As hedge funds continue to win a measure of acceptance from pension funds and other institutional investors, they seem set to change the dynamics of the relationship between consultants and their pension fund clients.
Across the board, consultants are finding that their larger, more active clients are expressing curiosity about hedge funds, although there is a long, long way to go before they are generally accepted as an investment vehicle by institutional investors. They are still largely a retail product, with 75–80% individual investors.
On the plus side for institutional investors, there is evidence that hedge funds can diversify risk in an equity portfolio. They also offer low to medium correlation with bonds and equities, yet with similar returns. At a time when equities are falling, this is appealing (although whether these low correlations are sustainable during a period of market decline is not assured). However, the riskiness and lack of transparency of hedge funds are obstacles to winning consultants’ and trustees’ acceptance. “There is a suspicion that the sort of activities that hedge funds get into are not appropriate for pension funds if they were investing directly,” says George Henshilwood, partner in the investment practice at Hymans Robertson. “And their lack of transparency doesn’t help.”
An educative process is still going on. “We have been raising the issue in our investment strategy reviews,” said Andrew Barber, senior consultant at WM Mercer. “If the trustees are reluctant, we do not push the issue. But broadly people are aware of the issues now, where two or three years ago, most had not heard of them.”
The funds that have been most interested are those that manage their funds actively, says Bob Collie, director of consulting at Frank Russell. “For those funds that are looking to add value through any means, hedge funds can be very rewarding. So we are giving them a cautious endorsement.”
“We are not making a blanket recommendation,” says Stephen Oxley, senior investment consultant and head of the hedge fund area at Watson Wyatt. “Our recommendations are connected with the individual client, taking into consideration where it makes sense in terms of asset allocation and in terms of the decision-making process within the fund.”
“A few clients have dipped their toes in the water and that’s all,” says Henshilwood. “The big decision for UK pension funds is how much should be invested in equities and how much in bonds. In terms of alternatives there is more confidence in property and private equity. Where the client cannot countenance property, then hedge funds may be some alternative.”
Other consultants agree. They all have a few clients who have taken small positions. “We have seen increased awareness and a one or two clients have made hedge investments,” says Mercer’s Barber.
One difficulty is in the way hedge funds are classed by institutional investors. “They don’t fit in the natural classification,” says Henshilwood. “In practice, hedge funds get lumped with private equity, but this is not a natural fit,” says Collie. Often they are considered as an alternative to property. According to Oxley at Watson Wyatt, hedge funds do not constitute their own asset class but rather fit into a group of alternative investment approaches that trustees should be in a position to consider, especially as they move away from their equities bias in line with the recommendation of the Myners report.
Before hedge funds win wider acceptance among consultants and their clients, many issues in their structure and management also need to be resolved, according to general consensus. One of the major problems is infrastructural, with real concern among consultants about the depth of the hedge fund industry. There is definitely skill and talent out there, but as Barber points out, “there are an awful lot of poor entrants and it would not surprise us if a number of horror stories emerge”.

Another concern is with the capacity of the industry. As investment in hedge funds grows, asks Oxley, “can the industry cope with the growth in assets, or will we see a dilution in skill?”
There is also suspicion about measurement and performance track records both in a sector-wide level and on an individual level. “So many funds have gone by the wayside,” points out Hyman Robertson’s Henshilwood. There is a feeling that if you assess the industry, taking into consideration those hedge funds that did not survive, the overall record is pretty poor.
In addition, the quality of documentation on individual hedge funds remains variable. “Hedge funds are not used to institutional investors,” says Oxley, and lack of transparency is a huge issue. Most are still quite short-lived, so historic returns are not necessarily valid, and the range of returns for any individual fund tends to be enormous. Their complexity also makes them hard to track. They engage in a variety of investment strategies, often chopping and changing short-term strategies and using exotic instruments, and they are usually domiciled offshore.
Finally, says Henshilwood bluntly, “the fees are ludicrous”. The high fees, often combining annual fees plus a percentage of the profits, are an incentive to the manager to take risks. “For a typical mandate, the interest of the pension fund and the mandate are allied – but this is not necessarily the case with hedge funds,” he warns.
Yet, despite all these difficulties, sometimes reasons to invest outweigh reasons not to. All the major consultants are recommending that those clients interested in the sector get in through a fund of funds approach. “Even though this means introducing an extra layer of fees, it is the only sensible way. Cherry-picking one or two is not feasible,” says Henshilwood. A fund of funds approach diversifies risk and adds a extra layer of due diligence to the process. In addition, “trustees cannot monitor individual hedge funds – they have to delegate,” says Barber at Mercers.
Selecting a manager of a hedge fund of funds is also a complex matter. The same concerns apply as to the hedge fund industry as a whole. “They have to have a reasonable amount of experience, access to the better vehicles, strength and depth of staff and appropriate statistical tools.They need to demonstate a diligent monitoring process along with the willingness and ability to alter the mix of investments rapidly and responsively,” says Barber.
Most consultants have been compiling some kind of rating list, and the industry consensus is that Watson Wyatt is the farthest along. Oxley says the firm has met with a number of managers and has done on-site due diligence on around 40 managers. They are looking for a well-managed business, with a plan for growth. “There is a lot of money coming in. Hedge fund of fund managers need to think about how they can grow their business sensibly,” Oxley warns.
The complexity of hedge fund investment looks set to further develop the role of consultants, according to Oxley and others in the industry. “I think we will see consultants becoming more involved. Trustees will be delegating some investment decisions to consultants.”
Collie at Frank Russell agrees. “Our line is that we cannot consult on the implementation of a hedge fund strategy the way we do on others. The role of the consultant within the implementation of a hedge fund strategy is very different. We can offer advice strategically but not on implementation.” For this reason, Russell launched its own hedge fund of funds out of Dublin around six months ago. “If you want our expertise, this is how you get it,” says Collie.
Stephanie Schwartz-Driver is a freelance journalist

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