Replicating returns

European pension funds typically haven't allocated as much to hedge funds as their US counterparts. Concerns over transparency and fees have held many back, but some are now looking at in-house approaches or passive replication as potentially the way forward. By Jayne Jung

Hedge fund allocations among many US pension plans dwarf those at even some of the largest and most sophisticated European funds, with concerns over transparency, high fees and the capacity of the hedge fund industry stymieing investment.

One of Europe's best-performing pension funds, the Dkr428 billion ($73.8 billion) Copenhagen-based Danish Labour Market Supplementary Scheme, for instance, doesn't have any hedge fund investments. "We have not been ready to accept on a broad basis the pricing structure of the hedge funds," says Lars Rohde, chief executive at the pension fund, commonly known as ATP.

While such concerns have hitherto led to small - or even zero - allocations, they are now prompting some innovation. ATP, the recipient of Risk magazine's 2006 pension fund of the year award (Risk January 2006, page 47), plans to create its own hedge fund management capability - and building an internal hedge fund management function may be an answer for cautious pension funds seeking an allocation to alternatives assets.

According to Rohde, ATP will begin to invest in hedge funds next year, a transition that will allow it to gain expertise and comfort before building a fully fledged internal management capability and possibly establishing an in-house fund-of-funds. "From a pure scale perspective, we are able to develop a lot of these products in-house," says Rohde.

The Danish pension fund achieved a return of around 20% without a hedge fund allocation in 2005. But Rohde believes recent success may be due to a brief tailwind from the equity markets, and cannot be relied upon to meet the performance goals on a long-term basis - hence the willingness to consider alternative investments.

Elsewhere, Netherlands-based ABP Investments has already begun to forge ahead with its plans for an internal hedge fund. ABP, the world's second largest pension plan with EUR196 billion under management, has just launched its own volatility fund, which will invest in derivatives across asset classes (see page 60).

Hedge fund investment still remains troubling for some, however. David Blackwood, London-based group treasurer of the chemical and paint company Imperial Chemical Industries (ICI), for instance, finds the lack of transparency and high fees a strong deterrent to having a large allocation. Blackwood says the breadth of strategies employed makes it difficult to assess the risks and rewards of a particular fund. "With many investments, you can look at what is happening - you can understand where the risk is, what the investment is and why it might work. Hedge funds are quite a lot more complicated," he says.

ICI has only 3% of its total £8.2 billion pension scheme assets invested in hedge funds. Around 1% is invested with London-based emerging market specialist Ashmore Investment Management, in its Emerging Markets Liquid Investment Portfolio and multi-strategy funds, while 2% is invested in a pooled currency fund managed by Goldman Sachs Asset Management. Blackwood says ICI has no intention of increasing the scheme's hedge fund allocation.

His reticence reflects widespread distrust of hedge fund investments among pension fund trustees. "Pension funds require transparency on the part of their manager and a fair amount of capacity because they have a large amount of assets. They are also very sensitive to fees because of the nature of their fiduciary role in allocating assets," says Andrew Lo, a professor at the Massachusetts Institute of Technology's (MIT) Sloan School of Management. The vast majority of hedge funds don't provide detail on their models to investors, and charge fees equivalent to 2% of the assets under management, and 20% of the annual returns.

Even if greater transparency is provided, there are broader questions that pension funds need to grapple with before deciding on an allocation. Guy Coughlan, managing director and asset-liability management strategist at JP Morgan in London, questions the hedge fund industry's ability to meet demand. "A lot of hedge fund strategies - I'm talking about hedge fund strategies they employ rather than the fund themselves - are non-scalable. Many are exploiting arbitrage opportunities or mis-pricings in the market, and as more funds chase the same opportunities, you start eliminating those mis-pricings," he says.

Some academics even argue that hedge funds don't provide the diversification benefits that are so often touted. "The diversification is a lot less than people think," says John Cochrane, a professor of finance at the University of Chicago. "If all hedge funds are making the same bets, then you don't have diversification. And you have no idea what the bets are."

For instance, with equity markets performing strongly over the past year, many equity long/short managers are likely to have a long bias, meaning returns on these funds are likely to be highly correlated with long-only managers and equity indexes - although the correlation should be lower during a market downturn.

However, Chris Mansi, a London-based senior investment consultant at Watson Wyatt, argues that hedge funds provide diversification through the manager's ability to trade in a unique fashion or develop one-of-a-kind models. Hedge fund returns can effectively be decomposed into a cash return, a portion attributable to market returns, and some manager skill component, he adds.

This failed to translate into strong returns for most managers last year. The Credit Suisse/Tremont Hedge Fund Index was up 7.61% for 2005, compared with 10.02% for the MSCI World index. This disappointing performance seems to have caused pension funds to slow down their investments into hedge funds last year, says Robert Howie, principal at Mercer Investment Consulting in London. "There's still a net investment into hedge funds by pension funds, so the amount going into hedge funds has continued to increase, but the rate of increase is very much slower," he says.

Stephen Oxley, a London-based managing director at California-based fund-of-hedge fund manager Pacific Alternative Asset Management Company (Paamco), has also seen a decelerating trend. "But there is still an undertow of an understanding that pension funds need further diversification in general, and we're beginning to see some of the smaller and the medium-size pension funds allocate," he says.

However, research on hedge fund risk and performance by MIT's Lo has created an intriguing possibility for pension funds seeking to replicate hedge fund-like strategies without actually investing in the asset class. His latest analysis shows that an investor can passively replicate certain hedge fund strategies to a large degree using derivatives. "Depending on the nature of the strategy, in some cases we're able to capture 20-30% of the alpha, in other cases we capture 80-90%," says Lo.

The results show that passive hedge fund strategies can actually outperform global macro funds, while taking on similar levels of risk (see figure 1). Hedge fund clones can be created using a combination of cash, forwards, futures and options on liquid equity and bond indexes.

For instance, a dedicated short-bias fund can be replicated by shorting out-of-the money S&P 500 put options with strikes approximately 7% out-of-the money and a tenor of less than or equal to three months. From January 1992 to December 1999, the passive strategy had a monthly average return of 3.6%, standard deviation of 5.8% and Sharpe ratio of 1.90. In comparison, the S&P 500 had a monthly average return of 1.4%, standard deviation of 2.6% and Sharpe ratio of 0.98 over the same period. Although Lo says a number of issues need to be resolved before pension funds can use these passive strategies, such as deciding the best method to calculate clone portfolio weights, he is optimistic that remaining theoretical challenges will be overcome.

For pension plans that decide to allocate to hedge funds in the old-fashioned way - via direct investment - the difficulty is how to identify good managers. Watson Wyatt uses both qualitative and quantitative procedures to assess manager performance, but Mansi admits the quantitative analysis has to be taken with a large pinch of salt. "You have to accept that you're going to have less confidence in the results if you have a much shorter period to base modelling on, and if the manager's return is based on subjective factors such as skill," he says.

In fact, University of Chicago's Cochrane is sceptical that it is possible to gauge the performance of a manager by looking at a hedge fund index with any degree of certainty. He points to an inherent survivorship bias in hedge fund indexes, meaning they often do not include data from those funds that have closed to new business or are performing poorly, and likens making judgments based on index comparisons to ascertaining whether gambling in Las Vegas is good or not. "So you can talk to your relatives, and they'll say, 'Oh, yeah I went and gambled and I made a fortune and it's a great thing to do', but you're likely to hear from people who made money and not hear from people who didn't," says Cochrane.

It means pension funds or their advisers need to conduct lengthy qualitative due diligence on a hedge fund, including an in-depth analysis of the manager's track record, the fund's investment processes, its organisation and its reporting. "If you're going to look at hedge funds, there's not much point in doing all the work to understand the asset class, getting comfortable with it, then turn around and say we're going to make a 1% allocation," says Mansi.