Diversifying Traditional Balanced Portfolios
by Dr. Ros Altmann

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Suitability of Hedge Funds as a Risk Management Strategy for Pension Funds

Mention the words ‘hedge funds’ to most people and they will immediately think ‘high risk’. But this is ‘old fashioned’ thinking. Many types of hedge funds can actually reduce portfolio risk (as well as enhancing returns). UK consultants have been very late in recognising the potential benefits of including hedge funds in institutional portfolios, whereas many US investors (especially endowments and high net worth individuals, but also many large pension funds) have profited significantly from investing in hedge fund assets.

This is a great shame for UK pension funds because the returns on their traditional assets have been so poor in recent years. By relying so heavily on ‘long-only’ equity investing, UK pension funds have lost significant value. They traditionally have had very little exposure to fixed income or property and have shied away from anything other than equity investment. This has been either passive or active, but has not focussed on including hedge funds.

Hedge Funds Can Reduce Risk – Other Alternatives Should Be Considered Too

Hedge funds can be used as a risk management strategy in a variety of ways. For example, by including ‘market-neutral’ funds in the portfolio, overall portfolio risk will be reduced. Since the returns of market neutral funds are not correlated with returns for other assets in the portfolio, overall risk will be reduced. Other types of hedge fund can also reduce risk, since their returns are generally not highly correlated with those of long only managers. Any reduction in correlation will reduce risk in a standard Sharpe asset allocation model. This can, of course, also be achieved by using property, and I would argue that property should be included in pension fund portfolios too, as another means of diversifying to reduce risk. As regards venture capital, however, this is more closely correlated with equity markets and I see this more as the ‘high risk’ end of the equity spectrum, rather than as a risk reduction tool. Venture capital is more useful as a means of enhancing returns, rather than reducing risk, whereas hedge funds can do both.

Suitability of Hedge Funds for Pension Funds as an Asset Class in Their Own Right

One of the problems with trying to consider hedge funds as an asset class in their own right is that there are so many different types. The majority of hedge funds nowadays are long/short equity funds, whereas in the early 1990’s, it was macro funds which caught all the headlines. Different hedge fund strategies have very different characteristics and it is not really fair to consider them all as the same type of investment. 

How to Include Hedge Funds in a Portfolio

Hedge funds can also be used in a pension fund portfolio in a variety of different ways. They can be used as a way of capturing an exposure to assets that are not correlated with the rest of the portfolio and, therefore as a true means of reducing risk via diversification. This would be a way of using hedge funds to reduce total portfolio risk. By careful selection of hedge funds, or using a good fund of funds, run by experienced managers, hedge funds are eminently suitable for pension fund portfolios. 

Alternatively, hedge funds can be used as a part of the traditional asset class exposure, for example by fitting into the equity or fixed income portfolio. For example, it seems logical to suggest that a long/short equity hedge fund would fit in very well as the truly active component of a core-satellite strategy, where the core is a passive index fund and the active satellite is a hedge fund, rather than a long only active fund. This is because the long only funds would be constrained by the index benchmark, which will be closely related to the passive core, whereas it would make more sense to allow full investment freedom to managers to generate returns from stock-picking without any benchmark constraint. This would imply hedge fund style management, where the manager was free to invest in any stocks they believed would perform well and also allow shorting of stocks that were believed to be overvalued. This would obviously mean that careful selection of the hedge fund manager was required, but it is surely also crucial to select good long only managers too. There is a wide dispersion of returns for long only, as well as for hedge funds.

Fixed income hedge funds could be included in a fixed income portfolio as a type of cash based asset or as a fixed income surrogate.

Why are UK Consultants Reluctant to Recommend Hedge Funds?

UK consultants have simply not devoted enough resources to investigating hedge fund managers. When working for the UK Treasury on the Myners Review, I asked several pension fund trustees why they had not invested in hedge funds and they replied that this was because their consultants had not recommended them. Then I asked the consultants why they had not recommended hedge funds to their clients and they replied that this was because their clients had not shown any interest in them! Surely the investment consultants should have taken more time to analyse a fast growing class of assets, especially one that has generated such good returns and has the ability to reduce portfolio risk. Is it really up to trustees to show an interest before the consultant looks at the asset class? I would have thought it should be the other way round.

Of course, one of the problems is that hedge funds are very difficult and time consuming to analyse and are much more complex than traditional equity and fixed income management. There is much more to examine with hedge funds, than with long only management. There is less transparency and many strategies are extremely complex, so that consultants would need to spend considerable amounts of time to analyse each fund. The skills required to be a good hedge fund manager are not the same as those required by top long only managers. In particular, just being a successful manager of active equity funds does not guarantee being a successful equity hedge fund manager. Hedge fund managers must also know how to control downside risk and this risk management expertise is something that not all active managers will possess. 

Analysis of hedge funds is not the same as analysing traditional fund managers. It requires a different type of analysis, which UK consultants may not be used to and would require significant resources to carry out. However, pension funds have not tended to want to spend much money on their investment advisers, so the consultants found it hard to justify investing significant resources in analysing a new asset class which would require extensive due diligence. If they knew they would not be recompensed for their research efforts, there was little incentive to do it. Of course, with hindsight, pension funds have missed out on exceptionally good returns and the possibility of significant risk reduction. Many hedge funds have outperformed traditional assets and, even in recent bear markets, active equity managers have struggled to outperform the index.

So why are pension funds still wary of investing in hedge funds? Partly, this is due to a lack of understanding and education. Partly it is due to consultants not recommending them. After the exceptionally strong performance of hedge funds in recent years, UK consultants are naturally somewhat reluctant to recommend their clients to invest. They are afraid of getting into them just at the wrong time, are concerned about capacity issues and degradation of returns. 

So, What About The Future?

It is still likely that good hedge funds will continue to provide superior returns and reduce portfolio risk. But, as the market matures and more funds are set up, it becomes ever more important to know how to select the best managers and what the potential pitfalls are. Such knowledge is available either by detailed due diligence on the part of consultants or trustees by analysing individual hedge funds, or by taking advantage of the expertise of the various multi-managers who have been established for many years and who have extensive experience of choosing hedge funds and constructing hedge fund portfolios. 

Overall, hedge funds can still offer substantial risk reduction opportunities for pension funds and it would be well worthwhile for trustees to seriously look at including them in their portfolios. It is crucial, though, to only invest with good managers and to carry out extremely careful due diligence before investing. This is becoming easier, as hedge funds are offering more transparency nowadays.