Experts Say Pensions Will Drive Growth Of Hedge Fund Industry

Aug 5 2010 | 11:05am ET

By Mary Campbell, Senior Reporter

The U.S. pension deficit, says Howard Eisen of FletcherBennett, is like a heart attack waiting to happen.

Estimates of the gap between the value of U.S. public pension plans and the amount needed to cover promised benefits range from $500 billion (Pew Center on the States) to $3 trillion (George Mason University). In the private sector, according to recent figures from Mercer, the deficit in pension plans sponsored by S&P1500 companies reached $451 billion at the end of June 2010.

“It’s like a person who has really high cholesterol and really high blood pressure,” says Eisen, managing director and co-founder of the firm, which specializes in business development and consulting for the hedge fund industry, “and right now they’re sitting in a relaxed position and it’s bad but it’s not to the point where they’re about to have a heart attack. So it’s a situation where, if you do nothing for the next five minutes you’re fine, for the next day you’re fine, for the next week and month you’re fine, but at some point in the future, a point that none of us can really define with any accuracy, you know there’s an impending event that’s going to happen and it’s going to be very bad and that event is a heart attack.”

The problem, he says, is threefold: underfunded pensions (both public and private, although he feels the problem is more acute in the public sector); pension funds using out-dated return assumptions; and government budget deficits—at all levels—making it unlikely governments can simply “write checks” to ensure pensions are fully funded.

“What does that mean today?” asks Eisen. “Today it’s not a problem because we’re not at a crisis, but at some point in the future—whether that’s a day, a week, a month or five years—it will become a problem. And not a problem for bankers, not a problem for hedge fund managers or other “wealthy” people… but a real problem for the middle class.”

The Treatment?

So, that’s the diagnosis, but what’s the cure?

Although quick to point out that they are “not a panacea for all the ills of the world—or even of the pension world,” Eisen believes hedge funds may be part of the answer—and he’s not alone in this belief.

Don Steinbrugge, managing partner and founder of Agecroft Partners, a hedge fund consulting and third-party marketing firm, says U.S. pension funds currently allocate about 3% of their investments to hedge funds (with some of the larger public pension funds allocating up to 20%). He believes the average allocation will rise to 10% to 20% over the next 10 years, driving growth in the hedge fund industry:

“Right now, the defined benefit marketplace in just the U.S. is between $5 and $6 trillion, so a 3% allocation, you’re looking at somewhere between $150 and $180 billion [in] assets which is roughly 10% of the hedge fund market place. And if you look at that allocation over the next 10 years going from 3% to somewhere between 10% and 20%, it’s going to drive a significant percent of the growth of the hedge fund industry even before you take into consideration pension markets around the globe.”

Steinbrugge says that among institutional investors, pension funds are relative newcomers to the hedge fund market. First to embrace them were U.S. endowments and foundations which began investing in hedge funds in the ‘80s. Some of the bigger ones, he says, now allocate as much as 50% to hedge funds.

Around 2000, says Steinbrugge, the average pension fund allocation to hedge funds was “probably less than half a percent" of their portfolio.

“At that point there were a few, leading edge corporate pension funds that had allocations which included Weyerhaeuser, Raytheon, GE, and the GM pension fund, and then the first prominent public pension fund to start making allocations to hedge funds was CalPERS [California Public Employees' Retirement System] … in 2002. And since that time, the percent of pension funds allocating to hedge funds along with the average allocation has gone up significantly.”

Why Hedge Funds?

But what can hedge funds offer pension funds staring down the barrel of a multi-billion deficit?

Well, for one thing, says Eisen, hedge funds can help insulate pension funds against the kind of shock that rocked the market in 2008—the kind of shock he says pension funds are “not equipped to absorb.”

“You can’t have a year like 2008 when the average global equities index was down something in the neighborhood of 40% to 45% …those kinds of shocks, when you’ve got a 40% to 50% to 60% allocation to equities, broadly defined…cannot be sustained.”

Especially, he says, when you’re trying to “play catch up” at an assumed rate of return of 7% or 8% in an economic environment where you probably cannot achieve that return.

Hedge funds, he says, can help to fix this situation “by virtue of the fact that they’re long and short.  As a result they don’t participate as wildly on the downside when markets decline sharply.  So they provide some degree of insulation to a core equity portfolio or a core fixed-income portfolio against really, really sharp beta shocks like we saw in ‘01, ‘02, and ‘08."

“Now, you could say that the inverse then is also true: that because they’re long and short hedge funds don’t participate as much on the upside and I think that that’s accurate—when you get a sharp beta move up, that part of a portfolio that is exposed to hedge funds is typically not going to move up quite as much. I think that’s fine for a pension fund. A pension fund applies an actuarial rate of return objective—say 7% or 8% in current times—and they say, ‘That’s what we want to achieve,’ and if the S&P 500 is up 35% that year, that’s great, but that’s not what they’re shooting for.”

Work in Progress

Steinbrugge thinks this is a message that pension funds—particularly public pension funds—are hearing loud and clear. He expects the percentage of assets allocated to hedge funds to rise for both public and private pension funds, but believes the growth will be faster for public pension funds, due to legislation passed in 2008.

“Basically in 2008 legislation was passed in the U.S. that is changing the way that ERISA [Employee Retirement Income Security Act]-based pension funds discount their unfunded liability and also the term that they’re allowed to amortize that unfunded liability. Historically, pension funds used a static rate that rarely changed—it was typically in the seven-and-a-half to eight range. This new legislation is going to require ERISA-based pension funds to change their discount rate on a regular basis and will require them to tie their discount rate to the yield curve, and basically, that fluctuation of discount rates over time is going to create volatility in corporate pension fund contributions which many corporations are not going to want to see on their balance sheets.”

As a result, he says, corporate pension funds are increasingly duration-matching a portion of their fixed-income portfolio with their liabilities to reduce the volatility of the annual contributions to their pension funds. To fund this increase in allocations, says Steinbrugge, pension funds will be taking money from long-only equity managers and shorter duration fixed-income managers and increasing their allocation to alternative investments—but at a slower pace than public pension funds.

Variations on a Theme

Naysayers, says Eisen, will argue that hedge funds employ too much leverage, are not sufficiently transparent, and are too secretive for pension funds’ taste.

“All of that is true for some of the hedge funds but not for all of them,” says Eisen. “Particularly coming out of the crucible of 2008, you find a lot of hedge funds are more liquid, a lot more transparent, they’re using a lot less leverage.”

Jeff Holland, managing director of London-based Liongate Capital Management, agrees.

“The reality is, the industry is one that is an innovation on long-only investing and hedge funds, when they’re run properly, are conservative vehicles that offer better risk-adjusted return for investors. That’s something that European pension investors—in the U.S., Europe and elsewhere—desperately need because they’re underfunded.”

For Eisen, hedge funds are just a variation on core equities or core fixed-income portfolios.

“A manager who is trading long/short equities is somebody who’s doing the same things as a long manager, except those stocks that a long manager doesn’t like and has to vote by just not buying…this manager can vote by shorting it.”

Moreover, he says, pension funds are big entities that wield a lot of clout at the negotiating table:

“Frankly, a pension fund is a very attractive investor, the most attractive investor for a hedge fund, and they’re not price takers—they’re price givers. They can negotiate on fees, they can negotiate on transparency, liquidity, leverage, you name it.”

Attracting Pension Funds

So what does a hedge fund manager have to do to attract pension funds as clients?

Steinbrugge says pension funds are approached by thousands of managers each year and use a number of criteria to separate the wheat from the chaff:

“They analyze the quality of the organization, investment team, investment process, performance, risk controls, terms and the service providers the organization is using. Pension funds utilize a process of elimination to narrow their universe of thousands of managers down to the three or four they may hire each year. If a firm ranks weakly in any of those categories, it would be eliminated from consideration.”

Steinbrugge says he could “go on for a 10-page article” about what hedge funds need to do to get hired by pension funds, but if he had to narrow it down he’d recommend “clearly differentiating” the advantages your firm offers in each of the above-mentioned categories.

Eisen says hedge fund managers need to show operational soundness—“you know, real institutional soundness in their back and middle office and their client reporting apparatus.”
Also important, he says, is understanding the plight of the pension officer or trustee:

“These are not highly paid individuals, yet they are given the massive responsibility of safeguarding hundreds of millions and in many cases billions of dollars of pensioner money. They don’t share in the glory when things do really, really well but they do share in the blame if things go really, really badly. So that’s sort of a long-winded way of saying that they don’t get paid to take career risks. They need to be made to feel that they’re being listened to and that the hedge fund that’s requesting their allocation understands what their needs will be, what their objectives are and has a strategy that will address both of those.”

Holland, who manages a fund of funds, which is often a pension fund’s entryway into the hedge fund market, says educating pension fund trustees is also important:

“The consultants that pension funds use are doing a better job of trying to educate pension trustees about hedge funds and conducting education days on hedge funds where they present the asset class and explain what hedge funds are all about to try to get trustees up that learning curve and I think that’s the right approach. It would be a mistake for pension funds to say, ‘Well, we don’t quite understand hedge funds so we’re going to avoid them.’ Or for regulators to say, ‘You know, the public don’t understand pension funds and we don’t quite understand them either so we’re just going to regulate them out of the market,’ which is at risk of happening in Europe at the moment.”

In the end, says Holland, hedge funds can improve investments on a risk-return basis but “they aren’t easy to understand.” They are advanced instruments, he says, requiring more advanced education.

Which inspires a final question: what to tell the average pension fund contributor, the public sector employee whose retirement is riding on these investments, if he or she is nervous about hedge fund investments? Says Steinbrugge:

“You know, I think the answer is it’s up to pension funds to make sure their beneficiaries are educated to the benefits of investing in hedge funds. The fact is that a diversified portfolio of hedge funds over the past 10 years has significantly outperformed the S&P 500 with a lot less volatility and the issue most individuals have is they’ve read the headlines about Madoff or some other high profile hedge fund that hasn’t floated, but what they don’t see is what the average hedge fund has done and what a well-diversified portfolio of hedge has done."

“If the media focused on individual stocks that went bankrupt the average citizen would be petrified to invest in stocks. Or if the media focused on bonds that defaulted, then the average plan beneficiary would be petrified to have the pension fund invested in bonds. So, the academic evidence shows that an allocation to hedge funds, from a risk versus return standpoint benefits the pension fund.”


In Depth

Q&A: Jeff Eaton Talks Capital Raising, CalPERS And The Secondaries Market

Oct 14 2014 | 10:16am ET

Global placement agent Eaton Partners has raised close to $60 billion for some of...

Lifestyle

MacDonald-Korth Offers Insights Into Paintings Bought, Sold By Hedgies

Oct 7 2014 | 9:00am ET

Definitive and complete ratings require an in-person examination of an artwork,...

Guest Contributor

PAAMCO: European Equity Exposure - Challenging Year, But All is Not Lost

Oct 16 2014 | 4:12am ET

European equity hedge fund managers have had a tough time so far this year. The...

 

Videos

Editor's Note

    Must Attend Hedge Fund Charity Events For October

    Sep 30 2014 | 9:29am ET

    The crisp Autumnal days of October are upon us, and so are a few of the hedge fund industry’s favorite charitable events. If you have never been to Rocktoberfest, well, you are missing out. And for a quieter evening of sipping and socializing, stop by HFC’s Wine Soiree. Read more…

 

Futures Magazine

October 2014 Cover

Deeply flawed risk benchmark

Most traders agree that proper risk management is the key to successful trading. However, many traders depend on the deeply flawed measure of standard deviation as a benchmark of risk. Here we put it ...

The Alpha Pages

TAP July/August 2014 Cover

The Alpha Pages Interview: Senator Rand Paul

Senator Paul sat down in the debut series of the Alpha Pages Interview to discuss the broken tax code, regulation surrounding Bitcoin, and his plans for the 2016 Presidential election.