Pension Fund Investment Brings New Assets and Challenges

Recent surveys conducted by Greenwich Research suggest that the pensions windfall also holds the potential to disrupt the industry by increasing competition for arbitrage opportunities, and renewing demands for transparency and fee structure reform.

“Greenwich research suggests that hedge funds will experience rapid and continued growth as pension funds increase their allocations to the asset class,” says Greenwich Associates consultant Woody Canaday. “But the fact is that trees do not grow to the sky, and the industry could soon be facing some major questions.”

Greenwich Associates interviewed 126 fixed-income investors at hedge funds and professionals at 1,032 pension funds and endowments for its 2003 research on the hedge fund industry. The results of the research are presented in a new white paper, which examines hedge fund use by institutional investors, the impact of hedge fund proliferation, and the compensation of hedge fund professionals.

New money, and a lot of it

Until quite recently, hedge funds relied on wealthy individuals and U.S. endowments and foundations for most of their investment capital. Greenwich research shows a marked change in recent months, however. “The predominant sources of hedge fund capital have changed, and they are about to change dramatically,” says Greenwich Associates consultant Frank Feenstra. “Pension funds, with their enormous resources, have started to allocate significant amounts of money into hedge funds, and they are planning to put in huge amounts.”

The USD 11 billion currently allocated to hedge funds by US pension funds represents only one-fifth of 1% of their USD 5 trillion asset base. Greenwich research indicates that target allocations for these pension funds are 7% of assets for corporate funds and 5% for public funds. “If they achieve these targets, we’re talking allocations to hedge funds of at least USD 250 billion,” observes Greenwich Associates consultant Tim Sangston. “These levels would far exceed the capacity that exists in the hedge fund industry today.”

The price of success

Along with these positive trends, Greenwich research has identified several areas of concern that hedge fund managers and investors should closely monitor in 2004. The most immediate threat to future hedge fund performance comes ironically from past success, and the resulting explosion in the number of hedge funds in the market. As Frank Feenstra observes: “There are now at least 6,000 hedge funds in operation, the barriers to entry remain extremely low, and the number is increasing every day.”

This propagation could make arbitrage opportunities more difficult to find, and eye-popping returns more difficult to achieve. Since the basis of most hedge fund management is arbitrage, the growing number of managers in the market is making it progressively harder to find or create arbitrage opportunities.

If the surge of new hedge fund entrants leads to lower returns, investors may begin to balk at hedge funds’ management fees. “Our pension fund research shows that plan sponsors are expecting hedge funds to outperform equities,” observes Woody Canaday. “But that expectation is built on the brilliant past performance of some famous hedge funds, and on the hope that others will continue to discover arbitrage opportunities.”

While pension funds are universally sensitive about management fees, many of them are hypersensitive about transparency. “Most hedge funds feel their approach is proprietary,” says Woody Canaday. “But many plan sponsors feel that they themselves have a fiduciary responsibility to dig deeply into the ways in which their beneficiaries’ funds are being invested.”

In light of informational demands from pension funds and the prospect of future government inquiry, hedge fund managers should be reviewing their disclosure policies. “Pension funds are particularly attractive to hedge funds from the viewpoint of size and hence fees,” says Greenwich Associates consultant Dev Clifford, “but hedge funds are going to have to do some hard and thorough thinking about their response to the required transparency.”

Hedge Fund Compensation

Total compensation for fixed-income investors at hedge funds increased 1% year-over-year, totaling USD 473,000. On average, bonuses decreased 2% from USD 299,000 to USD 294,000, and salaries increased 6% to USD 179,000 in 2002. By comparison, fixed-income investors overall reported a 3% increase in average compensation, totaling USD 321,000 in 2002 — 32% below their counterparts at hedge funds.

Background Note: Greenwich Associates is a leading international research-based consulting firm in institutional financial services worldwide. Greenwich‘s studies provide benefits to the buyers and sellers of financial services in the form of benchmark information on best practices and market intelligence on overall trends. Based in Greenwich, Connecticut, with additional offices in London, Sydney, Toronto, and Tokyo, the firm offers over 100 research-based consulting programs to more than 250 global financial services companies.