Fiduciary Alpha

Hedge Fund Regulation 12 Apr 2011

Does fiduciary management produce alpha?  For some years, it has seemed that some trustees were an obstacle to pension funds investing in alternatives. Now, governance models are evolving to allow appropriately incentivized professionals more freedom to make diversifying decisions.

Although developed, large cap equities have zig-zagged in the “noughties”, many smaller pension funds still seem frightened to embrace alternatives. There’s no need for exotic definitions of alternatives for this to hold true: for instance, plenty of UK pension funds are stuck in the same two dimensional bonds versus equities world as they were in the 1950s.  Many smaller UK funds have not even tasted currencies or property, let alone hedge funds, private equity or  “real” assets like commodities, forestry and infrastructure match inflation linked liabilities far better than nominal bonds. All of this could prove woefully inadequate if inflation takes off.

Believe it or not, politicians cannot be blamed for this particular pension problem: this OECD study shows that only Slovakia and Mexico legally prevent pension funds from investing in hedge funds. Given that the diversification benefits and alpha generation of alternatives are widely accepted, it must be governance models at some funds that act as a barrier between pension funds and alternative assets, as identified by a recent AAA posting.

The largest pension funds in most places have, of course, recognized alternatives. The world’s largest, CalPERS, has been investing in hedge funds since 1991 and this survey of the top 20 US funds shows all of them are now active in the space. Similarly with “down under” in Australia investing, 80% of large funds in alternatives according to this study commissioned by the Australian branch of AIMA.

So, do bigger pension funds have a better governance structure?  They almost invariably have investment professionals on their boards alongside laypeople, not to mention larger internal teams. However, smaller funds might find it too expensive to hire that kind of expertise – in which case, outsourcing some functions could be one solution.

Fiduciary management does not actually take governance responsibilities away from trustees, but empowers consultants or managers to take care of a wider spectrum of responsibilities. These duties range from top-down, long term strategic asset allocation and manager selection to short term tactical trading, dynamic asset allocation and overlays, as elaborated in this presentation.

Whereas trustees typically received fixed remuneration, fiduciary managers are incentivized to outperform a liability benchmark. The guiding star for a fiduciary manager is neither an absolute nor a relative exogenous investment benchmark, but rather is endogenous to each and every pension fund. According to last month’s AAA posting on the topic, by tailoring the benchmark to the individual pension plan’s liability profile, fiduciary management breaks out of the straitjacket of relative return investing that remains so prevalent.

The fiduciary responsibility forces the manager to reference decisions to the funding needs of the pension plan – and not the career advancement concerns of asset managers, who may be more interested in outperforming industry standard benchmarks than in meeting the specific requirements of the pension plan. This may sound similar to Liability Driven Investing (“LDI”). But whereas a blinkered and “comparative statics” approach to LDI can lead to a rather lazy and passive portfolio comprised entirely of assets designed to match or immunise liabilities – namely government bonds – the fiduciary approach simply defines the benchmark in terms of liabilities but still strives to beat that benchmark.

Fiduciary management has scooped up almost the whole Dutch pension market: it accounts for 89% of pension fund assets in the Netherlands, and is starting to make inroads into the UK and Germany. The trend is gathering momentum, with over half of the past decade’s appointments made since 2008, as the exponential function below shows courtesy of research firm Spence Johnson:

The growth potential for the fiduciary model is huge.  The chart below takes the UK as an example:

So, fiduciary management is a governance framework that increases potential for alpha generation from diversification, especially for smaller pension funds that have been slower to adopt alternatives. Traditional pension fund trustees, however, are bound point out that it is not a prerequisite for going into hedge funds: Some bigger pension funds such as that of internet inventor CERN have been doing forestry and hedge funds for years with a traditional trustee structure.

Trustees may also point out that, like partnerships, they remain “on the hook” for losses with unlimited liability, while fiduciary managers are usually incorporated as some form of limited liability entity. But, ultimately, neither group is likely to have the resources to fill the gaping billions of pension fund deficits. Only alpha generation can do that.

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