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SkyRank Comments in Global Pensions Magazine

Global Pensions Magazine, August, 2004
http://www.globalpensions.com/

By Brian Bollen

The mere mention of pension funds and hedge funds in the same breath is enough to send shivers of apprehension, even fear, up the spine of those market participants, observers, and commentators who have seen more than one economic cycle from start to finish, and have witnessed more than one wonder product plummet to earth after rocketing in popularity. The level of hype that has built up in favour of hedge funds is veering dangerously close to hysteria, setting off an equal and opposite negative reaction, fuelled by the publication of research which indicates that some of the momentum is stalling, both in terms of funds inflow and performance.

Against this background, according to some, author JK Rowling, if seeking new inspiration for a blood-curdling title in the endless chronicles of the uber-geek with the magic wand, might do worse than settle on Harry Potter and the Hedge Fund of Doom. But is this fair? Not at all, is the consensus in the industry. The question posed by the cheerleaders is not so much ‘should pension funds invest in hedge funds?' but more ‘When they do, how large should their asset allocation be, and how should they translate their theoretical interest into a quantifiable holding?'

Perhaps surprisingly, given the unwritten law that financial theory, innovation and practice in the USA must always be light-years ahead of the rest of the world, many of the same questions are still being posed there in relation to pension fund investment in hedge funds as elsewhere. Some of the answers are more unequivocal than others. "I think it makes sense for pension funds, like any investor, to invest in hedge funds because of the inherent risk-return specifics," says Antoine Josserand, director, structured and alternative investments, AXA Investment Managers. "They offer you an attractive diversification of features that enable you to design a portfolio you couldn't otherwise have. As long as you can identify funds that exhibit the right profile they should be in your portfolio, as long as there are no regulatory constraints. While pension funds normally test the water by using a fund of hedge funds, we find it interesting that we are seeing some investing directly in our single strategies."

Pension funds should without question be allocating a larger percentage of their funds to the right type of hedge funds, fund of funds, and investable hedge fund index products, says Joseph Omansky, president and 80% owner of New Jersey-based Sky Fund LLC, a hedge fund rating service. "Certain alternative investments show a zero correlation to the broad markets. With positive correlation, there is a specific amount of systematic risk, undiversifiable risk, which will cause the investor to lose money when the market falls. This risk can be measured by the correlation coefficient of the investments. With zero-correlation securities or alternatives, the portfolio of pension assets is immunised from market risk. Such alternatives should be available to all investors, independent of their individual wealth level." Kevin A Pollock, buyside partner at the delightfully named Resurrection Advisers in New York goes one further. "For some pension funds it may be more appropriate to not just invest in hedge funds, but to also buy stakes in them," he says. "Such investments could increase their potential returns and provide them with additional in-house expertise on hedge funds to leverage off."

Perspective is everything, though, and Will Wechsler, vice president at research house Greenwich Associates, is happy to supply it. "There has been a good deal more talk than action when you consider the sheer value of the assets that pension funds own," he observes. "The ratio of attention to assets is way out of kilter." Anything below 5% of the portfolio is not worth the effort in terms of a significant risk return, so if a fund is not going to reach at least that level, it would be better not to start, adds Dirk Soehnholz, managing director, alternative investments, at Feri Trust in Bad Homburg, near Frankfurt. Adds David Hogarty, senior business development manager at KBC Asset Management in Dublin: "Most market commentators expect a 5-10% allocation to hedge funds of the overall fund allocation within the medium term. "

"The problem is that hedge funds and pension funds don't speak the same language," continues Will Wechsler. "Many hedge funds find it hard to provide the level of service, transparency and information about basic operations that a pension fund routinely requires. Simply saying ‘Give me a hundred million dollars and I'll send you an email now and again telling you how brilliantly I'm doing' doesn't work for pension funds."

Or, as Hilary Till, a principal at derivatives strategies and risk management policy adviser Premia Risk Consultancy in Chicago, puts it in a slightly more scholarly manner, "A defining feature of hedge funds is their boutique nature. A hedge fund may only have one or two key decision-makers, for example. This does not give a lot of comfort to institutional investors who require a deep team of investors carrying out a disciplined and repeatable investment process that does not rely on any one individual for its continued success."

For a marriage between hedge funds and pension funds to truly work, they will have to find a common language. Hedge funds need to be able to demonstrate a clear and distinctive philosophy, an enduring and consistent strategy that can evolve to meet changing conditions and requirements, a process that can be explained and replicated, managers who are incentivised to stay for the long term, and a track record that is long enough to satisfy an investor with a decades-long investment horizon. The need for transparency, however, must be balanced against the continued success of the underlying strategies. "If we allow investors to see into our black box, we are giving away proprietary knowledge," says Michael T Seabolt, principal at Private International Wealth Management in Nassau. "If they see we're doing x, then x by definition becomes less valuable."

Pension funds cannot, however, ignore the most powerful reason for them to follow in the footsteps of the pioneers: they are missing out on outperformance. "One thing is certain, though, and must be remembered," warns Mark Mobius, a managing director of Templeton Investments. "In the investment world there is no such thing as a free lunch. For every supposed hedge, there is a payment to make, some time in the future."

The UK, observes Will Wechsler, has arguably the lowest institutional interest in hedge funds in the developed world, despite recent stirrings and declarations of intent. Japan, by contrast, he sees as the fastest growing as that market turns to hedge funds to deliver additional alpha and so rectify years of disappointment with the local market. Continental Europe, too, is developing encouragingly, with the Netherlands showing the way while,as a group, the Nordic countries currently lead in the proportion of institional investors using hedge funds.

In Germany, meanwhile, BaFin, the country's chief financial regulator, has already drafted a proposal that German Pensionskassen and insurance companies will soon be permitted to invest directly in hedge funds. "We believe that this development will add importance to the debate and accelerate allocation to hedge funds," says Herwig Kinzler, head of Mercer's Investment Consulting Practice in the country. "If we assume that hedge funds will become 1-2% of institutional asset allocations in five years and the current institutional asset volume of €1 trillion grows by 30% in five years, then the institutional hedge fund industry will be about €20bn by 2009."

More recent research published by Chicago-based Hedge Fund Research, which bills itself as the leading source of hedge fund information and performance data, showed a sharp slowdown of funds inflow, to $7.5bn for the second quarter of 2004, after an average of $21.2bn per quarter for the four preceding quarters. Performance across all hedge fund sectors also dipped, averaging negative 1% performance on the quarter, the first quarterly decline since the third quarter of 2002. However, hedge fund specialists lash out strongly against the idea of measuring hedge fund performance over such a short-term time scale, and HFR says that these results can be seen as modestly benign when considering the confluence of market conditions during the second quarter of 2004 that were particularly adverse to the many hedge fund strategies. In any event, the HFRI Fund weighted composite index still measures 2.7% year to date while total asset flow into the industry stands at $30bn, says HFR.

Elsewhere, hedge fund consultant Van Hedge Fund Advisors International (VAN) in Nashville keeps producing figures that serve to underline the reason for the underlying clamour for hedge fund investment, the Van Global Hedge Fund Index climbing to a value of 10,872.55 in June. The Index began with a value of 1,000 in January 1988 and over its 16-year history has generated a net compound annualised return of 15.6%, compared to 12.3% for the S&P 500. The Index, calculated from over 1,400 hedge funds following a broad range of investment strategies, rose 0.6% net of fees in June. This marked a turnaround for the Index, which saw net losses of -1.2% and -0.5% in April and May.

"This year we've seen one European pension fund a week expressing interest," says John Van, Chief Financial Officer of VAN. "While we welcome this initial interest, they are really only dipping their toe in the water, mostly through funds of hedge funds. Their hedge fund investments are very small compared to their total assets, and unless they make significant allocations, as with equities or bonds or real estate, the mathematics doesn't work; exceptional performance in the hedge fund portfolio will have little or no impact on overall performance if the hedge funds account for only one or two percent of assets. But you cannot fault them for their sheer prudence and adherence to their fiduciary duty; they are only doing what their advisers suggest, and the advisers are not suggesting they plough straight in."

Brian Bollen is a freelance writer, editor and media consultant
(brian.bollen@virgin.net)
Pension funds should without question be allocating a larger percentage of their funds to the right type of hedge funds, fund of funds, and investable hedge fund index products, says Joseph Omansky, president and 80% owner of New Jersey-based Sky Fund LLC, a hedge fund rating service.

"Certain alternative investments show a zero correlation to the broad markets. With positive correlation, there is a specific amount of systematic risk, undiversifiable risk, which will cause the investor to lose money when the market falls.

This risk can be measured by the correlation coefficient of the investments. With zero-correlation securities or alternatives, the portfolio of pension assets is immunised from market risk. Such alternatives should be available to all investors, independent of their individual wealth level."


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