Take for example Lane Clarke & Peacock, the international partnership of consulting actuaries which advises many of Europe’s largest pension schemes on, amongst other things, their alternative investments. While accepting that September and October were a disaster zone for hedge funds, partner Clay Lambiotte, who heads LCP’s hedge funds team, says many of his clients are far more concerned with what is happening to the long only segments within their portfolios.
LCP deals exclusively with funds of hedge funds as investments for its clients, but has seen YTD numbers for these vehicles down between 10 and 15%, “far better than the bulk of the assets at the moment,” says Lambiotte.
“There’s no rush for the exit going on,” he explains. “We are seeing a situation where clients have decided to include fund of funds as part of a strategic allocation. They may have put initial or further investment on hold, because they want to see where everything is going, and need a degree of clarity before they invest anything else.”
At this point, Lambiotte says, it is hard to make a call as to whether institutional investors will be net investors in 2009. “The notion of hedge funds protecting capital has obviously come into question. They’ve had a great run, and were resilient in 2001-03, but their reputation has been damaged as a result of this crisis.”
The big question is going to be whether the classic hedge fund fee structure is still appropriate. Lambiotte says he expects some savvy institutional investors will be looking to renegotiate fees or look at different types of structure before committing new capital. The old ‘two and 20’ formula may become a thing of the past.
Institutional money has been flowing into the hedge fund sector since those funds that made it through 2001-03 demonstrated that they could still provide positive returns during the dot.com blow-up. Lambiotte is aware that many investment managers turned to the hedge fund model as a means of earning big fees and sees the current shake-out as a good thing, as the overall quality of the managers available will probably improve.
Trustees to get selective
So what has been the big attraction for his clients? Why did they invest and will this hold true in the future? Diversification has been one of the major attractions for pension funds looking at hedge funds for the first time. Certainly, the recent numbers hedge funds have been posting will make pension funds re-assess that decision, but Lambiotte thinks they will still be back for more, but like more seasoned customers of any product, will be exacting about what they buy. Blindly investing with long/short managers looks to be a thing of the past. Now pension schemes and their consultants will be taking a serious look at some of the other strategies on offer, particularly those which, while still being relatively transparent, can also quantitatively demonstrate how and why they are not correlated to the market.
“[Hedge funds] have to be able to suggest that they don’t follow the market, and do have an element of protecting capital,” he says. “They have to create the impression that this is an investment that can stand up to stressful times.”
During the bull market many managers argued that if only some more volatility could creep into the market, they would be able to demonstrate to their investors what they could do. Lambiotte wonders whether this was used at times as an excuse for poor performance: “when volatility jumped, that was turned into a negative,” he says. “Can these guys really deliver? At the same time, there’s a danger of focusing too much on performance; just because someone has better than average performance, does that mean he is good, or just lucky?”
Currently, LCP recommends its clients gain exposure to hedge funds via funds of funds structures, but here, too, is a segment of the industry under pressure: from redemptions, from questions relating to their additional fees and from generally poor numbers. Will this mean the larger and more sophisticated pension funds will look at building their own fund of funds portfolios, perhaps hiring in professionals from the FoF sector to do so? It is a route some of the larger investors in the US have already followed. Lambiotte, however, is not so sure.
“In terms of going directly into the underlying managers, I’m afraid this crisis has created a lot of press around the relative riskiness of hedge funds. That suggests that it is actually far more difficult for an investor to choose the right funds. Unless you feel like you have really water-tight governance procedures, it still represents a daunting task if you are a pension fund trustee.”
Lambiotte says managers can expect the current crisis, particularly if accompanied by one or more high profile hedge fund failures, “to enhance suspicions” within the European pension fund community. Trustees are still acutely aware of the presence of reputation risk, now more so than ever.
While the weaker managers might be forced out of the business, polarisation of opinion is likely to occur within the pension fund community on the relative merits of hedge fund investing. This will be partly informed by ongoing coverage of hedge funds in the financial press: stories like the involvement of hedge funds in the Volkswagen/Porsche debacle will only raise doubts about the ethical role of the industry. Those proponents of the industry within the pension fund community will face more opposition as a consequence. Food for thought as hedge funds continue to grapple with the credit crunch fall-out.
Clay Lambiotte is an Investment Partner at Lane Clark & Peacock. He graduated in mathematics from the College of William and Mary in 1997. He is an Associate of the Society of Actuaries and holds a Chartered Financial Analyst (CFA) designation. Lambiotte joined LCP, moving to the UK from USA, in August 2004. He has a further six years of actuarial experience with qualified retirement plans and post-retirement medical plans for US-based domestic and multinational clients. As a member of LCP’s investment practice, he is responsible for providing advice on investment strategy and structure as well as manager research where he leads the hedge fund research team.