Leading from the top
There has been much fanfare about institutions going down the hedge fund route. The truth is that more and more on both sides of the Atlantic are waking up to the benefits that hedge funds can provide to their overall portfolios. However, as the market has evolved over the past 12 months it has become clear that these plans have very diverse requirements and approaches as well as particular challenges that need to be overcome. The main catalyst for institutional interest in hedge funds has of course been market volatility over the past few years. As a result, pension plans on both sides of the Atlantic have been forced to question the actuarial assumptions of the returns they are likely to achieve on their investments.
A look at the main developments in the market over the past year or so provides a number of illuminating insights. Perhaps the clearest single conclusion in this diverse marketplace is that it is not so much the ability to achieve stellar returns that has fuelled institutional investment; indeed, very few have shown much interest in macro or directional equity long/short strategies. It is rather the ability of hedge funds, when correctly incorporated into investment portfolios, to achieve consistent returns with a low correlation to the movement of major markets. As a result the focus is primarily on non-directional or market-neutral strategies – those that provide the best diversification opportunities away from conventional investment portfolios.
The hedge fund world is almost as difficult to navigate for many institutions as it is for the smaller investor, with similar problems of access, research and transparency. In addition the sheer scale of assets that can be allocated by these plans poses a whole new set of problems, potentially a major hurdle in an area that has innate constraints on capacity.
Looking at the evolution of the market, US plans have historically been very much the leaders. Perhaps this is partly because college endowment funds there have been long-time hedge fund investors – and such august institutions as Harvard and the University of North Carolina have for many years invested substantial portions of their assets in hedge funds.
However the big wave of investment over the past few years has come from giant public plans in the US. The largest and most high-profile is Sacramento-based California Public Employees Retirement System (CalPERS).
With $135bn (e119bn) under management, the plan announced some three years ago it planned to invest a fraction of its assets – totalling around $1bn – in hedge funds. Since that announcement other public plans of considerable size – including Texas Teachers ($80bn), Louisiana State Employees Retirement System ($6.5bn) and Virginia State Retirement System – have announced hedge fund investment plans totaling $500m.
However, probably the most decisive strategic allocation of 2002 was from Pennsylvania State Retirement System. In taking its innovative step it has upped the ante, paving the way for other big state plans. The Harrisburg, Pennsylvania-based fund, with around $21bn under management, decided to start using hedge funds – or absolute return strategies as it prefers to call them – as a way of controlling risk rather than achieving large returns. The fund trustees decided to go ahead with an investment of the much larger scale required to have any real impact on overall portfolio returns, deciding on an allocation of around $2bn, or 10% of total assets.
Faced with the problem of researching hedge funds to invest an amount of this size in a diversified portfolio, it decided funds of hedge funds would offer the advantages of research, expertise in combining strategies and ability to provide due diligence
It looked for expertise in non-directional strategies and access to otherwise-closed managers. But equally important was the need for funds of funds to demonstrate they had the ability to handle the size of mandate the fund would need to give out. In the end it handed out four mandates of around $500m each.
By contrast, the other major allocation announced in the US in 2002 was the giant Teacher Retirement System of Texas. With around $80bn under management, the huge plan decided to invest around $1bn in hedge funds. However it decided not to use a fund of funds, but to invest directly in a number of hedge funds, using an advisor – part of the reason for this being that the plan felt it had the capability in-house, and was unwilling to pay the extra layer of fees demanded by funds of funds.
There have been echoes of this in Europe, where a number of the largest plans have taken steps in hedge funds – at first with the aid of funds of funds and then via a ‘go-it-alone’ route. The common thread here is the focus on market-neutral and non-directional strategies, which these sophisticated pension funds believe offer the lowest correlation to their existing equity and fixed income holdings.
The largest European pension funds to go down the hedge fund route are Netherlands-based, such as the e136bn civil servants’ fund ABP and e17bn BPMT metal workers’ fund managed by MN Services. ABP has opted so far to hand out three mandates to fund of hedge funds, totaling around $500m, with more set to follow in 2003. However, built into this plan is a degree of knowledge transfer; as the plans build up their hedge fund expertise it is understood that they will look increasingly to build their own portfolios of single-manager hedge funds.
MN has already started to go down this route. Having already allocated around $450m to four funds of funds, it has now told these operations to shift all assets into just four strategies: fixed income arbitrage, convertible arbitrage, equity market-neutral and managed futures – a combination it believes provides the best diversification opportunities. In addition it will also look to make direct investments.
While many of the largest plans have decided increasingly to go it alone at the next tier down in terms of asset size, funds of funds look to be a long-term part of the hedge fund investment process. Apart from Switzerland and the Netherlands, Scandinavia has been perhaps the most progressive region in terms of hedge fund investing. Last year the public pension fund AP7 issued two mandates of around $50m each to two funds of funds.
The mandates were again selected on the basis of their diverse strategies, with one based on conservative, arbitrage strategies and the other more aggressive with a tilt towards long/short equity. An interesting twist is that managers in the underlying funds were discouraged from investing long in certain stocks – including a number of well-known blue chip names – on the basis of a socially responsible investment policy. Other AP funds now look set to go down the hedge fund route.
Surprisingly perhaps, it is UK pension funds that are the laggards of Europe. This seems paradoxical because on average these funds tend to have higher equity components than their continental peers, and as a result have suffered worse volatility. Part of the reason is thought to be attributable to pension fund consultants. Although some, most notably Watson Wyatt and William Mercer, have researched the hedge fund area, some of the other main consultants are thought not to favour the investment class, despite the potential benefits of diversification.
Some UK pension funds have taken tentative steps to making trial allocations in hedge funds – for example, the Mercer-advised West Midlands pension fund, based in Wolverhampton, may make a roughly $70m allocation to funds of hedge funds. But for the most part little actual investment has taken place.
To sum up the main lessons from the rapidly evolving hedge fund marketplace is not easy. It is clear, however, that hedge funds are increasingly on the map as a part of the institutional investor’s asset mix.
It is also clear, and not surprising given their level of sophistication as investors, that those funds deciding to incorporate hedge funds are doing so for their diversification characteristics, and as such are favouring mixed portfolios with a non-directional slant.
While the largest plans are increasingly trying to operate their own investments, all but the very biggest and most capable investors are finding that funds of hedge funds offer the best ways to move into the hedge fund world, providing the advantages of experience and investment expertise. The winners in this market will be those funds of funds that offer steady and consistent returns together with flexibility and the right infrastructure to cater to this sizeable and fast-growing market.
Stephen Attenborough is head of European sales, fund of hedge funds, at Gartmore Investment Management in London