“This house believes that pension funds investing in hedge funds will all end in tears.”

Philip Coggan attended the National Associationof Pension Funds investment conferencein Edinburgh in March 2005. He reports onthe provocatively-entitled debated motion"This house believes that pension funds investing in hedge funds will all end in tears."

Philip Coggan

For hedge funds trying to break into the UK pension fund sector, there has been good news and bad news in recent weeks. The good news is that at a debate at the National Association of Pension Funds investment conference in Edinburgh, a majority of delegates came out in favour. The bad news is that all the talk about hedge funds has translated into little in the way of action when mandates are handed out.

The NAPF debate was on the provocatively-entitled motion “this house believes that pension funds investing in hedge funds will all end in tears.” The motion was due to be proposed by James Montier, the bearish Dresdner Kleinwort Wasserstein strategist who specialises in behavioural finance. Somewhat mysteriously, Montier pulled out at the last minute.

In Montier’s absence, the case for the prosecution fell to George Henshilwood, the senior partner in the investment consultancy practice of the actuaries Hymans Robertson. The defence was mounted by Ian Morley, the chief executive of Dawnay Day Olympia, the hedge fund of funds group.

The duo represented a severe clash of styles. Henshilwood seemed very much of the “old school”, and spoke without any visual sides (this may have been because of lack of preparation time). His accent was Scottish, his speaking manner drily ironic, his figure portly. Morley, who is a regular speaker at conferences, had a presentation packed with facts, graphs and pictures (some of himself). He was confident, aggressive and slender. The absence of facts and figures in the Henshilwood speech may also have been a question of philosophy. The actuary said he regarded much of the data in the hedge fund world to be unreliable. “The conclusions about the suitability of hedge funds have thus been drawn on scanty evidence.” This was not simply a matter of innate conservatism, Henshilwood argued. “One shouldn’t confuse an attitude of healthy scepticism with Luddism.” He would consider using a hedge fund manager to add currency overlay to a portfolio.

… Henshilwood worried whether there was enough alpha around to feed what has been the exponential growth of hedge funds. “We struggle to find long-only managers who can add 1 per cent per annum. Is there enough alpha around to pay the fees?”

Henshilwood said there were big issues of transparency and due diligence that applied to trustees giving money to hedge funds. “A trustee who employs a hedge fund manager needs to know that manager’s maximum exposure and level of gearing. They also need to understand how the manager uses stop-loss positions. One might be able to understand these positions for a couple of funds but as the number grows, so does the complexity.” He was concerned that, instead of doing this work, “all too often, trustees are buying on the back of a strong track record.” The actuary added that “This is not personal money we can afford to lose. We are subject to prudent man principles.” And he worried that the greatest benefits accrued to hedge fund managers and not to their clients. Henshilwood also raised doubts about some of the touted advantages of the sector. “The argument is that hedge funds can give you a positive return when markets are falling” he said “but so can cash.” He said that hedge funds do not actually hedge a pension fund’s liabilities and moving from equities to hedge funds did not improve asset-liability matching. He also raised a number of questions for those who were keen on backing hedge funds. “Why do investors believe that tactical asset allocation, so discredited in the 1990s, can work within a hedge fund wrapper? Do we really know what we are investing in? Are market neutral funds truly market neutral? Even if I understand the strategy, do I really think it is appropriate? If the strategy is trading in commodities, that is speculation, not investment.” “What are the characteristics of hedge funds?” Henshilwood continued. He said they were noted for high levels of turnover which sounds rather like the churning of portfolios and leads to high levels of commission and on the issue of compliance, he worried that trustees were happily investing in funds “which are registered in locations better known as tourist locations than for their financial stability.” Finally, Henshilwood worried whether there was enough alpha around to feed what has been the exponential growth of hedge funds. “We struggle to find long-only managers who can add 1 per cent per annum. Is there enough alpha around to pay the fees?”

In reply, Morley attempted to demolish many of what he called the “myths” that surrounded the hedgefund industry, that they were risky, used lots of leverage or regularly collapsed like Long-Term Capital management. “Hedge funds are about preserving capital”, he argued. Morley said that over the last 10 years, hedge funds have had a better risk-reward ratio, with lower risk and higher returns than other asset classes. Contrary to popular opinion, Morley said that most hedge funds use little or no leverage. And he cited figures showing that the largest drawdown on hedge funds over the last decade was the 13.1 per cent fall from April to October 1998. He invited pension fund trustees to compare that number with the losses suffered by investors on Nasdaq.

He added that the wider range of techniques available to hedge fund managers represented an advantage. “Why tie the hands of the manager by preventing them from going short?” he asked. “Avoiding losing money when markets are falling allows managers to stay ahead of the game.” Other alternative investments such as property and private equity had suffered just as significant losses as the equity markets at certain times. And property and private equity investment can involve long lock-ups and limited liquidity.

On the issue of fees, he said that hedge fund charges were negotiable according to size and client demand. But he warned that investors “cannot buy alpha at a discount”. Although many worried that the growth of hedge funds was creating capacity issues, Morley said that “While there is tax and regulation and while some investors pursue indexation, there will always be the potential for hedge funds to out perform.” There was some support for Morley’s case from the floor with one pension fund trustee noting that wealthy individuals and foundations such as Harvard and Yale had successfully used hedge funds. But another argued that hedge funds may only work so long as they are niche players. Morley accepted that hedge fund capacity was not sufficient to solve the problems of the entire pension fund industry, which is struggling to plug massive deficits, prompted by increased longevity, low bond yields and an over-exposure to equities in the early years of this decade.

When the votes were tallied, Morley was deemed to have the better arguments. Before the debate, 45 per cent said yes (investing in hedge funds would end in tears), 46 per cent said no and 9 per cent were don’t knows. After the debate, the no camp increased to 51 per cent, while the yes camp stuck at 45 per cent. Morley had won over the undecided.

In reply, Morley attempted to demolish many of what he called the “myths” that surrounded the hedge fund industry, that they were risky, used lots of leverage or regularly collapsed like Long-Term Capital Management.

While that vote showed that pension funds had a fairly open mind towards the hedge fund issue, the sector was not the only alternative investment being discussed in Edinburgh. Fund managers and consultants were pushing ideas such as “portable alpha” (an attempt to exploit the ability of fund mangers to outperform in small market niches), “alternative beta” (combining returns from different asset classes such as property or commodities) and liability matching, using the swaps market. Some managers were trumpeting their ability to produce “liability plus” products (with benchmarks such as inflation plus 4 per cent); others were offering “manager of manager” services in the long-only field, promising to enhance returns by picking the best of breed. All of these products were attempting to solve a central dilemma for trustees. They are overcommitted to equities, relative to their liabilities. But they do not want to switch to bonds, since this would “lock in” their deficits. They would thus like an asset that is less volatile than equities but offers higher returns than bonds. Hedge funds are just one product competing in this field.

A survey that came out before the Edinburgh conference showed that progress in awarding mandates had so far been slow. Analysis by Russell Mellon showed that UK mandates for alternative assets such as private equity, venture capital and hedge funds comprised just 0.2 per cent of the total in 2004. Worse still, interest seemed to tail off last year, after a flurry of interest in 2002 and 2003, presumably related to the long bear market. Only 1 per cent of new mandates went into alternative assets in 2004.

This indicates that, when push comes to shove, trustees are still cautious. A few large pension funds, such as the Railpen, may be backing the hedge fund concept, but others are worried by the factors cited by Henshilwood. They are still clinging on to equities and hoping for the best. But at least the Edinburgh debate showsd they can be won round.

Philip Coggan is Investment Editor of the Financial Times