Preparing for the inevitable
The UK pensions investment community knows it is looking for something new, but is not sure it wants that to be hedge funds. However, these funds may yet prove to be managers' date with destiny - a little down the road.
Already biting that bullet is Midlands-based engineering company Caparo Group's pension fund run by Chris Kemp. It took the decision to put a proportion of its assets into a market neutral hedge fund strategy and became something of a cause celebre, being seen as a fund that has taken a step into new waters. As Kemp explains the scheme was looking for something different: It was not something we took a flier at. The fund was looking for non-fixed interest assets, which would have features that would appeal to us." While he describes the fund as mature, it still did not want to be in a situation of being driven by minimum funding requirements, which for most funds means increasing fixed interest levels. "We wanted to get away from a strictly equity alternative and to have another asset classto look at." The market neutral fund strategy put forward by the advisers Buck Consultants clearly appeared to fit the bill.
Kemp says the initial reaction to anyone hearing that a pension fund is taking such a step is to ask: 'What is a fund doing hedging?' "But the way that these market neutral strategies are set up means that they are not a hedging animal in the terms of the vast US funds that got into difficulties," he says. "We feel we have adequate protection in a balanced way and that our exposure is limited." The fund placed about 10% of its total assets £130m (E189m) into a fund run by State Street Global Advisors (SSGA). Another and much larger pension fund confirms that it was taking a close look at the area, particularly following the research coming out from managers, such as Goldman Sachs. Its fund manager says: "If it had not been for Long Term Capital Management (LTCM) and unpleasant press, I would have gone further in my review. I have talked to my peers in the US, who have a place where they would allocate this investment to."
His view is that the use of hedge funds is "not inconsistent with part of the active investment of the overall portfolio - but now is not the time to touch it. But I will revisit the area and look at it again." Any moves to present hedge funds as an option to the investment committee would only be after very serious research, he adds.
Particularly after the frissons that went through the marketplace after LTCM, most pension funds would not regard the area as one to be pursued currently, if ever. William Douglas, who is investment director of the Lucas Varity scheme, says the fund can use derivatives to achieve the fund's objectives, for example, futures to effect portfolio position changes, adding that the fund does use hedging strategies on occasion. But to consider investing in hedged funds would not be permitted.
Angela Docherty, who is senior corporate investment consultant to the Unilever schemes outside the UK and US, says: "None of the funds are invested in hedged funds and none of our investment managers would be able to do so without prior approval." Though, she adds, hedging strategies are from time to time used in appropriate circumstances. Such practices and views are likely to reflect those of most UK funds at present.
But there is a strong feeling among those working with pension funds that all this is changing. Investment management groups who are both close to the institutional investors and have had relevant product are stepping up their activities. For SSGA, the Caparo win may prove to be a milestone as far as the UK is concerned. Kanesh Lakhani, the group's London-based business development director, says: "We have been running the market neutral strategy, which Caparo signed up for, for over nine years.
The strategy is highly risk controlled, as we would sell on the long side an equal position to the short side, with the returns appearing to come from the stock selection." What ap-peals to the institutional investor is that is the fact that they do not have the ex-posure to a particular market, he says.
Up to now, SSGA has been using a US fund which pension funds in Europe can access for these strategies in the drive to generate the excess returns (see box), but the group sees the opportunity to go further. "We are launching a Dublin-based fund, which is more of a leveraged type of fund - on the lines of a conventional hedged fund," says Lakhani. Up to a couple of years ago, such a fund would only have been looked at by high net worth individuals or some insurance companies, but now more investors are interested. "The UK pensions market is changing so dramatically, and it is not just balanced funds, but with the MFR and other requirements, pension funds are having to decide where their returns are to come from."
At London-based Pareto Partners, they are singing from almost the same hymn sheet, with three hedged funds on the Dublin stocks ready for launch this month. Marketing director Dan Lass says the firm is targeting institutional investors with these funds, comprising three long short global bond funds, of which two are US dollar denominated and one is euro-based. "The funds are using the output from our global bond strategy, which we have been running successfully for five years. But we have been ignoring half of the output as we have been looking at the most attractive ."
This work has been done at the behest of the firm's pension fund clients, he claims. "They are looking more and more at portable alpha strategies. Strategies that are not correlated to the direction of the market, which we see as the next step from the core satellite approach."
Lass says that the funds have been designed to take into account in-vestors' concerns on transparency. "Once they have traded, we will make the portfolios available to clients. They can see exactly what is in the funds, so there is not any opportunity to take any more leverage than they were anticipating." As a result of the upsets in the hedged fund market, he reckons institutional investors are "looking towards more mainstream providers, with risk control technology in place to monitor things on a continuous basis".
First Quadrant, who ran a close second for the Caparo mandate, has been running both US and UK market neutral strategies for a number of years. Managing director William Goodsall be-lieves that "market neutral is going to get a lot more attention in the years ahead". He predicts confidently that the group's UK market neutral programme "will be getting some pension fund money in the very near future". The position on the continent is even more encouraging in his view. "The appetite and interest in market neutral strategies is at a more advanced stage, and we are working on a Euroland product."
Goodsall reckons that the dynamics of the market are running in favour of alternative strategies. Pension funds must ask themselves, where can they expect to get returns in double digits: "There is a dawning realisation that the returns of the last 15 years will not go on forever." And where will funds get real diversification? "The third quarter of 1998 was a sharp reminder that conventional diversification seemed not to work when you most needed it."
But their programmes came through the period unscathed, he claims.
In the UK, Goodsall believes that the underperformance of the balanced managers in the equity area has shaken people up. "Investors are more willing to consider alternatives." But the trend will be gradual: "Pension funds are not going for market neutral tomorrow, but if we get choppy conditions, we will see an in-creasing trickle of people going for it. In five years' time, it will be much more accepted.""