European pensions to hedge funds: Wherefore art thou Romeo?

For hedge funds, getting an allocation from a pension fund has long been the golden carrot. Big, thoroughly diligent and generally “sticky” when it comes to putting their capital to work and keeping it there, they have long been the Juliet to hedge funds’ Romeo.

It seemed that might not be the case in the aftermath of the credit crisis and global downturn, particularly as pensions and other institutional investors got smacked with negative returns and surprise gates.

But if Mercer’s latest pension fund investment survey (click here for a brief overview and to download a free excerpt) is any indication, the bloom may still be on the rose – at least among European pensions.

According to the survey, investment in non-traditional asset classes remains strong, with increases observed in many countries such as the UK and Ireland (both up from 6% to 9% in 2010), and Switzerland (up from 19% to 23%).

In the UK, schemes favor hedge funds, GTAA and private equity, with 4-9%  holding some form of strategic allocation to one or more of those kinds of opportunities. In the rest of Europe, funds of hedge funds are the preferred route (8% have an allocation), along with high yield bonds (8%) and private equity fund of funds (6.6%).

Driving pension interest in alternatives is the broader trend away from equity allocations, according to the survey, in the UK in particular, with 29% of UK schemes and 35% of European schemes (ex-UK) planning further reductions in domestic equity markets. A further 20% of UK schemes and 33% of European schemes (ex-UK) are planning a reduction in non-domestic equity.

Indeed, from a broad perspective, the percentage of pension funds indicating they plan to allocate to “other” – i.e. not, equities, bonds or property – was up from 2009, with Norway being the most aggressive and Spain the least (see chart of broad asset allocation strategy interest below).

Source: Mercer

To be sure, Mercer noted that many pensions are still contending with both volatility and currency risk.

“Although we believe it is appropriate for schemes to diversify away from their domestic markets, there is a danger that they will merely reduce domestic concentration as one type of risk, only to increase it with currency risk, as another,” said Crispin Lace, Senior Investment Consultant at Mercer.

Looking at those schemes that have addressed the question of currency hedging, around 10% expect to introduce a target hedge ratio or increase their current target over the next year, he said.

Of course, what is practiced and what is ultimately preached may be two very different things, particularly if the European Union’s Directive goes through.

In current form, the Directive, officially called the Alternative Investment Fund Memorandum (AIFM), would prevent EU investors, including pension funds, from allocating money outside the EU – at least not without some fairly stringent rules. The same would go for hedge funds outside the EU looking for European pension money.

(CAIA’s sister organization, the Alternative Investment Management Association (AIMA), has a complete overview of the Directive and its implications on its Web site.)

We suspect the Directive in its final form will be less intrusive and allow for the free flow of capital to – and from – European pensions, particulary after the G20 informally chimes in on the topic at its meetings in Washington DC later this month.

After all, it would be a shame to see a Montague / Capulet-style feud get in the way of what appear to be two star-crossed lovers.

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