Hedge funds report

Tessa Kohn-Speyer continues her review of the role hedge funds can play in a European pension fund portfolio, in the second of three reports

Are hedge funds still appropriate as a diversification strategy?
Market turmoil has created negative sentiment towards hedge funds, some being blamed for the current situation. But is this fair? Many factors led to the state of the markets, not least excess leverage and complex financial structures. Neither can be blamed on all hedge funds, which come in different guises with different risk profiles. Rather than a single asset class, they should be viewed as a range of strategies employing non traditional investment methodologies, investing in various assets and developed out of market demand for high returns with lower volatility.

For many, the term 'hedge funds' evokes managers using highly risky strategies with clients' money. There are a variety available – some very high risk, others not at all and some with a much higher correlation to equities. But it is not always clear which is which; better labelling of hedge funds would help prevent confusion, but so would a better understanding of the risks.

Risk is a sensitive issue, particularly when considering new asset classes/strategies, where the risks are less clear and traditional measurement tools do not necessarily apply. This is certainly true of hedge funds. The key risks include a lack of transparency, illiquidity, the amount of leverage and the risk of blow up, where a fund suffers a significant loss and may even go bankrupt.

But what risk is important to you?
Inability to pay benefits as they fall due is a fundamental risk for pension fund trustees. They are concerned with the volatility of assets relative to their funds' liabilities. Often, there is a need or desire for higher returns that may come at a cost. By combining different assets in a diversification strategy a trustee can satisfy the need for return with less risk. Diversifying the assets can allow a fund to reduce its overall risk level without a significant reduction in return expectation. One can argue that some hedge funds fit this category; they have little correlation to long-only equity investments and can reduce volatility.

However, many may fear that the diversification argument has broken down. Everything has suffered giving the impression there is no benefit from diversification. So it is important to put what has happened into context. While assets expected to move independently of equities have moved in the same direction, let us not forget that the current situation is exceptional; being cited as "the worst economic crisis in over 60 years". Hedge funds suffered in 2008 but rarely to the same extent as equities. A few even delivered the absolute returns promised. Despite rising correlations, there has still been a benefit from combining a global equity exposure with a hedge fund exposure. We believe the diversification argument still holds.

It should also be noted that most risks can be mitigated through careful analysis and selection of the hedge fund strategy best suited to your needs. If a hedge fund "does what it says on the tin", it should help achieve a pension fund's goals over the medium term.

Finally, it is important that investors understand whether the return they expect is reasonable given the level of risk being taken. Given the options available, it is possible to select a strategy or fund of funds that best suits your risk/return needs. Strategies available range from the more aggressive, offering, say, Libor+15% with high volatility, to the more modest, offering Libor+4% with much lower volatility. The key consideration is selecting a strategy that offers an efficient return for the desired level of risk.

WRITTEN BY TESSA KOHN-SPEYER, HEAD OF INSTITUTIONAL, SOCIETE GENERAL ASSET MANAGEMENT (SGAM)