Lift-off comes at last
A he sudden flurry of activity by UK pension funds in announcing asset allocations to hedge funds this spring must surely have piqued the curiosity of many an observer. Not least because of the almost ritual incantations of fear and warning from the traditionalists that quickly follow each announcement.
There is of course a sense that the UK is simply catching up with trends elsewhere. From north America comes the news that hedge funds gained a record $38.2bn (e31.1bn) in net assets during the first quarter of the year, a fourth consecutive quarterly record for industry inflows, according to research compiled by TASS Research, owned by Tremont Capital Management.
And the Alternative Investment Management Association is quick to point out that a number of more forward-thinking institutions in Europe have been investing prolifically in hedge funds for years. “We are really not surprised to see the UK waken up to the possibilities,” says Emma Mugridge, director, AIMA. “We are delighted; it demonstrates that the educational process is paying off. The consultants have a very important role to play in the sea change; the more people become involved and realise what it entails and learn and understand and experience, the more likely we are to see more UK pension funds invest in hedge fund strategies.”
Britain does, though, have a long way to go to catch up. While the WM Company's annual review of UK pension funds notes that over the past three years the interest in hedge fund strategies has increased, Graham Wood, a senior consultant at WM, points out that only a handful of funds have so far introduced these strategies into their asset structure. “Only one fund that I am aware of has made any significant commitment to hedge funds prior to 2004.”
Going forward, he agrees, the picture looks slightly different. But only slightly. “There has been much talk in the press, and it would be fair to say that amongst the largest UK pension funds there is considerable discussion on hedge funds and how they fit with fund strategy, and if they do, how should they fit into asset allocation. In statistical terms, however, the amount in hedge funds today would approximate to zero.”
Anecdotal evidence from elsewhere points towards the growing interest while putting developments firmly in a broader context. Chris Mansi, senior investment consultant and head of the worldwide hedge fund research team at Watson Wyatt, says: “We’ve been looking into hedge funds for the past four or five years, researching fund of hedge funds in detail. We work at two levels: firstly, is there a strategic case for hedge funds?; secondly, if there is one, it becomes an asset class issue and then a manager issue. Until two years ago, the majority of our work was educational. Over the past two years, there’s been a reasonable amount of activity. There has been a minority looking at and allocating to hedge funds. But it’s a significant minority. There has been a marked growth in the number of selections we have assisted on.” Where the decision is being taken to invest, around 5% of assets on average are being allocated to hedge fund strategies, he says.
Robert Ross, director of client services at Russell Investment Group, says that while five years ago no pension fund looked at the asset class seriously, today the majority do. The emphasis is still, though, on looking rather than doing. “But there are some exceptions; this year I’ve had one pension fund (Shropshire) making an asset allocation of 10% (£60m) to funds of hedge funds while another will be allocating 5% later this year (equal to £100m).” Across the industry, he suggests that the total level of assets involved amounts to perhaps half a percentage point.
Why now? What has changed? The answer lies in the cumulative effect of the educational process needed to increase understanding of hedge funds, greater transparency in hedge fund operations, which helps to enhance comfort levels, and the sobering effects of the bear market in equities in the three years to March 2003, says Wood at WM. “In the face of the very large negative equity returns experienced over that period, the expectation that hedge funds would deliver cash-positive return for little risk has its attractions. Moderate-risk hedge funds should give you Libor + 4%. They are not an inflation-linked investment like equity but offer lower risk than equity.” Or, as Michael McKersie of the investment department at the Association of British Insurers puts it: “Hedge funds offer a means to spice up performance while keeping the bulk of your money in safe assets; this is more attractive than running an old-fashioned balanced portfolio.”
Mansi points to two factors. One, the hedge fund market is now larger and more institutional. Two, in the 1990s market environment, the arguments for diversification were just as valid but had less penetration when equities were delivering stellar returns. As hedge fund managers have become more institutional, they have become more palatable to pension funds, who see the arguments for tapping into new methods of investment diversification.
A tactical element also comes into play, he argues. “A lot of talented asset managers have left to go into hedge funds; the market is following them. If you want skilled active managers, you have to go into hedge funds. We believe the strategic case exists for hedge fund investments, but only if you can invest with the best managers. The return you get is driven by the manager’s skills. With a long/short fund, you get some cash plus some market return plus outperformance generated by skill, minus the fees. With an unskilled manager, the equation doesn’t work; you get cash plus the market return minus the fees. Is the average hedge fund possessed of the requisite skill? It’s a hard proposition to justify.”
“Hedge funds represent a diversified way of adding value for funds have had their fingers burned in the short term and have been looking for alternatives,” says Ross. “Changes have also taken place on the supply side as well as on the demand side. Access to and transparency of hedge funds has improved. There are enough funds in the market place that are open to be researched, give you information on their holdings, etc, enabling the use of long-only portfolio research techniques to analyse them. This increasing openness has been necessary for those hedge funds without access to private money to attract investors.”
Another underlying factor is the reduced importance of peer group risk, he believes. “Arguably since Boots made its famous switch out of equities and into 100% bonds, any strategy is acceptable. When equities were rising, the risk was in being out of the market. You got locked into a moving average with no real objective. Nothing is extraordinary any more.
“In the years where funds were 75-80% equities, investment strategy was set by the fund managers acting in line with instructions from trustees. Funds have gradually switched to more customised strategies and the range of asset mixes held today is very much wider. This marks a new phase of development and maturity in the UK pension fund industry.”
Despite the general cheerleading atmosphere, there are warnings that need to be heeded. “Simply slapping the hedge fund badge on an investment vehicle doesn’t make it a Rolls-Royce,” says Mansi. “There are a lot of hedge funds out there. You need to know that they’re capable. You need to do thorough due diligence. Frauds do happen. Once that’s covered, the main risk is the risk of return disappointment, exacerbated by the inflows of money into hedge funds. So many are starting up you need to question the return potential of the average hedge fund manager going forward. You cannot manufacture skilled asset managers on demand. As money flows in, it becomes more difficult to achieve the return. The bar in terms of successful investment has been raised, highlighting how crucial is implementation.”
For Ross too, the element of danger can be traced back to the very fact of growth. “It’s all about active management. If the anomalies that managers are attempting to exploit disappear, or their ability to exploit the anomalies wanes, so will performance. You have to get good managers. Selection is critical.”
Wood adds: “It is a challenge moving into any particular area. There are 6-7,000 discrete hedge funds and around 1,000 funds of hedge funds to choose from. As a risk diversifier, it is better to go for funds of hedge funds. Even that decision leaves the pension fund with a selectable universe of approximately 1,000. That’s a major challenge; there are simply too many. In the normal equities investment world, there might be a selectable universe of 80-90 managers. Being able to filter 1,000 in any meaningful way is difficult.”