After five strong years in the equity markets, some US pension funds are disappointed by the performance of their alternative assets and moving out, while others are keeping them but focusing on de-risking.
The largest US pension fund, CalPERS, for example, is reportedly cutting its hedge fund investments by 40%, to around $3bn (€2.3bn).
“CalPERS’s decision is consistent with what we see in the US pension fund industry – a move away from alternatives such as hedge funds and private equity,” says Steve Guggenberger, senior portfolio manager for Wells Fargo institutional Asset Advisors.
The move started in 2008 after the Pension Protection Act imposed stricter rules on liquidity when the financial crisis struck, says Guggenberger. “Since then pension funds have not focused on total return anymore, but it’s more on de-risking,” he explains. “Managers have shifted more toward liability-driven strategies, concerned about interest rate volatility and discount rate volatility. De-risking means being more in tune with long-term bonds and long-duration vehicles. It doesn’t matter if interest rates rise or fall, because the value of liabilities will raise and fall at the same time.”
The new trend, according to Guggenberger, is ‘hibernation’ – keeping the pension fund on the company’s books through de-risking. “Three or four years ago there was a rush to terminate corporate pension funds, but that implies the cost of paying a premium to an insurance company that takes over the liabilities,” recalls Guggenberger. “The next phase will be thinking of the net present value of termination, maybe finding out that it’s expensive and that hibernation is a more valid option.”
Bill Muysken, CIO for alternatives in Mercer’s Investment business, has a different view: “We think institutional investors are still too exposed to stocks and should diversify out of equity market risks. For them, hedge funds are a good long-term investment. We advise our US institutional clients to have about 50% of their portfolio in assets that match liabilities such as bonds, and to invest 10-30% of the other half, the growth portfolio, in hedge funds.”
Muysken agrees that public pension funds often feel uncomfortable with assets that have not performed well in the last five years. “They have different levels of tolerance towards complexity and different needs of liquidity,” he observes. “We never expected hedge funds to perform very well during bull markets. Historically, they do better during bear markets.” Over the five years to end-2013, hedge funds achieved an average annual performance net of fees of less than 5% versus more than 14% for the MSCI World index. In the previous five years hedge funds outperformed with a 2% annual gain versus a loss of 2% for equities.
“If we consider the whole 20 years, hedge funds generated equity-like returns but with one-third to one-half the volatility of stock markets, without being too highly correlated with equities. That’s a very attractive proposition for our clients,” concludes Muysken. “The bottom line is that we don’t think it’s the time to leave hedge funds. The problem is to choose the right hedge funds. Some are very correlated to stock markets and therefore they are not useful risk diversifiers.”
Musken observes a further trend where investors are running their own fund of funds to avoid the extra layer of fees. “We also see fees trending down. We know of at least one hedge fund manager who voluntarily cut his management fees, although not performance fees, and others are introducing a new model where the longer clients lock their money into the fund, the lower the management fee.”
Rafael Silveira, a portfolio strategist at JP Morgan Asset Management, does not see a tipping point for alternatives. “The move into alternatives investments as a group, including private equity, real estate, infrastructure and hedge funds is on-going and, in our opinion, will continue because pension funds are trying to invest in more efficient asset classes,” he says.
But the main trend Silveira observes is de-risking and liability-driven investing, which has become stronger as funded ratios have improved.