IPE asked two European pension funds how they invest in absolute return strategies, with a focus on hedge funds

Gustav Karner

Only invest in the best
We allocate about 30% of our assets to absolute return strategies, including 25% to hedge funds, 3.5% to risk premia strategies and 1.5% to insurance-linked securities. 

In my experience, if an institutional investor wants to invest in hedge funds, it needs to seek out the absolute best ones, otherwise the return and diversification potential of the allocation will be sub-optimal. Finding the best hedge funds may not be difficult, the problem is finding those with spare capacity. 

Thanks to my previous experience working with the Nobel Foundation, I have managed to get access to some of the best hedge funds. It would have been harder without those relationships. 

When investing in hedge funds, I look for track record, but also at the ability to explain and maintain the investment process. Fund managers need to be able to explain how they are going to maintain their track record.

I also favour fund managers that have been through the last financial crisis, and are able to demonstrate that they delivered results throughout by following a coherent strategy. 

I look for funds that provide zero or negative exposure to market beta. A large size is also a requirement, since fixed costs fall as size grows. 

Finally, references from other investors are key.

Generally speaking, the hedge funds we invest in have been relatively disciplined in terms of risk management. They have not raised leverage to deliver higher returns. However, many strategies available in the market, such as macro or fixed-income relative value, have found it hard to deliver returns because of the recent lack of volatility. 

We are agnostic in terms of the types of strategies we invest in. We will invest as long as we can find good managers. At the same time, we try not to invest in too many similar strategies, because hedge funds often pursue crowded trades. 

We have not benefited from a decline in the high fees some hedge funds charge. The funds we invest in are constrained in terms of capacity, which means they do not need to attract investors, and as a result do not need to renegotiate fees. 

There may be cheap ways to mimic hedge fund returns on an aggregated level, but it will never be the same as investing in the best hedge funds. Often they focus on complex strategies and technology, which means that replicating their investment process is almost impossible.

Peter Wallach CIO

Looking for capital protection
Our asset allocation strategy targets a 4% allocation to hedge funds. As of the end of March 2019, the actual allocation was 3%, down from 3.2% the previous year. 

The portfolio is internally managed in the sense that our internal investment team selects and monitors the hedge funds. The intention is to construct a diversified portfolio of hedge funds and other alternative asset funds that derive returns less correlated with equity.  

The portfolio includes emerging market debt, US high yield, mid-cap distressed credit, European long/short equity and UK long/short equity hedge funds. We also invest in commodity trading advisers (CTA), alternative beta strategies, arbitrage as well as an emerging market multi-asset strategy. 

We also invest with a fund-of-fund manager where we have a formal agreement for it to undertake legal and operational due diligence on our direct hedge fund investments.  We see this as a value-add that ensures that due diligence is not just undertaken when the investment is made but continues to ensure no detrimental changes to the operational management of the funds.

Over the next three to five years, we may raise our strategic target allocation to 5%. This is part of a repositioning of our asset allocation, based on revised, forward-looking return assumptions with the intention of reducing overall equity risk.  For this reason, in reviewing our hedge fund portfolio we will favour strategies with a low correlation to equities and expect them to provide us with a higher degree of liquidity than our illiquid alternatives.

The Merseyside Pension Fund has been a hedge fund investor for about two decades. Our advisers forecast that absolute-return strategies will deliver an annualised 3.9% nominal return over the next decade, with a 9% median annual volatility. The return forecasts for other asset classes are more promising, but we are confident in our portfolio’s ability to maintain a low correlation with equity and fixed-income markets.  

Over the recent past, the returns from our hedge funds have been subdued relative to the strong returns from equities, bonds and other private-market assets. This is not a comfortable situation as hedge fund fees continue to be high.  We have had some modest success in negotiating fee reductions but this is often with the quid quo pro of a period of lock in which is something we are willing to consider as long-term investors.  Greater transparency by the managers is also helpful in managing the portfolio but, ultimately, we are investing in manager skill and do not attempt to second guess or inhibit their activities.  After the strong returns from public market assets over the past decade, we are anticipating that hedge funds will provide us with some capital protection should volatility increase in the near future.

Interviews by Carlo Svaluto Moreolo