There is almost universal consensus that pension funds’ future allocations into hedge fund strategies will increase. The real debate is by how much, and when? Recent market intelligence reveals that approximately 3% of UK pension funds’ assets are in hedge funds or fund of hedge funds – which is significantly lower than the US and many countries in continental Europe. Bearing in mind that several defined benefit schemes of FTSE100 companies are reported to have recently lurched into deficit, the diversification benefits and risk-adjusted return profile offered by funds of hedge funds, as well as other low-correlated alternative investments, are becoming increasingly hard to ignore.

So what are the reasons for UK pension funds’ relatively low exposure to alternatives? Undoubtedly, the scepticism shown by the large consultants towards hedge fund strategies was a major factor until quite recently, which, in turn has contributed to low levels of understanding of hedge fund strategies amongst Trustees.

Paul Myners, Chairman of Ermitage, has highlighted that “one of the core problems in the UK is that the average Trustee spends less than 12 hours a year on investment management. Being a Trustee is a grown-up job that requires a lot of time, effort and hard work to understand the issues. What is required is the ‘professionalisation’ of Trusteeship, or the inclusion of investment professionals at an executive level in pension schemes.”

It is interesting to reflect on the fact that other European markets (such as Scandinavia), where the historical influence of consultants has been lower, have a greater acceptance of hedge funds and their role within a balanced portfolio. Clearly the US Pensions/Endowment market has embraced the use of hedge funds and, on that basis, as seen in ‘Waves across the Atlantic’, it is only a matter of time before the UK adopts the same model. We are not alone in the industry in believing that we are at the tipping point in terms of UK pension schemes allocating assets to hedge funds. The recent decision of BT – the UK’s largest retirement fund – to switch around a third of its UK equity holdings (about £3bn) into alternative assets is significant.

Taking a more global perspective, Infovest21’s Sixth Annual White Paper on Institutional Developments in the Hedge Fund Community (June 2005 to June 30th 2006) observed that over half of the inflows into hedge funds were from institutions, and this was expected to rise to about 53% by 2008. Another study estimates pension fund allocations will be $400 billion in 2006 and reach $950 billion by 2010. Undoubtedly, hedge funds are becoming more mainstream, as the number of institutional investors allocating to hedge funds builds and market penetration grows.

The greatest challenge facing sponsors is the ability to achieve target returns in a low-return environment. Asset-liability risk management and improving or maintaining funded status are also high on the list of concerns. Hedge funds can help pension funds to match their liabilities, because they can achieve the absolute return that pension schemes require. In general terms, the case for an allocation to a fund of hedge fund centres around the ability to enhance asset return at an acceptably low cost in volatility, or, conversely, to reduce overall volatility with little or no effect on return. As the performance of many hedge fund strategies is driven by risk factors that are largely independent of market direction, the intelligent combination of traditional and alternative strategies within a portfolio can combine to create a more desirable or consistent investment outcome.

Our experience, which we feel is reflected across the industry, is that an increasing number of clients are approaching it in this way – viewing hedge funds as a set of complimentary tools to enhance the overall risk/volatility profile of their investment portfolios. Under these circumstances, it is clear that there is no “one size fits all solution”. The type of hedge fund portfolio that is most suitable will depend on the circumstances of the individual plan.

Our view is that we are moving into an era of ‘intelligent investing’ where the boundaries between traditional and alternative will blur and where investment managers will become far more innovative and solution-orientated. By this we mean using hedge funds as an integral part of portfolio construction, considering the whole rather than segregating hedge funds into a separate asset class. You only have to look at Portable Alpha initiatives to illustrate this thinking – the transition of a long only portfolio into a tracker plus alpha generator – as an example of ‘blurring of boundaries’ of traditional and alternative asset management.

Liability Driven Investment is becoming a bigger topic on a daily basis, as is the acceptance that absolute return may well be a better answer than ‘tracking the MSCI World Equity Index’. Looking forward, those Pension Fund Trustees who appreciate the value of adding risk controlled hedge funds to a portfolio will be well placed to manage scheme liabilities with greater certainty than before.