Love or hate relationship?
This month’s Off The Record looks at the prickly issue of whether pension funds should be invested in hedge funds and hedge fund strategies.
One of the arguments for including alternative investments like hedge funds as a component of pension fund portfolios is that there is simply not enough juice in the traditional asset classes to provide the returns that European pension funds need to restore their funding levels. Only alternatives can provide these.
Yet hedge funds are no longer delivering the double-digit returns they once achieved. Many are not delivering returns at all. The Lille-based business school Edhec’s ‘index of hedge fund indices’ shows that nine out of 13 investment strategies posted negative returns in April. Recently, MSCI reported that all but one of their strategies posted negative returns in May.
So have the glory days of hedge funds gone? Funds of hedge funds managers have warned for some time that pension funds should lower their expectations of hedge fund returns, since most of the best-performing funds are now closed to the new institutional investor. As a result pension funds cannot expect the high levels that the pioneers of hedge fund investing achieved.
So what else is left? A stronger case has been be made for hedge funds as diversifiers of risk.
Certainly pension funds’ appetite for hedge funds is growing. Last year hedge fund assets grew by e50bn, and the biggest contributors to this growth were pension funds. This appetite has worried financial regulators and supervisors who fear that the hedge fund market could overheat.
Although returns are falling, the risks of hedge fund investing are increasing. Hedge funds are borrowing more, as the availability of cheap credit makes it easier for funds to increase their leverage. The head of a leading UK pension fund has warned that this leverage makes the hedge fund industry “inherently unstable”.
There are also issues of transparency and risk reporting. By their nature, hedge funds cannot provide pension funds with the same degree of transparency that pension funds demand of traditional asset managers. Managers of some hedge fund strategies are more like poker players than fund managers - they do not want to reveal their cards.
So are hedge funds really a suitable investment for pension fund assets? Or are pension funds and hedge funds, with their different horizons and objectives, fundamentally unsuited to each other?
As ever, we wanted your frank and unattributed views and, as ever, we got an even-handed response that puts hedge funds firmly in their place. Forget the fireworks, you say. Hedge finds are currently a useful firewall against systemic risk. And pension funds may grow to need them if not to love them.
Most of the pension fund managers and administrators (71%) who responded to our survey have no doubt that hedge funds have a place in a pension fund portfolio, although a few (6%) have no strong views either way.
There is far less agreement about whether most pension funds are likely to be invested in hedge funds to some extent in the future. Only a small majority (52%) of managers feel that there will be no obligation to invest, and a clear majority (90%) feel that hedge funds have been over-rated as a source of high performance.
This scepticism seems to extend to future as well as past performance of hedge funds. A substantial majority of managers (81%) do not believe that hedge funds will return to their initial spectacular gains.
We also wanted to know what you think is the primary purpose of hedge fund investment in a pension fund portfolio – higher returns than can be expected from equities, diversification of risk through non-correlated asset classes, or a combination of both higher returns and diversification of risk?
Most of our respondents (80%) see the primary role of hedge funds as a risk diversifier. Under half (45%) see it as a source of both diversification and returns, while only a small minority (6%) say their primary function is to provide higher returns, although one Spanish fund manager suggests the role of hedge funds in a pension fund portfolio is to provide “absolute return at core asset”.
The percentages do not total 100% because many of our respondents chose more than one option.
If pension funds should invest in hedge funds, how should they do it – directly or through a fund of hedge funds? The accepted wisdom is that a fund of hedge funds is the only practical and cost-effective way. This draws broad agreement from our respondents. A majority (64%) agree that fund of hedge funds offer the best route in, although “not the only route but a reasonable way in,” as one manager observes.
We then wanted to know what percentage of its assets the managers of a medium-sized pension fund should allocate to hedge funds either directly or through a fund of hedge funds.
Obviously pension fund managers who hold that pension funds have no business investing in hedge funds want to see no exposure at all (16%). Yet most managers expect pension funds to have an exposure to hedge funds of anything up to 10%. The largest single group of managers (39%) suggest an exposure of between 5% and 10%, while a slightly smaller group (35%) suggest anything up to 5%.
There is an impressively large vote (16%) for an exposure to hedge funds of 10%-20%, perhaps reflecting the fact that some leading European pension funds are already well within this range. For example, Nestlé, one of the largest Swiss pension funds, increased its hedge fund allocation from 15%-18% earlier this year. However, there is no support for an exposure of more than 20%, .
Transparency is an issue: pension fund boards and trustees expect to be able to see and understand what is going on in their hedge fund investments. The growing ‘institutionalisation’ of hedge funds means that hedge funds must provide more transparency if they are to be accepted by institutional investors as mainstream asset strategies.
Yet the essence of some hedge fund strategies is not to reveal positions, and investors are often forced to bet blind.
Perhaps high performing hedge fund managers cannot be expected to be as transparent about their positions as a traditional asset managers? A small majority (55%) agree with this suggestion, although a substantial minority want equal levels of transparency .
Similarly, should pension plan sponsors be prepared to pay higher fees to hedge fund managers than they would pay the managers of traditional assets? A slight majority (52%) think that they should, although there is clearly a feeling the current levels of reward are unjustifiably high. For example, the manager of a UK pension fund agrees that hedge fund managers should be paid more than traditional asset managers but “not at the levels currently common”.
Pension funds may ask themselves whether the risks of hedge funds are really worth the returns. The managing director of a leading UK pension fund caused a stir earlier this year when he suggested that hedge funds were “inherently unstable”. Slightly more than half of our respondents (55%) agree with this view.
If hedge funds are so risky, should they not be regulated like any other investment vehicles? Bill Gross, head of Pimco, recently described hedge funds as ‘ unregulated banks’ and argued that if banks are regulated, so should hedge funds. A substantial majority of pension fund managers (87%) agree with this suggestion, although one UK manager adds the caveat that the regulation should be “to the same degree as other funds – low in both cases”.
Finally, we wanted to know whether you thought the current love affair between some pension funds and hedge funds will last. Many of the managers in our survey (64%) feel that it is not likely to last, and that, like any infatuation, it will run its course and die
However, there is also a feeling that the interests of pensions funds and hedge funds could converge over the coming years. The manager of an Austrian pension fund is probably closest to the mark when he observes shrewdly: “ No the love affair will not last. It will develop into a relationship.”