Expert Predicts Pension Plans Will 'Significantly' Increase Exposure To Mid-Sized Hedge Funds

Nov 4 2010 | 11:48am ET

By Don Steinbrugge, Agecroft Partners -- Agecroft Partners predicts that pension plans will significantly increase their exposure to mid-sized hedge funds over the next 10 years. The pension fund industry is in the process of a major evolution in its use of hedge funds that has implications on what percent of their portfolio they allocate to hedge funds and how they achieve their hedge fund exposure, which will have profound implications for mid-sized fund managers. The pension fund industry has a very glacial approach to changes in asset allocation which can take a couple decades to fully implement across the industry. Although pension funds' asset allocation trends are slow to develop, they tend to be very strong and consistent.
To better understand this phenomenon, it is instructive to examine the example of pension allocations to international securities beginning in the mid-1980s. In the early 1980s, almost 100% of U.S. pension plan assets were invested in U.S.-traded securities. It was viewed as imprudent and highly risky to invest in non-U.S. based securities, despite the strong academic evidence that diversifying outside the U.S. could enhance returns while reducing volatility.

The process of U.S. pension plans diversifying their portfolios with investments based outside the U.S. began with a few very large and high profile pension plans adding international equity as a component of their asset allocation. Initially, they limited that exposure to 1% or 2% of their total assets, even though their asset allocation models suggested an allocation in the mid-20% range. This cap was slowly increased every few years until allocation levels in the 20% range were achieved over a 10 to 20 year period. The largest, most high profile pension plans tend to follow the lead of the largest endowment funds, but act as first movers in the pension industry. Mid-sized pension plans typically follow the lead of the larger funds a couple years later, which is repeated yet again by the smaller pension plans several years after that. This trickle down effect is one reason why investment decisions by CalPERS receive so much media coverage: many of the decisions they make will slowly be replicated across the industry.
A similar trend can be seen currently within the pension plan industry that will benefit hedge funds. Ten years ago, the average pension plan allocation to hedge funds was less than 1% and only a very few corporate pension plans had an allocation to hedge funds, with some of the first including General Motors, General Electric, and Weyerhaeuser. In 2001, CalPERS became the first public pension plan to allocate directly to hedge funds. Since then, we have consistently seen an increase in the percentage of pension plans allocating to hedge funds and an increase in the average percent of their assets allocated to this sector. This holds true even with the financial meltdown of 2008 and the subsequent media coverage of the Madoff Ponzi scheme and similar scandals, because pension plans have observed that hedge fund indices have outperformed the long-only benchmarks they use to evaluate how their assets are performing.
Agecroft believes that overall approximately 5% of pension plan assets are invested in hedge funds, and pension plans which have approved an allocation to hedge funds will have an average of 8% of their assets devoted to this sector. In a fully discretionary asset allocation model, with no constraints, hedge funds would assign an allocation multiple times this current level, which is where Agecroft believes the industry will gravitate over time. The current pension allocation is only a fraction of the allocation of many of the leading endowment funds, many of which have up to 50% of their portfolios invested in hedge funds.
The typical process most large pension plans follow to achieve their hedge fund allocations begins with a very small initial allocation utilizing hedge fund of funds. This is increased every few years as the pension plan increases its knowledge of the hedge fund marketplace. At that point, the pension moves to a second phase of investing directly in hedge funds with assistance from a consultant. An overwhelming majority of the hedge funds a pension plan will invest in at this stage of the process are the largest, "brand name" hedge funds with long track records. Performance is of secondary consideration to perceived safety and a reduction of headline risk. A vast majority of pension plans that have a hedge fund allocation are currently in these initial two phases.

After a few more years of making direct investments in hedge funds, pension plans move to the third phase and begin to build out their internal hedge fund staff, which shifts the focus from name brand hedge funds to alpha generators. These tend to be more midsized hedge funds that are more nimble. In a study conducted from 1996 through 2009 by PerTrac, small hedge funds outperformed their larger peers 13 of the past 14 years. Simply put, it is much more difficult for a hedge fund to generate alpha with very large assets under management. Many hedge funds do limit the amount of assets they will accept for a particular strategy, but there remains a large financial incentive to grow the fund above its optimal size in light of the strategy.

There are other hedge fund organizations that are morphing into large asset gathers and will grow their funds significantly above optimal levels, at times changing their investment process or type of securities traded in order to accept more investor assets. The fund at some point may bear little resemblance to what it looked like during earlier days when it was able to achieve strong investment returns. There is surprisingly little focus by investors on determining capacity constraints for individual hedge funds. Many investors limit their due diligence on this important question to an interview of the manager, who has a conflict of interest.
The pension industry is slow to move, but will gravitate over time to enhancing the risk adjusted returns of their portfolios. This is exactly the process they followed in the late 70s and early 80s after The Employee Retirement Income Security Act (ERISA) was passed by Congress in 1974, requiring all pension plans to prefund their liabilities. At that time, 90% of pension plan assets were invested with large banks, insurance companies and brokerage firms. The top 10 managers of pension plan money were large brand name firms like Prudential, The Travelers, Metropolitan Life, and Equitable. However, pension plans soon realized that these large organizations were not able to generate the same returns as their smaller independent competitors focusing on niche strategies. As a result, the 1980s saw a huge shift away from the brand names to smaller independent firms. This same shift will also take place with hedge funds. This is the process many of the largest endowment funds experienced. These endowment funds began making direct hedge fund investment in large brand name funds, but as their sophistication with hedge funds increased, they increased their allocation to smaller and mid-sized mangers. Agecroft also believes that some of the largest pension plans will adopt a hub and spoke approach to hedge fund investing, in which the hub of their hedge portfolio will be in the largest hedge funds to gain exposure to the "asset class," while the spoke will be invested in smaller, high alpha managers.
The final step of this evolution will occur when pension plans stop viewing hedge funds as a separate asset class and instead allow hedge fund managers to compete head-to-head with long-only managers for each part of the portfolio on a best-of-breed basis. Many of the leading endowment and foundations have evolved to this point: their portfolios are primarily invested in alternative managers, with large allocations to midsized hedge funds. This allocation strategy is now being called the "endowment fund approach" to managing money. Historically, the large endowment funds have been many years ahead of pension plans in implementing new strategies and as a result have significantly outperformed their pension plan peers.
"Agecroft is not predicting that pension plans will only be allocating to mid-sized hedge funds. What we are predicting is that over the next 10 years we will see a significant increase in the percentage of pension plans investing a meaningful percentage of their hedge fund portfolio away from the largest managers to small and mid-sized managers" said Doug Rothschild, managing director of Agecroft Partners. This evolution is not necessarily a negative for fund of funds or large brand name hedge funds, because the business they lose from their clients evolving to the next phase of the hedge fund allocation process will be offset by a significant increase in the number of pension plans making their initial allocation to hedge funds, as well as a significant increase in the average pension plan asset allocation to hedge funds. 
Don Steinbrugge is Chairman of Agecroft Partners, a global consulting and third party marketing firm for hedge funds. Highlighting Don's 26 years of experience in the investment management industry is having been the head of sales for both one of the world's largest hedge fund organizations and institutional investment management firms. Don was a founding principal of Andor Capital Management, which at its peak was ranked by Absolute Return Magazine as the second largest hedge fund firm. Prior to Andor Capital, Don was a Head of Institutional Sales for Merrill Lynch Investment Managers and Head of Institutional Sales for NationsBank (now Bank of America Capital Management).

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