Many European pension funds have dipped their toes into the water of investing in hedge funds. Some have been bolder than others. While UK pension funds have allocated on average less than 5%, some Swiss pension funds have allocated up to 20%.

Yet the recent decision by France's Fonds de Réserve pour les Retraites (FRR) to exclude hedge funds from its 10% allocation to alternative assets suggests that the water is still too chilly.

The FRR says it was reluctant to invest in hedge funds, either directly or indirectly, for three reasons:

First, the risk/return profile of hedge funds is unsatisfactory. Second, the data in hedge fund indices is biased. Third, the much-vaunted diversification benefits are not as great as they are supposed to be.

A recent study by the research centre Edhec challenges this. The study suggests that if a pension fund allocates 10% of its portfolio to hedge funds it can reduce by 25% the probability that the assets of the fund will fall below 75% of their liabilities. So this month's Off the Record looks at European pension funds' investment in hedge funds and poses the question ‘are hedge funds really a suitable investment for pension funds?'

Hedge funds have certainly lost some of their initial gloss. Last year, hedge fund returns were disappointing compared with the returns generated by most global equity and commodity markets.

Standard & Poor's measure of performance, which tracks 42 funds across nine different investing styles, gained only 2.3% in 2005, less than half the 4.9% total return for the S&P 500 equities index.

More than half the pension fund managers and administrators who responded to our survey agree that hedge funds have not delivered the performance they initially promised. Only a third think they have performed as expected, while the remainder are undecided.

Most agree that hedge fund returns are unlikely to return to the double digit returns of the 1990s. However there is some disagreement about the degree of likelihood. Most think it is ‘highly' unlikely that the good times will return. A minority, mostly managers of Swiss pension funds, feel that there is still some likelihood.

A UK pension fund manager points out that hedge funds are not the only asset class of which has failed to lie up to expectations. "This need not be damaging provided inflation remains under control," he points out.

The question therefore is whether hedge funds have provided the risk return characteristics they promised, even if the last few years of disappointing returns are taken into account.

Research by Edhec shows that apart from the short selling strategy, all hedge fund strategies display lower risk than the S&P 500, which is representative of equities.

In terms of risk-adjusted performance, all hedge fund strategies post results that are better than the Lehman Brothers Global Bond Index, which is representative of bonds, and results - other than from short selling - that are better than the S&P 500

From this evidence, the Edhec researchers conclude that hedge funds do present an attractive risk/return relationship, since they outperform traditional asset classes when the risk is taken into account. These findings square with our managers' perceptions. More than half say that hedge funds have shown an attractive risk-adjusted performance. There are qualifications, however. "It depends on the strategy" a French pension fund manager points out.

Most managers agree that the main attraction of hedge funds, or funds of hedge funds, is their strong potential for diversifying risk. However, the manager of an Austrian pension fund suggests that the diversification benefits
of hedge fund investment will depend on the strategy of the fund.

Similarly, most managers - two in three - agree that pension funds should include hedge fund investment in their portfolio to reduce the risk of asset-liability deficits. This idea gains strong support from Swiss pension fund managers. The manager of a UK fund is more cautious. "It should be considered, but investment won't be appropriate for all pensions funds," he says.

One objection to hedge fund investment within a pension fund portfolio is that the short-term benefits of hedge funds do not square with the long-term horizon of a pension fund. Yet only a minority - one in four - of the managers in our survey think this is a valid objection.

A more valid objection is that there is no benchmark for hedge funds. There are now a number of hedge fund indices, some of them invest able, which provide a measurement of how different hedge fund investment strategies have performed each months.

There are objections to these indices, however. One drawback is that they are often self-reporting, and will report results during the good times but not during the bad times. A more important objection is that they suffer from ‘survivorship' bias. Since the database is populated only by hedge funds that have survived, rather than those that have blown up or closed down, the index provides a biased measure of performance. This bias has been evaluated at 3% per year.

The point about survivorship bias is that it chips away at the empirical evidence about the risk/return relationship of hedge funds. If the data is wrong, then conclusions based on the data are likely to wrong, too.

Certainly there is some scepticism about the usefulness of hedge fund indices among pension funds. A substantial majority of the managers who responded to our survey - more than three quarters - do not think that hedge fund indices are a useful guide to the likely outcomes of actual hedge fund investment.

Their usefulness is limited to a generic descriptiveness, it appears. "They do give some idea of the shape of the performance profile of each of the main types of hedge fund relative to other assets," one UK pension fund suggests. This scepticism would seem to make a stronger case for pension funds investing indirectly in hedge funds - through a fund of hedge funds - rather than directly. If there is some doubt about the performance of individual investment strategies, exposure to a wide range of strategies would seem the safer option.

Yet only a minority - one in four - of our managers think that if a pension fund decides to invest in hedge funds, it should do so only through a fund of hedge funds and not directly.

The general feeling is that if the pension fund has the wherewithal and know-how to pick its own hedge fund managers, it should do so. "It depends on resources - due diligence is crucial," says the manager of one Swiss pension fund.

Fund of hedge funds are also
seen as an additional layer of costs. "Fund of hedge fund investment just make the fees more exorbitant," one UK pension find manager observes.

How much of their portfolio should pension funds allocate to hedge fund investment, either direct or indirect? It has been suggested that worthwhile allocation should be 10% or more.

Yet only one six managers would support an allocation of this size. "The manager of a Swiss pension fund suggest that a more reasonable allocation would be 5% to 10%.

Some say that that is not possible to set a figure, since it depends on the other asset classes and allocation. The manager of an Austrian pension fund points out that "it will depend on the pension fund's asset allocation and learning curve".

So will hedge funds always be a useful but marginal investment for European pension funds? Opinion is very evenly divided here. Just under half of all respondents feel that hedge funds should never be more than a marginal investment - that is, less than 5% of the portfolio - for a pension fund.

Only one in three managers think that pension funds that have already invested in hedge funds should reduce rather than increase their exposure in future, although as the manager of an Italian pension fund points out: "that depends on how much they have invested in them already"

So have hedge funds had their day? Or are they waiting for the next bear market to make a comeback? Most of our respondents - three in four - think that hedge funds are here to stay.

A Swiss pension fund manager suggest that hedge funds will continue to flourish, "even if probable future returns will tend to be lower than past returns, just because more money is invested in this asset class."

However, there is some dissent. An Austrian pension fund manager warns that, "in terms of the product life cycle, they have seen the top." Time will tell.