A growing number of U.S. pension plans are investing in hedge funds and private equity funds, reports the U.S. Government Accountability Office (GAO).
According to a GAO survey of large plans, the share of plans with investments in hedge funds grew from 11% in 2001 to 60% in 2010. Investments in private equity also grew over the same time period, from 71% in 2001 to 92% in 2010.
However, hedge funds and private equity generally make up a small portion of plan assets (5% and 9%, respectively, in 2010). Such investments are most common among large pension plans (assets more than US$5 billion).
Given the recent market volatility, the GAO’s report stresses that plan fiduciaries must apply best practices and choose accordingly when investing plan assets to ensure that plans are adequately funded.
“Hedge funds and private equity investments pose a number of risks and challenges beyond those posed by traditional investments,” says the report.
“For example, investors in hedge funds and private equity face uncertainty about the precise valuation of their investment. Hedge funds may, for example, own thinly traded assets whose valuation can be complex and subjective, making valuation difficult. Further, hedge funds and private equity funds may use considerable leverage—the use of borrowed money or other techniques—which can magnify profits but can also magnify losses if the market goes against the fund’s expectations. Also, both are illiquid investments—that is, they cannot generally be redeemed on demand.”
In its research, the GAO spoke with various plan sponsors about how they address the challenges presented by hedge funds. Recommendations included making careful and deliberate fund selection and negotiating key terms such as fee structure and conditions, degree of transparency, valuation procedures, redemption provisions and degree of leverage employed. Ongoing monitoring and due diligence beyond that required for traditional investments was also suggested, including regularly reviewing valuation, risk management processes and compliance procedures.
Lastly, several plan sponsors said they address some of the challenges by investing in a fund of funds.
“Investing in a fund of funds provides investors with diversification across multiple funds, which can mitigate the effect of one manager’s poor performance,” says the report. “In particular, a fund of private equity funds can allow plans to invest in a variety of managers, industries, geographies and year of initial capital investment. In addition, a plan sponsor may be able to rely on a fund of funds manager to conduct negotiations, due diligence and monitoring of the underlying hedge funds.…[F]unds of funds can be appropriate if plan sponsors do not have the skills necessary to manage a portfolio of hedge funds.”
The complete report is available on the GAO website.