “significantly” reduce average returns in the future; another 29% believe that they will fall “slightly”.
There are clearly risks related to the ability of funds to absorb the flood of capital and there will always be multiple risks within each strategy. The ability of a fund of funds manager to vet unproven funds and turn around due diligences quickly has never been more important.
The issue of transparency may also be highlighted once again if hedge funds disappoint the new institutional investors. Operational due diligence is clearly a problem in the hedge fund environment. Don Murphy of Capco suggests the traditional opacity of hedge portfolios will have to be addressed: “Investors want to know that the information they receive about their portfolios is accurate. In some instances, managers (have been known to) provide misleading statements, showing valuations that are not representative of the true valuation of the fund.”
There are some who consider that greater levels of transparency wouldn’t make much difference. Tim Hughes, chief investment officer of the Australian Catholic Superannuation Fund recently commented that he doesn’t need to see “all the technical guff” relating to hedge fund portfolios he is invested in, since he wouldn’t understand it and so it would be no help in the due diligence process.
Bijesse confirms that it would be “extremely difficult” for the average pension fund manager to understand and monitor all the risks involved in the hedge fund space: “Without careful qualitative, quantitative, and operational due diligence performed by seasoned professionals in multiple offices around the world it is impossible for even the most sophisticated pensions or endowments to monitor and access the risks within each strategy and fund. Most investors focus on a rough quarter or disappointing year of performance and see risk purely in a volatility of return (“Did they get the return they hoped for?”), but there are numerous manager and operational risks involved that require vast experience across numerous skill sets.
The relative performance of managers in different parts of the world also needs to be considered. Readers might be surprised to learn that Asian managers have performed appreciably better than their European counterparts in the last two years. According to Eurekahedge figures, Asia vastly outperformed Europe in 2003, in 2004 and for the year to date. On average, Asian hedge funds have outperformed Europe by 4% a year, with about the same amount of volatility (see charts).
Eurekahedge director Alex Mearns suggests there are a number of reasons for this: “We’ve seen lower volatilities around the globe and particularly in Asia over the last two and a half years. During this period Asian markets have been very bullish. The upside has been well captured by long/short equity funds with little volatility.” Long/short equity funds constitute the majority of Asian managers. On the fixed income side, Mearns adds that “Asian funds have fantastic risk/reward profiles, with an average annualised Sharpe ratio of almost 4.” Asian Macro funds have experienced higher volatility than the European players. Mearns suggests investors should stick with euro managers for relative value.
EIM’s Bijesse says it is important to note that the US still provides a broader pool of funds (across styles, sectors, net exposure etc): “The need to diversify is heightened by the relative concentration of
long-biased hedge funds in Asia. Our mission as CIOs is to focus on
a broadly diversified approach across strategies and regions, and tilt the portfolios (2-5%) when we see a strategic or geographic
opportunity. Regardless of how positive we are on a given region, we will always have a global mix to avoid political and concentrated systemic (or market) risk. I
strongly believe that to find the best strategic mix and the best funds you need a team around the world with close contact with the local market.”
The stricter operational requirements imposed by institutions will result in a new generation of hedge fund managers, who have learned how to run a business as well as they run money.
Bijesse concludes: “I am confident that the passionate hunt for inefficiencies and the advantage of a performance-focused business model will allow hedge fund investors to meet their long-term objectives.”