If defined benefit pension funds de-risk in a rising yield environment, and defined contribution plans grow in assets, what impact will this have on hedge funds? Joel Hartley, investment consultant, Lane Clark & Peacock The defined contribution (DC) space is not particularly accommodating to hedge funds, with the liquidity terms and high fees in particular presenting two significant obstacles. However, it is questionable whether DC members should only have access to funds with daily or weekly liquidity. If any investor is able to lock money away, one could argue it is the 25-year-old DC member with 40 years of saving ahead of them. Daily dealt low-fat Ucits versions of hedge funds aren’t necessarily the answer. Why should investors be forced to compromise with a watered-down, constrained version of what is ultimately meant to be an unconstrained investment? In my view, much work is needed to broaden the range of funds and strategies available to DC investors. Despite the expected trend from higher to lower-risk assets, the impact on hedge funds may be less obvious. Many pension funds view their hedge fund allocation as a less volatile performance asset. As such, de-risking tends to be focused, at least initially, on moving out of equities, as this tends to have the most meaningful impact on reducing risk. Hedge funds could even be a beneficiary. Some schemes may switch from equities to lower-risk hedge funds/multi-asset funds as an interim step in their de-risking journey, especially with current low yields making bonds unattractive to many. The popularity of leveraged liability driven investment (LDI) strategies could also present an interesting opportunity for hedge funds. These strategies, in place of physical bonds, allow schemes to hedge interest rate and inflation risk in a more capital efficient way. A key consideration when using leveraged LDI is how to invest the cash collateral supporting the hedging programme, and absolute return investments are a natural fit here, given their focus on capital preservation and ‘cash plus’ objectives. Jon Exley, pensions partner, KPMG It is questionable that pension funds divide their physical assets between ‘matching’ and ‘growth’, with the latter including hedge funds. In practice, pension funds with LDI programmes are largely able to separate the decision to reduce asset risk from the decision to hedge interest rate and inflation risk. The main factor that has discouraged hedging of the latter two risks has tended to be the levels available – apparently low interest rates and high inflation break-evens – rather than funding levels. Both weakly and strongly funded schemes would probably have hedged if the market rates had been appealing. On this front, however, we are sceptical as to whether rates will rise as rapidly as the market expects and inflation break-evens are unlikely to fall substantially. Indeed, given the limitations on supply, it seems inevitable that the pace of hedging will always be moderated by capacity constraints – especially if government issuance declines as the economy recovers. This natural moderation based on supply and demand dynamics suggests to us that the ‘flood of money’ argument and any positioning to take advantage of this needs to be tempered. However, the general improvement in funding levels due to asset performance, significant company contributions and moderate rises in rates, benefiting unhedged schemes, have reduced demand for aggressive return targets and changed the attitudes of many pension funds nearing full funding. In this context, we are now seeing a new focus on assets that deliver a ‘no surprises’ journey over the remaining short, five to 10-year path to full funding and less appetite for assets with more aggressive return targets and less certainty of delivery. The main impact of this trend to date has been on physical equity allocations. Indeed, this quest for stable returns could potentially have played well into demand for hedge funds if they had weathered the financial storm more successfully. However, although some hedge fund strategies have clearly delivered reliable returns, the disappointing experiences of many pension funds have tended to push perceptions of hedge funds more towards equity-type assets at precisely the time when more credit-like return profiles are being sought. Given the relative sizes of defined benefit (DB) and DC assets, the general conservatism of DC pension strategies, the daily pricing and liquidity requirements and the impact of the UK 2014 budget, allowing DC members to target cash at retirement, there is in our view quite limited DC pension fund demand for hedge funds although there is no doubt that there will be some lower volume demand from the more sophisticated investors – particularly those who use the new flexibility of DC plans to manage their own ‘do it yourself’ drawdown annuity. In summary, we are sceptical about any great sell-off in gilt markets and believe that this market will be moderated by the pension fund demand if and when yields rise or inflation break-evens fall. Although equities have to date seen the most significant asset allocation reductions, we do believe that demand for hedge funds will decline as pension funds focus on their ‘end game’ and as stability of return becomes a critical consideration. DC arrangements may generate some demand from more sophisticated investors, but this is unlikely to replace the DB allocations. Hedge funds will instead need to adapt their product offering if they wish to maintain their overall markets share of the UK pension market in the longer term. Hartwig Kos, investment director, global multi-asset group, Barings While I agree that pension funds might switch their low-risk alternative investments into index-linked bonds as they become more attractive, such substitution is in my view likely to be only marginal. Taking a step back, I would say that a rising yield environment has more profound implications on the asset management industry as a whole, as it makes it more attractive for corporates to engage in buy-out solutions for their pension liabilities. Nonetheless, we are still a far way off such yield levels and the path there might well trigger a little renaissance for hedge fund investments. From a diversification – as well as a return – perspective, hedge funds have not been the most attractive asset class over the last five years. Fixed income assets, on the other hand, were highly effective diversifiers with staggering performance over that time period. Now asset allocators face a profoundly different environment. So far, they have benefited from a positive correlation between bond yield levels and equity market returns. The question is how long such a positive correlation is likely to last. It is not unfeasible to picture a scenario where rising bond yields are associated with falling equity markets. In such an environment, asset allocators will desperately look for new diversifiers and hedge funds might just fit the bill. Stuart MacDonald, managing director, Aquila Capital Institutional inflows – notably from DB pension schemes – have underpinned the post-crisis recovery and the continued growth of hedge funds’ assets under management. It has, however, been suggested that, as broader economic conditions improve, and amid concerns in some quarters about potentially rising interest rates, DB schemes will lock in gains in risk assets and improved funding rates. Does this de-risking pose a threat to hedge funds? The answer is almost certainly ‘no’. The case for hedge funds’ ability to offer superior risk-adjusted returns is autonomous of such considerations. Their potential for growth in institutional portfolios is nowhere near exhausted. By their nature, hedge funds are agile enough to adapt their scope as market conditions and investors’ requirements change. The real challenge is a more positive one: to plug effectively into other sources of capital, such as the growing DC market. Liquid alternatives’ proliferation may be a threat as well as an opportunity, but the growth in US ‘40 Act funds against the backdrop of the relaxation on advertising through the Jobs Act, and the growing footprint of hedge fund strategies using Ucits structures in Europe show that the industry retains its adaptability. The industry must nevertheless be responsive to changing conditions. For example, what might the effects be on, say, monetary policy – and therefore on markets – or on demand for hedge funds of schemes switching into inflation-linked bonds? The best managers will be able to respond effectively. We should bear in mind, though, that consensus views on future outcomes, especially noise from market commentators, are notoriously unreliable. It is probably more helpful to examine investors’ actual views and intentions. For example, in mid-2013, when sentiment about rates was at its nadir, Aquila surveyed more than 150 institutional investors throughout Europe. One of the most interesting results was that fewer than 20% believe in the much-vaunted ‘great rotation’ out of bonds. As a reflection of this, a majority intends to hold fixed income exposures steady or to increase them in the next three years. Whether investors’ intentions will remain steady is moot. We can, however, be sure that conditions are in flux and that for every talented hedge fund manager who can generate attractive performance, there will be others unable to make the correct calls. Aquila’s own response to uncertainty and institutional investors’ demand for effective solutions has been through its risk-parity strategies. These eschew forecasting future returns at the level of specific sectors or stocks. Instead, these systematically combine uncorrelated assets that benefit from different conditions. So, for a broad-based approach to capturing the potential risk premiums sustainably across highly liquid asset classes, our portfolios are a risk-weighted blend of equities, government bonds, commodities and short-term rates. For investors who, by choice or necessity, maintain fixed income exposures, we manage risk-weighted allocations across government bonds, inflation linkers, corporate bonds and emerging markets exposures. In each case, falls in one asset class should typically be counterbalanced by rises in another. Bechara Azar, senior analyst, and Ramez Chalhoub, managing director, business development and investor relations, Innocap As far as asset allocation is concerned, we tend to believe that the traditional equity and fixed income allocation within DB pension fund allocations are more likely to suffer if the plans were to switch some of their allocation to inflation-linked bonds. Hedge funds are part of alternative asset allocation and fall under the ‘alpha’ bucket, which plays a different role in pension fund portfolios than traditional fixed income investments or inflation-linked bonds. They are used as a diversification tool with little regard to current market conditions and typically will at least partially hedge interest rate exposure. In addition, we believe that an increase in inflation expectation should bring more assets to hedge funds buying structured credit instruments linked to real estate. Some of those securities have positive interest duration, so when rates rise, their market value generally decreases. That component of rates is relatively easy to hedge in portfolios. If money flowing into inflation-linked bonds was to support bond prices generally and eventually impact the course of monetary policy, this would create further opportunities for hedge funds to generate profits and potentially drive more assets into the alpha bucket of pension plans. For example, the regime switch could generate greater volatility in rates, which would be beneficial to fixed income arbitrageurs via longer-dated forward volatility trades. Roll-down strategies along the very steep government bond curves are also attractive to take advantage of any easing in purchases that might see longer dated rates rise. Other funds will build options and swaptions-based strategies that seek to minimise negative carry if interest rates do not move, but offer potentially rewarding returns in the event that rates do rise significantly over a short period of time. Accordingly, we do not believe that hedge funds are likely to experience a wave of redemptions linked to a rotation into inflation-linked bonds. Simon Jagger, director, Jagger & Associates Evidence from our client base suggests few pension fund trustees are now interested, not least because of the declining trend in returns for both individual funds and for funds of funds, and even fewer trustees have managed to overcome the hurdles normally associated with hedge fund investment to proceed with an investment. They have been deterred by transparency, liquidity, low regulation, gearing/shorting, high fee rates and difficulty in selecting a manager. Some clients of ours that did go into hedge funds in the early 2000s have had to deal with their managers needing to operate side-pockets over the last five years or so, simply because the schemes did not exit the products before the credit crunch started. DC-specific features could make creation of DC-suitable hedge fund products difficult in the UK. For example, DC schemes have a typical requirement for daily liquidity and a transparent fee structure, so the proposed 0.75% a year fee cap for default auto-enrolment funds could be a problem, plus there is the need for member communications. Increasing gilt yields could well lead to increased funding positions for schemes that have not matched off all their interest rate risk, and could trigger a move from return-seeking assets, such as hedge funds, into bond assets or some form of annuity buy-in or buy-out, which just means the insurer buying the bonds instead. However, the UK’s total combined private and funded public pension scheme liabilities are estimated to be at least £1.6 trillion, and generally of medium and long-dated maturity. The available comparable maturity area of the combined gilts and sterling corporate bond market is considerably smaller, particularly once you allow for non-pension fund investors, such as insurance companies, holding some of it. Any material medium or long-term gilt yield rises, such as arising from short-term interest rates moving back up to more historically conventional levels, would probably get countered to some extent by institutional investors de-risking. If hedge funds experience high withdrawals, then you could argue that further culling of poor performing funds would be a good thing for the industry, although the scope for redemption lock-ins would probably result in a gradual exit rather than mass exodus....
Start a FREE trial or subscribe to continue reading:
Start a 4 week free trial
Try Risk.net's premium content for a limited period. Register now for your FREE trial to one of our leading brands.
*not available to previous trialists or subscribers.
Log In or Subscribe Now
Subscribe to Risk.net Business now to access all our premium news & features content for 1 year.
Pay by Credit Card for immediate access.