22/09/2010 Author: Stephen Oxley

Comment: Stephen Oxley

UK pension funds first started investing in hedge funds 10-15 years ago. At that time, most UK pension schemes had up to 80% of their assets in equities with the balance in government bonds and in real estate. Assets were often actively managed in multi-asset ‘balanced’ mandates by one or more of the mainstream asset management firms. Most of these multi-strategy mega-managers failed to demonstrate much ability to add any discernable value over a sustained period.

Later in the 1990s, the investment consulting industry, which had overseen the establishment of these arrangements, began to advise pension fund clients to diversify their asset allocations into other markets and alternatives. UK pension portfolios then developed explicit alpha and beta components. Exposure to specialist managers and multiple asset classes burgeoned. Around the same time, disenchanted investment managers from the mainstream houses were throwing off the constraints of benchmark hugging to establish or join absolute return hedge funds.  

The alternatives pension pioneers were a handful of schemes providing limited allocations to a hedge fund industry hungry for assets. Allocations increased but were restricted to those from the larger or better-run pension funds enabled by either a very focused governance structure or inspired by a visionary consultant.   

Despite this vision, today there are many pension funds that still shy away from investing in hedge funds and other alternative assets because they lack the decision-making ability to do so with comfort. Others have rightly decided, having listened to the evidence and considered their position objectively, that alternatives are not for them. But for the large majority of pension funds, of all sizes, and whether public or private, active investment in hedge funds and alternatives is an entirely logical – indeed, even necessary – part of their maintaining a balanced portfolio.

Most hedge fund investments by UK pension funds continue to be managed by a fund of hedge funds (FoHF). The arguments for a portfolio approach are strong and most pension schemes do not have the resources for research, due diligence, risk management, operational management and monitoring required.

In recent years however there has been an increasing trend for larger pension funds to go direct to the hedge funds themselves.  This has been driven by the perception that FoHFs involve an additional fee layer and that hedge fund investment is more about manager selection than portfolio construction. ‘There may be thousands of hedge funds out there’, goes the thinking, ‘but there are only 20 that matter and my consultant can help me find those and I will save money’.

This argument, which I have shamelessly simplified, is dangerous because in its simplicity it hides a couple of fallacies and it may take pension fund investors backwards rather than forwards in their investment strategy. One point that needs to be challenged is the idea that FoHFs cost more. Larger FoHFs are able to negotiate fee discounts with the underlying managers because they are often investing early and in size. Another fallacy is that only the larger funds matter or are suitable for institutional investors and the implication that there is less risk involved in investing in a large, well-known hedge fund. There is much empirical evidence to support the view that emerging hedge funds can and do provide better returns and concentrating investments in a small number of blue-chip names increases both agency and investment risk.

Consultants see manager selection as one of their core skills. Even if they lack the resources and experience to provide clients with a portfolio of hedge funds, most are now able to produce a shortlist of single hedge fund managers for their clients.  

The real danger is that the trend towards direct investment leads to a lot of money being focused on a small number of large multi-strategy hedge funds at the expense of alpha opportunities elsewhere, combined with an increase in agency risk.  

It would be undesirable for pension funds to find that their alternatives portfolios are populated by mainstream multi-strategy mega-managers much in the same way that their traditional portfolios were back in the 1990s. When it comes to investing in alternatives, the focus should be on diversification and calculated risk, not simply piling into the biggest and best-known names