In a climate of low interest rates and low growth, pension funds are finding it increasingly difficult to earn a reasonable return without an unacceptable increase in risk. A bull market in equities is now a distant memory, and returns from equities and bonds continue to converge.
This is creating problems for second-pillar pension schemes in countries like Switzerland, where pension funds have to meet a required rate of return. In Switzerland, notably, occupational schemes are required to produce a return of 4% net. Yet in the first half of this year, according to the Pictet-BVG index, they managed a paltry –0.7%.
Heinrich Wegmann, chief executive officer of Credit Suisse Asset Management in Switzerland, suggests that this is the main reason behind the strong interest pension funds are showing in alternative investment products such as private equity and funds of hedge funds.
Wegmann points out that modifications to the BVV2-Anlagevorschriften, the regulatory regime for Swiss occupational pension schemes, will have accelerated this process. The modifications, which came into force 18 months ago, are an attempt to make the regime more flexible by including alternative investments, such as private equity, commodities and hedge funds, as permitted investment instruments.
Some European pension funds now see alternative investments as the answer to all their problems. Roland van den Brink, managing director of the e13bn pension fund of the Dutch heavy industry union PMI, says: “Hedge funds are now seen as a magic tool, the way to get high yield without risk.” The main driver, he believes, is higher returns rather than control of risk: “Return is the key. If you diversify your alternative investments you can get returns of 5–8%. You cannot expect that from bonds and equities.”
However, van den Brink warns that the role of hedge funds will always be limited, and that they are unlikely to represent more than 5% of a pension fund’s portfolio.
The level of demand for hedge funds is hard to gauge. A survey by Dublin-based research consultancy Sector Analysis suggests that at the end last year, European financial institutions had invested around $41bn in hedge fund vehicles. They concluded that European investment is broadly at the stage of development that the US hedge fund industry was at 10 years ago.
Hedge fund holdings as a percentage of total assets under management are still modest. Sector estimates that European financial organisations allocate on average 1.3% of their total assets under management to hedge funds. However, this is likely to increase to above 5% in the future
Sector predicts that the hedge fund holdings of European financial organisations could increase fivefold to $220bn. New users are expected to invest around $69bn of this total.
Most of this (78%) will come from the largest pension plans and insurance companies. These organisations are looking for low-risk vehicles and are likely to focus initially on market-neutral strategies. The hedge fund industry hopes that these low risk vehicles will act as a Trojan horse for the acceptance of other hedge fund strategies – principally, global macro, event-driven, long-short, currency and systematic.
The European pension fund market for hedge funds is currently dominated by one country – Switzerland. According to the Watson Wyatt/Indocam survey of 196 European pension funds last year, Swiss pension funds invest on average about 1.3% in alternative investments. Outside Switzerland, alternative investments are far less popular and represent significantly less than 1% of the total pension funds.
However, this picture could change in the next few years. The London-based hedge fund consultancy Asterias surveyed 96 funds earlier this year and found that half of the funds in Denmark and Norway, and more than a third of those in the UK, are looking to increase their exposure to alternative investments. Interest in hedge funds is also growing in France. Asterias estimates the current assets invested in French hedge funds and private equity funds is close to e50bn.
Inevitably, the largest funds are most likely to invest in alternative, non-traditional vehicles. The e3bn Vorsorge, the pension find of ABB’s Swiss operations, is planning to make a strategic allocation of 4% to hedge funds next year.
Christoph Oeschger, managing director of the Baden-based fund, says that the aim is not to increase returns but to achieve a low correlation with existing assets. “The implementation should take place within the second quarter of next year, when we will implement a broadly style-diversified hedge fund product. The goal is to reach a better risk profile,” he explains. ABB Vorsorge has not yet decided on a fund manager.
Another substantial Swiss fund, the e3bn Basellandschaft Pensionskasse (BL-PK), is also planning to increase its exposure to alternative investments. Earlier the preliminary asset liability study from the Bern consultancy Dr Claude Chuard recommended a 15% allocation to alternatives.
Hans Peter Simeon, investment director at BL-PK, says that the fund has yet to decide on the allocation. “BLPK is currently in the process of defining a new strategic asset allocation. Until now, no decision has been made on new investments in private equity, hedge funds and commodities. The decision on the new asset allocation depends mainly on the final version of the asset liability study, which is expected to be available by the end of November.”
The Swissair airline pilots’ pension fund; VEF is increasing its allocation to alternatives. as part of its ‘Getting to Yes’ investment strategy of increasing investment in ‘non-traditional’ vehicles – private equity, hedge funds and ‘various investments’, mainly within the SAir Group parent company.
VEF’s strategic allocation in non-traditional investments increased from 10% in 1999 to 20% last year, comprising a 5% investment in hedge funds and a 15% investment in private equity. It plans to double hedge fund exposure to 10% this year, funding the move from its 8% exposure to bonds.
Unlike VEF’s private equity investment – where the aim is higher than equity yields – the aim of hedge fund investment is ‘de-correlation’ or investing in assets that do not move with the market. VEF says the aim of the hedge fund portfolio is to “hold an investment whose development is as independent as possible of those of other investment vehicles”.
Outside Switzerland, pension funds are looking to hedge funds for similar ‘decorrelation’. ABP, the Dutch public employee pension fund, plans to invest between 1% and 2% of its assets in hedge funds, first through a fund of hedge funds, then directly. In Sweden, AP-7, the default fund for the Swedish Premium Pension scheme (PPM), plans to investigate the possibility of investing up to 5% in hedge funds and private equity. In Finland, Varma Sampo, the country’s largest pension and insurance group, also plans to allocate up to 5% of its portfolio in alternatives with 3% in private equity and 2% in hedge funds.
The different legislative environments in which European pension funds operate will largely determine the extent to which they can make use of hedge funds. Some countries have discouraged speculative investment vehicles with restrictive definitions of admissible investments. Others have actively encouraged it. In Ireland hedge funds have been authorised and listed since December 1999. In France the authorities have created OPVCMs, with a minimum e500,000 investment subject to flexible investment restrictions.
However, the most spectacular growth of hedge funds has been in Italy where the fondi speculativi, introduced by law in 1999, are now beginning to attract interest. With a minimum investment of e1m, these funds are aimed at a segment of the high-net-worth market that wants to diversify into uncorrelated assets.
Institutional interest is also likely to grow as legislation is relaxed. A recent survey of institutional investors in France, Germany, Italy and the Benelux countries, by UK Invesco Asset Management revealed that the vast majority (91%) believe that alternative investments, and particularly hedge funds, will continue to grow in significance,
Certainly the market thinks so. One current estimate is that a new hedge fund or fund of funds opens every day in Europe. So someone must be buying.

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