Dipping a toe in the water
With equity markets in the doldrums, investors are turning their attention to alternative investments such as hedge funds for their high potential returns and their ability to reduce overall portfolio risk.
Over the past decade or so, the global hedge fund industry has grown rapidly from an estimated 1,500 funds with a capital of $20bn (e22.7bn) in 1990 to an estimated 6,000 with capital of about $500bn in 2000.
The decision by US pension fund CalPers in 2000 to allocate billions of dollars to hedge funds marked a significant advance in the acceptance of hedge funds by the institutional investment management market. Since then, in the US at least, asset allocation by pension funds to hedge funds has increased markedly.
European pension fund managers, by contrast, are treading carefully. Only countries with funded pension schemes, such as Sweden, the Netherlands and the UK have shown relatively strong interest in this asset class, with only a handful of funds investing.
Switzerland is unusual in that is has embraced hedge funds for a good few years. There hedge funds were developed to accommodate the requirements of high-net-worth individuals, which made Swiss pension funds among the first in Europe to allocate assets to them. “I suppose the availability of this local knowledge and experience, the banks’ natural disposition towards attracting clients and institutions’ search for diversity could explain developments in the Swiss market,” explains Stephan Chauderna of the Nestlé pension fund. Indeed the E4.5bn fund has been investing in hedge funds since 1998. Moreover its allocation to hedge funds as of the end of last year was a substantial 7%.
In the Netherlands, ABP, the employee pension fund for government and education, is the only pension fund known to have invested in hedge funds, having so far invested E200m as part of its alternative investment strategy. The E150bn fund, the largest in Europe and second biggest in the world, has an overall target of E900m–1bn to go into hedge fund of funds by the end of the year, representing less than 1% of its portfolio.
“Our longer-term strategic plan is to have 40% in equity, 40% in fixed income and 20% in alternative, to include property, hedge funds and private equity amongst others,” says ABP’s alternative investment manager Robert Coomans. He is looking for absolute returns of 10–12%, net of fees. If things go as planned, he will increase the hedge fund allocation to up to 3%.
Other Dutch pension funds are showing a keen interest in this asset class and it is likely to be just a matter of time before they follow ABP’s lead. The E7.5bn KLM pension funds, for example, are researching the asset class, findings of which will be finalised in the third quarter of this year. If it does pursue this type of investment the allocation will initially be 1–3%.
In Sweden, AP7, the default fund within the state defined contribution pension plan, is also believed to be the only Swedish pension fund to have announced its decision to invest in hedge funds. In June it will be investing E110m, representing 4% of its E2.75bn pension fund, in two fund of funds. The pension fund, which is just a year and a half old, is also investing the same amount in private equity.
AP7 believes that hedge funds make use of an “extensive range of financial instruments and investment strategies to generate a stable, positive return, regardless of how well or poorly the stock market and other financial markets perform”.
“Working together with Watson Wyatt our consultants we found that both hedge funds and private equity have very attractive risk–return characteristics for long-term pension savings. It gives us something that is uncorrelated with other assets, especially equities,” says Richard Grottheim, the executive vice president of the fund.
In the UK, AstraZeneca was among the first pension funds, if not the first, to invest in hedge funds. Last year it allocated 3.5%, which amounted to £70m (e114m), to a fund of funds managed by Goldman Sachs.
Although the evidence to date shows that hedge funds are the preserve of the larger funds, this need not be the case. “I think anyone can play, pretty much,” asserts Chris Woods of State Street Global Advisors in London. Rob Kirkwood, executive director of alternative investments at UBS Warburg, agrees. “Our experience is that a broad spectrum of pension funds are looking at hedge funds and it is not really a question of the size of assets under management. We have experience of $1bn funds to large pension funds putting money into hedge fund products.”
In practice, however, it is much harder from a governance point of view for smaller pension funds to implement a hedge fund investment. “Hedge funds are quite a challenging area for trustees and therefore it tends to be the larger funds that have more focused decision-making processes, higher levels of investment knowledge and the ability to satisfy themselves that they are an appropriate investment,” explains Stephen Oxley, a senior investment consultant at Watson Wyatt. He says that hedge funds could be equally appropriate for smaller schemes so long as the trustees are satisfied that they have undertaken the right level of due diligence.
In a similar vein, Coomans of ABP argues that the smaller funds can enjoy the benefits, so long as the industry becomes more transparent. “In principle I do not think hedge funds should be for bigger players only. The problem is that the hedge fund industry is very opaque. While this may be okay for the private individual it is not suitable for any pension fund, small or large, which does not have the resources to conduct their own research and analysis.” He anticipates that as the industry does become more transparent the smaller investors may be seduced by the fund of funds route.
It seems that pension funds of all sizes are pursuing the fund of hedge funds route, which looks to allocate across a range of hedge fund strategies. This has become a major feature of the global market for investors who want steady returns by diversifying across different strategies with different managers.
Moreover, this approach overcomes some of the problems associated with direct hedge fund investments. “You are really relying on the quality and ability of the hedge fund of funds manager to achieve the transparency with the underlying hedge funds, to monitor performance and assess risk and reward,” says the spokesman of the AstraZeneca pension fund.
Cooman, who has also opted for this method, observes: “Hedge fund of funds as a characteristic have low volatility and also a low correlation with traditional equities and fixed income. We believe the fund of funds approach allows the manager to give us access to the best hedge funds, of which there are thousands.” Because of its unusually large size ABP plans to become its own fund of fund manager in future. But for now it is on a “learning path”, building up expertise for future use. It does, however, conduct its own portfolio analysis and style allocation before leaving it to the fund of fund managers to select individual funds for its segregated fund of funds.
To avoid a high level of risk, AP7 is using two fund of funds giving it access to 40–50 underlying, funds, which will provide “healthy diversification,” says Grottheim. While negotiations are still taking place, Grottheim does know that up to 50% will go in one strategy alone, with the remainder being shared among other strategies. Real returns of around 5.5% per annum including fees are expected in the long term, which Grottheim believes is appropriate considering how much less risk is involved compared to equities. The return target for the managers will, however, be higher than that, he adds.
Jacob Schmidt, director at Allenbridge Hedgeinfo, a rating and research agency, argues there is a lot of risk involved in going with an individual manager, largely because of the enormous amount of due diligence to be done. “The fund of fund is the best route for all pension funds unless the pension fund has an in-house due diligence capability that will allow it to investigate different managers, of which there are around 6,000 globally trading in many different strategies.”
The introduction of a tracker hedge fund is a new alternative, although not of great appeal among many consultants. “I think a tracker is what you don’t want, because it gives you the average performance of the universe,” argues Schmidt. “An investor does not want the average performance of the industry but real value added, the so-called ‘alpha’. That is why investors should go with a fund of fund manager who will give them better risk-adjusted performance via a diversified portfolio for which they pay him.”
In a similar vein Kirkwood of UBS Warburg says there is a massive difference between the good and bad managers: “We don’t endorse a tracking approach to investing in hedge funds as it is not sufficient to just get exposure to the asset class. If you are investing in hedge funds you need to be invested in the upper quartile for it to be successful over time, otherwise it can be fraught with risk and investors are likely to be disappointed.”
Kirkwood observes that there is no rush for European pension funds to get into hedge funds right now, although in the next five years this may change. “The numbers that have been touted in the press are an exaggeration. At the moment there is a fear of the unknown and negative press.”
According to Allenbridge Hedgeinfo, 2001 saw a general trend in lower returns, coinciding with a proliferation of new funds and a sharp fall in all major financial markets. A good diversified fund of hedge funds manager could have been some 25% ahead of the equity markets.