Christopher Andrews explains why trustees shouldn’t write-off hedge funds based on their recent rocky past

Back in 2008, global economic meltdown, plus the biggest investment fraud in history courtesy of Bernie Madoff, led some commentators to question whether hedge funds had had their day. They hadn’t.

The latest figures from US-based firm Hedge Fund Research have shown that in the first quarter of this year, total capital invested in the global hedge fund industry exceeded $2 trillion for the first time in history, up from a financial crisis low of $1.33 trillion in the first quarter of 2009.

Commentators can be forgiven for having asked the question, though, as it was a very patchy time for the industry. At the end of 2007 and beginning of 2008, says John Anderson, managing director within J.P. Morgan Asset Management's
fund of hedge funds team, pension funds globally had been moving into hedge funds to help lower the overall volatility of their portfolios. Indeed, the previous record for capital invested was $1.93 trillion set in the second quarter of 2008, according to HFR's figures.

However, after 2008 a number of pension funds that had been considering hedge fund allocations put their decisions on hold, mainly as a result of broader market meltdown. "Obviously, a lot of them took significant losses in other parts of their portfolios, so they weren't looking to readily make changes at that point," says Anderson. "But by the end of 2009 going into 2010, you saw renewed interest. Looking at how hedge funds did in 2009, they realised that long term they could still generate the level of risk adjusted returns that they had historically, and that it still made sense to add them into the portfolio."

The Madoff effect
For the hedge fund industry, however, a ‘business as usual’ approach was no longer acceptable if they wanted to attract institutional funding. Indeed, as a result of negative perceptions arising from Madoff and others, some are now loath to even refer to themselves as 'hedge funds', potentially considered something of a dirty word, says Antony Barker, managing director for investment advisory services at Pension Capital Strategies. "So now some managers may say 'well I actually do long/short strategies, or it's morphed into 'risk neutral approaches', which sounds a lot better. So there's been a degree of subtle rebranding."

There has also been a change in the sometimes mysterious nature of hedge funds, with 'ask no questions and reap the benefits' a thing of the past for pension fund investors. Ironically it was Madoff that really put the focus on transparency and due diligence, which has now made investors comfortable enough to invest those record figures into funds.

"I think Madoff put a spotlight on it, but transparency continues to improve from a reporting standpoint as more institutions enter the space, because they've been more demanding on the level of transparency that they need to get comfortable with a hedge fund allocation," says Anderson. "So you've seen better reporting from underlying hedge funds, you've seen hedge funds for the most part now using independent administrators, where ten years ago, they may not have."

"Clearly after the financial blow-up we have witnessed an increase in due diligence, not just in how the portfolio is created but operational due diligence," says Fabrice Cuchet, head of alternative investments at Dexia AM. "So now many fund of funds or investors are looking more in depth in terms of due diligence before selecting a fund manager. So yes, there has been an aftermath from the Madoff fiasco, though it was not just Madoff, but the entire financial situation that led to it."

Of course, the Madoff situation was not one of bad management, it was outright fraud, and rules on transparency probably wouldn't have made much of a difference; by its very nature, once you see a fraud it is no longer a fraud, and people seemed very willing to turn a blind eye to the situation as returns continued to be produced. The difference now is that, fearful of getting burned in a similar situation, people are actually asking all the questions that proper due diligence requires, says Alastair Barrie, global head of hedge fund sales at Martin Currie.

"I think you've historically had funds that disclosed very little, the statutory minimum. And I think that some of the industry has found that if they want to attract pension fund assets, then they must disclose more information. So it's kind of chicken and egg. If you want the assets you have to behave like an institutional investor and give the client what they want. If you choose to stay offshore and keep clients in the dark, then arguably you probably won't have a very big fund."

Winning strategies
Pension funds providing those assets are generally looking at something between five and 20 per cent of their return seeking portfolio, according to Barker, as less wouldn't have much of a bottom line impact, and more is perhaps getting a bit too concentrated. Also, he says, many are using hedge funds within a diversified growth fund strategy. "So as they become a more popular alternative to pure equity investment, then by implication more people are going to be using alternatives within that space, and that inevitably is going to lead to an increase in hedge fund allocations," he says.

Anderson says that the historical trend of UK pension funds investing in multi-manager, multi-strategy fund of funds is set to continue. This is to provide low correlation to traditional markets, in a low beta move for diversification from other parts of their portfolio.

He says that pension funds are also starting to look at hedge fund strategies as a non-separate asset class. "So looking at long/short equities for example, people are saying 'why are we thinking of that as a hedge fund? Why don't we think of it as a less constrained equity allocation?' That's the trend we're seeing now."

Along those lines, says Barrie, there is a developing school of thought that in strategies such as long/short equities, or long/short credit, those allocations no longer necessarily have to be funded from the alternative allocation within a scheme. "What schemes are trying to do is reduce the volatility in that particular part of their pension scheme assets. While that may be a hedge fund investment, it's not in a specific hedge fund structure, and schemes might fund this directly from an equity or bond allocation."

This new allocation strategy is confirmed by Cuchet, who says that his firm's division which advises clients on asset allocation is putting around 20 per cent into hedge funds. And recently, he says, the percentage relative to bonds has increased, taking into account low rates, and risk on sovereign debt being more on the downside.

"So part of the allocation is coming from the equity bucket, targeting similar expected returns to equities with lower risk; lower drawdown and half the volatility," he says, referring to this as a 'return-enhancer strategy'. "Also, part of it is coming from the bonds buckets, targeting similar level of risk (drawdowns and volatility) but with diversified sources of returns. These are called all-weather strategies. So, money is being allocated to hedge funds from both buckets of a traditional portfolio."

Of course not all pension scheme trustees will be comfortable with hedge fund investment, whatever bucket it's coming out of; the events of 2008, despite hedge funds generally performing much better than pure equity strategies, left a bad taste.

"When people hear 'hedge fund' they think of Madoff, they think of some of the big blow-ups that have happened," says Anderson. "But if you step back and look at the characteristics of high quality fund of funds, and their risk return statistics historically, they're very attractive from both a return and a risk standpoint, leading investors to take the time to understand the benefits and seriously consider them as part of their allocation."

And for trustees who still have bad memories from 2008? "My advice would be to take the time to learn more about hedge funds, get education from a number of different sources to make sure you're not just dismissing it because of initial perceptions," concludes Anderson. "Take your time, do the work, and if after that you decide no, then you have made an informed decision. But just don't take it that because you read about a hedge fund blow-up in the press that that's what all hedge funds are like."

Christopher Andrews is a freelance journalist

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