When it comes to pension plans and hedge funds, size matters. That message came across loud and clear last fall when the US$298-billion California Public Employees’ Retirement System eliminated its $4-billion hedge fund program.
The decision was due, in part, to costs and complexity—but it wasn’t just the fees, explained CalPERS’ interim chief investment officer, Ted Eliopoulos. The program would never be able to “move the needle” relative to the plan’s huge size. CalPERS originally invested in hedge funds to boost returns, but that strategy didn’t play out as expected.
The CalPERS announcement triggered lots of client questions, says Dave McMillan, partner and CIO of hedge funds with Mercer, since plan sponsors were eager to know what the decision would mean for them. However, he notes, the answer really lies in the investor’s expectations for hedge funds in the first place and how plan sponsors structured their hedge fund program.
Read: CalPERS getting out of hedge funds
“Hedge funds are not really an asset class,” McMillan explains. “You can make them what you want — you can try to get home runs or you can try to be more conservative. We tilt to the latter.”
He says plans of all sizes are looking to hedge funds to address their two biggest risks: equity and interest rate. “Hedge fund managers provide exposure to different, non-traditional risks,” he explains, adding strategies such as long/ short, relative value and event driven produce a different return profile.
The biggest Canadian pension plans are already well invested in hedge funds — notably, OMERS and the Ontario Teachers’ Pension Plan. But smaller plans are also making their way into the space.
What’s a hedge fund For?
Terri Troy, CEO of the $1.5-billion HRM Pension Plan, says her plan has been using hedge fund strategies since 2007, starting with specific strategies to hedge out interest rate, credit and equity market risks.
Today, the plan has a dedicated hedge fund strategy focused on North American long/short equity as a hedge against equity market risk. The strategy is a good fit because, as Troy explains, “it’s easy to understand, and we obtained full transparency of positions. At the same time, a good stock picker can identify both under- and over-valued companies.
A long/short mandate gives the portfolio manager an extra lever to create value.” At the Canadian Medical Protective Association, hedge funds have also been a growing part of the Reserve for Claims (a portfolio of assets providing legal representation to doctors and compensation to patients harmed by negligent care) as it works to reduce exposure to equity market volatility. Josée Mondoux, the plan’s director of investments, says the role of hedge funds has grown from a handful of portable alpha strategies into a $400-million program making up about 12.5% of the $3.5-billion fund.
Read: The three main types of hedge funds
“We initially put three strategies in place: equity market neutral, global macro discretionary and commodity trading advisor or global macro systematic, which some refer to as managed futures. We believed this combination could provide us with a bit of crisis alpha, which outperforms during times of extreme market stress,” Mondoux explains.
Since then, the CMPA has rounded off its hedge fund exposure with additional strategies. “We find the absolute return profile from our hedge funds strongly benefits our portfolio,” she says. “It displays significantly lower volatility than our equity exposure, a better return expectation than our fixed income allocation, and uncorrelated performance relative to all portfolio asset classes.”
The challenge, however, is in the implementation — particularly for smaller pension plans without the assets and staff to build and monitor a portfolio. In the case of smaller plans, the hedge fund strategies you can choose may depend on what you’re able to negotiate.
Read: Investors still like hedge funds
“It’s definitely challenging,” says Troy, on implementing a strategy. “We required a separate mandate with full transparency. Size usually makes a difference when you’re asking for a separately managed account, but we were able to negotiate this with a relatively small plan size.”
However, she adds, size shouldn’t matter for plans investing in pooled funds, where minimums are usually low.
Do your homework
One area requiring extra attention is due diligence. Conducting and monitoring this upfront can be tough for small plans, notes Mondoux — and while her plan has the expertise and capacity, many don’t.
This concern is echoed by Chris Addy, CEO of Castle Hall Alternatives, which conducts operational due diligence on hedge funds around the world. “The two biggest obstacles for investors are knowledge and access,” he says, adding that before the financial crisis, hedge funds of funds were considered a magic bullet for overcoming these challenges.
But that’s changed. Today, investors of all sizes are more inclined to build their own portfolios. “Where people have gone, post-crisis, is to allocate directly to underlying managers,” he says, adding it’s a lot harder to do this than to rely on a third-party pooled solution.
Read: Hedge funds: A matter of compliance
And it’s not just monitoring that can be tough — it’s also the fees. “Hedge funds at ‘two and 20’ are expensive,” Addy notes. “I think the hedge fund industry might need to do more to provide an evolving validation of its business case. In markets like Australia, for example, they are far more fee-sensitive, and other markets are going down that road.”
Uncertainty prevails
While the fees might be high, as Addy admits, the value hedge funds deliver depends on how badly investors want to dampen volatility and tame portfolio swings. And, with rising interest rates on the horizon and a new normal of low global growth, plan sponsors are contending with a lot of uncertainty.
In particular, during bull markets, McMillan hears plans questioning why they own hedge funds. “They ask, ‘Why am I paying more to perform less?’ But this is an investment that provides its benefit over a full market cycle — that is when you see the benefit of being hedged.” It’s essential to understand this, he says. “You can’t have it both ways. If you want protection in difficult markets, you have to be willing to trail in strong markets.”
If that’s the case, how useful is the term hedge fund in the first place?
“[It] doesn’t properly describe the range of strategies,” says Gary Ostoich, president of Spartan Fund Management. “Hedge fund strategies are very broad, and it really depends on what pension funds want [them] to do. Some could be used as an equity or fixed income replacement, or to generate absolute returns.”
Read: Hedge funds post gains
Misconceptions about hedge funds abound among investors. “When they hear ‘hedge fund,’ people put their backs up and think it’s risky,” says Tim Pickering, president of Auspice Capital Advisors. “The term hedge fund is a misnomer. Anything can be risky, but it depends on how it’s done. The approach is key.”
Whether it’s due to the perception of added risk or the issue of fees, hedge funds remain a small allocation for the typical plan. The Pension and Investment Association of Canada reports they stood at 2% of Canadian assets in 2013.
Change is happening, but smaller plans haven’t been as quick as their larger counterparts to move into the hedge fund space, says Peter Fink, senior vice-president with Kensington Capital Partners. He adds they could get more attention as smaller plans recognize the volatility that comes from long-only equity allocations.
“Growth in the use of hedge funds among Canadian plans has been more sporadic in Canada than in the U.S.,” admits Fink. “It’s still a question of education, and pension trustees are very conservative in Canada. It’s been slow going for smaller plans — maybe because public markets have done so well. People talk about risk-adjusted returns, but the focus is still on returns.”
Rise of liquid alts
And these aren’t the only barriers for plan sponsors. Dan Elsberry, head of alternative sales with K2 Advisors, says many smaller plans have been unable to explore hedge funds. “The Canadian market is very fee-sensitive,” he says, noting the other hurdle for many plan sponsors (mainly DC) is the need for daily liquidity and improved transparency.
Liquid alternatives offer a new way for plan sponsors to invest in hedge funds through a closed-end fund structure, without the gates and higher fees (think 100 basis points versus the typical model of two and 20). Troy sees them as helpful for plan sponsors, particularly those exploring smart beta or factor investing.
Read: Hedge fund assets reach new high
Academic research shows factors such as value, size and momentum can explain most of the value added from traditional actively managed equity mandates and hedge funds with a significant beta component. Factor investing can be seen as a complement to traditional equity strategies, adding value relative to a market cap index but at a lower cost. It also applies to fixed income, currencies and commodities.
While big plans such as CalPERS might find it challenging to move the needle using hedge funds, smaller plans are turning to them to manage their own risks. And the hedge fund industry is opening up to accommodate plans of all sizes, with new more flexible products to address their challenges.
Caroline Cakebread is a freelance writer based in Toronto.
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