Investing in hedge funds is often seen as a risky business for pension funds but some see this as an unproven prejudice. Certain hedge funds are indeed better steered away from, but others are a safe investment well worth looking into.

Despite the fact that the image of hedge funds has improved in the last 20 years, European pension funds are still not very active in the hedge fund market compared to other investors. But due to modern technology and the abandoning of traditional asset allocation strategies, correlations among asset classes are a lot higher and require the pension funds to be actively involved in their investments.

Pau Morilla-Giner, senior portfolio manager at London and Capital, believes that, because of their specific needs and in order to fulfil return expectations, pension funds need to look for things that behave differently. “If bonds and equities correlate, what doesn’t correlate? This is where hedge funds can help out. They went up until 2008, after which hedge funds in general did poorly. But in a year when equities were down 40 per cent or high yield was 60 per cent, hedge funds were only down 20 per cent. And what is also very important is that a lot of these hedge fund strategies actually made money in 2008.”

Jakob Lage Hansen, investment strategist with SEB X-Asset team, sees two major advantages of having hedge funds in a portfolio. Returns will go up due to the skilful managers in the industry and the portfolio will be more diversified due to hedge funds’ ability to invest in alternative betas and go short. This is particularly valuable at the moment as for the next five to ten years, returns on traditional assets are expected to be lower and loss risk on traditional balanced portfolios will be higher. “Many pension funds are struggling to meet their liabilities in the current environment, and including hedge funds can help them address that issue.”

Among the European countries there are huge differences between investments in hedge funds, mainly caused by a big discrepancy in regulations. Morilla-Giner continues: “Some countries are certainly on the fore-ground when it comes to the ability to invest in hedge funds. But there are many other countries were regulation is still very far behind. Local regulators do not allow local pension plans to invest in them, or, if they do, as in the case with Spain, they make sure it’s not in a very tax efficient manner. So effectively, they are not allowing it.”

Morilla-Giner believes that Eastern Europe and countries like Spain will eventually catch up and in ten years or so will create a healthy exposure to hedge funds, like Italian pension plans have achieved in the last decade. European pension funds that are currently investing in hedge funds often choose for global macro strategies, because of their liquidity.

“A lot of hedge fund strategies are very good, but if there’s too much money that goes into the space, opportunities just dry up. That’s not the case with macro, because it can invest in a global basis and in some of the more liquid asset classes in the world like currencies, interest rates or equity indices. There’s never too much money that can be allocated before returns begin to suffer.”

SEB’s latest report, Do hedge funds add value to portfolios?, concludes that an average hedge fund is highly correlated to traditional assets providing limited hedge in multi-asset portfolios. Therefore it is essential for pension funds to identify managers delivering either high alpha or an investment process targeting diversification. Allocating assets to hedge funds would thus only be beneficial if a good manager is appointed.

Lage Hansen says: “For investors it would mean dedicating resources to set up an adequate investment process and ongoing resources to monitor the industry, select hedge funds and keep track of the actual risks inherent in their hedge fund investments. Alternatively they can team up with an advisor that can assist in the process.”

Otto Franke, senior portfolio manager, alternative investment team at SEB, explains that pension funds should determine what they want to achieve with their hedge fund investment, whether this is return enhancement or diversification. Then they should select those strategies that suit their needs, as not all hedge fund strategies are created equal. Pension schemes have to understand the strategy and the risks taken to generate returns and not just buy track record.

“This sounds self-evident but it is interesting how investors tend to buy good track records without fully grasping the risks. Pension plans should also do comprehensive due diligence on the managers selected to implement the strategy (operational, investment, risk management, etc). My impression is that pension funds appreciate partnering up with fund-of-funds in this respect, to have a discussion partner, and not just buy an of-the-shelf fund-of-fund.”

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