Agecroft Partners predicts that pension plans will significantly increase their exposure to mid-sized hedge funds over the next ten years.
The firm says the pension fund industry is in the process of a major evolution in its use of hedge funds that has implications on what per cent of their portfolio they allocate to hedge funds and how they achieve their hedge fund exposure, which will have profound implications for mid-sized fund managers.
The pension fund industry has a very glacial approach to changes in asset allocation which can take a couple decades to fully implement across the industry. Although pension funds asset allocation trends are slow to develop, they tend to be very strong and consistent, says Agecroft.
In the early 1980s, almost 100 per cent of US pension plan assets were invested in US-traded securities. It was viewed as imprudent and highly risky to invest in non US based securities, despite the strong academic evidence that diversifying outside the US could enhance returns while reducing volatility.
The process of US pension plans diversifying their portfolios with investments based outside the US began with a few very large and high profile pension plans adding international equity as a component of their asset allocation. Initially, they limited that exposure to one per cent or two per cent of their total assets, even though their asset allocation models suggested an allocation in the mid-20 per cent range. This cap was slowly increased every few years until allocation levels in the 20 per cent range were achieved over a ten to 20 year period.
The largest, most high profile pension plans tend to follow the lead of the largest endowment funds, but act as first movers in the pension industry. Mid-sized pension plans typically follow the lead of the larger funds a couple years later, which is repeated yet again by the smaller pension plans several years after that.
Agecroft says a similar trend can be seen currently within the pension plan industry that will benefit hedge funds. Ten years ago, the average pension plan allocation to hedge funds was less then one per cent and only a very few corporate pension plans had an allocation to hedge funds, with some of the first including General Motors, General Electric, and Weyerhaeuser. In 2001, Calpers became the first public pension plan to allocate directly to hedge funds. Since then, there has been an increase in the percentage of pension plans allocating to hedge funds and an increase in the average per cent of their assets allocated to this sector.
Agecroft believes that overall approximately five per cent of pension plan assets are invested in hedge funds and pension plans which have approved an allocation to hedge funds having an average of eight per cent of their assets devoted to this sector. In a fully discretionary asset allocation model, with no constraints, hedge funds would assign an allocation multiple times this current level, which is where Agecroft believes the industry will gravitate over time. The current pension allocation is only a fraction of the allocation of many of the leading endowment funds, many of whom have up to 50 per cent of their portfolio invested in hedge funds.
"Agecroft is not predicting that pension plans will only be allocating to mid-sized hedge funds. What we are predicting is that over the next ten years we will see a significant increase in the percentage of pension plans investing a meaningful percentage of their hedge fund portfolio away from the largest managers to small and mid-sized managers," says Doug Rothschild, managing director of Agecroft Partners.
