Another month and another round of fund of hedge fund mandates are announced from the European pension fund community – howtimes have changed from the dark days of the early Noughties when hedge fund marketers would have their business cards threatened with combustion if they were proffered to many a pension fund chief. So is this relative onslaught into the sector by pensions borne of a full level of satisfaction with the hedge fund story? Is there widespread comfort with an expectation met by investments made into a uniform product-style purpose-built to satisfy the pension funding conundrum?

The generalist hedge fund pitch of 'alpha generation', 'low correlation to equities and bonds' and 'higher risk-adjusted returns than long-only equity' has now been tried and tested by the pension industry with a clear vote in favour of pushing further into the format. But have the product offerings used to date delivered and how are pension funds looking to increase their exposure – more of the same or an amended offering?

Will performance meet expectations?

Following two years of soft performance from the hedge fund industry, 2006 restored faith in its ability to provide strong risk-adjusted returns. The pattern of returns from a diversified, 4-vol portfolio running at double the risk-free rate has continued into 2007 and has been well received by the pension fund community. However, there remains a feeling that the returns are still too heavily reliant on beta rather than the alpha generation that was expected. Whilst this beta-driven performance is not seen as problematic in itself, there are concerns that performance will meet expectations in the absence of a continued equity market rally.

Following two years of soft performance from the hedge fund industry, 2006 restored faith in its ability to provide strong risk-adjusted returns. The pattern of returns from a diversified, 4-vol portfolio running at double the risk-free rate has continued into 2007 and has been well received by the pension fund community. However, there remains a feeling that the returns are still too heavily reliant on beta rather than the alpha generation that was expected. Whilst this beta-driven performance is not seen as problematic in itself, there are concerns that performance will meet expectations in the absence of a continued equity market rally.

Moving towards single strategy multi-managers

The focus has therefore shifted towards investing in more defined strategy groups that better meet their investment criteria. The relative value strategy area has received significant attention along with other strategies that display much lower correlation characteristics to the main equity markets.Investment interest in macro and CTA's is increasing at a greater rate than the hedge fund universe. However, all is not lost for the fund of hedge fund community. There are still relatively few pension funds that have sufficient internal resources to invest and monitor a full portfolio of single-manager hedge funds. The product of choice has therefore become the single-strategy, multi-manager fund which enables the pension fund to specify its strategy selection but to out-source all of the labour and skill-intensive tasks such as due diligence, manager screening and risk monitoring to the fund of funds organisation.

Funds of funds response

The fund of funds community has responded to this demand by increasing the range of strategy-specific, multi-manager funds available. In some case this has been through 'unbundling' their diversified fund of funds into sub-sectors such as directional, relative value or fixed income arbitrage. Some firms have produced baskets of single strategies such as CTA's by creating fund structures around baskets of managers that had been run as a sub-set of their main fund of funds for many years. This has created the advantage of a real, long-term track record on which the product can be assessed despite being a 'new' product.

There are also many new single-strategy, multi-manager formats being developed particularly in the 'pure alpha' area. One such example looks to solve the problem of entirely beta-driven returns in the equity long/short area by creating a fully market neutral equity long/short fund of funds that isolates the alpha generated from the world's most active asset area. Such a product is well placed to satisfy pension funds that have sufficient equity beta in their long-only portfolio, or obtain it more efficiently through derivatives. There is also a view amongst some pension funds that equity markets are well, or over, valued and that we are a short way into a fairly flat period of returns from equities. Such thinking drives an investor away from high-beta equity strategies but shouldn't detract them from searching for alpha in these highly active markets.

Another area of the hedge fund world that is grabbing the attention of the more aggressive pension funds is that of investing in the management companies of hedge funds either through share holdings in the few listed management companies or through seeding. It was recently pointed out by one pension fund manager experienced in hedge fund investing that, whilst the returns from his hedge fund investments had done quite well, the most interesting returns were to be found in the values of the hedge fund management companies. It was not lost on him that placing significant capital into the fund of a 'boutique' hedge fund company had a strong impact on the value of that firm.

Changing the approach to asset allocation

Having taken those first tentative steps into the world of hedge funds, and alternatives generally, by making what are effectively de-minimus holdings that have little or no real impact on the overall portfolio, pension funds are now faced with a whole different set of issues as they step-up their allocations to a level that will have certain impact on their overall performance and fulfilment of their liabilities. The general approach to alternatives by the pension fund sector to date has been to treat each of the three 'categories' as isolated silos, investing in private equity, property and hedge funds completely independently of one another. This has been relatively safe when each accounted for between 1% and 3% of the total portfolio but is heavily flawed as these allocations move to between 5% and 10% and an overall allocation to alternatives approaching 30% in some cases and moving on towards the majority levels of the US endowments and others.

The challenge facing pension funds as they further engage with hedge funds is not only to resolve the already identified issues of manager selection, value for money, infrastructure, risk monitoring etc but to develop a holistic approach that enables them to obtain the best out of each alternative sector whilst avoiding a build up of similar exposures. There is significant evidence of an increased level of correlation between hedge funds, particularly in the event-driven and distressed strategy areas, and private equity for instance. Hedge funds are increasingly getting involved in what have been traditionally private equity investment either through direct investment or through financing. There is also a growing body of hedge fund investment in the financing of property-related transactions.

The new world of pension funds investing in hedge funds is therefore one of the hedge fund industry delivering a wide range of increasingly strategy-specific products to an investor community ever more conscious of how the engagement of such strategies impacts on their overall exposure analytics and how the total behaviour of their portfolio interacts with their liability obligations.

The very large pension funds will seek to dis-aggregate as far as possible to meet their very specific objectives – this will be welcome to the single manager community. Smaller pension funds will be seeking blended, co-ordinated, hybrid products. The fleet of foot fund of hedge fund operators will benefit nicely from this.