Trustees’ guide to investment strategy supplement – Spring 2003: Hedge Funds – Peering over the hedge

Many trustees’ suspicion at the complex and speculative activities of hedge funds has faded in the face of disastrous equity returns. Three consecutive years of negative equity returns between 2000 and 2002 have left some trustees, in the words of National Association of Pension Funds investment council director Ken Ayers, “desperate” for any asset class that can bring positive returns. The UK’s largest pension funds have led the way, with the ¬£26bn BT Pension Fund and the ¬£18bn Electricity Supply Pension Scheme making their first hedge fund investments over the last year, while the ¬£15bn Royal Mail Pension Plan and the ¬£20bn Universities Superannuation Scheme are actively considering a move. A common way for pension funds to make their first hedge fund investment is to allocate 1 or 2% of their assets to it, increasing this once the trustees are comfortable with the way the investment works and performs. However, Mercer Investment Consulting senior investment consultant and hedge fund specialist, Robert Howie, points out that a pension fund is unlikely to see much benefit at such low levels. Howie says that only at allocations of between 5-15% will a pension fund notice the real benefits of boosted investment returns or true risk diversification. But allocations above 10% remain unusual for most pension funds and most experts believe that they will remain fixed at this level owing to limited capacity in the hedge fund industry. Put simply, some of the investment strategies taken will only work if relatively small amounts of money are used. This is true of one of the most easily understood hedge fund strategies; the long short equity fund. Here a manager will borrow shares from other investors and promptly sell them in the belief that their value will fall. Once this happens, the manager buys the shares back and returns them. This strategy is matched by an opposite position where the manager buys an equivalent amount in shares it believes are soon to rise in value. Other hedge fund strategies aim to profit from the anticipated market movement in shares of companies that are involved in mergers, acquisitions and restructuring. Some will take advantage of pricing anomalies in stock exchanges worldwide or cheaply buy the bonds of companies popularly believed to be on the verge of bankruptcy in the belief that it can be turned around. Owing to the numerous and complex nature of many hedge fund strategies the decision of choosing which hedge funds to invest in is usually left up to fund of fund managers. Goldman Sachs Hedge Fund Strategies’ group co-head Europe, Hugh Lawson, says: “Not all that many pension funds will have the internal resources to actively seek out and manage a portfolio of individual hedge funds – fund of hedge funds providers can meet that need. “Also many pension funds value sophisticated fund of funds as investment thought partners, so the benefits of working with them go beyond just simply the access to hedge funds, they are a valuable investing partner too.” He adds that if a pension fund is looking to make allocations of between 5-10% in hedge funds, then it is important for this allocation to be diversified among many sectors of the hedge fund universe and that consequently a fund of funds is an efficient way to do this.