Thursday, November 1, 2012

Hyping Up Hedge Fund Hipsters?

Hedgeco reports, Pension funds to increase Hedge Fund allocation despite recent poor performance:
Pension funds will continue to increase their allocation to hedge funds despite the recent poor performance within the hedge fund industry, according to Don Steinbrugge, Chairman of Agecroft Partners, a global consulting and third party marketing firm for hedge funds.

“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.
Problem is the "endowment fund approach" has cost public pension funds billions in losses and has been hard on endowments too. The reality is that most US public funds are ill-equipped to understand the risks of alternative asset classes like hedge funds and private equity, and lack the compensation scheme to attract and retain the right people to take the right approach into alternatives.

What ends up happening is they hire brainless pension consultants who act as gatekeepers, shoving them in 'brand name' funds and these pensions end up getting hosed on fees, with little or no return to show for their allocation. It's what I call the "alternatives circus" and it's been going on for years.

But faced with serious funding woes, defined-benefit plans simply don't know where to turn to get the yield they require to meet their actuarial target return. According to Mercer, the funded status of DB pension plans in Canada, the U.S. and the Netherlands has fallen since December 2011:
The greatest decline has taken place in the Netherlands, where funded status has dropped from 96% to 80% due to declines in the discount rate used to measure pension liabilities. According to Mercer, as the interest rate used to measure the liabilities has fallen in the eurozone, liabilities across the region have increased. Multinationals with pension obligations in Germany, the Netherlands and Ireland, in particular, will all be facing larger liabilities. Funded status in the U.S. declined from 75% to 73% during the time period, while Canada saw a drop from 87% to 83%.

On the other hand, the Mercer data show that DB plans’ funded status has improved in the U.K. Funded status levels there remained relatively level in the months since December 2011, until September 2012 when there was a sharp improvement to 92%. In the U.K., the yield on high-quality corporate bonds increased, and the market saw a 33% reduction in FTSE350 deficits for the month of September.
Meanwhile, according to Northern Trust, US institutional plan sponsors gained in the third quarter:
Institutional plan sponsors in the Northern Trust Universe gained about 4.5 percent at the median in the third quarter, as U.S. and international equities bounced back from a negative performance in the prior quarter and fixed income assets continued to generate modest positive returns.

The Northern Trust Universe tracks the performance of about 300 large U.S. institutional investment plans, with a combined asset value of approximately $748 billion, that subscribe to Northern Trust performance measurement services.

“A strong rebound in the equity markets boosted results for institutional investors in the third quarter, and over longer time periods,” said William Frieske, senior performance consultant, Northern Trust Investment Risk & Analytical Services. “While the financial markets have had some negative quarters in recent years, the median plan sponsor in our Universe now has a three-year return of nearly 9 percent. The mix of asset classes in these institutional plans, including private equity and fixed income, has helped to moderate the effects of market volatility and produce steady gains over time.”

In the third quarter, Corporate Pension Plans, for private-sector employees, were the best-performing segment, gaining approximately 5 percent at the median for the three months ending September 30, 2012. Public Funds – pension plans for public employees – gained 4.7 percent and the Foundations & Endowments segment – funds managed for philanthropic organizations, colleges and universities – rose 4.3 percent in the quarter, according to Northern Trust Universe data.

Positive returns in the third quarter were driven by U.S. equities, which make up 30 percent or more of all assets in most institutional portfolios in the Northern Trust Universe. The median U.S. Equity program in the Universe gained almost 6.5 percent in the third quarter, after dropping 5 percent in the previous quarter. Other asset classes also performed well: the median International Equity program returned 7.2 percent in the quarter, and the median Fixed Income program gained 2.9 percent. International bonds, especially those from Emerging Markets, outperformed other fixed income segments but are a relatively small allocation in most plans.

“Looking at a longer time horizon, U.S. fixed income has produced the best returns over the last five years,” Frieske said. “The median U.S. Fixed Income Program in the Northern Trust Universe gained 8 percent in the five years ending September 30, 2012, compared to a return of just 1.3 percent for U.S. Equity Programs and a 3.9 percent return for Private Equity Programs. Over the last three years, however, private equity has the edge. The median Private Equity Program return was 13.3 percent for three years, while U.S. Equities gained 12.8 percent and U.S. Fixed Income Programs returned 8.1 percent over that time period.”

In the one-, three- and five-year periods, as of September 30, 2012, performance results for all plans in the Northern Trust Universe are:
                                                      1 Yr  3 Yr  5 Yr
Corporate Pension Plans                 18.3% 10.4% 2.9%
Public Funds                                   16.7% 9.7% 2.3%
Foundations & Endowments       14.0% 8.2% 1.5%
Interestingly, allocations to fixed income have helped corporate plans outperform public funds and endowment funds. But with corporate bond sales surging  to $3.3 trillion this year, challenging the record in 2009, allocations to US fixed income have reached bubble levels. Maybe plan sponsors will go global, following PE giants who are bullish on corporate lending in India.

But my bet is that they'll keep doing whatever their brainless gatekeepers recommend, running through their meaningless asset allocation optimization models, shoving billions more into hedge funds and private equity, hoping for the best. Good luck with that strategy.

Finally, for those looking to venture into hedge funds, there are some excellent funds of funds who do know what they're doing. Below, Jane Buchan, co-founder and chief executive officer of Pacific Alternative Asset Management Co., talks about investment in hedge funds, financial regulation and the potential impact of the U.S. presidential election on the stock market. She speaks with Scarlet Fu and Stephanie Ruhle on Bloomberg Television's "Market Makers," warning investors about 'hedge fund hipsters'.

And Bloomberg's Dominic Chu reports that a group of wealthy investors are choosing ETFs over hedge funds, according to a recent survey of the Tiger 21 Investment network. He speaks on Bloomberg Television's "In The Loop." Even the super wealthy have figured out the hype on hedge funds hipsters.