I remember attending an asset managers’ conference in San Francisco, Cal., in the summer of 2007, and listening to a keynote speaker who was boss at a northern California municipalities’ pension fund. He said of himself with a touch of pride: “I don’t do hedge funds.” In context this clearly meant that he doesn’t invest his fund’s money in them, and he thinks himself virtuous in that refusal.
Just days before that, colleagues of his, and fellow Californians, the execs of the San Diego County Employees Retirement Association, had filed a lawsuit against Amaranth Advisors, accusing that hedge fund of misleading them into believing that it, Amaranth, offered a safe investment product.
Now, it seemed pretty clear to me that no sophisticated person (such as anyone who had any business making decisions for SDCERA) could really have failed to understand that Amaranth was a speculative investment, and that if you invest in a hedge fund you take chances with that portion of your portfolio – in the reasonable hope (though not in the certainty) of satisfactory reward. Relatedly, the motto of the City of San Diego is Semper Vigilans.
At the conference I had the opportunity to ask Mr. I-don’t-do-hedge funds about Amaranth and San Diego. He stood up for his colleagues, asserting that he was certain they had been deluded. The lesson here is that even hedge fund-allergic pension fund managers will rise, when the occasion presents itself, and affirm their solidarity with those managers without that allergy.
It did not surprise me, then, to learn from a paper newly released by PricewaterhouseCoopers that the pension fund world is shedding the allergy generally. The question in 2012 is not whether hedge funds (and other alternative investment vehicles) can attract such funds, but how they should go about it. (The PwC paper is called “Attracting Pension Plan Assets: What alternative investment managers need to know.”)
The trend is likely to continue. PwC refers to a survey by Russell Investments finding in 2010 that institutional investors in general were likely to swell their allocation to hedge funds from 14 percent (2010) to 19 percent (2013). That study also found that the nature of the “alternative” universe within pension allocations is changing, the role of commodities and infrastructure investments (the alt-alternatives, so to speak) increasing, the role of hedge funds and private equity (the traditional alternatives) somewhat declining. [See below.]
Pension plan sponsors are plainly attracted by one or another tier of alternatives as part of their search for high absolute and risk-adjusted rewards, and low correlations.
What Spooks Them
But alternatives managers will benefit most from the heightened interest of pension funds if they address the continuing concerns of their pension fund colleagues.
For example, pension managers are well aware that investment in exotic and illiquid products is something hedge funds do, and they know that these products can help make a quick exit impossible.
What can hedge fund managers do about this? PwC suggests that investors be offered monthly or quarterly redemption rights, after the initial lock-up period is over; that they be offered managed accounts or fund-of-one structures; and that they be advised that “a diversification of funds or a stacking strategy can help mitigate the liquidity risk associated with extended lock-up periods.”
Pension fund managers also understand, and lose sleep over, the valuation problems associated with alternative investments in general and with certain hedge fund strategies in particular.
Managers can introduce improvements here, if they are not already in place, such as ASC 820 and back testing for level 3 assets. Such policies should be “regularly reviewed by an independent oversight governance board.”
Then there are “operational complexities.” PwC means by this phrase mostly the opportunities for conflict that arise when, for example, back and front office tasks are not well segregated, and the opacity of actual or potential conflicts from the point of view of investors. What can managers do to ease the minds of their institutional investors on this point?
They should first assess whether existing controls are operating effectively to resolve such issues, again with the help of an independent third party, prior to an investor due diligence review. They’ll then be in a position to “provide evidence that internal controls have been reviewed.” PwC also thinks it wise to use third parties for middle and back office functions as needed to eliminate potential or perceived conflicts of interest.