Human Capital & Careers

Looking over the Hedge

With stocks in a bear market, some pension managers are checking out hedge funds.
Andrew OsterlandSeptember 28, 2001

Pension fund managers may be long-term investors, but they are not oblivious to short-term pain. And like anyone invested in U.S. equities over the past 18 months, they are feeling a lot of pain.

U.S. corporate pension plans invest most of their money in stocks and bonds, typically in a 60/40 proportion. That strategy served them very well between 1995 and 1999, when assets in the average pension plan more than doubled, with about 75 percent of the gains coming from investment returns and just 25 percent from increases in corporate funding. Indeed, until recently, a CFO’s biggest concern with the pension fund was how to account for the huge surpluses being generated.

That’s no longer a problem. Instead, the bear market in stocks has pension managers rethinking their asset-allocation strategies and looking farther afield for alternative investments. “Pension funds have had a great run, but with interest rates falling and liabilities increasing, they’re looking for new sources of investment return,” says Maarten Nederlof, head of pension strategies at Deutsche Asset Management, a division of Deutsche Bank. Specifically, they want sources of return that don’t correlate with the performance of stocks and bonds.

In their broadest definition, alternative investments for pension portfolios are anything other than stocks and bonds, including real estate, commodities, private equity, venture capital investments, and distressed securities. For more than a decade, managers of large pension funds, like Bob Angelica of AT&T, have been increasing their investments in such asset classes in order to diversify their portfolios. The $35 billion AT&T fund currently has about 10 percent of its assets in alternative investments, primarily private equity and venture capital.

However, the largest potential source of uncorrelated returns, and arguably the only truly effective diversification tool for long investors, is hedge funds. By one estimate (and there are many in the notoriously opaque world of hedge funds) there are about 5,000 hedge funds managing upward of $500 billion in capital worldwide. That’s probably slightly higher than investment levels prior to the infamous near-collapse of Long-Term Capital Management, which sent financial markets into a tailspin in the fall of 1998. Wealthy individuals currently account for about 75 percent of hedge fund investment, and institutions make up the other 25 percent.

Last year, a composite index of 1,500 hedge funds representing more than $260 billion in assets, calculated by Hedge Fund Research, had a return of 5 percent. In a year when the S&P 500 was down 10.1 percent and the Nasdaq 100 was down 36.8 percent, that kind of performance has drawn the attention of the pension fund community. “Hedge funds are pure alpha products, with their returns depending on the skills of the manager,” says global asset consultant Sandy Chotai of Towers Perrin. “A lot of pension funds are now asking themselves, ‘What would happen if we added hedge funds to our portfolio?’”

Ideally, the answer would be better, less-volatile, long-term returns. The managers of university endowments such as Harvard’s and Yale’s, as well as international organizations like the World Bank, have bought into the idea, but most of their pension fund colleagues are yet to be convinced. While the low correlation between hedge fund returns and those in the stock and bond markets may be attractive, the lack of control and transparency has kept most pension managers on the sidelines.

“The upside to hedge funds is that they expand the range of approaches to extract returns from the asset markets,” says Charles Froland, managing director of General Motors Asset Management (GMAM), the largest corporate pension fund in the country, with $85 billion in assets. “The downside is you don’t know what you’re invested in.” For pension managers–control freaks by nature–that is a very big downside. GMAM is one of notably few corporate pension plans that have made investments in hedge funds. Last February, GMAM announced it would allocate one percent of its portfolio to a number of different hedge funds. Other companies whose pension funds have made similar investments include Weyerhaeuser and GTE (now Verizon). Given the gloomy stock market and the pension community’s heightened interest in hedge funds, however, larger allocations could be forthcoming.

OIL AND WATER

At face value, pension funds and hedge funds couldn’t be more different. Hedge funds are run by star money managers who answer to no one and often pocket as much as 25 percent of the investment profits. They are free to pursue or abandon any investing strategy they want, including the use of leverage to pump up investment returns. The practices and conventions in the hedge fund industry are about as far from the conservative, risk-management orientation of pension funds as you can get.

“It’s a natural mismatch,” says Bob Boldt, whose firm, Pivotal Asset Management, currently manages $600 million in three different funds. “Pension funds are interested in hedge funds, but they’re not yet sure how they want to use them.” Boldt’s biggest client is the $152 billion California Public Employees’ Retirement System (Calpers), where he spent four years before launching Pivotal.

The major problem pension funds have with hedge funds is their lack of transparency. The high-net-worth individuals who currently supply most of the cash to the industry basically hand over their money and hope for the best. They are given few details on investment strategies or risk profiles, and fund performance is typically disclosed on a monthly basis. That kind of no-questions-asked policy doesn’t fly with pension managers. “As fiduciaries, we need to understand what outside managers are doing,” says AT&T’s Angelica, who has no investments in hedge funds right now.

Managers like Angelica want detailed information on the types of investments that hedge funds make, the level of exposure they carry, and the degree of leverage they employ. They also want to ensure that outside managers don’t stray from their stated investment programs– called “strategy drift” in the industry. With the current levels of disclosure and performance reporting in the hedge fund world, pension managers can’t make those assessments.

They also can’t judge how well hedge fund managers are performing relative to a benchmark, because there currently are no adequate benchmarks. A number of firms, including Hedge Fund Research, Van Hedge Fund Advisors, and Managed Account Reports, provide indexes of industry performance, but the reporting from the individual funds is often shoddy and incomplete. Part of the problem is that hedge funds are less a class of assets than a range of investing strategies that operate in a variety of different asset classes. Still, pension managers live and die by benchmarks, and they need a standard by which to measure their active money managers, hedge fund or not. CS First Boston and Tremont Advisers currently provide an asset-weighted index of 337 hedge funds, and Morgan Stanley Capital International intends to launch a series of indexes that will measure the performance of a variety of strategies, ranging from long/short equity investing to convertible arbitrage to global macro investing.

Mark Anson, senior investment officer for global public equity at Calpers, says the lack of an industrywide benchmark for hedge funds isn’t a deal-breaker for him. The $152 billion fund recently allocated $1 billion to hedge fund investments. Anson says he can work out the issue of an appropriate benchmark with the hedge fund manager. “When I meet a manager, I simply ask, ‘What is a reasonable benchmark to judge your performance by?’” says Anson. If the fund focuses on the telecom sector, the benchmark would be a sector index. If it pursues an absolute return strategy that deals in a variety of assets, the benchmark might be the Treasury bond rate plus an agreed-upon premium. Whatever the case may be, most institutions require some kind of yardstick to determine what value a money manager brings to the table.

“High-net-worth people don’t care much about risk management, but pension managers can’t live without it,” says Paul Platkin, director of investment strategy at GMAM. “The hedge funds need to come up with an institutional-quality product.”

MATCHMAKERS

What constitutes institutional quality? Jim Rowen, co-head of global equity prime services at Deutsche Bank’s asset management division, says growing numbers of hedge fund managers are asking him that question. Deutsche Bank and other prime brokers on Wall Street, such as Morgan Stanley, Goldman Sachs, and Bear, Stearns, are positioning themselves to play matchmaker between the pension fund and hedge fund communities. “More and more hedge funds have come to us for packaging that will make it easier to pitch their product to pension boards,” says Rowen. “We’ve set up a platform for them to communicate better with institutions.”

Essentially, Deutsche Bank is offering to monitor hedge funds and supply information on their activities to institutional investors. Pension funds, of course, are used to getting what they want from outside money managers: namely, complete, same-day disclosure of investment positions. For hedge funds that rapidly trade in and out of security positions, end-of-day disclosure might not be such a burden. But for those that sell stock short, or try to capture spreads between securities through arbitrage–two of the more popular strategies among pension managers–disclosing their positions could make them vulnerable in the market.

One solution: summary disclosure. Sophisticated portfolio-analysis software can provide summary information on the types of securities a fund invests in and the proportion of long and short positions it holds. It can also stress-test a given asset mix and provide quantitative measures like value-at-risk for a portfolio. This allows pension managers to see hedge fund investments in the context of the rest of their portfolio without compromising the hedge fund manager’s trading flexibility. “We’ve established a middle-of-the-road approach, and we let the institutions and hedge funds work out the details,” says Rowen.

FROM ALTERNATIVE TO MAINSTREAM

So far, pension funds have barely dabbled in the hedge fund industry. One approach has been to invest in a fund of hedge funds, and thereby reduce the exposure to individual managers. Dave Tsujimoto manages one such fund for the asset management division of Frank Russell & Co. “We advocate diversifying by manager as well as by strategy,” he says.

The fund of funds vehicle, however, introduces another layer of fees to the investment. Also, critics say the approach reduces the attraction of investing in hedge funds. “You end up diluting the good managers with the bad,” says GMAM’s Froland. With its huge staff of investment professionals, GMAM intends to establish a framework through which other pension plans can access quality hedge fund managers. It is currently in the process of registering the product with the Securities and Exchange Commission.

The true institutionalization of the hedge fund industry would likely raise a number of new issues. U.S. pension funds currently total $7.2 trillion in assets, according to InterSec Research Corp. A small allocation to hedge funds might not be a major event for pension managers, but the potential flood of money could swamp the hedge fund world, and there’s already a shortage of good managers to handle the demand in the market. “There’s a finite number of really good investment opportunities,” says Pivotal’s Boldt. “As assets under management grow, managers have to move down to lesser and lesser ideas.” And if the pension funds wade into the picture, performance will almost certainly deteriorate.

Furthermore, the most popular hedge fund groups in the industry– outfits like Caxton Securities or Pequot Capital Management–want nothing to do with pension money and the demands that will accompany it. In fact, Alan Kaufman of AssetSight, which develops analytical tools and benchmarks for alternative investments, predicts there will be a bifurcation in the hedge fund industry. The more-established managers who have wealthy individuals throwing money at them will continue to operate as autonomously as they have in the past. At the same time, new, more-accommodating managers will pursue the pension money. Again, performance could suffer.

Pension funds and hedge funds are still worlds apart, and there are plenty of managers in the pension community who aren’t eager to see them come together. “I cringe at the thought of massive movements into hedge funds,” says Stanley Wright, manager of the $6 billion pension fund at Sears, Roebuck and Co. He doesn’t doubt that there are very smart hedge fund managers who can deliver very good returns, but the difficulty of finding them and incorporating them into his investment program is a task he’s not yet willing to take on.

“In the abstract, hedge funds aren’t good or bad,” says Wright. “You just better have a clear notion of the potential outcomes and the risks you’re assuming.”

Andrew Osterland ([email protected]) is a senior editor at CFO.

TRANSPARENT MOTIVES

Calpers wants a clearer view of hedge-fund strategies.

Corporate pension managers may be interested in hedge funds, but they’re not keen on whipping them into “institutional” shape. That job, however, has recently been embraced by the California Public Employees’ Retirement System (Calpers), the country’s largest public pension fund.

The $152 billion fund never shies away from taking a lead role on corporate-governance or investment-policy issues that affect the broader pension community. Through its alternative-investment management program, Calpers has become one of the largest investors in private equity and venture capital in the country during the past decade. It now has its eye trained on hedge funds.

Last October, the Calpers board of trustees authorized a $1 billion allocation to hedge funds. That’s less than one percent of the fund’s assets, but it is nevertheless a clear signal that Calpers intends to be a factor in the evolution of hedge funds. “I hope we can bring some rationality to the industry,” says Mark Anson, a senior investment officer at Calpers. In essence, the rationality means transparency with regard to both investment strategies and performance. “I need to understand the investment process, and I need a certain level of transparency,” says Anson.

Calpers is adopting a kinder, gentler approach to communicating those needs to the hedge fund community. Several years ago, when Calpers decided to invest in the venture capital industry, it initially demanded lower fees and smaller takes of the investment profits by venture capitalists. The best of the venture funds said no thanks, and it wasn’t until Calpers enlisted Grove Street Investment Advisors as an intermediary that it gained access to some of the better venture funds, such as Kleiner Perkins and Menlo Ventures.

Calpers doesn’t want to make the same mistake with the hedge fund industry. In May, it struck a deal with Blackstone Group, a New York­ based money manager known mostly for buyout transactions, to serve as gatekeeper for the hundreds of hedge funds that have already pitched Calpers for money. Blackstone will screen for the best candidates and help draft a reporting regime that both Calpers and outside managers can live with. The monitoring of the funds will be handled by institutional investment research firm InvestorForce Inc. “I think a lot of other institutions will watch this program carefully,” says Anson. “If we move the industry toward more transparency and achieve good results, we’ll have done our job.”

And likely paved the way for other pension managers to follow suit. — A.O.