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Alpha’s hot, Beta’s not

Melanie Stern is section editor for Families in Business magazine.

Exacerbated by high-profile blow-ups, UK pension funds just can't shake their fear of hedge fund risk, finds Melanie Stern

Not having a taste for risk in its genetics, the UK pension fund market has to work hard to get to grips with the seemingly swashbuckling world of hedge funds.

Telling of the differences across the water in investor sentiment and the power of media reports, the UK's approach is far more conservative than elsewhere. US pension funds are increasing their exposure to the sector all the time as they sharpen their understanding of the risk-reward ratio (California Public Employees' Retirement System, CalPERS, doubled its investment to $2bn last November); In the Far East, over half of Japan's 300 largest pension funds are poised to invest some $300bn in fund-of-hedge funds next year.
In the UK, however, research shows that pension funds have been very slow to pick up this asset class – around 0.5% of the sector invest in hedge funds there, according to Mercer Investment Consulting, who have forecast that as equity markets continue their slow decline, over 10% of UK pension funds would invest in hedge funds by mid-2005. Still, while 'Alpha' or risk-adjusted performance is hot, 'Beta' – volatility – isn't yet a fully accepted part of the package.
Conversely, Pioneer Investments, a hedge fund manager owned by Italy's UniCredito banking group, found last August that of 94 UK pension funds managing a total of £77bn in assets, 12% thought hedge funds were simply 'a fad'.

One issue pension trustees see is the use of perceived high-risk products within hedge funds. Derivatives are a key ingredient for many, as they allow managers to sell in and out of stocks quickly in order to follow market movements and exploit price anomalies – in essence, to bet on future developments – but these risk-management products have themselves got a very bad name. Ex-Barings trader Nick Leeson traded them, and they were both the making and downfall of Enron. The $3bn state-backed bail-out of US hedge fund Long Term Capital Management following its disastrous bad bet on interest rates, which at the time was thought capable of bringing down the entire global financial system, still rings in people's ears eight years on. Such lingering contagion just isn't palatable to UK pension funds trustees who are wired to avoid any unnecessary risk.

The reason behind these calamities was that hedge funds are often not collateralised and therefore depend solely on the creditworthiness of the counter-parties for their final value. Even super-investor Warren Buffett calls them "potentially lethal financial weapons of mass destruction." However, while the creditworthiness of sellers and intermediaries involved in this market carries infinite variations, pension funds usually carry enough assets to cover their liabilities. Collateralised products is now a growing market in answer to these and other concerns – but the collateral comes from the global debt markets, one cornerstone being derivatives, another being pre-collapse Enron favourites, special purpose vehicles. The mere mention of these products feels like scare-mongering.

Additionally, risk and volatility are often seen as one and the same by pension fund trustees, something that those advising on hedge funds lament. Hedge funds were traditionally seen as low volatility products due to their illiquidity – they have always carried a negative correlation with equities – but that has changed with the increased use of derivatives and other 'alternatives'. Hedge funds need a little volatility, but a range of strategies can assist the diversification of any risk. Fund-of-fund or fund-of-hedge funds are two popular styles, grouping together a selection of hedge funds and management teams that are themselves managed by a top manager, diversifying not only asset allocation risk but also strategy risk and manager risk.

But before considering those avenues, understanding the DNA of hedge funds is the key roadblock for pension funds. Said Buffett after closing down his own derivatives business in 2002: "When I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing I understand is that I don't understand how much risk the institution is running." Charlie Metcalfe, deputy chief executive officer at UK pension fund giant Hermes – owned by its biggest client British Telecom with some £47bn in assets under management – sees change among UK pension funds, but slow change. "[They've] got a board of trustees who meet quite irregularly, so you can't go from knowing nothing about hedge funds and perhaps being very frightened of them, to the other," says Metcalfe.
"There is increasing understanding and acceptance, but the world of institutional pension funds moves a bit like a super-tanker so it takes a long time for a group of maybe 15 people to understand what they do, how they do it, and then get an understanding of how they might invest. It is totally about education and becoming confident about the market, which I think is the place to be if you are looking for absolute return".

Hedge fund products have been popular with supposedly risk-averse high-net-worth families for a long time, and they have done well overall from them. Now, some quarters of the market believe that UK pension trustees are moving towards an outlook similar to that of private clients, which will enact a sea change in the way they define their returns. According to Hermes' Metcalfe, pension funds want to see positive returns regardless of the performance of equity indices, which until now most funds have benchmarked themselves against. This is termed 'absolute return.'

"If you're a wealthy client whose investment manager happily reports a 6.5% loss on your money against a 7% market drop as a good year, you'd be furious – private clients don't care what the index did or how well they did against the markets," explains Metcalfe. "Although the measures of risk for the private client market versus the pension market have been different, that is now changing. Increasingly pension funds are beginning to think a bit like private clients and disregard index performance, seeking absolute return. So increasingly, the people managing pension funds are recommending hedge funds to trustees."

HSBC Republic Investment's Jamie Murray adds that this new approach can itself remove some risk from hedge funds. "This approach does not mean that hedge fund managers take more market risk than a traditional manager – indeed, when well executed, they generally assume less market or directional risk, whilst perhaps acquiring more credit or counterparty risk than traditionally benchmarked strategies," Murray told European Union Banking & Finance News Network of the emerging demand for absolute return in 2002. "The absence of a benchmark against which risk is measured and taken means that many hedge fund styles can position their portfolios in a relatively risk-neutral manner, to preserve investor capital when market conditions require." Fund-of-hedge funds serve this purpose.
And then there's the regulatory issue. Last December the US Securities and Exchange Commission (SEC) announced it would force hedge funds (and fund-of-hedge funds, though with slightly differing terms) with more than £25m in assets and 15 or more single clients to register from February 1 this year, whereas previously any investment adviser with less than 15 clients did not have to register – a hedge fund being classed by the SEC as a single client because it was a 'pooled' investment vehicle. The SEC recommended hedge funds there appoint compliance officers to oversee the changes, another step in recognising the need for more transparency and credibility for the products. So as the US is moving towards a stronger market it's no wonder hedge funds are well used by pensions.

In the UK meanwhile, hedge fund managers are required to seek authorisation from the Financial Services Authority, but the hedge funds themselves are not – the agency says merely that it recommends all funds operating in London "must take reasonable care to maintain systems and controls appropriate to their business". Additionally, many hedge fund operators are registered with offshore financial centres, and the FSA makes clear it has no powers over these entities even if they operate within its jurisdiction and sell to UK clients.

Although the FSA sought consultation with the market to tighten regulation in 2002, to which it said most respondents did not see a need for closer control, this benign approach to a market steeped in controversy and misunderstanding can only make UK pension fund hand-wringing worse. Pioneer's head of distribution for UK and Scandinavia, Nigel Meir, says it is time to push for real change. "Some outdated perceptions do remain [regarding hedge funds] and this could result in certain schemes failing to understand the risk reduction strategies that hedge funds can bring to efficient portfolio management."

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