Jump in - the water's lovely
European institutional investors are catching up their US counterparts in using hedge funds as a risk diversifier. Although some pension funds, such as the ATP or Tapiola schemes in Denmark and Finland, respectively, are not investing in hedge funds, others are waiting for board approval, such as the Netherland’s Blue Sky fund, or have just allocated money, for example Shropshire County Council in the UK.
Those that have already invested money for several years are becoming more confident and increasing the strategic allocation: the SFr6.2bn (€4 bn) Nestlé scheme, for example, has 18% in three funds of hedge funds, up from less than 1% in 1996. The average strategic allocation, however, was 3.6% last year, compared to 1.7% in 2001, according to the Goldman Sachs International & Russell Investment Group’s Alternative Investing Report 2003, which surveyed 71 institutional investors and found 15 had already invested.
The main reason for investing in hedge funds, reducing risk/volatility of returns, has been taken on board by institutional investors. Tony Wheeler, pension fund manager at the £620m (€930m) Oxfordshire County Council scheme, which has committed 2%, or £12m, to hedge fund investments after an asset liability study by Watson Wyatt in 2002, said: “Watson Wyatt felt that alternative investments, ie those not closely correlated to other stock market assets, were a good opportunity for investment.
“We are dipping a toe in the water to gain confidence in the asset class. In the future asset allocation could be more. In our ALM the risk/return profile showed reduced volatility using hedge funds. Although in a bull market the returns are not so good we are aware of that and are using them hedge_funds for risk control.”
And Theo Jeurissen at the €20bn pension fund for Metalworking and Mechanical Engineering (BPMT) in the Netherlands says it did invest in hedge funds and other alternative assets, including commodities and private equity. “Studies clearly show that having significant proportion of alternative investments reduces risk/volatility of returns in a meaningful way. And you do not sacrifice returns. There is a low correlation of hedge funds to equities and bonds so they deserve a place in the portfolio.” BPMT’s hedge fund allocation returned 7.4% in 2003, with 12.3% the total return of the fund.
Jean-Pierre Steiner, director of corporate pension and risk services at the Nestlé fund, which invests in three fund of hedge funds created to its mandate by Unigestion, UBPAM and Grosvenor, says: “Performance has been like in the textbook: uncorrelated, stable returns within our risk parameters. You need to be convincing to sell the idea to the company and pension fund boards, which was tough initially but has been proved now.”
Nestlé chose to outsource management of the hedge funds to funds of funds rather than hire an in-house team, Steiner says. Another factor was to have access to good hedge funds. “If you want access to good hedge funds it is better to be known in the marketplace and to have a long-standing relationship with them. It is crucial to get access to the superior hedge fund managers (which are often closed to new investors), having medium performance is not good enough.”
Steiner says capacity was one big issue. “The rule is to be patient when you need new allocations. Not to push and get a second tier hedge fund.” Chris Hitchen, the incoming chairman of the UK’s National Association of Pension Funds’ investment council and managing director of the £12.5bn RailPen fund, in an article for PricewaterhouseCoopers’ Investment Management Perspective said pension funds must bear in mind that the hedge fund industry was “inherently unstable, because it uses leverage and seeks to generate long-run returns with short-term horizons (at the expense of other marketplace players).
“Moreover, it does not, in general, seek to exploit any theoretical source of economic return. Unlike equities or bonds, hedge fund returns should primarily be derived from pure skill. This may be the greatest limited factor in determining the eventual size of the hedge fund industry,” since then the RailPen fund in the UK has indicated its intention to invest.
Huge schemes, with large governance departments in-house, such as the ABP scheme in the Netherlands, Europe’s largest, and now the £26bn BT pension fund through its managers, Hermes, are trying to pick these star single strategy hedge fund managers. But slightly smaller funds, such as BPMT scheme, are primarily using funds of hedge funds for its 4% allocation but Jeurissen says it also made two small investments in single strategy hedge funds.
And rather than trying to pick these star hedge funds themselves, most pension funds are using funds of hedge funds. Derek Scott, chairman of the trustees at the £360m Stagecoach group pension scheme, says: “We have invested 7% to 8% of our assets in fund of hedge funds run by International Asset Management as we tend to choose managers with longer track records. We are too small to invest in single managers, as we are a medium-sized pension fund.”
Peter Norman, executive president of AP7 in Sweden, which has a Skr1.6bn, or 4% of its assets, in the EIM and K2 funds of hedge funds, says: “We choose funds of hedge funds because we didn’t think we had the capacity or money to hire staff to look at all hedge fund investments.”
EIM and K2 won their mandates after on-site visits to 20 funds of hedge funds by AP7. Norman says the winning firms needed five years experience; to be able to explain thoroughly to the fund their investment process and philosophy; and how they picked the underlying funds in turn and mix the different strategies. The minimum requirement was to hold 15 different hedge funds, split across strategies, and with an ethical criteria, he says.
This SRI policy of blacklisting 20 companies, however, was difficult to enforce in hedge funds, Norman says. As a result it was only to be discussed by EIM and K2 with the underlying managers in the future EIM and K2 would have make sure the net effect of holdings in these 20 companies was zero. Another lesson by Norman for other pension funds was to hold on-site visits and implement private equity and hedge funds at the same time. “Private equity increases returns and risk while hedge funds reduces risk so it is better when doing an ALM to combine both changes.”
His final requirement to the funds of hedge funds was the need for complete transparency of the underlying managers. “Transparency is important, so all underlying managers are public on our website”. And the ATP fund in Denmark said one reason it had decided against investing in hedge funds was because of this lack of transparency as to what managers were doing.
But Steiner says such transparency was not as crucial for the Nestlé fund. “We did not require to know the underlying holdings, necessarily, but we do visit some of the hedge fund managers. They do have the right not to divulge trading strategies to us.”
He did, however, try and hire the funds of hedge funds as it would a regular manager, ie, a long list of possible funds, RFPs, then a short-list and interviews, although with slightly different questions in the RFP. And he says it was important to make sure the fund of hedge fund had two teams doing due diligence on portfolio: one looking at the underlying hedge fund’s front office’s strategy and reasons for success; and the second team concentrating on the hedge fund’s back office, for example the accounting, settlement and administration.
And Steiner says the hedge fund strategies wanted was not the equity long-short, which were most easily understood, as the Nestlé scheme already had equity exposure in its long positions but the macro and arbitrage strategies for diversification.
But other pension funds disagreed. Jeurissen says: “Our focus, among other strategies, is long/short. Other strategies provide excellent results but not the diversification we are looking for.”
But Jeurissen summed up the consensus among those pension funds investing in hedge funds asked by IPE when he says: “It has all gone smoothly. It has not been as difficult as we were told beforehand.” As a result other schemes are likely to start investing in hedge funds in the future.