‘More talk than action’ is a comment often made during discussions about hedge funds for European pension funds. In this article, I would like to present the perspective of a pension fund trustee on this topic. The conclusion will be, in short, that the debate about the use of hedge funds in pension funds needs to make funds move on a degree. The question is no longer whether or not you ‘believe’ in a ‘mysterious asset class’ but what hedge funds strategies can do for the long-term risk/return profile of your assets. Also: How can a well-defined alpha strategy contribute to your liability-matching strategy?
People are often surprised when I tell them about our practical experience with hedge funds as trustees of pension schemes. And indeed, some (but not all) of the experiences have been quite positive in recent turbulent times. However, it is early days, and much better communication is needed between the hedge funds industry and pension fund boards.
Where do we stand with hedge funds in pensions? It is being reported that there are over $500bn (E500bn) invested in hedge funds globally, spread over 5,000 different hedge funds and a broad range of strategies. It is also said that the share of institutions is roughly 30% and rising. These are, of course, not all pension funds. More specifically, recent surveys show only a 1% to 2% average allocation to hedge funds in European pension plans, and it seems to be quite concentrated on a small number of plans.
What is the way forward? Are hedge funds a good investment for pension funds? The arguments pro and con institutional hedge funds investing are often repetitive. This is not the place to discuss the points in favour of hedge funds in detail. Some arguments have financial logic, for example the greater investment universe available to hedge funds manager and also the greater flexibility, eg, through the possibility of shorting and the use of derivatives.
However, I get more concerned when people talk about all the superior investment talents suddenly mushrooming in this industry. And I become rather nervous when I see some pension experts recommend hedge funds simply by projecting (favourable) five year statistics into the future. Indeed, some mandate specifications with institutions seem to feed unreasonable expectations (such as double-digit return figures with single-digit volatility) and thereby ask for trouble sooner or later.
The argument that always beats the layman is that alternative asset classes are ‘non-correlated’ with traditional asset classes and, therefore, offer strong diversification benefits. This cannot be denied but low correlation is neither a necessary nor sufficient condition for inclusion in the list of pension assets. The real question here is, of course: Are these diversification benefits better than those of other asset classes, including cash or bonds? To sum it up: it is time to sift the arguments pro hedge funds.
It is not the job of pension plan boards to rush into little known territory. On the other hand, one can argue that their fiduciary investment duty includes the assessment of new asset classes. This is the route the Myners review has taken in the UK. When you ask people why they are not invested in hedge funds (yet), the answers often refer to: ‘lack of time’, ‘bigger issues at the moment’, ‘the investment consultant has not brought it up yet’, ‘we are too small’, ‘see what other funds do first’, and so on. This won’t be good enough in future.
More seriously, many people in institutional investment have expressed their reservations about:
o short history and questionable statistics;
o insufficient transparency;
o regulatory issues (off-shore vehicles);
o administrative peculiarities (eg, trading);
o excessive fee levels and asymmetric incentive structures;
o concerns about the fragmented industry with unknown players and a high drop-out rate; and
o weak reporting, unclear definitions, and the industry jargon in general.
I appreciate that the hedge funds industry has started to tackle most of these points. Some hedge funds managers now seem to have gone a long way with their understanding of the concerns and the requirements of institutional investors. A lot of work still needs to be done to become more (pensions) client-orientated but I am sure it can be done, and will be done.
After all, the hedge funds industry itself is maturing and has probably seen the best of the high return/high margin world already. Pension funds always found it difficult to beg for an investment slot with a small new shop in bull market spirit. In short, it will become much more of a buyers’ market than in the past.
Looking forward, the bigger challenge seems to me the following: How should we look at hedge funds in terms of strategic investment and risk management? In the panel above, the key questions that should be asked are listed.
I believe hedge funds will have a bigger role to play in pensions investing. There is some academic support and there are some successes in practice. However, it is time to move on from the years of jargon and pseudo-science. Just promising “equity-like returns with bond-like volatility” won’t help.
Pension plan boards can’t afford hoping for miracles from hedge funds. But they are certainly interested in well-defined, risk-controlled strategies that add to absolute returns in an environment of low nominal economic growth and high market volatility. The challenge is to align hedge funds strategies with scheme-specific objectives, in particular matching pension liabilities.
There is still a lot of groundwork to be done by investment managers and consultants. For trustees, this clearly poses a new challenge for their investment governance.
Georg Inderst is an independent trustee and director at Law Debenture Pension Trust Corporation in London

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