The arcane nature of hedge funds still has many pension funds shying away from the investment vehicles. But asset managers report that there is a growing acceptance of them, and the view that they can play a useful role within portfolios.

Hedge funds have become far more visible to institutional investors in Europe in the last few years. "A couple of years ago, it was only for a privileged group," says Ruud Hendriks, who is co-head of business development Continental Europe (excluding Germany) at Goldman Sachs Asset Management. "But at least now it is on everybody's agenda."

"It's now an open debate… The sector is growing and taking on a high level of professionalism; it is far more transparent than before, and all of that is good," he says.

While in the overall picture, pension funds in Europe are stepping up their use of hedge funds, there are differences between countries, says Franziska Blindow, vice president at LGT Capital Partners, an alternatives asset manager with offices in Switzerland and New York. In the UK, the percentage of funds using the vehicles is relatively low, but it is higher in Switzerland, Sweden and Finland. In Denmark, however, there is more hesitation, she says.

Pension funds have turned to hedge funds for access to a wider range of performance sources, she says. "Pension funds see that they don't want to be limited to stocks and bonds… they want to broaden the spectrum," she says.

The move in Europe towards hedge funds has been a gradual one rather than any real sea change, and is part of a longer-term trend, says Jean-Louis Juchault, chairman of Systeia. Systeia is a French hedge fund manager and a partner of Credit Agricole Asset Management. "There is a constant effort from pension funds to diversify."

One of the obstacles to institutions in Europe investing in hedge funds is the legal status of their domicile. "Obviously, it is not very easy for European investors to place assets in non-European vehicles… pension funds are sensitive to the legal environment, and the organisation of the hedge fund in terms of transparency," he says.

So Cayman-domiciled hedge funds prove more problematic than those registered in Luxembourg or Dublin, he says.

"There are global issues, including the credibility of the counterparty; pension funds invest in the long-term and clearly they see investment as being a credit risk," he says. However, platforms have now been developed which overcome this, making it easier for pension funds to deal with the counterparty risk, the legal environment and the transparency issue, says Juchault.

"Our experience over the last 12 to 18 months has been that institutional investors are increasingly looking into funds of hedge funds and specialist funds of funds, and also at customised mandates and multi-strategy single funds," says Blindow.

Institutions are not as interested in single funds. They are less willing to divert funds into these because of the high level of resources that it would take to pick out and then monitor single hedge funds.

However, the approach that pension funds in Europe take in hedge fund investment also depends on their individual level of experience with the vehicles. "Typically new entrants would go for diversified funds of funds, and those with more experience would opt for single-strategy funds of funds," says Blindow.

Those pension funds that adopt this more sophisticated method would usually use some kind of customised mandate that allowed them to tailor their investment, creating a portfolio of specialised funds of funds.

Pension funds are showing interest in funds of commodity hedge funds and Asian long/short funds of funds, she says. "You see all the big topics for pension funds reflected in the hedge fund arena."

Pension managers aiming for a long-term strategic allocation to Asian equities, for example, may see hedge funds as a less risky way of getting exposure to this market, she says. "They are aware they have to give up some of their upside, but in turn they are rewarded with a downside protection and a return potential even in sideways and falling markets," she says.

Even though funds of hedge funds tend to be the starting point for institutional investors new to the sector, says Juchault, when they feel comfortable with the vehicles, many then move in deeper with the aid of technology.

"What we see is that they are developing special programming, giving them the technology and know-how to evaluate specific strategies so that they can then allocate to them individually," he says.

The larger pension funds that have built up some experience with funds of hedge funds, are now moving into direct single strategy funds, says Hendriks.

But there are still many pension funds in Europe that do not want to invest in hedge funds at all, and they give many reasons for avoiding the vehicles, he says.

Though he stresses these are not the views of GSAM, the reasons given include a perceived lack of transparency, a double layer of fees (for funds of funds), somewhat disappointing investment results and the fact that the stock market is now performing better.

But Hendriks says GSAM does not believe in pushing hedge funds as an investment product where clients do not feel comfortable. "We would explain about some of the strategies and try to find out where we could be of help," he says.

"We are much better off with a well-informed client than a client they buys as a result of hype… that inevitably leads to disappointment," he says.

Dutch pension servicing firm Mn Services also offers hedge funds, but says its focus on the needs of pension funds sets it apart from other large providers. "Our priority is completely different from them," says Philip Jan Looijen, head of fiduciary management at Mn Services. "It's part of fiduciary management."

"Already at the earliest stage in developing an investment strategy for clients, we see whether hedge funds would add value for them, given their requirements regarding risk and return," he says. The fact that the firm is focused on pension funds gives clients a lot of confidence in Mn Services' approach, he says.

The firm is a subsidiary of Pensioenfonds Metaal en Techniek; the pension fund spun its administration and investment operations off as Mn Services and then outsourced to it. Now Mn Services serves a wide range of pension funds, and manages assets of more than €33bn.

Niels Oostenbrug, head of hedge funds and GTAA at Mn Services, adds that Mn Services' hedge fund offering is specifically designed for pension funds.

"We typically offer a portfolio that reduces risk in the total portfolio of the pension funds; it's a diversifier and market neutral, particularly on the downside, so it doesn't correlate with bond and equity markets when those markets go down," he says.

Serge Ledermann, head of the investment unit in charge of strategy at Lombard Odier Darier Hentsch, says that increasingly customised solutions for hedge funds are being used for mid to large pension funds, such as managed portfolios composed of single funds.

For the institutional market, LODH recommends hedge fund exposure as an integrated solution for portfolio management, says Ledermann, mixing arbitrage and trading strategies to substitute traditional fixed income exposure.

Aegon offers hedge funds in two ways, says Frans van der Horst, senior vice president at Aegon Corporate and Institutional Clients.

First, as part of its North American equities portfolio, where it separates alpha and beta; beta makes up the largest portion of the portfolio and consists of equities, while a mix of US equities hedge fund strategies are used to generate the alpha component. Secondly, the firm offers hedge funds as one of the 10 components that make up each of its three institutional investment products.

Clients are comfortable with the inclusion of hedge funds in the North American equities portfolio, because it forms a part of the overall idea and the distinction between alpha and beta, says van der Horst.

Though there are many newcomers to the hedge fund asset management business, Hendriks says that when it comes to winning clients, a large established player such as GSAM has a real advantage. But Ledermann at LODH says the size of an asset management firm will not determine its success in winning clients on the hedge fund side. "Size does not really matter since competences and specialisation are key factors," he says.