Since the financial crisis of 2008, pension plans have struggled for additional returns. Unable to meet their liabilities with the typical equities and fixed income portfolio, a lot of plans have been moving into alternative investments, specifically, hedge funds. According to the most recent Goldman Sachs Global Hedge Fund Investor Survey in 2011, 37% of institutional investors invested directly in hedge funds, compared with 24% in 2010, said Catherine Thrasher, managing director, BNY Mellon Performance & Risk Analytics, speaking last week at CIBC Mellon’s breakfast seminar.
But while more investors are looking into hedge funds, these funds are difficult to valuate and benchmark. But this is changing.
Performance management
Performance-wise, while it’s relatively easy to calculate the performance of traditional assets such as equities from a total fund to a security level it’s not quite as straightforward to report the performance of hedge funds.
“Valuations are slower and subject to revisions,” said Thrasher. The net asset value (NAV) of equity or fixed income portfolios, for example, is available on a daily or monthly basis. With hedge funds, the valuations are typically only available on a quarterly basis and usually four to six weeks, after the end of the quarter.
This causes much more work for plan sponsors. “It becomes more operational [for them]; they have to be involved in that process more so than for their equity and fixed income portfolios,” she explained. Plan sponsors have to make decisions on the valuation used—for example, ‘Do we use the June or the September valuation for our report in October?’.”
Thrasher does admit that some hedge fund managers have a better infrastructure in place and that they can deliver more frequent valuations but due to the illiquid nature of many of the investments, “the vast majority of them are quite slow, and it’s a quarterly process.”
Benchmarks
In the case of hedge fund benchmarks, they’re not constructed like those for the equity market (such as the S&P 500), where the benchmark comprises the securities traded on that particular stock exchange.
Hedge fund benchmarks are really a universe of hedge funds, designed to reflect hedge fund industry performance. These benchmarks are constructed by equally weighting composites of constituent funds as reported by the hedge fund managers listed within the index vendor’s database. One of the problems with these benchmarks is that they can suffer from “survivorship bias.”
Survivorship bias refers to the fact that universes can create an unrealistically high benchmark because poor performers in the universe are dropped off as those funds close, leaving only those better performers and, thus, an “artificially inflated” universe. With many hedge funds being created all the time and many closing, there is much more turnover in this asset class than in others, explained Thrasher. As a result, when the hedge fund manager’s performance is compared to that of the universe, that manager looks worse by comparison.
Compliance monitoring
As for compliance monitoring, plan sponsors follow a Statement of Investment Policies and Procedures (SIP&P), and also have written investment guidelines that correspond to their SIP&P for the majority of their managers. These guidelines would detail the percentage a manager could have in a particular stock or sector, among other directives, said Thrasher.
However, hedge fund managers typically don’t have written investment guidelines. As Thrasher put it, it’s as if the investor says to the manager, “Here’s my money. I trust you’re going to invest it in accordance with what you showed me in the initial due diligence,” she quipped.
“There hasn’t been the regular oversight [with hedge funds] that we’ve seen with other asset classes,” she continued, adding that this is why pension boards and investors are uncomfortable with hedge funds as a whole.
With a hedge fund, you don’t get the underlying security holdings to be able to see the fund in that amount of depth and detail, Thrasher explained.
“Historically, you see the NAV level or total fund price, but that’s as much transparency as the plan sponsor has had,” said Thrasher.
But Thrasher said that this is starting to change. Institutional investors can get the underlying holdings and the independent oversight for their hedge funds by structuring their portfolio of hedge funds in a different way, like through a managed account platform.
Managed accounts
If you think of the Madoff hedge fund, for example, they priced the securities, priced the fund, traded the fund and calculated their own performance. “They controlled every aspect of that fund, which just isn’t good governance,” said Thrasher.
The managed platform takes the hedge fund manager out of that position (i.e., controlling everything), so a firm that offers a managed platform (e.g., HedgeMark) “manages the managed account.”
That firm hires an independent third party to price securities; it runs compliance, writes the investment manager guidelines and makes sure the manager is doing what it says it’s supposed to do, she explained.
“They separate the hedge fund manager from the cash movement to try to prevent the fraud we’ve seen in the industry. The hedge fund manager is managing the fund and making those investment management decisions, but that’s it. They don’t have access to anything else,” she said.
“It makes the hedge structure look more like [a pension plan’s] other managers’ structure.”