The prospect of prolonged weakness in equity and fixed-income markets is sending more pension funds out in search of return-boosting strategies - especially hedge funds.
Plan sponsors, consultants and managers say hedge funds will further diversify portfolios, lower volatility and add a few basis points to portfolio returns. That seems to be enough to give a number of pension executives the incentive to pursue hedge fund investments - something they may not have been comfortable with even a few months ago. In recent months, a number of plans either invested in hedge funds or launched asset-liability or asset allocation studies designed to figure out where hedge funds could fit in and what strategies work best.
This year, New England Pension Consultants Inc., Cambridge, Mass., has performed more hedge fund manager searches and allocated more money to hedge funds on behalf of more clients than ever before, said Peter Gerlings, a senior partner at the firm. The interest, and the action, is related to the weak markets, he said.
Plan sponsors' perception of hedge funds also has changed, he said. "Back in the late 1990s, people would ask, why would you need a hedge fund? The S&P 500 was doing all the work for you. Now, many investors have soured on the public markets. They're looking for any way they can to get higher returns."
`Expediting' the process
Kelsey Biggers, managing director of risk management for K2 Advisors, New York, a $1 billion fund of funds, agreed. "The market dynamics have changed very dramatically," Mr. Biggers said. "Lots of people are skeptical of the equity markets. The environment we're in is expediting the (hedge fund) review process, no question."
Mr. Biggers said two large corporate pension funds recently made allocations to funds of funds. He wouldn't name them.
In May, the $3.3 billion YMCA Retirement Fund, New York, committed $100 million to two fund of funds firms - Tremont Advisers Inc., Rye, N.Y., and Grosvenor Capital Management LP, Chicago - in its first hedge fund investments.
Also in May, the Pennsylvania State Employees' Retirement System, Harrisburg, committed $575 million each to funds of funds run by Blackstone Alternative Asset Management, New York; Pacific Alternative Asset Management, Irvine, Calif.; and Morgan Stanley Alternative Investment Partners, New York. The $24 billion system also hired Morgan Stanley to run an equity overlay strategy for its absolute-return fund of funds program, a fund spokesman said.
The list goes on - $44 million from the $795 million capital fund at the Sisters of Mercy Health System, St. Louis; $10 million from the Pentegra Group's $1.6 billion Financial Institutions' Retirement Fund, White Plains, N.Y.; $5 million from the $274 million New Haven (Conn.) Police & Firemen's Pension Fund - all of it flowing either directly to hedge fund managers or into funds of funds.
And that's just the institutional investors that have reported making hedge fund allocations since March. Many more are conducting studies that might lead to hedge fund investments. The $1 billion Marin County Employees' Retirement Association, San Rafael, Calif., is one of those.
The plan's board will meet in July with consultant Callan Associates Inc., San Francisco, to discuss possible hedge fund allocations, which trustee Milbrey M. "Casey" Jones said he thinks would be a good idea, given the current stock market.
Although Mr. Jones said Marin County is 99% funded, the calendar year return for 2001 was -2.25%, far below the fund's actuarial return assumption of 8.25%.
`A pretty ugly time'
"The reality is we're looking at a pretty ugly time in the pension fund world," Mr. Jones said. "You're 21/2 years into a bear market, and most funds haven't (met) their actuarial assumptions for two years. I think people are going to have to take a hard look at alternatives strategies."
Specifically, Marin County could explore a small allocation to a market-neutral equity strategy - a sort of "toe-in-the-water" approach to hedge funds, but prudent nonetheless, Mr. Jones said. As the results come in and the trustees become more familiar with hedge funds, the system could increase its exposure. Ultimately he sees no reason not to try hedge funds.
"Unless the market makes a dramatic comeback, you have basically one choice," Mr. Jones said. "You can cut your actuarial assumptions, which creates an unfunded liability and forces you to issue pension obligation bonds. Taxpayers hate pension bonds."
Still, the best most plan sponsors can hope for from a hedge fund allocation is a boost of only a few basis points of return, said Joseph Nankof, a partner at consultant Rocaton Investment Advisors LLC, Darien, Conn. Many pension funds, he said, opt for a conservative approach that amounts to an enhanced index strategy. Instead of investing $100 million in the Standard & Poor's 500 stock index, or buying S&P futures and investing the bulk of the assets in a risk-free vehicle as an overlay, a pension fund might spend $5 million on S&P 500 futures and allocate the other $95 million to a market-neutral hedge fund or fund of funds.
Any returns the hedge fund investment generates in excess of LIBOR are "ported" over to the S&P 500 investment, resulting in outperformance of the index.
"It's a common use of hedge funds we've seen among our clients," Mr. Nankof said.
But the return boost from such a strategy isn't exactly turbo-charged, and in fact Rocaton does not advise clients to expect a big return boost from an overlay hedge fund investment.
"If you get three percentage points of added return on a 5% allocation to hedge funds, you can expect about 15 basis points of added return on the total portfolio from investing in hedge funds," Mr. Nankof said.
The YMCA Retirement Fund gave Tremont and Grosvenor the freedom to invest across a broad spectrum of hedge fund strategies, said Victor J. Raskin, YMCA chief investment officer. He said the goal is to achieve equity-like returns with "half the market risk" and a correlation to the S&P 500 of between 0.2 and 0.4.
The YMCA plan's decision to allocate to hedge funds came out of a confluence of events. New managers and new trustees came on board just about the same time that equity and fixed-income returns started falling, Mr. Raskin said. The YMCA had trouble even meeting its relatively low 6.5% actuarial return assumption.
Following an asset allocation study, Mr. Raskin helped convince the fund's board that an allocation to hedge funds would help diversify the fund and give it a little return boost during a period of lower returns.
"Unlike the corporate world, we have no deep pockets to dig into if we find ourselves underfunded," Mr. Raskin said.