Hedge funds suffered more than just financial damage in the carnage of last year – although a near 40% decline in assets across the industry was disastrous. Scandals in the mainstream press, combined with broken performance promises, meant that the reputational impact on these funds was equally devastating.
This fall from grace came amid a growing trend towards diversification by pension funds. In the US, around 40% of public pension vehicles now invest in hedge funds, more than doubling from 13% in 2005. Use of hedge funds in the UK pensions market has lagged behind other developed countries, with trustee conservatism and lack of knowledge cited as the main barriers. Figures from the National Association of Pension Funds showed that UK schemes had an average of 1.9% invested in hedge funds last year. So, have UK pension funds been put off before they have had a chance to appreciate the strategy?
In performance terms, hedge funds are benefiting from the post-March rally in markets and enjoyed their best single month since 2000 before stalling in June alongside with most other asset classes.
But according to S&P analyst Randall Goldsmith, while some flows have followed returns as expected, the response has been muted. “Allocations have taken longer to follow the return of performance, trailing the first signs by five months,” he says. “We think investor’s disappointment over management of portfolio liquidity is the primary reason. Weak due diligence in relation to exposure to Madoff strategies has also dented investor perceptions.”
However, there have been exceptions. For example, Berkshire Council has just announced plans to take a 7% position in hedge funds. The £6.5 billion West Midlands Pension Scheme moved 8% of assets into absolute return strategies earlier this year and the £23 billion Universities Superannuation Scheme has announced plans to double its alternatives weighting to 20%.
Hymans Robertson manager research analyst Claire Ballantyne says overall institutional money invested in hedge funds has stayed put and typically lost less than in straight equity portfolios. “Where we did see some selling was in those funds suffering liquidity problems. Investors were more concerned about changes to redemption terms than short-term performance issues,” she adds.
Ballantyne advises her clients to use the fund of hedge funds approach and believes these products are in a stronger position than ever before. “With fewer players and less leverage, many of the short-term concerns have gone and fund of hedge funds managers can negotiate better terms with underlying funds and access vehicles closed in the past.”
A More Positive Approach
Figures from Watson Wyatt support the view that where pension investors have braved the hedge fund space, they are sticking with their bets. Watson Wyatt global head of investment consulting Carl Hess says, “In spite of poor short-term performance last year, demand for alternative assets by pension funds aiming to diversify their portfolios and access skill remains. As a result, inflows continued last year, and combined with their illiquid nature and less negative performance than pure equity, resulted in only a marginal decline in assets.”
Despite the problems of 2008, Hess’s firm still believes in the ability of talented hedge fund investors to adapt to a changing environment and generate risk-adjusted returns for pension funds. “Change in this sector will continue as larger funds invest more assets directly and start to have a greater influence on fees,” he says.
“As we move into a different and difficult market environment, we expect more rapid developments around some emerging trends. One notable theme is transparency, particularly the separate identification of alpha and beta as well as an increased focus on risk,” he adds.
In the changed environment, Mercers principal Robert Howie says he feels institutional investors can now start trickling capital back in with more exacting requirements. Using its new voice in the sector as example, the Universities Superannuation Scheme is already calling for hedge funds to appoint more independent directors to protect the interests of investors. “Pension funds now have power to negotiate and can really push on areas like fees, where several hedge vehicles still levy performance charges without hurdle rates,” says Howie.
“Hedge funds will be seeking inflows so this should encourage their models to evolve into a better client service proposition, particularly for smaller- and medium-sized pension clients that might have struggled to invest in the past,” he adds.
Education of smaller schemes also has a part to play. Barnett Waddingham, head of investment Marcus Whitehead, has concerns about smaller schemes using hedge funds unless trustees have specialist knowledge. He says, “Investing in these vehicles requires serious due diligence and we have advised clients to steer clear unless they have the time and resources to do this."
“In essence, hedge funds are a reasonable investment for most pension funds but we want to see greater liquidity, transparency and tradability before being comfortable promoting them to smaller schemes,” adds Waddingham.
Measuring the Risks
In October 2008, Mercer advised any new allocations to hedge fund type strategies should be delayed, claiming certain risks were accentuated. Earlier this year, the firm said some of these had abated but new investments should follow good practice principles.
Consultant Simon Fox explains: “The average hedge fund, like the average long-only manager, is generally not worth considering, especially in this environment. Counter-party risk remains, liquidity is poor in many markets, new regulations are likely and the broader global economy may not yet have reached a nadir. Dislocation can bring opportunity, however, and a selected number of strategies and managers may well be in a position to capture this.”
In terms of investment principles, Mercer advises clients to avoid being providers of liquidity, particularly as many funds are still facing redemption pressures.
“Clients should also demand greater transparency as part of an institutional service,” adds Fox. “Funds of hedge funds have historically provided the institutional link for investors but the level of client servicing can vary significantly from manager to manager. Investors should know who is managing their money, how they are doing it and what positions are in the book.”
He also highlights funds that control counter-party risk and have low leverage, and encourages clients to challenge fees within reason. “It would be inaccurate to suggest the industry is back to business as usual or will ever return to what it once was but winners and losers are starting to emerge. More importantly, the level of uncertainty has dropped, especially on an individual manager and strategy basis.”
Another potential hurdle for hedge funds is much increased regulation after the excesses of 2008, spearheaded by the European Commission’s draft directive on Alternative Investment Fund Managers.
While still subject to debate, key proposals include forcing European hedge fund managers to register with regulators in their home country as well as adhering to capital requirements and leverage limits.
It is difficult to predict what new regulations will be placed on hedge funds and the likely impact of these on their return potential, but Fox is optimistic, adding, “Regulation is not a panacea; however on balance, we believe it may help to further institutionalise the industry and as such, provide some additional comfort to investors.”