Guest Contributor

Economies And Value In The Pension Universe: Is Protection Worth The Price?

Nov 7 2011 | 5:31am ET

By David Smith, Chief Investment Director for GAM Multi-Manager -- The financial crisis and recent industry scandals have left many pension fund managers with stringent mandates to protect performance and maintain liquidity while slicing costs. Challenging return targets within the US$26 trillion global industry (Source: Towers Watson, Global Pension Asset Study, Dec 2010) continue to test allocation decisions, with few traditional asset classes currently able to offer stable returns and diversification.  

In order to meet liabilities, pension funds seek uncorrelated returns while adopting a calculated attitude to risk, often relying on allocations to hedge funds to diversify their source of returns and protect capital when equity and fixed income markets fall. Many pension funds seek the services of fund of hedge fund (FoHF) specialists to research, select and manage their hedge fund allocations, due to the size and complexity of the investment universe. But such specialist services are accompanied by fees, averaging 1.07% (Source: bfinance, Investment Management Fee Study, May 2011), which managers can often baulk at paying in times of austerity. As a result, some investors prefer to invest directly in the underlying hedge funds, rather than use a FoHF.

However, in return for their fees, FoHFs offer a number of benefits, including performance that is uncorrelated to traditional asset classes and in-depth knowledge of the vast hedge fund industry. In addition, they should offer a rigorous due diligence and risk management process and transparent client reporting. If pension fund managers choose to bypass the services offered by the FoHF professionals and select a blend of hedge funds themselves, these essential requirements may become compromised. 

So what makes the FoHF investment approach an attractive alternative to direct manager investment? 

Due Diligence: Digging Deep In Search Of Quality 

Capital security continues to be a primary concern for all hedge fund investors, emphasizing the importance of thorough due diligence procedures. Widely reported frauds such as Madoff and Galleon, coupled with mixed returns and the upheaval caused by the recent financial crisis have led to many investors becoming wary of the industry.  

To avoid such concerns, a good FoHF due diligence function will analyze thoroughly any prospective investment. Firstly, it will evaluate the investment strategy of the hedge fund, seeking to understand how the manager generates its competitive edge and sustainable returns, using both qualitative and quantitative analysis. Secondly, and of equal importance, is the detailed review of the fund’s operational processes, which should include the accounting methods used, legal structures, valuation procedures, prime broker relationships and any liquidity constraints. This in-depth analysis can often identify critical ‘red flags’ that superficial checks may overlook.  

The Information Universe: Keeping Up-To-Date 

The hedge fund industry continues to evolve and up-to-date information is often difficult to access. Not all new hedge fund launches are widely publicized, as some managers prefer to concentrate on a focused group of trusted investors. However, well-established FoHFs with a track record for early stage investing are able to remain at the forefront of this evolving universe.  

The hedge fund industry currently numbers more than 7,000 funds, according to recent Hedge Fund Research data, and in order to have as comprehensive and as current a view as possible of this group, a FoHF needs to be well-resourced with the necessary systems to support its analysis.  

The most experienced FoHF managers have a multi-stage investment approach, employing extremely rigorous screening processes and risk metrics. In addition, most FoHFs demand and receive full transparency from their underlying managers, which results in a huge amount of data. Without the systems and resources to process and analyze all this information, a pension fund cannot claim to be in a position to make the most informed investment decisions for their beneficiaries. 

Industry Status: Optimizing Access And Terms 

Making an informed investment in hedge funds and monitoring that investment requires an appropriate infrastructure and scale. In addition, the big FoHFs often have the weight and the status to negotiate more favorable investment terms with their underlying managers such as waived minimum investment restrictions or lower fees, particularly when the hedge fund has just launched. Additionally, the leading FoHF names may offer access to some of the world’s most renowned hedge funds which may be closed to new investors.  

The hedge fund industry continues to attract some of the brightest minds in the investment universe. The responsibility of selecting and investing in that talent, in funds that are appropriate to a client’s investment needs, requires skill, experience and resources, plus rigorous and consistently applied investment and risk management processes. Combining industry status with the ability to screen the vast universe and implement strict due diligence controls enables FoHFs to make more informed manager selection decisions, laying the foundations for stronger performance. The skills offered by the leading FoHFs comes at a price, but side-stepping this approach in an effort to economize may, at best, not lead to significant cost benefits and, at worst, may put retirement funds at serious risk.   

David Smith is Chief Investment Director for GAM Multi-Manager. He is responsible for GAM's multi-strategy investments and co-manages several single strategy portfolios. Prior to joining GAM in April 1998, David was head of investment research and management at Buck Consultants.

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