Not all pension funds are abandoning hedge funds. And the ones that are could be making the same mistake that investors often make – basing decisions on the past.

Over recent weeks and months the attacks against hedge funds have intensified, starting with the news that the New York City Employees’ Retirement System (NYCERS) has decided to liquidate all its existing hedge fund investments and stay away from the asset class. 

Then, several leading investment figures declared the hedge fund industry to be a failure. Warren Buffett, for example, at his ‘Woodstock of Capitalism’ said large investors should be frustrated with the fees they pay hedge funds as they fail to match the returns of index funds.

However, some point out that the situation is not so simple. “It’s true that hedge funds [the HFRX Global Hedge Fund index] got beaten by the S&P500 [total return index] for the last seven years,” the Bloomberg Gadfly columnist Michael Regan has observed. “But during the last bear market, from October 2007 to March 2009, hedge funds managed to outperform, even after fees.” While they outperformed after the dot-com bubble, Regan went on to say, they underperformed in the mid 2000s bull market.

So is it wise to divest from hedge funds after seven years of a bull market in stocks? That is the question according to Regan: “Who knows whether a third bear market would result in another spike of outperformance; maybe the proliferation of computerised trading and competitors in the last decade has changed the paradigm for good.”

Recent lacklustre performance does not guarantee they will not outperform in coming years.

Indeed, many pension funds started investing in hedge funds after the last bear market – NYCERS did so in March 2011. Some were attracted by past hedge fund performance and also by their promise of fixed income-like volatility and equity performance, according to Jay Love, partner and senior consultant of Mercer Investment Consulting. “But that’s a difficult goal to achieve and it’s not happening,” Love continues. “The problem with hedge funds is that there is no inherent source of return, it’s only the skill of managers that can make a difference.”

The quality of hedge fund managers is the key, agrees Donald A Steinbrugge, founder and managing partner of Agecroft Partners, a hedge fund consulting and marketing firm. “The industry has grown to over 15,000 funds, which is too many,” he wrote in an open letter to investors. “The majority of these are not very good, which hurts the performance of the overall industry. However, I believe 10 to 15% of hedge fund managers are very talented and their funds can add significant value to a portfolio.”

Steinbrugge also claims that hedge funds are a fund structure, not an asset class. Each underlying strategy should be evaluated on its merits, which requires qualified investment staff. Another problem is the high 7-8% actuarial return assumption of US pension funds, which is hard to achieve using traditional asset classes.

Mercer recommends clients reduce their expectations, says Love: “Among the pension funds that are our clients, we don’t see a big trend of reduction of their asset allocation in hedge funds.”

That confirms the results of the last Alternative Investment Survey by Deutsche Bank of 500 investors with $2trn (€1.8trn) in hedge fund assets. The first quarter started with $15bn outflows, but 41% of respondents to the survey plan to increase their hedge fund allocations during the year.

“The argument for hedge funds in pension funds’ portfolios remains compelling,” says Anita Nemes, global head of the hedge fund capital group at Deutsche Bank. “Pension funds’ allocations to hedge funds are trending upward year on year. The average pension fund has an 8% allocation to hedge funds, up from 7% last year. Additionally, 71% of pension fund respondents utilise an investment consultant, compared with just 15% in 2010.