28/04/2010 Author: Shannon Hawthorne

A singular approach

The pension fund sector's relationship with hedge funds has been a long-running one, but one which has frequently seen the strategy held at arm's length, with investments restricted to 'alternatives' buckets. However, recent moves by many pensions to revise their approach to portfolio structure, and to learn more about hedge funds, could see them take a more integral role in pension schemes' allocation plans

The institutionalisation of the hedge fund industry is, by now, a well-established phenomenon. As funds continue to search for solutions to the age-old problem of capital-raising, particularly in the wake of the global financial meltdown, it comes as no surprise that pension funds and other large institutional investors are being hailed as the road of salvation for many a struggling manager.

Currently, this redemptive highway is a two-way street. With both UK and US pension funds facing mounting deficits – $261bn and $247bn respectively at the end of 2009, according to data by investment consultant Mercer – the fact that the hedge fund industry has emerged from the crisis with notably strong performance, relative to the global markets, has led to an increasingly symbiotic relationship between the two sectors.

In fact, according to a recent report by research firm Preqin, pension funds – both public and private – currently account for 30.7% of all hedge fund institutional investors, more than any other investor class. “There has been a shift in attitudes,” says Stephen Oxley, managing director of fund of hedge funds (FoHF) Pacific Alternative Asset Management Company (Paamco). “Hedge funds aren’t necessarily seen as wild, racy and risky. Today, they’re more likely to be seen as a real alternative way of investing.”

This shift in perception is making it presence felt in a new and adventurous approach in the least expected of places – the portfolios of pension funds. As the allure of volatility-reducing, high-return-producing hedge funds grows ever stronger, many pensions are making fundamental changes to the way they structure their investment portfolios. A new trend is emerging, which sees the traditional approach to asset allocation – where hedge fund strategies are all banded together as part of an alternatives allocation alongside private equity, property and the like – being abandoned.

“There are two ways of thinking about hedge funds in a portfolio,” explains Jaeson Dubrovay, a partner at hedge fund research and advisory firm Aksia. “The first approach is to include them in the alternatives bucket; the second is to include them as part of the various asset classes, based on what the hedge funds do. In other words, hedge funds are not so much an asset class as they are strategies.” Dubrovay, for one, is a keen advocate of the latter
approach.

“I think that there is somewhat of a move away from thinking about alternatives allocation as a concept,” agrees Nicola Ralston, director of PiRho Investment Consulting. “Pension funds are beginning to think more about risk sources than asset labels – and personally, I think this is to be welcomed.”

It’s a distinction many pension funds are beginning to make as they look to adopt this non-traditional, strategy-focused approach. As the general understanding of the term ‘hedge fund’ begins to change, naturally so too are investment methods.  

“There are some funds beginning to look at, say, long/short equity as part of an equity allocation rather than as part of an alternatives allocation,” says Ralston. Indeed, last year, HFMWeek exclusively revealed that the $5bn San Bernardino County Employees’ Retirement Association (SBCERA) would be increasing its investments into the long/short equity space, with said allocations forming part of its equities allocation ‘bucket’, not its alternatives portfolio.

It’s an approach the pension fund still uses today. “We at SBCERA don’t have an alternative asset allocation so to speak, although we have private equity, real estate and commodity allocations,” says investment officer James Perry. “However, we try to look at everything more from a factor-risk exposure point of view.”

The fund – which also has a large credit portfolio that utilises a number of hedge fund managers as part of the strategy but is classified as part of their debt allocation – sees this approach as one that focuses less on structure and more on identifying the risks and the opportunities presented by each particular strategy.

“My concern is not about investing in a long-only traditional account or a hedge fund or private equity structure; rather the objective is to find the best opportunities set and then identify the best structure or approach to get an investment in that opportunity set – and in a lot of cases, the hedge fund structure is the best structure to attack an opportunities set,” says Perry.

Of course, there’s no denying that the ‘alternatives bucket’ approach to hedge fund investing still has its supporters. According to Guy Saintfiet, senior hedge fund researcher at consultancy firm Hewitt Associates, while putting long/short equity in the same bucket as, say, global unconstrained equities is something that they recommend, in reality, many of their clients still look at hedge funds as a separate component of their portfolio.

Indeed, for pension schemes taking their first cautious steps into the space, it’s unsurprising that the traditional approach is often deemed to be the most appealing. Yet, despite this reticence, there is a growing recognition among the investor class that this way of classifying allocations into the sector may not necessarily yield the best results.
“It’s a model that a lot of pension plans still follow, but a growing number recognise that it’s still quite imprecise and doesn’t have the flexibility that allows opportunistic investing,” said Robert Howie, a principal at Mercer. And it's for this reason, says Aksia’s Dubrovay, that the strategy-based approach to allocation is one which is likely to gain prominence in the future.

“It [the approach] makes a lot of sense because what you’re effectively doing is loosening the constraints on the managers in the ‘alternatives’ portion of the various asset classes – you’re allowing them a bit more latitude and giving them more tools,” he says. “Well-known public funds in the US are definitely studying this approach, as are some endowments and foundations.”

So does this shift in the way that pension funds are allocating to hedge funds necessarily imply that schemes will be allocating more into the hedge fund space?

Certainly it seems to imply a growing understanding of the various facets and intricacies of hedge funds. As stated by Chris Keen, a partner at FoHF Culross Asset Management. “As people become more aware of the range of different outcomes that you can get from understanding the variations between different hedge funds, this logically leads to the use of more, rather than less, of the hedge fund toolkit.”

Likewise, Aksia’s Dubrovay, who believes that this strategy-based approach to allocation is a logical step to take “once pension funds become used to the ‘quirks’ of hedge funds”, anticipates a subsequent inflow of more capital into the hedge fund space, and into long/short equity in particular.

PiRho’s Ralston, however, remains unconvinced. While she agrees that such a method of asset allocation is likely to lead to a more diverse approach to investment and a greater understanding among pension funds of precisely why they are using certain assets and asset classes, this does not, she believes, necessarily suggest that allocations to what most would deem ‘hedge funds’ will increase.

She explains: “What is more likely to happen is that we’ll get more allocations to hedge fund-type strategies – but not necessarily in the hedge fund wrappers.”

The road to alpha never did run smooth, however, and so while the non-traditional approach to investing in hedge funds – or rather, hedge fund strategies – clearly has its advantages, there are still a number of factors that any pension fund looking to implement this approach to allocating should take under consideration.

The growing popularity of this particular allocation style can cause problems in itself. “While I think the idea of including long/short hedge funds in the traditional equity buckets is philosophically sound, from a practical standpoint, as more investors come into the long/short space to replace long-only dollars, the good managers will reach capacity and pension funds can potentially end up investing with second-tier managers,” warns Aksia’s Dubrovay. “This is where, without the proper advisor, they can run into problems.”

The practicalities of this approach must also be taken into account, says SBCERA’s Perry. “You have to think about the diversification aspects and consider the question, ‘how are we going to build this?’,” he said. “It’s a matter of resources as well – many clients may not have all the required resources in-house and so may have to look towards third-party providers for, for instance, operational due diligence and ongoing monitoring aspects.”

As the hedge fund industry slowly begins its ascent towards the all-important $2trn mark, and expectations of future performance for the sector grow ever more optimistic, it’s likely that an increase in institutional mandates will follow.

What’s more important, however, is that large institutional investors like pension funds today not only have more confidence in the hedge fund industry but are investing time into truly understanding the sector. It’s a trend that clearly demonstrates just how much attitudes towards hedge funds are improving, and a positive sign for future inflows.

THE APPEAL OF DIVERSIFICATION

Of the various ways in which pension funds are now implementing the strategy-based allocation approach, investing in long/short equity as part of an equities allocation is steadily emerging as the most popular. With an estimated $1trn worth of US pension fund assets said to be looking for a better way for their equity allocations to be managed, it’s an area that clearly holds a great deal of opportunity of hedge funds.

As more and more pension funds that have traditionally allocated to long-only equity begin to add long/short to their equity portfolios, Carrie McCabe, founder of independent advisory firm Lasair Capital and formerly CEO of FRM Americas and Blackstone Alternative Asset Management, explains the driving forces behind the strategy’s growing appeal.

Down-side protection
“The global equities markets fell in dramatically in 2008, and while the sector did experience gains in 2009, this still wasn’t enough to enable investors to fully recover the losses of the previous year, primarily because they had lost principal value. Unlike long-only equity, long/short equity protects on the down-side and provides significant value, particularly in volatile markets.”

Performance
"Over market cycles, we expect hedge fund managers to outperform traditional long-only managers – over the past decade (through end of 2009), the Credit-Suisse Tremont Index has outperformed the S&P 500 by 7% on an average annual basis. That said, this performance is, of course, dependent upon choosing the right managers."

Talent pool
“Hedge funds are not an asset class; they are essentially a format for managing money, and some of the most talented asset managers in the world only manage money via a hedge fund format. Excluding hedge fund strategies from their equity portfolio means that a pension fund will, by definition, also be cutting out these top managers.”

Flexibility
“Being a format, hedge funds have a broader toolbox at their disposal in comparison to a traditional long-only manager. They are much less constrained, and so can be far more flexible and tactical in terms of looking for opportunities, something that is crucial in the current volatile markets.”

Leverage
“The dynamic nature of hedge funds means that they can prudentially use leverage in response to the changing nature of the market, something that long-only managers are unable to achieve.”