When public sector pension funds take decisive, almost revolutionary, investment decisions it is time the private sector sat up and took notice. Last September the California Public Employees Retirement System (CALPERS), America’s largest public pension fund, announced plans to invest $11.25bn (e11.1bn) in hedge and other ‘hybrid’ investment categories. Soon after the British Coal Pension Fund decided to increase its exposure to alternative investments from 3% to 5%. These decisions mark significant changes in attitude towards hedge and trading funds as well as other forms of alternative investment.
The benefits of ‘alternative investments’ are available to all institutional investors provided they exercise due care and diligence in formulating their policy. They are not the sole preserve of large, American or public sector pension funds.
The typical European pension fund enjoyed double-digit rates of return throughout most of the 1990s, a period of noticeable but declining price inflation. In most cases this has been done through investing in equities and bonds, which have a relatively high level of correlation with each other. At the back of investors’ minds is the nagging doubt that this cannot go on for ever. European interest rates have recently risen by a small amount from historically low levels and price inflation is almost non-existent. What prudent steps can be taken to preserve the significant gains of the 1990s in the event of an unexpected increase in inflation, without simultaneously jeopardising the possibility of making even further gains if inflation remains dormant?
Clearly, investments that are not correlated with the traditional equity and bond markets will fulfil that role. In practice, if such investments are related to the traditional markets with which investors are familiar, such as equities, bonds, interest rates and currencies, then this familiarity will increase the comfort factor.
Traditionally, high-net-worth individuals have been the keenest investors in equity hedge and trading funds. Their investment approach is far more aligned with achieving absolute rates of return than is the case with institutional investors. Historically, institutional investors have been more concerned with the effects of inflation on their liabilities, hence the need to invest in assets that have the best chance of counteracting the impact of inflation. As we are now in a period of almost zero inflation worldwide inflation is less of an issue and, possibly, the fears of market corrections are uppermost in investors’ minds.
So, why should pension funds include equity hedge and trading funds in their portfolios? Statistically, such funds have shown near zero correlation with equity markets and bond markets (see table). They exhibit low volatility comparable with bond markets but have produced long-term returns more akin to equities. They provide a further form of portfolio diversification which, in the event of major market corrections, will provide stability and minimise the losses that would be experienced.
A number of these funds are highly leveraged and aim to produce spectacular rates of return, usually with a correspondingly high level of volatility. As these are entirely contrary to the fundamental tenets of stewardship of pension fund assets they will be disregarded. There are plenty of funds available that have low or zero leverage. Such funds seek regular annual returns in the range 12–14%, with low volatility.
In practice, choosing specific equity hedge and trading funds is no different from choosing a traditional fund manager – except that there are more of them. It is a rapidly growing market and of the 55,000 individual funds and fund managers that we monitor nearly 5,000 are equity hedge and trading fund managers. We treat those funds and fund managers like individual stocks, buying and selling them as needed to build multi-manager portfolios. For all but the largest institutional investors this approach takes the sting out of the research and due diligence required to invest sensibly in equity hedge and trading funds. It also ensures the two prime requisites – low volatility and almost zero correlation with traditional markets.
Further increases in US interest rates might be the catalyst for significant market corrections. Increases in US bond yields in 1987 and 1994 certainly had that effect worldwide. For those of a cautious disposition partial diversification into equity hedge and trading funds will reduce and soften the blow if it happens.
What evidence is there to show that what is required will actually be provided? Three examples, all expressed in terms of Deutschmark/euro returns, demonstrate what has happened in the past to the world’s major markets (see Figures 1–3). They are compared with the US-based index provider Managed Account Reports’ Trading Advisor Qualified Universe Index, which reflects the price movements of a broad range of hedge and trading funds. The results in sterling are the same relatively but on an absolute basis are only slightly different. In all three cases the MAR index produced a positive rate of return for the quarter.
The important point of these examples is that not only can losses be avoided but, unlike money placed on deposit, which will earn a modest return, these investments continued to earn the type of return we have grown too accustomed to receiving on equity investments.
David Duncan is director, institutions at Global Asset Management in London

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