US plans bide their time
In a nation of investment sophisticates, the term 'hedge fund' still strikes fear into the hearts and minds of the vast majority, an estimated 80-90%, of US plan sponsors. And for those who do dare to venture into the controversial asset class, few actually want to admit it.
The Long Term Capital Management affair however, has not acted as the main deterrent for plans, more to say it has reaffirmed already firmly grounded beliefs that hedge fund investing does not fit in with a US plan's prudent person principles under ERISA guidelines. ERISA does not explicitly forbid hedge fund investing, but while plans may be able to tolerate the high fees accompanied by the high risks, the perceived lack of transparency is the line plans just simply refuse to cross. Even stretching prudence to its limits, plans cannot and will not justify entrusting assets to a set of investments, which for all intents and purposes, they cannot see, at least to the extent to which they are accustomed.
The transparency issue is very big for us," says Brad Pacheco, spokesperson at the world's largest pension fund, the $133.5bn (E118.8bn) CALPERS, which has a position in alternative investments but has to date not been swayed by the argument for hedge funds. "We want them to open up their books to us and we want to know why they want the fees that they want and we want some transparency." He adds: "It is something that we just feel has too much risk, so we don't do it."
The $29bn AT&T plan does not consider the asset class to be of interest either. David Couette, spokeperson says: "It just hasn't figured into our plans." Neither does the $21bn Chrysler pension plan, nor the $8bn Amoco plan for that matter, though following the BP merger, it is unknown as yet how that will affect the US company's asset allocation strategy. "It is really not something that we are involved with at this stage," says Marvin Damsma, director investments at Amoco in Chicago.
The $15bn Philip Morris plan does not venture into alternative investments at all, never mind hedge funds, and for the $6.5bn Unisys plan in Pennsylvania, the question of leverage is an overriding issue. Edward Sarkisian, director trust investments at Unisys says: "The problems that have arisen in the past both in 1994 and 1998, when derivatives were getting a bad press, it wasn't so much derivatives, but leverage, so we avoid situations with leverage and I don't foresee that changing."
The $87bn General Motors plan does invest in the area but is currently keeping its strategic cards close to its chest. For those plans who actually do invest in hedge funds, they seem to adopt the same mystique attributed to the investment they have taken on board. One major US multinational who also has a significant presence in the area, would like to maintain the same level of anonymity, quietly allocating 10% of its notable sum of assets into hedge funds and hedge fund-type strategies. It is aware of the black mark that has been placed against hedge funds, but is willing to live with it, and to date its fingers remain unburnt. However, standing out as an exception to a rule established by the majority of the plan sponsor community, it does not want to publicise the fact. "They get bad press from time to time. The word hedge fund is really a conglomeration of different strategies and definitions for everyone. The first thing that comes to mind is high leverage and very risky," says the plan's head of investments. The plan splits its allocation via 10 different fund of hedge fund managers, based on an objective of yielding 12% after fees with no correlation to the stock and bond markets. "We think of it more as a fixed income substitute and it is an absolute return strategy - we don't look to compare it to the S&P500 or any equity benchmark," he says. Continued on page 44 The plan has built up its allocation over a period of four and a half years, and ventured into the arena as an alternative to equities and as a defence against corrections in the market. He appreciates his peers' aversion to the asset class, but he notes that when you actually do commit to a hedge fund, that managers are willing to disclose more information than otherwise would be imagined. "It's funny, that once you put your money in, that most of the managers are willing to talk about their strategies and their investments and we have a consultant that helps put all of that together," he says.
While the plan does not know what kind of actual securities or derivatives that the funds are invested in, it does know what the strategies are and keeps a regular check on these. "We measure the volatility of the strategy and we measure the diversification, just to make sure that they are doing what we are paying them to do."
He admits there are drawbacks of course, namely the high fees and the UBTI taxes it must pay because of the leverage. But he feels the liquidity aspect counters some of that. "They are a lot more liquid than other alternatives," he says. "Most of the LBO funds and private equity funds and real estate have long lock ups."
One major US plan which Chase Alternative Investments in New York approached has rejected the idea of hedge fund investing based on the fact that the plan sponsor thought it not feasible to invest in a fund where he did not have the exact details of what the fund manager was investing in. Joel Katzman, president of Chase Alternative Investments' argument is that because of this inherent fear of the unknown, plans could potentially be missing out on some of the best talent out there. "Some of the best managers out there are not going to give you full transparency and as a result of being dogmatic about wanting 100% transparency, as opposed to just transparency of the key positions which is knowing what they are doing, you are essentially cutting yourself off from some of the best talent," he says.
Chase manages around $760m via 41 different hedge fund managers in its fund of funds programme and has to date recieved minimal interest from plan sponsors because of this issue. "If you decide to allocate 'X' to hedge funds and you further decide that you are going to hire a dozen managers and no manager is going to make up more than 10% of that allocation, you've done a lot to mitigate some of the risks you have, by not having full transparency. And I would argue that that would be a much better approach for a fiduciary to use than to automatically rule out some of the best investors in the world."
Aside from private client interest in hedge funds, the insititutional contingent in the US is taken up by endowment funds and foundations. The University of Michigan recently hired four hedge fund managers to oversee $100m of its $2.5bn endowment fund and the $20bn Commonfund in Connecticut invests around $750m with 16 different hedge funds. And the University of Carolina's $1bn endowment fund invests a staggering 25% of its portfolio to a group of investment strategies which would all fall under the collective 'hedge fund' umbrella (see box). As far as investment manager, Mark Yusko is concerned, the transparency argument has been hyped up far too much. "Transparency is something that if you know the people that you are working with and you have good relationships with them and you trust them, then you'll know when they are doing something that you don't approve of. You don't need to see what they are doing day by day, minute by minute, as none of that information is actionable. You have to focus on what is actionable, you are not going to fire a manager for a daily trade, you might fire them for, over a period of time, substantially deviating from a strategy." It doesn't help matters of course, if pension fund consultants are not educating their clients in both the benefits and pitfalls of hedge funds.
One of the market's leading consultants, Frank Russell has backed off from making recommendations partly down to the fact that it takes up too much resources to research them properly in the first place. "One hedge fund is as different from another as non US equity is to US fixed income," explains Monica Butler, consultant at Russell in Tacoma. "We think it would require a huge amount of effort and resources to research them, as there are lots of them, and managers aren't willing to share as much information as large institutional managers." Butler adds that Russell is educating its clients in the subject area though only to the extent that the plans show an initial interest themselves.
The prudent person rule under ERISA has provided pension funds with a good enough reason not to invest in hedge funds based on the lack of transparency, and while there are calls in the industry for more transparency to be introduced, many think that this could actually mean the downfall of the hedge fund industry.
Part of the hype and subsequent attraction of hedge funds is the mystery which surrounds them, not knowing quite what they do to get their returns. As Richard Ennis, principal for consultants Ennis, Knupp & Associates in Chicago says, introducing the very thing that is deterring so many plans, could in fact be detrimental not only from the point of view that competing hedge funds know each others positions - it could just be a bit of a disappointment to investors. "As soon as they start affording the disclosure and reporting their portfolios regularly and all the particulars, I think people will realise that some of these investments that have been pursued for the very fact that people didn't know what they were doing, that the mystique is gone and they will say 'well, these guys are just trading securities and charging high fees and using leverage.'" He adds: "I think when the actual contents of LTCM was known, and people looked at the trades, many people said 'well this is pretty pedestrian stuff.""