Getting a head start

These issues are of concern both to plan sponsors and their consultants. It is important to illustrate why investing in hedge funds—as a result of increased market pressures and an enhanced awareness of fiduciary duties—is at the forefront with many plan sponsors and their consultants.

Trustees of pension plans are facing two major issues: the first involves funding deficits; the second, dissatisfaction and disappointment with poor single digit returns. With respect to the deficits, a 2004 Mercer study, Get Used to Canadian Pension Solvency Deficits, indicated that 70% of Canadian plans had “a solvency deficit at the end of 2003(compared with 75% at the end of 2002 and only 25% at the end of 1999).” Furthermore, internal research has found that trustees are seeking investment vehicles that would deliver absolute returns with lower volatility. Seeking additional funding from the organization to meet deficits is not a viable option.

Trustees also are firmly aware of one of their key fiduciary duties—they have a duty to search vigorously for those investment vehicles that will provide their plans with the necessary returns to meet their planholders’ needs. Merely recommending and relying on a traditional asset allocation model may not be acting in a reasonable and prudent fashion, especially if it is reasonable to assume that the existing asset allocation is not meeting these needs.

PORTAL OF ENTRY
Education is critical. A board of trustees must fully understand how alternative investments can and have played an integral and vital role in a portfolio’s overall asset mix. The Yale Endowment’s experience as an institutional pioneer in alternative investing vividly illustrates this point. The chart illustrates how the Yale Endowment’s risk/return profile improved from 1987(when alternatives were introduced) to 2002(when alternatives represented approximately 60% of the asset allocation mix). Other institutions have embraced hedge funds as well. According to the 2004 National Association of College and University Business Officers Endowment Study (NACUBO), higher education endowments with assets of $1 billion or more allocate an average of 20.2% of their assets to hedge funds. This 20.2% compares with a 19.9% average allocation in 2003, 17.8% in 2002 and 9.6% in 2001.

The aforementioned, however, still raises key questions: It is clear that hedge fund investments have the potential to improve a portfolio’s overall risk/return profile, but which hedge fund strategy should be deployed and during what time period?

A fund of hedge funds is perhaps the best portal for a plan sponsor to begin its hedge fund allocation. A fund-of- hedge-funds manager provides crucial due diligence for a client in the following three areas: sector allocation, manager evaluation, and continuous monitoring, analysis and assessment. Sector allocation and manager evaluation are often classified as pre-investment risk management screens; and continuous monitoring, analysis and assessment are classified as a post-investment risk management screen.

SECTOR ALLOCATION
There are many hedge fund strategies from which to choose. The hedge fund universe comprises three main investment pillars: relative value, event driven and opportunistic. The relative-value pillar primarily consists of market neutral, convertible arbitrage and fixed income arbitrage. Event driven largely consists of merger arbitrage and distressed securities; the opportunistic pillar focuses on global macro, managed futures, equity long/short and emerging markets.

A fund of hedge funds provides a client with an ongoing “top down” approach in terms of analysis, allocation and rebalancing of the overall hedge fund strategy. The portfolio manager(or allocator)of a fund of hedge funds constantly assesses the market environment to ascertain and develop the appropriate blend of underlying funds. Although many trustees sitting on institutional boards are sophisticated in the investment universe, these same trustees and their consultants recognize that they often require supplemental expertise to weigh the global investment climate and select hedge fund strategies capable of capturing current as well as projected trends. For example, when economic indicators point to tremendous growth and buoyancy, which may mean the merger arbitrage component should be increased(and if so, by how much and in which sectors). If we are heading into a higher interest rate environment, one must determine whether to alter one’s fixed income arbitrage allocation. If significant global trends are developing, one’s current global macro allocation may be inappropriate.

The “top down” analysis associated with sector allocation is the first, but not the least, value-added service provided by a fund of hedge funds. Boards of trustees and their respective consultants often look to fund-of-hedgefunds management to advise them of the appropriate hedge fund asset mix.

MANAGER EVALUATION
Once the fund-of-hedge-funds manager(or allocator)determines the asset allocation mix necessary to achieve the targeted return and risk profile, the team proceeds with a “bottom up” analysis of the underlying portfolio managers. In this pre-investment risk management phase, the allocator will look to both quantitative and qualitative screens in order to determine which underlying hedge fund portfolio manager(s)should represent the prescribed sector weighting. There are thousands of hedge fund portfolio managers around the world. Boards of trustees and their consultants look to fund-of-hedge- funds managers to provide detailed, “bottom up” due diligence analysis on each underlying portfolio manager who warrants consideration.

From a quantitative perspective, the fund-of-hedgefunds manager will look through key databases and begin to compare all the portfolio managers within a particular hedge fund strategy. Comparable performance and risk management metrics often will involve: total return and compound return(annualized and since inception), standard deviation, breadth and depth of drawdowns, and Sharpe and Sortino ratios for each hedge fund manager being considered. If leverage is used, how is it calculated and what determines the extent of leverage employed? What are the position limits relating to credit, credit-spread volatility, concentration, market capitalization, industry sector concentration, liquidity, counterparty risk, interest rate exposure, and volatility risk?

As important as the quantitative perspective, the fund-of- hedge-funds manager will ask numerous qualitative questions. What is the firm’s “edge” factor? What distinct methods, if any, does the firm employ in its investment process? What market environments are most conducive to the strategy? What are the strengths and weaknesses of the strategy, the investment team and the management of the entire organization?

A fund of hedge funds provides a critical “bottom up” portfolio manager selection process from both a quantitative and qualitative viewpoint.

CONTINUOUS MONITORING
The post-investment risk management phase involves continuous monitoring, analysis and assessment by the fund-of-hedge-funds manager. The allocator assesses the global macro environment and decides whether to adjust the overall hedge fund mix. As well, from a “bottom up” perspective, the allocator will be monitoring the underlying hedge fund portfolio managers. One of the greatest values that a fund-of-hedge-funds manager can bring to a pension plan is the ability to review each fund manager’s position and monitor against style drift. Underlying fund managers often offer a respected fund of hedge funds a higher degree of transparency with respect to their investment positions than they would for other clients.

The boards of trustees of pension plans are confronting significant funding deficits. In addition, they are facing dissatisfaction and disappointment with low single digit returns of such plans. The boards and their respective consultants also recognize that they have a fiduciary duty—proactively and vigilantly—to source such asset classes that will increase return while decreasing the overall pension plan’s risk. The Yale Endowment as well as other American and Canadian institutions have embraced hedge funds as a means to provide a better risk/return profile to each institution’s overall risk/return profile.

As many institutions may not have the internal hedge fund due-diligence processes, a fund of hedge funds is perhaps the best portal for a pension plan to begin its hedge fund allocation. Trustees will take comfort in working with an established fund-of-hedge-funds manager to guide the plan’s allocation. Sector allocation, manager evaluation, and continuous monitoring, analysis and assessment are tremendous value-added due-diligence processes that an established fund-of-hedge-funds manager typically brings to a pension plan. A proven manager will combine such due-diligence processes with highly sophisticated and effective financial modeling and portfolio simulations—with the goal to provide the overall portfolio with the desired risk/return objective.

Thomas Gerginis is managing director, BluMont Capital Corporation in Toronto. tgerginis@blumontcapital.com