Thinking about direct
The City of Zurich of Pension Fund, with assets of CHF 11.4bn (e7.4bn), moved into hedge fund investment at the end of 2000 with a hedge fund allocation of 2.5% which increased to 5% at the beginning of 2002.
The main aim was risk diversification, says Vera Kupper Staub, the fund’s deputy chief investment officer with responsibility for hedge fund investments. “The objective was risk reduction without reducing return expectations too strongly. What we expect to achieve with hedge funds in the long run is a return between that of fixed income investments and equity investments, and a little bit nearer to fixed income than equity.”
The pension fund invests through six fund of hedge funds (FoHF), which specialise in different strategies. These are disposed across four strategy ‘modules’, with one FoHF managing arbitrage strategies, one FoFH managing event driven strategies, two FoFHs managing CTA and macro strategies and a further two FoFHs managing long/short equity strategies.
“The different modules we have chosen are nearly equally weighted and should more or less cover the entire universe of hedge funds,” says Kupper Staub. “The main motivation for the split was to have a good diversified hedge fund programme and to have a programme also with a low equity beta exposure. So a really diversifier with not too much equity risk in it.
“This split is roughly stable over time. We have made some changes but these have been small. We originally had a short-biased module also in the programme. We eliminated this a year ago because it didn’t really work out.”
The City of Zurich pension fund selects its FoFHs with Harcourt Investment Consulting, a Zurich-based consultant specialising in hedge fund investment. “Harcourt proposes the selection, we discuss it and then our investment committee decide on it. We select on the basis of their dedication to the specific area, their resources, their people, their process as well as their risk control capabilities and operational security, the normal part of the due diligence process.”
The relatively high cost of investing in hedge funds through FoFHs could persuade the City of Zurich pension fund to move towards direct investment in hedge funds at some point, says Kupper Staub. “ We are thinking about it but we haven’t come to a decision yet. Next year we will be making a thorough review of the hedge fund programme and that might be one path to go. If we moved in that direction it wouldn’t be a total move it would be a partial substitution. But costs are certainly a pointer in that direction.”
However, the attraction of the FoHF route is that it reduces the risks of individual hedge fund failures, she says. “The original motivation to go only via fund of funds was to really limit the risk of an individual hedge fund going bust. With our programme currently we are indirectly invested in more than 100 hedge funds. This is diversification that perhaps is too broad, but diversification certainly guarantees that if an individual hedge fund were to go bust it wouldn’t hurt us badly.
“This gives comfort to the investment committee and the board, as hedge funds are always politically a more exposed asset class than others.”
The indifferent performance of hedge funds for much of last year has meant that hedge funds have delivered below the pension fund’s expectations. “2004 was certainly a very difficult year, although in the last month they have been much better than the year up to August. For us certainly we will remain for this year below our long term expectations, “ says Kupper Staub
However, what is more important is whether hedge funds continue serve the purpose that the fund originally wanted them to serve. “From the point of view of risk diversification we are quite happy with our programme, but from a return side it could be enhanced. Returns have been okay but we would aim to get a little bit more.
“From a risk-adjusted basis the performance has been good but perhaps we will decide to take a little bit more risk to get a little bit more remuneration.”
Currently there are no plans to increase the City of Zurich pension fund’s allocation to hedge funds to more than the existing 5%. However, exposure could increase if the pension fund decides to concentrate its active risk within hedge funds,” says Kupper Staub.
“We are currently reviewing our entire use of active management. We are a large part indexed but we do still have some traditional active mandates and performance has been on average similar to passive investment. We could therefore decide to switch a part of our active exposure to hedge funds, which might in the end increase hedge fund exposure somewhat.”