UBS pension funds report examines impact of hedge funds
UK pension funds and other institutions are increasingly awakening to the diversification benefits of hedge funds, according to a new report by UBS.
The detailed report, entitled 'Pension Fund Indicators 2005', includes research on hedge funds and derivatives in the context of pension fund portfolios.
The following is extracted from the section on Hedge Funds:
"What exactly are hedge funds? Narrowly defined, they are unregulated private pools of capital that have the ability to use leverage and take both long and short positions, mainly in publicly traded securities and derivatives.
However, some groups expand this definition to include commodity trading advisors (CTAs), distressed debt funds that are basically long-only, non-hedging equity funds employing leverage, and short-only funds. Consequently, different industry observers reach disparate conclusions regarding the number of funds and total hedge fund assets.
According to data from Hedge Fund Research (HFR), over the past ten years, hedge fund assets have been expanding at a rate of about 19 per cent per year. Interestingly, the net number of hedge funds has grown at only 13 per cent annually, while funds of hedge funds (FOHF) have multiplied at a record 19 per cent pace, with thousands of new vehicles being added in 2003 and 2004. HFR estimates there are roughly 5,800 hedge funds and 1,650 FOHF as at the end of 2004, representing USD 975 billion in assets.
Key to the industry's ascent has been the rapid growth in the assets under management in FOHF, which have grown from approximately 17 per cent of the total in 2000 to over 50 per cent at the end of 2004, by some estimates. The FOHF share of the hedge fund market is expected to continue to grow strongly, driven by a number of factors, including:
• Regulatory developments enabling the offering of hedge funds to retail investors (mass affluent and high net worth) in Europe and Asia.
• Increasing allocations by early institutional adopters, driven by the prospects of lower future returns from traditional investments
• First-time institutional investors seeking diversification, embedded advice and greater liquidity
• Inflows to FOHF also continue from ultra-high net worth clients through the offshore private banking sector.
During 2004, USD 129 billion flowed into hedge funds according to Tremont Advisers' quarterly funds flow report. This record influx was 70 per cent larger than the impressive USD 72 billion inflow seen in 2003, and the vast majority came from institutional investors.
As investors pour money into the industry, observers believe that the age of the average hedge fund is decreasing, due to a growing number of new fund startups, but at the same time, the number of funds going out of business may also be accelerating, due to the higher percentage of mediocre managers. This, some analysts believe, will further polarise the market into skilled and unskilled managers.
STRATEGIES AND PERFORMANCE
The hedge fund arena can best be dissected via a strategy and sub-strategy nomenclature, although one should note that classifications vary and many funds employ multiple approaches.
'Equity hedged' is the broadest category, in which managers strive for alpha (excess return) through superior sector allocation and stock selection. These funds buy stocks perceived to be undervalued or otherwise desirable, and sell short overvalued or undesirable ones, attempting to produce profits regardless of market moves. This category can be divided by market exposure (short bias, neutral, conservative, aggressive), sector (technology, energy, financials, healthcare, etc.), or other means such as capitalisation, geography, or style.
'Event-driven' funds invest in companies where corporate events such as mergers, restructurings, or bankruptcies are catalysts for a performance opportunity. For example, merger arbitrageurs typically buy shares of a target firm and sell short those of an acquirer to lock in a guaranteed profit - provided, of course, the deal is consummated.
'Relative value' funds pursue arbitrage opportunities by buying securities and selling related issues short.
Subcategories include convertible bond arbitrage (buying the convertible bond and selling short the underlying stock), fixed-income and mortgage-backed security arbitrage (involving spread plays between instruments of different credit quality, maturity, or other features), and statistical arbitrage (using mathematical/statistical models to buy and sell baskets of securities simultaneously).
'Trading' funds seek profit from discretionary or systematic trading techniques. Examples include global macro (allocating top-down to any or all world asset classes long or short), managed futures (buying and selling futures on commodities, indexes, and rates using mechanical rules), and emerging markets (buying and selling, where possible, the typically illiquid debt and equities of developing nations).
Figure 1 (see end of article) shows performance in US dollar terms of hedge funds by strategy over the past ten years, computed by HFR. A cursory observation suggests that hedge funds moderately trail the S&P 500 Index in bullish markets, whereas in bear markets, hedge funds protect capital and in many cases offer uncorrelated, positive results.
However, several important statistical considerations may diminish these reported results.
First, HFR indices are equal-weighted net return composites of over 1,600 active funds, yet only funds that report monthly numbers are included and their names are not made publicly available. Second, indices suffer from 'survivorship' bias, which some academic studies have shown to be as high as 3 per cent per annum for hedge funds.
This bias occurs when creating composites today of performance that occurred in the past - the indices include survivors and exclude losers. To its credit, HFR strives to minimise such bias by including all reported returns of defunct managers. Nevertheless, survivorship bias is hard to get around when funds with poor performance generally refuse to report their numbers.
Third, a study by Getmansky, Lo, and Makarov (March 2003) shows that hedge funds' returns may exhibit significant serial correlation due to illiquid pricing, thus implying that investors should use caution when evaluating index performance on a risk-adjusted basis.
PENSION FUNDS AS HEDGE FUND INVESTORS
According to Watson Wyatt's 2005 Global Investment Review, recent market underperformance, new accounting rules, and increasing funding deficits have forced many sponsoring companies to rethink the role and risks of their pension funds. Corporations traditionally classified their pension fund assets and liabilities as strictly off-balance sheet items; now, businesses are keen on comparing the risks associated with pension funds on an equivalent basis with all the other risks the company takes. The Investment Review concludes that as companies take this enterprise-level view of risk, pension fund allocations to equities will become less popular since the firms are already exposed to equity risk in their own core businesses. Instead, other diverse sources of risk and return are recommended such as active management and alternative investments, particularly hedge funds.
Ingrained in the UK's relatively developed investment culture is a distinct bias toward equity over bonds or other alternatives. However, with many British pension funds in deficit, old habits may be changing. A study by Mercer Investment Consulting of 360 large and small UK pension funds representing GBP 112 billion total assets indicated that respondents had cut their equity allocations from 68 per cent to 64 per cent and have increased their stake in alternative assets, seeking superior, diversified returns.
How active have UK pension funds been as allocators to hedge funds? In 2004, UK pension funds advised by Watson Wyatt allocated some GBP 1 billion to hedge funds, more than twice that pledged to property and private equity and four times the amount invested in 2003. And Mercer's clients have escalated apportionment to hedge funds from GBP 180 million in 2003 to GBP 760 million in 2004.
Nevertheless, a sense of hedge fund reluctance lingers.
Three recent studies in 2004 examined the issue of actual versus contemplated stakes in hedge funds. The JP Morgan Fleming study summarised in Figure 2 (see end of article) concluded that, although only 12 per cent had existing hedge fund holdings, some 40 per cent of respondents would consider investing. Pioneer Investments conducted a similar study of 94 of the largest UK pension funds, collectively representing GBP 77 billion. Only 16 per cent of respondents reported hedge fund allocations, though 33 per cent claimed to be actively considering an investment. While larger pension schemes appear more sophisticated and knowledgeable about alternative assets, mid-sized and smaller pension funds are still wary. The government's survey on progress in implementing the Myners Principles found that, although 27 per cent of the 1,580 pension funds surveyed considered including hedge funds in the last two years, only 7 per cent actually made the investment. Perhaps 2004 was a period of education for pension funds, and investments will flow into hedge funds in 2005 and beyond.
Assuming pension funds do approve alternatives in principle, what is the appropriate allocation to hedge funds? Consultants recommend a modest foray into hedge funds that should grow over a few years to the 5 per cent to 10 per cent range. Data from JP Morgan Fleming indicate that those UK pension funds that have chosen to invest have done so with serious commitments averaging 5 per cent of assets.
On the European front, the 2003 Goldman/Russell Global Report on Institutional Alternative Investing found that respondents made an average 3.6 per cent strategic allocation to hedge funds, and expect to increase this figure to 4.5 per cent of assets by the end of 2005. Pioneer also found that of those pension funds already invested, some 12 per cent plan to increase their holding by the end of 2005.
Hedge funds are not without risk, and often there are knowledge barriers to entry. Figure 3 (see end of article) summarises the main stumbling blocks expressed by UK pension funds hesitant to invest. The Pioneer study reported respondents' concerns with high levels of undefined risk, high fees, fear that hedge funds are just a fad, and inability to commit due to size. The poll also noted the greatest single obstacle to investing in hedge funds: 38 per cent of respondents indicated perceived lack of transparency, 22 per cent claimed performance risk, and 14 per cent were dissatisfied with the use of gearing. On the other hand, the two most important criteria for choosing amongst various hedge funds were, overwhelmingly, track record followed by length of time in operation.
In terms of strategy, global pension funds place their faith in long/short equity funds. Europe and US pension funds differ most remarkably in the event-driven and relative value sectors. Whereas 76 per cent of US pension funds embraced distressed debt hedge funds (which, coincidentally, had extraordinary results in 2003 and 2004), only 36 per cent of European pension plans made similar investments. As seen in Figure 3, European pension funds rely most heavily on relative value arbitrage approaches.
The data thus far suggest both opportunities and challenges for pension funds considering hedge fund investments. As noted, the exponential growth of the hedge fund industry is likely to produce a wider dispersion of performance between superior and average to inferior funds.
Meanwhile, the most desirable managers - including many new entrants with limited track records - are often oversubscribed at launch and will immediately close their doors to new money. This means that there will be a greater need not only to identify the best talent, but also to conduct due diligence rapidly.
On top of this, pension funds must grapple with other issues such as lack of transparency, management and incentive fees that are perceived as high, and liquidity constraints (such as withdrawals permitted only quarterly, frequently with a one-year 'lock-up').
Another potential issue historically has been the relative dearth of governmental oversight within the hedge fund industry. In October 2004, however, the US Securities and Exchange Commission voted in favour of mandatory registration for all but the smallest of hedge funds that cater to US customers, the result of years of discussion and debate on this sensitive issue of regulation.
Regulation of hedge funds in the UK by the FSA is currently relatively light and focuses on the authorisation and regulation of hedge fund managers located in the UK, rather than the funds themselves or the administrators, which may be offshore. The FSA continues to develop its approach in the light of the developments in the US and in Continental Europe.
In recognition of these factors, consultants commonly recommend that first-time hedge fund devotees invest via FOHF vehicles. Indeed, the Pioneer study showed that 86 per cent of UK pension funds that incorporate hedge funds do so through a FOHF, rather than selecting individual managers. In the broader European arena, 89 per cent of respondents in the Goldman/Russell Report use FOHF, up from 62 per cent in 2001.
Meanwhile, the use of consultants or externally managed accounts has decreased from 62 per cent to 50 per cent of respondents. On the downside, a FOHF charges its own fees on top of the fees it pays to the underlying managers. However, such fees may be well justified when considering the benefits provided. A FOHF can tailor a portfolio to the specific needs of the pension fund; provide due diligence, reporting, and performance calculation; and handle all research and allocation decisions. Critically, leading FOHF have strong industry networks in place and possess investments in managers that are closed to other interested investors. A FOHF can offer pension funds the needed expertise, guidance, and education regarding specific managers, strategies, or the industry as a whole.
In conclusion, hedge funds present significant opportunities for investors. Early indications are that UK pension funds and other institutions are increasingly awakening to the diversification benefits of hedge funds and their useful role as an additional source of alpha. The year 2004 saw great strides by UK institutions in both education and actual allocations made in the hedge fund industry, though the full extent and realisation of such commitments remains to be seen.
Figure 1: Hedge fund performance by strategy<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
Strategy Yearly returns % Annualised % pa
2004 2003 2002 3 yr 5 yr 10 yr
Equity hedged 7.6 20.5 -4.7 7.3 6.2 16.1
Event-driven 14.3 25.3 -4.3 11.1 10.4 14.7
Relative value 5.1 9.7 5.4 6.7 8.5 10.5
Trading 4.7 21.4 7.4 11.0 8.3 12.1
HFR Fund Weighted 8.9 19.5 -1.4 8.7 7.1 12.6
HFR Fund-of-Funds 6.8 11.6 1.0 6.4 5.2 8.6
S&P 500 9.0 26.4 -23.4 1.8 -3.8 10.2
Source: Hedge Fund Research, S&P
Figure 2: Why some <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />UK pension funds don't invest in hedge funds
( per cent of respondents)
High fees 26
Undefined risk 23
Just a fad 12
Too small to invest 12
Figure 3: Hedge fund investments by strategy (per cent of respondents)
Strategy North America Europe
General Equity Long/Short 90 79
Fundamental Market Neutral 55 71
Convertible Arbitrage 66 71
Event-Driven/Merger Arbitrage 72 71
Fixed Income Arbitrage 45 64
CTA/Managed Futures 1 4 64
Multi-Strategy Arbitrage 66 64
Short Bias 24 57
Global Macro 28 57
Quantitative Market Neutral 59 57
Sector Specialist Long/Short 45 43
Statistical Arbitrage 45 43
Volatility Arbitrage 31 43
Distressed Securities 76 36
Source: Goldman Sachs International and Russell Investment Group Report on Alternative Investing by Tax-Exempt Institutions 2003.
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