Many UK institutional investors - the large pension funds, local authorities and charities - are now showing keen interest in alternative investments.


Indications are that following a slow start 2-3 years ago, interest in alternative investments such as private equity and hedge funds is steadily growing, with UK pension funds allocating to the latter mainly through funds of hedge funds.


This article reviews developments in the UK institutional investment market over the last two years and highlights the role played by funds of hedge funds within pension funds' asset allocation mix.


What are hedge funds and funds of hedge funds?


A hedge fund is a pool of capital, used mainly by wealthy/financially experienced individuals and institutions, which is allowed to use aggressive investment strategies that are unavailable to mutual funds and unit trusts, including selling short, leverage, program trading, swaps, arbitrage, and derivatives.


Hedge funds are usually restricted by law to no more than 50-100 investors per fund (unlike mutual funds or unit trusts, which may have no such restriction), and as a result most hedge funds set extremely high minimum investment amounts, ranging anywhere from USD 250,000 to over USD 1 million.


As with traditional mutual funds or unit trusts, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%). Many hedge fund managers invest in their funds along with their investors, indeed this is viewed as a strong incentive for them to perform well.


A fund of hedge funds does not manage individual funds, instead it selects a number of hedge fund managers and invests into their funds, providing the benefits of risk diversification across its portfolio of hedge fund managers.
In essence, the attraction for investors is that the manager of the fund of hedge funds bears a significant responsibility for due diligence, while the broader spread of investments and strategies reduces the potential impact of the failure of a single fund.


Performance and size of hedge funds industry


According to data released in October 2005 by Hedge Fund Research (HFR), a provider of hedge fund information and performance data, average third quarter hedge fund returns jumped to 5.38 per cent, up from 1.12 per cent in the previous quarter.


This compared to returns of 3.61 per cent for the Standard & Poor's 500 and 6.58 per cent for the MSCI World during the same period. For the year, the HFRI Composite Index, an average of overall hedge performance, is up 7.36 per cent.
Total hedge fund industry assets stood at USD 1.1 trillion as of 30 September 2005.


Growing interest in the UK


According to a report by investment bank Morgan Stanley, one in six continental European pension plans invests in hedge funds, compared with one in 50 in the UK.
But there are signs that the situation is fast changing in the UK, where a number of key pension schemes have recently begun allocating to hedge funds, mainly via the fund of hedge funds route.


For example, Railpen Investments, RT Group's pension fund, which includes the British Railways and the British Transport Police superannuation funds, is planning to invest over GBP 600 million or 5% of its assets in funds of hedge funds.


Many local authorities are also taking a keen interest in hedge funds. Dorset County Council is allocating GBP 45 million - or 5% of its scheme - to two fund of hedge fund managers. The GBP 45 million hedge fund allocation is equally split between fund of hedge funds manager Gottex, which already manages USD 3.6 billion of hedge fund assets, and Pioneer Alternative Investments, a unit of UniCredito Italiano SpA.


Flintshire County Council, which administers the GBP 550 million Clwyd scheme, has appointed fund of hedge fund managers Quellos and Pioneer to run GBP 11 million each. This brings Clwyd's exposure to hedge funds to 17% of its total scheme assets. This level of exposure is higher than average in the UK.


A spokesperson on behalf of Flintshire County Council gave some clues as to what it was looking for in a fund of hedge funds manager, noting: "In this highly specialist area, we selected these managers for the strength of their process, their performance record and the stability of the investment team."


Shropshire reduces risk of market falls


Shropshire County Council has allocated GBP 61 million, representing 10 per cent of assets from its pension fund, to two hedge fund managers, Man Investments and Quellos Group LLC.


Commenting on the allocation, Phil Guy, the Council's Treasury & Pensions Manager said: "Man Investments and Quellos are good complementary managers, and provide additional diversification to our investment structure. Although the Shropshire Fund is one of the best funded local authority schemes, this further reduces the risk of deterioration in our funding level from market falls."


J Sainsbury's Pension Fund allocates to funds of hedge funds


The GBP 3 billion J Sainsbury's Pension Fund has decided to increase its allocation to hedge funds from 1% to 3% of assets, i.e. from GBP 25 million to GBP 90 million.


The decision was made in response to a resilient first year's performance in difficult market conditions from the fund of hedge funds managers it had selected last year, including London-based manager La Fayette, which won half of this new allocation.


Benefits for UK pension schemes


The J Sainsbury's Pension Fund news demonstrates that funds of hedge funds are increasingly attractive to mainstream UK pension schemes.


Jan Pensaert, Chief Executive Officer at La Fayette, noted: "Investing in multi-manager funds is increasingly appealing to UK schemes because fund of hedge funds managers are specialised professionals who offer diversification across different strategies and hedge fund managers."


Pensaert added: "Pension funds benefit from a professionally managed, specialised team who focus entirely on manager selection and portfolio management. Experience and knowledge of the investment environment are crucial factors."


Investment in funds of hedge funds is set to grow, driven by growing interest among UK institutional investors in allocating to hedge funds. Stephen Oxley, who heads the UK-based European operation of US fund of hedge funds manager PAAMCO (Oxley was previously a Partner and Senior Investment Consultant at Watson Wyatt LLP), says hedge fund assets are attractive to institutional investors for three main reasons:


1) Diversification of the strategic (long term) asset allocation policy:  Pension funds tend to hold bonds as the closest match they have for their known liabilities and have traditionally invested in equities for growth. The shock of the equity bear market has brought home the case for better diversification of growth assets over the long term.  Hedge funds are attractive because they offer the potential for equity-like returns with low correlation to equities.
2) Short term downside protection:  With the introduction of market-based accounting standards and a move to a more market-value basis for valuing institutional assets and liabilities, any asset that can help protect the downside in the short term is also attractive.
3) Alpha:  Institutions have been somewhat starved of alpha (the out-performance of a fund in comparison with its benchmark) in the world of long-only active management.  There is strong evidence that investment skill can be accessed through hedge funds.  There has been a trend in recent years for institutions to index-manage their core portfolios and overlay high alpha strategies - hedge funds therefore can sit well in the high alpha layer or as a diversifier of the overall benchmark.


In summary, allocating a proportion of their portfolio funds of hedge funds offers the following advantages to UK pension schemes:


• Funds of hedge funds can provide pension funds with stable and consistent returns by employing investment strategies that are not reliant on traditional market movements.


• Funds of hedge funds have the capacity to identify managers that successfully exploit inefficiencies in directionless markets.


• These funds are also focused on absolute (pre-defined) returns, providing low correlation with other conventional asset classes, being more nimble and not constrained by benchmarks. Also, they select, rely on and follow some of the industry's most highly skilled managers rather than relying on market direction.


• Investing directly in hedge funds, rather than using funds of hedge funds, involves a need for substantial resources both in terms of infrastructure and expertise. The pension fund and its consultants would need to continuously monitor funds and managers and carry out extensive quantitative and qualitative analysis.


• Furthermore, the investor would be confronted with the problem of limited liquidity and lack of critical mass thus making access to talent increasingly difficult.


• Spreading risk by diversifying between lowly correlated, uncorrelated or inversely correlated assets is increasingly appropriate for many UK schemes.


 


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