Looking over the Hedge

With stocks in a bear market, some pension managers are checking out hedge funds.

Pension fund managers may be long-term investors, but they are not oblivious to short-term pain. And like anyone invested in U.S. equities over the past 18 months, they are feeling a lot of pain.

U.S. corporate pension plans invest most of their money in stocks and bonds, typically in a 60/40 proportion. That strategy served them very well between 1995 and 1999, when assets in the average pension plan more than doubled, with about 75 percent of the gains coming from investment returns and just 25 percent from increases in corporate funding. Indeed, until recently, a CFO’s biggest concern with the pension fund was how to account for the huge surpluses being generated.

That’s no longer a problem. Instead, the bear market in stocks has pension managers rethinking their asset-allocation strategies and looking farther afield for alternative investments. “Pension funds have had a great run, but with interest rates falling and liabilities increasing, they’re looking for new sources of investment return,” says Maarten Nederlof, head of pension strategies at Deutsche Asset Management, a division of Deutsche Bank. Specifically, they want sources of return that don’t correlate with the performance of stocks and bonds.

In their broadest definition, alternative investments for pension portfolios are anything other than stocks and bonds, including real estate, commodities, private equity, venture capital investments, and distressed securities. For more than a decade, managers of large pension funds, like Bob Angelica of AT&T, have been increasing their investments in such asset classes in order to diversify their portfolios. The $35 billion AT&T fund currently has about 10 percent of its assets in alternative investments, primarily private equity and venture capital.

However, the largest potential source of uncorrelated returns, and arguably the only truly effective diversification tool for long investors, is hedge funds. By one estimate (and there are many in the notoriously opaque world of hedge funds) there are about 5,000 hedge funds managing upward of $500 billion in capital worldwide. That’s probably slightly higher than investment levels prior to the infamous near-collapse of Long-Term Capital Management, which sent financial markets into a tailspin in the fall of 1998. Wealthy individuals currently account for about 75 percent of hedge fund investment, and institutions make up the other 25 percent.

Last year, a composite index of 1,500 hedge funds representing more than $260 billion in assets, calculated by Hedge Fund Research, had a return of 5 percent. In a year when the S&P 500 was down 10.1 percent and the Nasdaq 100 was down 36.8 percent, that kind of performance has drawn the attention of the pension fund community. “Hedge funds are pure alpha products, with their returns depending on the skills of the manager,” says global asset consultant Sandy Chotai of Towers Perrin. “A lot of pension funds are now asking themselves, ‘What would happen if we added hedge funds to our portfolio?’”

Ideally, the answer would be better, less-volatile, long-term returns. The managers of university endowments such as Harvard’s and Yale’s, as well as international organizations like the World Bank, have bought into the idea, but most of their pension fund colleagues are yet to be convinced. While the low correlation between hedge fund returns and those in the stock and bond markets may be attractive, the lack of control and transparency has kept most pension managers on the sidelines.

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