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November 30, 2016 12:00 AM

How pension plans can build the case for hedge funds

Brian Robinson
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    Brian Robinson

    At the beginning, allocating to hedge funds seemed smart and easy. Allocations to a diversifying and non-correlated set of elite investors that could protect against market turmoil and improve long-term performance would be helpful to asset owners and retirement plan sponsors. The high fees would be justified by the performance benefits.

    When the thesis faltered — funds underperforming vs. what is now seven years of low yields and rising equity markets, and fees paid exceeding value delivered — allocators demanded quick answers. These answers came as a flood of disparate information. Hedge fund managers provided justifications, access and sometimes even increased transparency; consultants offered models and other funds that have done better; technology vendors offered sophisticated analytical tools.

    Buried under a pile of paper and under attack from boards, pension staffers tasked with overseeing hedge fund allocations are wondering where to go from here.

    The fact is that, in most cases, there still are good justifications for allocating to hedge funds, but these allocations need to be understood and monitored properly. Hedged assets will generally not outperform a rising equity market with low volatility. Dislocated markets, bear markets, inefficient markets are where hedge funds tend to do best, and these have not been the overall conditions during the slow and fragile recovery starting in 2009. Even so, many funds have outperformed. Unfortunately, unless pension fund officials were shrewd (or lucky) enough to find a set of outperformers, chances are their overall exposure to hedge funds has caused a drag on the portfolio.

    There is also reason to believe that walking away from hedge funds now would be like abandoning a hedge because it was too expensive right before the bottom falls out. It is reasonable to expect that global rates will begin to rise in the next year or so, and that equity markets (generally overvalued from a price-to-earnings perspective) should correct. In this case, hedge funds might offer exactly the performance and protection that justified the initial allocation.

    Where the above justification for hedge funds is the forest, the volume of information coming from hedge funds and the demands for information coming from plan sponsors are the trees. Maintaining a long-term investment perspective requires cutting through the wood to keep sight of the strategic objective, including:

    • What was the original reason for deploying assets to a specific hedge fund manager? Is that reason still sound?
    • Has the manager stayed true to its investment process or has it drifted over time? Do you have the core information and tools to assess drift?
    • If hedge fund allocation is designed to protect against adverse market conditions, have you tested the hedge fund in models of adversity? Do you have the necessary tools and resources to do this? If you reduce or eliminate this allocation how will you replace it with other investments to achieve the same strategy?
    • In assessing underperformance, has the manager performed in line with expectations for the prevailing conditions, or has the manager made bad decisions?
    • What operational and reputational threats does your manager pose? Do you have an ability to assess these? Hint: Beware of hubris and following the crowd.

    Strategic long-term investment clarity is the first step. Accessing and analyzing complete information becomes a critical execution tool. Cutting through reams of information to distill these questions and perform good analysis should provide some clarity on which managers to hold, which to redeem and the long-term value of the hedge fund program overall. Similar questions should be asked of hedge fund replacements like liquid alternatives funds, portable alpha, exchange-traded funds and smart beta.

    Any single data point a manager can collect about their investments can be useful, but being able to see trends, patterns and actionable information from millions of data points is required to effectively manage a portfolio of hedge fund allocations, and most plan sponsors do not have the tools and resources to do this. Where Excel and file systems are the primary data handling tools, the task of assembling data is more than many plans can handle, much less making sense of the data and extracting useful information and analytics. As noted in the New York State Department of Financial Services review of the New York State Common Retirement Plan released in October, “making a commitment to alternative investments places a much greater monitoring burden on the investor.”

    Given the good and proven reasons for maintaining exposure to hedge funds, where plan sponsors are considering elimination of the entire hedge fund class, they should first consider improving their tools and resources managing the asset class itself. Making better use of the information they have, answering the core questions around the costs and benefits of the funds they work with, will help plans stay focused on long term objectives over medium-term market conditions.

    Brian Robinson is sales and marketing director at Vidrio Financial LLC, New York.

    .

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