LONDON -- Pension funds could boost performance and reduce risk by adding hedge funds to their asset mix, a new report from Goldman, Sachs & Co., New York and Financial Risk Management Ltd., London, says.
The report found that, in the last five calender years, hedge funds have outperformed traditional stock and bond benchmarks during six market corrections, defined as more than a 3% drop in the Standard & Poor 500 index.
Yet, under 2% of plan sponsors use hedge investment vehicles at all, while 50% invest in private equity or other alternative investments, said John Taylor, vice president Goldman Sachs' pension services group. He explained that Goldman Sachs decided to study hedge funds and their correlations to each other and different benchmarks to see whether plan sponsors could create more efficient portfolios by using certain hedge fund strategies.
The report, "Hedge Funds Demystified: Their Potential Role in Institutional Portfolios," is based on data collected by FRM from 275 funds that have been trading for the five years from 1993 through 1997. It includes two theoretical models in which hedge funds are given a 10% allocation from a pension fund.
In one scenario, the 10% hedge fund allocation replaced 10% invested in the Lehman Aggregate Bond index, the portfolio showed an increased total return plus improvements in other areas such as standard deviation. In the second scenario, the 10% allocation replaced 10% from the S&P 500 index, the hedge fund addition resulted in a lower total return, but with much lower volatility as well as improvements in downside deviation and Sharpe ratio.
For the theoretical studies, FRM used a subset of 44 hedge funds that it calls "absolute return funds." These place strong emphasis on the disciplined use of investment and risk control processes, which have resulted in returns that have both low volatility and low correlation with traditional benchmarks. For the purposes of the study, it was assumed that a fund used all 44 managers.
Mr. Taylor noted that the report was prepared by the pension services division, which is separate from Goldman Sach's broker dealer division which has many hedge fund clients. He declined to name the clients, adding that the broker dealer division probably deals with most of the hedge funds.
Hedge fund managers employ a variety of strategies, and as a result the correlation between the different categories is frequently low and stable, while stock or bond fund managers have a high correlation to a specific benchmark, noted Mr. Taylor.
"This means that hedge funds represent a different source of return for the traditional manager."
The main strategies used by hedge fund managers are "market neutral" or "relative value strategies," which are the most conservative and which invest in fixed-income and/or equity products but aren't dependent on market movement; "event-driven strategies," which are based on the actual or anticipated occurrence of a particular event such as a merger, are not dependent on market moves; "long/short" strategies which combine long investments with short sales to reduce but not eliminate the broadest array of risk/return profiles; and "tactical trading" funds which are the riskiest and speculate on the direction of market prices of currencies, commodities, equities and/or bonds in the futures and cash markets.
The low correlation of returns between hedge fund managers using different strategies has important implications for pension funds, said Mr. Taylor. "When traditional managers are selected by pension funds, the tendency is to approximate an index. But the low correlation within the hedge fund universe means you might want to use more hedge funds rather than fewer, because the low correlation is stable," he said.
There is a misconception about hedge funds that they do a lot of trading and take a lot of risk, yet the vast majority are not doing either, Mr. Taylor contended. "In fact their risk controls are so secure that the equity-oriented funds have a volatility level that is lower than that of the Lehman Aggregate Bond index, which is around 4%. Many hedge funds have a volatility range of 2% to 3%, but their returns are in the double digits," he said.
But William E. Jacques, chief investment officer at Martingale Asset Management, Boston, which uses long-short strategies, questions whether the benchmarks used in the report are appropriate. "It's like comparing apples and oranges," he said. "It's hard to know which benchmark is suitable when doing these analyses. Hedge funds are so secretive, they could be invested in anything, and usually you don't know what it is."
Mr. Jacques is also skeptical about the high returns touted by hedge fund managers. "Some of the funds are extremely volatile and may not be suitable for a pension fund. Certain styles could not take the place of a domestic equity fund, for example," he said.
The tactical trading style funds are the riskiest, and could have a volatility of 30 to 40% said Mr. Jacques. "Those do not belong in a pension fund except maybe in a small percentage and lumped into an 'anything goes' category, but buyers should beware," he said.
Mr. Taylor of Goldman Sachs conceded that pension funds have been reluctant to use hedge funds because they are so much more secretive about their investments than traditional funds.
While it may be harder for pension funds to hire hedge fund managers than it is to hire traditional managers, the process is similar, Mr. Taylor said. "You can ask what their investment process is, what kinds of securities they invest in. The questions you ask are the same as those traditionally asked, but getting the answers is more difficult."
FRM studied all the hedge funds with five years of performance history for its analyses. The report notes that the results are subject to survivor bias because funds that stopped trading are not included, and those funds have often performed poorly. The authors state that while the bias may distort results, they believe if there is a distortion, it will be small.
Patrick Moriarty, partner and senior vice president, Evaluation Associates Capital Markets Inc., Norwalk, Conn., concurred. "If the data is only for five years, survivor bias should not be a problem," said Mr. Moriarty.
