Pension fund investment in hedge funds is predicted to rise significantly over the next five years. However, a new breed of product needs to evolve in order to meet their specific requirements.
Institutions are relatively recent buyers of hedge funds. But industry watchers, some of whom might have a vested interest, are predicting that more that 50% of net new inflows will be coming from institutional investors, bringing an additional $250bn (E201bn) over the next five years.
In the European pension fund industry, appetite for hedge funds is predictably lower than that of the US. But it is also predicted that it will increase – mainly through fund of hedge fund investments. This represents a tiny proportion of all institutional assets, but is a large figure for the hedge fund industry.
There are, however, some factors which make institutions reluctant to enter the hedge fund market. For a start, there is a perceived poor risk/return balance – the personal risks taken by trustees when authorising hedge fund allocations could outweigh the potential corporate benefit. Potential returns may be outweighed by the ‘headline risk’ of a market or fund blow-up, especially given the poorer returns posted in 2004. This is compounded by ongoing concerns about high fee levels.
Then there is the comparatively small allocation which can be made to hedge funds. This may be insufficient to make a meaningful difference to overall fund returns. Could governance time be better spent on other areas of the fund?
If large amounts of institutional money does materialise, commentators question the benefits for the hedge fund industry. Funds could become shackled to strict definitions of investment styles as institutional investors demand inappropriately fixed investment strategies to include hedge funds into their risk-managed portfolios. Institutional investors may also negotiate lower fees and make employment with hedge funds less attractive for talented managers.
Thirdly, the influx of money may dilute the talent pool as the capacity caps, which many funds use in order to perform well, allow incoming capital to trickle down to less-talented managers. Studies also show that many institutions would be satisfied with a lower rate of return if it is expressed in terms of the risk-free rate rather than absolute figures.
So, a two-tier hedge fund system could be on the cards. A ‘classic’ hedge fund is offshore based, lightly regulated and virtually unconstrained in the range of instruments and leverage it can use. None of these factors are required by pension funds, which are just looking for an investment aiming to deliver an outperformance over cash of around 4-5%, uncorrelated with other investments.
In the new model, the ‘classic’ product continues to be run in an unconstrained way at high and increasing fees for investors who are more focused on return than risk. A new product enters. This is the hybrid child of hedge funds and long-only management, using hedge fund techniques to give more freedom in a risk-controlled product and to deliver a solid return after fees.
In order to support the effective marketing of these funds, hedge fund indices would ideally be clearly segmented according to the risk profile of funds, rather than the current method of labelling indices by strategy. This would give a clearer basis for comparison and articulation of expected results. A new set of labels based on the actual investments made by the fund could also help cut through the jargon which makes hedge fund investing so difficult for outsiders – what, precisely, does ‘global macro’ mean?
Funds specifically designed for pension funds need higher levels of client servicing and reporting. Hedge funds would have to be more transparent, in line with funds’ reporting requirements, so a higher degree of trust should exist between the fund and its investors than is often the case with hedge funds. They may also need to offer information in a format that each pension fund administrator to use.
The new breed of funds would also have fee structures which reflect the less aggressive expectations and the different style of investment expected. Currently, hedge funds are designed for nimble investors who are continually performing a high level of monitoring and are willing to move fast. Their fee structure, with a high basic rate and an additional performance levy on all performance over zero percent, is justified by assertions that investors will only be there as long as the fund is visibly performing.
Pension funds will often have a longer decision-making cycle and so will tolerate short periods of underperformance; they will also be making relatively large single investments. But most importantly, when they are looking for a more controlled risk level they should expect to pay appropriately lower fees.
What we are outlining here is a new breed of product. This will allow pension funds to diversify across a new range of investments – but one trustees can understand, and where they feel comfortable with the risk and return profile. And hedge funds can continue to run free, less constrained by specific client requirements. This new breed would probably benefit from a new name. Suggestions welcome.
Catherine Doherty is a principal at consultants Investit in London, where she heads up the systems practice. She is also the co-ordinator of the Investit Intelligence service

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