Pension Funds to Increase HF Allocation Despite Recent Poor Performance
Contrary to recent articles in the main stream media, pension funds will continue to increase their allocation to hedge funds despite the recent poor performance within the hedge fund industry. This is being driven by the fact that pensions funds are forward looking in their investment return assumptions when determining their asset allocation. Recent relative performance of a particular asset class has little relevance in their decision making process.
Typically, pension fund boards of directors, investment committees, and internal staff meet annually, often along with their investment consultant, to determine what their asset allocation should be going forward. This process includes identifying the asset classes to which they want exposure. For each of these asset classes they forecast an expected return, volatility and correlation with other components in the portfolio. These assumptions are based on a combination of long term historical returns for an asset class, current valuation levels and economic expectations. Once all assumptions are determined and maximum exposure constraints are applied to individual asset classes, these variables are run through an asset allocation optimization model to determine the optimal asset allocation with the highest expected return for a given level of volatility. This output is then compared to the current asset allocation of the portfolio, and a decision is made on whether the portfolio asset allocation should migrate towards the optimal portfolio.
When a new asset class is being added to the portfolio, such as hedge funds, it is typically limited to a small initial allocation of the portfolio. As the pension fund becomes more comfortable, this allocation is typically slowly increased every couple of years until it reaches its optimized percentage of the portfolio. It can often take over a decade to reach a full allocation.
Currently, multibillion-dollar public pension fund’s average allocation to hedge funds is approximately eight percent. This is significantly lower than that of unconstrained endowments and foundations who have been investing in hedge funds for decades. Some endowment and foundation investors have as much as 50% of their portfolio allocated to hedge funds.
Each asset class is competing for space in the portfolio based on its future expected return characteristics. Over the past 5 years pension funds have lowered their return expectations for hedge funds to the 6% to 8% range. However, return expectations for fixed income over the past 5 years have declined significantly further. Most public pension funds have a large allocation to fixed income mangers that manage portfolios against the aggregate bond index whose expected returns 5 years ago were in the high single digits. Since then, we have seen interest rates decline to near historic lows, and credit spreads decline to 5 year lows. As a result, net of fees, forward looking return assumptions for an aggregate bond mandate should be in the 3.0% range.
While the asset allocation for most public pension funds is glacially changing on an annual basis in order to maximize risk adjusted returns, their actuarial return assumptions rarely change. If a pension fund’s performance is below the actuarial return assumption, then the unfunded liabilities will increase, and ultimately the pension fund will require additional contributions to pay long term benefits.
On average, pension funds were already under allocated to hedge funds before the significant decline to 3.0% for fixed income return assumptions by pension funds. With current actuarial return assumptions averaging approximately 7.5%, we will see more pension fund assets shift from fixed income to the hedge fund portion of their portfolio. This trend will continue as long as interest rates stay low.
As pensions struggle to enhance returns to meet their actuarial assumptions, we will also see an increase in the speed of the evolution of pension funds’ hedge fund investment process. This process typically begins with a very small initial allocation to hedge funds via hedge funds of funds. This is gradually increased every few years as the pension plan enhances its knowledge of the hedge fund market place. The second phase of the process is investing directly in hedge funds, which may often include assistance from a consultant or a fund of funds acting in an advisory role. An overwhelming majority of the hedge funds a pension plan will invest in at this stage of the process are the largest, “brand name” hedge funds with long track records. Performance is of secondary consideration to perceived safety and a reduction of headline risk. A vast majority of pension plans that have a hedge fund allocation are currently in these initial two phases.
After a few more years of making direct investments in hedge funds, pension plans move to the third phase and begin to build out their internal hedge fund staff, which shifts the focus from name brand hedge funds to alpha generators. These tend to include small and midsized hedge funds that are more nimble. In a study conducted from 1996 through 2009 by Per Trac, small hedge funds outperformed their larger peers in 13 of the past 14 years. Simply put, it is much more difficult for a hedge fund to generate alpha with very large assets under management. Some pension funds are also allocating a portion of their hedge fund investments in niche oriented funds of funds.
The final step of this evolution occurs when pension plans stop viewing hedge funds as a separate asset class and allow hedge fund managers to compete head-to-head with long-only managers for each part of the portfolio on a best-of-breed basis. Many of the leading endowments and foundations have evolved to this point. Their portfolios are primarily invested in alternative managers, with large allocations to midsized hedge funds. This allocation strategy is now being called the “endowment fund approach” to managing money.
Over the next 5 years, we will continue to see a very strong trend of pension funds increasing their allocation to hedge funds in order to enhance returns and reduce downside volatility in their portfolios. This is good news for the hedge fund industry. However, these institutional investors are becoming increasingly aggressive in their negotiation of fund terms which will put downward pressure on hedge fund fees.