Pensions' Taming of the Hedge Fund

Tue., Nov 13 - HedgeWorld.com (Excerpt)

By Maggie Shea
Financial Correspondent
 

CHICAGO - As institutions now pour more capital into hedge funds than any other single group, they are demanding better risk controls and more transparency in pricing and the overall investment process. Hedge funds have answered the call by providing more information, but by doing so they may risk losing their edge.

Hedge funds are not the same products they were nine years ago when another credit crisis struck global markets and triggered the collapse of hedge fund Long-Term Capital Management, said Mark Anson, president and executive director of investment services at Nuveen Investments LLC and the former chief executive at U.K. asset manager Hermes. Prior to joining Hermes in early 2006, Mr. Anson was the chief investment officer at the California Public Employees' Retirement System, the United States' largest public pension fund. There, he led the fund's build-up of its alternative investments portfolio.

Today's hedge fund strategies are less opaque as prime brokers demand to see managers' entire portfolios and clients better understand risk controls, Mr. Anson noted.

While many hedge funds suffered losses this past August, most strategies regained their footing in September. Hedge Fund Research Inc.'s Weighted Composite Index lost 1.31% in August, but returned 2.98% in September Previous HedgeWorld Story. Similarly, Hennessee Group LLC's Hedge Fund Index was up 2.26% in September, after losing 0.72% in August.

When it comes to hedge fund investing, institutions have evolved from where they were nine years ago, also. According to Deutsche Bank's 2006 Alternative Investment Survey, pensions, government organizations, endowments and foundations make the largest allocations to hedge funds. Corporate pensions generally invest between 5% and 10% of their portfolios in hedge funds, and endowments and foundations allocate anywhere from 10% to 25%, Mr. Anson said. Public pensions are the most conservative, usually allocating between 2% and 5% of their portfolios to hedge funds.

Pension funds' infrastructure has improved to accommodate hedge funds, Mr. Anson said. Pensions now have better middle and back offices to handle hedge fund pricing and accounting and valuations of hedge funds. They also have improved internal risk management. Fund administrators offer software and expertise to pension plans looking at hedge fund investments. Consultants are coming up to speed as well, adding staff and developing their own in-house expertise on hedge funds and other alternatives, Mr. Anson wrote in the email.

As a result, institutions' portfolios have become more sophisticated, said Craig Asche, executive director of the Chartered Alternative Investment Analyst Association. "Like any industry, as [institutions] get more developed and mature, there is a greater move toward customization," he said. This trend, in turn, pushes hedge funds to have better operational organization and risk controls, Mr. Asche said.

As pension plans make further allocations to hedge funds, some are going directly to single-manager funds as opposed to using a fund of funds, Mr. Asche said.

He noted that a pension fund's size and available resources affect whether it can opt for single-manager funds. "If you can't invest broadly across strategies, across single-manager hedge funds, you can't get enough diversification," Mr. Asche said. "Large pension funds can diversify. If you're smaller, you often don't have the option."

Not only that, but smaller pensions that aim to outsource portfolio management, say by investing in a single-strategy fund of hedge funds, face due diligence issues. The same goes for large funds that outsource aspects of their business despite having all the internal resources to manage every aspect of the decision-making process, he added. "Certain things have to be done internally. It's sometimes not enough to turn to the board and say, 'I hired XYZ and they have a good reputation.' There are limitations in terms of what you can manage within your portfolio."

Funds of funds still serve an important purpose, Mr. Anson said. They offer institutional investors access to hedge funds that might otherwise be closed to investment. In such a scenario, "it's more about diversification and price controls," he said.

Citing the 2001 white paper he wrote, Mr. Anson said that institutionalization by definition means to put someone in a correctional or penal facility. This would suggest that hedge funds are being punished for some kind of wrongdoing, perhaps their lack of transparency and a tendency to focus on the skills of a few "star" managers.

The punishment, then, is to curb such tendencies, Mr. Anson said. "Institutional creativity is kept such that it's much lower. Large institutional investors are going back to 'best-idea' portfolios. . . . Hedge funds are resembling long-only products more."

Indeed, institutionalization has tamed returns somewhat. Hedge fund managers looking for institutional business are curbing creativity in favor of a more traditional long-only-type approach to alpha generation-i.e., simply going "long the good and short the bad," Mr. Anson said. "Institutions are ... giving broad, flexible mandates for smart managers to do what they do best."

Not only that, but institutions are less trustworthy of the "star" manager, simply because for a single-strategy manager with hard-to-define, qualitative skills that are tough to quantify, the institution essentially is betting on the strategy expertise of one individual in the face of market turmoil. "If you can't explain the [investment] process well to your institutional clients, they may not feel comfortable," Mr. Asche said. "Institutional clients have the right to demand transparency."

Mr. Anson said pension funds are more attuned to looking at investment processes rather than star employees. "They like to see a process because it gives the indication that past performance is indicative of future returns," he said. "Pension funds are good at getting hedge funds to realize they have to put in processing to show they can replicate performance."