Knowing what lies behind hedge funds

Dutch pension funds are increasingly adopting diversification strategies, according to WM Performance Services' Universe of Dutch Pension Funds. Private equity, commodities and hedge funds yielded 32.6%, 28.7% and 14.1% respectively during 2005, reflecting the success of alternative investment classes, said WM.

Owen Thiers, director at Citigroup Alternative Investments, says it is clear that alternative investments are a significant growth area for Dutch funds. "But what strikes me the most is the range of alternative investments that are being used in the Dutch market," he says. "A few years ago the main alternative investments were property, private equity and maybe some absolute return funds, whether hedge funds or not."

Pension funds are rethinking their portfolio allocations in order to find new ways to get the appropriate risk return. This has led to an explosion in the options available to funds; what Thiers calls "alternatives to alternatives".

He says: "Whereas a few years ago property investment was in the Dutch market, there is now an amazing amount of interest in property in Asia Pacific, particularly India and China. There are also overlaps between property and private equity investments as the strategies are very similar.

"In fixed income, investors are looking outside their typical Lehman aggregate allocations and are looking at municipal bonds in the US and asset or mortgage backed securities."

One of the drivers of the growth in alternative investments is the historical imbalance of portfolio allocations - these were too concentrated in public equities. The downfall in the equities markets made this very visible, he says.

Egon Tibboel, director of the institutional investors division at KAS Bank, says alternative investment activity by Dutch pension funds is on the rise and the share taken by alternative investments in asset portfolios will continue to grow. "Pension funds look to alternative investments in order to increase both the diversification and performance of their portfolio," he says. "Hedge funds - which is now a generic term for a wide array of investment activities in which, or so it seems, nothing can be excluded - and private equity are the main vehicles of interest."

Changing demographics (an aging population plus increasing longevity), developments in accounting practices, including IFRS and IAS 19 and the new regulatory framework nFTK in the Netherlands have all compelled pension funds to explore alternative investments, says Tibboel. "These issues also force pension funds to reform their operational methods, good governance practices and perhaps even more important: to adjust their risk profile."

Ross Whitehill, chief operating officer at custody risk rating company Thomas Murray, says there is a greater appetite among Dutch pension funds to invest part of their portfolio in alternatives such as hedge funds, fund of funds and commodities. Like Thiers, he points up the sheer diversity of these investments: "The challenge is to define what exactly an alternative is. The take up among Dutch pension funds, and pension funds globally, is becoming very, very diverse. Dutch pension funds generally follow the same investment strategies as those in the UK and more and more of these funds are allocating up to 5% of their portfolios in alternatives. Some will scope beyond that."

This shift in focus is having an impact on securities services providers. John Gout, senior sales manager, Benelux at ABN Amro Mellon says there is an increasing investment in OTC derivatives, which is putting a strain on back and middle offices, particularly in terms of regulatory reporting. "Pension funds are becoming interested in what lies behind the hedge fund and are demanding more transparency," he says.

It is now a ‘given' that custodians can deal with alternative investments, says Gout. Pension funds don't have the money to invest in the IT necessary to deal with these instruments and will outsource administration to custodians.

"The small to medium pension funds, with between e50m-e1.5bn in assets under management are the most likely to outsource alternative investment fund administration. These institutions don't have the economies of scale to do it themselves," he says.

Industry consultancy KPMG agrees with this assessment. In its July 2005 report into the offshore hedge fund industry, for example, it said administration was becoming increasingly specialised, technology intensive and more demanding in terms of information dissemination and real time pricing.

The report said: "Market feedback suggests that clients are increasingly demanding wider service offerings which include performance measurement, risk management, middle-office strategies, tax, legal and financial reporting. If the market follows the classic maturity model exhibited by many other industries corporate activity is likely to occur as the specialist providers seek to combine to achieve scale while the existing large players seek to add in more specialised functionality, service and cross border coverage."

Any large fund administrators that are lacking expertise in hedge fund and alternatives administration are buying third party providers. In February this year, JP Morgan Worldwide Securities Services acquired the middle and back office operations of Paloma Partners Management Company, part of a privately-owned investment fund management group, based in the US.

The bank had earlier acquired Tranaut Fund Administration and has pooled the two acquired companies into JP Morgan Hedge Fund Services, which will offer hedge fund operations and administration services.

Similar acquisitions include Bisys' 2002 takeover of Bermudian player Hemisphere and Citigroup's deal with Forum Financial Group.

Tibboel says the services offered by custodians reflect the growth in alternative investments. "Custodians such as KAS Band have geared up their services to include risk management and risk mitigation capabilities to counter the increased risk produced by alternative investments. By virtue of their function as a collecting point of information flows coming from the pension funds themselves, their asset managers, brokers, and other agents, custodians are well positioned to monitor risks and to mitigate these risks through services such as asset rebalancing, currency and duration overlay products."

Performance management delivered by an impartial custodian helps the managers of a pension fund to assess the (relative) success of investment activities and allows fair comparison with pre-determined benchmarks and peer groups, says Tibboel.

"As a result of the shift in emphasis to hedge funds and private equity, we have also experienced noticeable growth in the areas of transfer agency services, integrated fund administration and registrar services."

KPMG predicts that alternative investments such as hedge funds will grow as part of an holistic solution to achieve absolute returns. "[Hedge funds] are perceived to complement, not compete with, other asset classes. That said, there are widespread concerns about high charges, opaque strategies and absence of governance structures."

In the meantime, securities services providers will continue to invest heavily in order to position themselves as providers of alternative investment administration services.