More haste, less speed
Worldwide, pension funds have shown an interest in hedge funds as part of a holistic solution to achieve absolute returns. They are perceived as complementing, not competing, with other asset classes. Contrary to media headlines in the recent past, however, pension funds’ allocations will be very small; with less than 3% of assets currently. In cash terms, however, the sums involved may double the size of the hedge funds industry over the next five years.
That said, most pension funds have three concerns about hedge funds: high charges, opaque strategies and absence of governance structures.
These are among the key findings from a year-long research study carried out jointly by CREATE, a research consultancy, and KPMG International*. It is the most comprehensive study ever carried out on the future of hedge funds and their impact on the global investment landscape. It canvassed the opinions of six sets of key players in the investment value chain: pension funds; pension consultants, managers of hedge funds and fund of hedge funds; mainstream fund managers; administrators of hedge funds; and prime brokers.
It shows that the last bear market savagely exposed the scale of the funding crisis and damaged the reputations of many pension finds. Now, they are understandably cautious about investing in hedge funds: ‘sticking to the knitting’ is the new mantra.
But that does not detract from the most important conclusion of the study, namely, what mobile phones did to land lines, what low-budget airlines did to flag carriers, hedge funds are now doing to the global fund management community – but, notably, without destroying traditional revenue streams.
As a disruptive catalyst, hedge funds have started a chain reaction that extends well beyond their immediate universe. Unwittingly, they have forced mainstream fund managers to go back to their time-honoured raison d’être: to provide absolute returns.
Pension Funds: How would you describe your pension fund’s current approach to hedge funds, or fund of hedge funds?
The two camps
Looking at the hedge fund industry in its totality, the study found that pension funds perceive three distinct groups of managers:
q Around 15% of managers are clear ‘stars’: they provide the prime capacity that is capable of generating high risk-return characteristics in line with client expectations. Most of them have an investment banking background; with the majority based in the US.
q A further 55% are ‘wannabes’: many are second generation long only managers with the right pedigree. All aspire to be stars before long; with the majority based in Europe and, to a lesser extent, Asia Pacific.
q The remaining 30% are ‘has beens’: they are the victims of brutal burn and churn that characterise their universe.
Accordingly, around one in two pension funds are not in hedge funds and a sizeable proportion of this group intend to stay out (see chart). Around one in two is in; but do not expect to increase their allocations substantially. So far, the size of their average allocation is typically less than 3%, being higher in the US and Japan than Europe. The UK pension funds are far more cautious than their peers on the continent, and in many instances the first move has been via the hedge fund-of-fund route.
Furthermore, two in three pension funds believe that high returns on hedge funds depend upon: a high and rising inflow of new talent; rapid innovation, as strategies go out of fashion; and ability to commercialise the new strategies. There are widespread doubts on each of these factors. Hence, those investing prefer no lock-ins, with dealings once a month.
Nor are pension funds convinced that hedge funds managers can scale their business without sacrificing performance; or that regulation can prevent periodic blow-ups.
Many pension funds also do not have internal governance structures to regularly monitor complicated investments. In any case, for them, there are other - more intelligible - sources of alpha. Nine in 10 pension funds staying out can meet their liabilities, requiring a weighted average return of around 7% on all their assets, without hedge funds. Equity market increases of over 25% in the last two years have helped, too.
Thus, like mainstream fund managers, pension funds fall into two groups, when it comes to their involvement in hedge funds: pragmatists and fundamentalists.
The first group perceives hedge funds as but one of many credible strategies for generating alpha. Their view is that the last bear market has created major discontinuities. Indeed, the current interest in absolute returns is nothing short of the revival of the investment mentality of the 1960s and 1970s, before the rhetoric of relative returns and benchmark hugging blinded so many investors, so many times, for so long.
On this argument, it is better to swim with the tide of absolute returns than go against it. That said, the allocations made by the first group are small; from a tiny base, their growth looks impressive. Outside the US, they are largely channelled through fund of hedge funds to manage the reputation risk. Collectively, the weight of new money has the potential to industrialise the hedge funds industry on a scale that can make the majority indistinguishable from mainstream funds. That convergence is already evident, for example, with ever more hedge funds venturing into the absolute long only space. On their part, mainstream fund managers are emulating hedge fund type strategies and structures.
In contrast, the second group - the fundamentalists - believes that investor appetite for hedge funds will evaporate as markets recover; after all, many investors chase returns, not asset classes. Many do not understand hedge funds and dislike the hedge fund ‘2 and 20’ charging structures when they have been used to paying 25-50 basis points for traditional asset classes.
Furthermore, there are other ways to achieve absolute returns. In any event, long short strategies can be self-defeating for those pursuing shareholder activism. Finally, for the majority of pension funds, hedge funds carry huge reputational risk; the charges are high, as are the prospects for low returns. Better education may help to change their attitude. But their resistance boils down to investment basics: opaqueness, fees and performance.
Both groups, however, recognise an interesting paradox: those who can afford to invest in hedge funds, do not need to; those who need to, cannot afford to.
That said, it is important to underline that pension funds in North America are most sanguine about hedge funds, followed by those in Asia Pacific, and Europe (especially the UK). It partly reflects the different levels of influence exercised by consultants and partly the prime mover advantage enjoyed by some US pension funds.
For those one in two pension funds that are already investing in hedge funds, or planning to do so, the single most important reason is the diversification opportunities which they offer; especially since returns from traditional asset classes have not been attractive. Some are indeed questioning the lack of correlation between mainstream asset classes and some certain hedge fund strategies, particularly over the last 12-18 months
In North America, far more pension funds also perceive hedge funds in three distinctively favourable roles:
q as an established asset class;
q as an effective instrument for bridging the funding gap;
q as a smart way of retaining key talent.
In contrast, in Europe and Asia Pacific, pension funds are far less inclined to ascribe these roles to hedge funds.
In large measure, the difference is a reflection of two facts about pension funds in the US.
First, many of them went in far earlier than their peers elsewhere and enjoyed the earlier fruits of high returns; they also believed that hedge funds will become an established asset class in their own right. Second, many of them manage a large tranche of their money in-house and thus have a superior familiarity of hedge funds that enables them to tailor their investments in line with their medium and long term goals. As a result, their trustees’ comfort level is far higher.
Not surprisingly, therefore, over the next five years, the biggest proportion of large allocations to hedge funds or fund of hedge funds will be made in the US.
Outside North America, pension funds’ investment in hedge funds so far is less strategic and more opportunistic. More a matter of dipping a toe in the water than diving in deep. Over time, doubtless, this may change. Education, history and risks are the key contributory factors.
Doubtless, institutionalisation will professionalise the hedge fund industry beyond recognition by 2010. For example, pension funds want independent valuations based on transparent pricing models. They also want to receive valuation reports directly from the administrators, not via hedge funds managers. Finally, they want all the regulatory and risk controls in place.
Together, these requirements will make administrators a seamless extension of hedge funds managers. Indeed, as hedge fund managers evolve to become multi-strategy houses, they will use multiple prime brokers but perhaps only a single administrator. This will make administrators a focal point for investors.
Hence, the demands of moving from life-style boutique to institutionalised investment firm should not be underestimated. Things that made the hedge funds industry great – talent, individualism, enterprise – are the very things that will change. A sustainable business requires scale; but scale is the enemy of alpha. Pension funds require discipline; but discipline could be seen to stifle creativity. Only the most adaptive hedge funds managers will survive and flourish in the new world.
* A copy of the report entitled ‘Hedge funds; a catalyst reshaping global investment’ can be downloaded from www.kpmg.co.uk
The authors: Amin Rajan is with CREATE and Neil Fatharly and Giles Drury are with KPMG International