Pension funds are beginning to actively invest in hedge funds in a significant way. Market pressures on pension portfolios have pension managers worldwide looking to hedge funds to improve risk-adjusted returns.
Moreover, many observers believe that asset inflows into hedge funds will continue to accelerate. If sustained, these trends will have major implications for the hedge fund industry. Consequently, hedge funds must begin to focus on the distinctive needs of pension fund managers and administrators to tailor their performance and support.
In December 2002, Putnam Lovell predicted that the hedge fund industry would become more institutionalised and would grow to over USD 2 trillion by 2010. With that assumption, Putnam Lovell noted that Pension Funds would invest between one half to one percent of assets by 2010 with a total investment of USD 500 billion. In May 2004, Happauge, N.Y.-based data firm CorrectNet Inc. and Alternative Fund Services Review reported that hedge funds had over USD 1 trillion in assets. This measure of "money in the bank" suggests that initial predictions for growth in the hedge fund sector were actually too conservative.
Recent commitments to invest in hedge funds come from ABP, committing up to 2% of assets, around USD 3.5 billion, and a CalPERS announcement to expand hedge funds to between USD 3 to USD 5 billion of their global allocations, as well as British Telecom's pledge to invest up to USD 920 million. Hundreds of pension funds are following suit with up to 23% of US pension funds intending to make allocations according to Greenwich Associates.
Watson Wyatt reported that the global pension fund industry now faces a USD 1.5 trillion deficit and an impending era of single-digit returns. Under these kinds of financial pressures, pension fund trustees require strategies to boost their funds' returns to meet impending obligations.
Trends in pension fund investing
Pensions that are investing in hedge funds are integrating sophisticated methods for measuring the performance-adjusted risk of hedge funds into their investment process. Performance and controlled volatility are necessary considerations but are not sufficient. Pension funds are also assessing the implied risk of specific investment and trading styles as well as measuring the correlations with both hedge fund indices and other investments in their portfolios. Moreover, pension managers are requiring hedge funds to respond with these and other details or else fail the due diligence process.
In addition, hedge funds have to manage their investors. Should the fund assets from pensions in the US exceed 25%, the entire fund would fall under onerous ERISA restrictions as to how funds trade and invest, limiting pension fund investments in individual funds and their control over the management of the fund as well.
If a major hedge fund were to fail and adversely affect a pension fund, the industry would likely experience increased scrutiny from governmental bodies. It is hoped that the ERISA limitations of no more than 25% investment by pensions in any one fund will significantly decrease the impact of a possible failure and the resultant scrutiny by regulators.
Even for the hedge funds that pension funds do not invest in, there are significant implications. As pension funds invest, there will be reduced capacity in high quality funds that are available in the industry. Moreover, with the hedge fund growth that could occur during 2004 and 2005 there could be new pressures on the industry as more hedge funds reach capacity and close to additional investors.
For the institutional managers that currently invest through mutual funds, stock or bond advisory services, assets under management may begin dropping noticeably. Both of these trends can be expected to accelerate. The implications are not entirely predictable. Like the trend towards quality/value in the retail industry, the exact impact may not be understood until it is too late for many of the participants.
Opportunities for HFs and FOHFs
In the early stages, many pension funds can be expected to go with the familiar, investing with organizations with which they have had strategic relationships. Many pension funds, however, don't have any strategic partners who offer hedge funds. This will be an opportunity for new hedge fund of funds to enter the market space.
Most early-investing pension funds build a portfolio of a few funds of funds to reduce perceived risk and to provide multiple learning environments for their managers to become experienced with hedge fund investing. Fund of funds will be among the first to have the opportunity to work with these pension funds.
The more sophisticated pension funds may build their own balanced portfolios of hedge funds. Consequently, they may eventually need high quality managers. Building these teams will be challenging as the best managers are already working for major hedge fund of funds. As they grow out of their portfolios of single-manager funds, new single- manager funds may have new opportunities. These new teams will be interested in portfolio management tools, fund administrative support, software, computers and hedge fund performance data.
Emergence of Indices
Another strong competitor for pension hedge fund investment is not an active hedge fund of fund manager at all. With the recent advent of branded hedge fund indices such those provided by Hedge Fund Research, S&P, CSFB/Tremont and MSCI, investable hedge fund indices are quickly acquiring assets at heady rates, over USD 1 billion from investors of all types, in 2003 alone.
Some institutional investors are drawn to these indices because they provide theoretical diversity with lower fees. However, some active fund of funds can persuasively argue that the performance and balance of the indices may not provide the diversity, lower volatility and non-correlation that a good active fund of funds manager can.
What about pension funds that don't invest in hedge funds? If they underperform their peers, they may be forced to join the trend late in the process with less access to the better funds and managers.
The current trends appear to be foreshadowing a true phenomenon. Bubble or sustained growth, hedge funds must prepare for a potential watershed of change in the investments of the pension fund industry.
Larry Ortega is a Vice President at Global Partners Group, a diversified financial services firm with principal offices in New York & Fort Lauderdale offering institutional asset management, electronic trading platforms, trade execution services, and hedge fund incubator and emerging manager programs. He may be reached at firstname.lastname@example.org .