Pension Funds` Hedge Fund Investments

Capital Market Opinion
Pension Funds’ Hedge Fund Investments
Nam, Chaewoo＊
Korean pension funds are increasing the share of alternative investments
in their portfolios in response to the global financial crisis and persistent low
interest rates. Pension funds have a strong interest in hedge funds seeking
absolute returns because they now need to maximize the diversification
effect and keep up investment returns. Generally, pension funds start to
invest in hedge funds through a fund of hedge funds (FoHF). Then, pension
funds gradually move towards investing in single funds as they accumulate
their hedge fund investment capabilities. Among hedge fund strategies, the
equity hedge strategy is recommended for pension funds when they begin
hedge fund investments. However, the macro investing strategy is more
suitable for large pension funds given their investment purpose.
Pension funds around the world have seen steep growth in assets under management
(AUM). Furthermore, the prolonged global financial crisis and the low interest rate environment
increase the need for pension funds to diversify investments for better returns and maximize the
diversification effect. Korean pension funds are also expanding their allocations to alternative
assets. The scope of alternative asset classes is widened to include commodities and resources
in addition to traditional alternative assets such as real estate and infrastructure. In this context,
many domestic pension funds consider introducing hedge funds as an investment asset class or
investment strategy.
Against this backdrop, this article examines how hedge fund investments should be adopted
by pension funds given their nature and offers hedge fund investing strategies for pension funds.
All opinions expressed in this paper represent the author’s personal views and thus should not be interpreted as Korea Capital
Market Institute’s official position.
Ph.D., Research Fellow, Fund & Pension Department, Tel: 82-2-3771-0827, E-mail: zeuss@kcmi.re.kr
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Capital Market Opinion
Characteristics of hedge funds and current market conditions
It is difficult to define a hedge fund in one sentence because of the diverse nature of hedge
funds. In general, they seek absolute returns using leverage and through various investment
strategies. Hedge funds are also known to seek absolute returns regardless of market conditions.
The US Securities and Exchange Commission (SEC) defines a hedge fund as an “entity that
is not registered as an investment company under the Investment Company Act, invests in
securities and other assets, and is not offered publicly.” In practice, hedge funds are described
as an “investment cooperative that raise funds from professional investors over a certain asset
level through private placement, operate diverse investment strategies to generate returns, and
distribute profits to its investors according to investment performance.” With this definition,
hedge funds are not clearly distinguished from private equity funds.1)
In addition to the different definitions, hedge funds also have different risk return profiles
from other financial assets and investment strategies. Hedge funds can be characterized by the
generation of absolute returns regardless of market conditions, low correlation with traditional
assets, and high management and performance fees. These unique characteristics stem from
the following two factors. First, hedge fund management is heavily reliant upon fund managers’
discretion compared to other investment approaches. This means that the source of profits is
excess return (α), not market return (β), which enables hedge funds to maintain relatively low
correlation between investment assets in situations such as a financial crisis where correlation
between heterogeneous asset classes increases sharply. This justifies higher management
fees charged by hedge funds than those by other investment methods. The downside is that
hedge funds’ dependence on the skills of individual fund managers can be the direct cause of
reputation risk when a financial incident occurs. Reputation risk can be fatal to institutional
investors such as pension funds.
Another important feature is that most hedge funds take both long and short positions
in the same market. This widely used investment strategy suggests that hedge funds rely on
the influence of individual stocks or incidents rather than removing market ups and downs.
1) Hedge funds are similar to private equity funds in many aspects, for instance, placement method, disclosure obligation, leverage
and short sales. A striking difference is that investment targets are mainly corporations for PEFs, and a wide range of assets,
including securities for hedge funds. In addition, PEFs are close-end funds with more than 10-year investment horizons whereas
hedge funds are open-end funds with relatively short-term investment horizens. Another difference is that hedge funds require
investors to inject their entire commitment of funds in the early stage of investment, but most PEFs call capital from their investors
as needed.
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Therefore, short-selling is essential for fund management, and as a consequence, most hedge
funds pursue absolute returns regardless of market performance. However, when the stock
market stumbles, for example, because of a financial crisis, the harmful effects of short-selling
come under the spotlight. If short sales are regulated as a result, then this severely undermines
the efficient management of hedge funds in one way or another.
While meddling through the 2008 financial crisis, global hedge funds contracted much like
traditional investment assets. According to a report released by a renowned research institute,2)
the hedge fund market shrank nearly 25 percent from $1.9 trillion in 2007 to $1.4 trillion in 2008.
Later, the market rapidly recovered and grew larger than the pre-crisis level in 2010. However,
capital withdrawn from hedge funds has returned mostly to large funds. The financial crisis
intensified capital concentration in large hedge funds.
In Korea, the revision of the Enforcement Decree of the Financial Investment Services and
Capital Markets Act in September 2011 paved the way to establish a legal framework for the
introduction of Korean hedge funds. At present, 12 asset management companies and 19
hedge funds are registered as Korean hedge funds. The combined size of hedge funds reached
720 billion Korean won. Most registered hedge funds in Korea use long/short or equity hedge
strategies. Some hedge funds execute event-driven or relative value strategies. Since the Korean
hedge fund market is in its infancy, it will take considerable time to see institutional investors
such as pension funds in the hedge fund market due to the absence of hedge fund track records.
Hedge fund investment strategies
Dividing hedge fund investment strategies into categories is as difficult as defining a hedge
fund. Nevertheless, the strategies fall into four main categories: equity hedge, event driven,
relative value, and macro strategies. First, equity hedge is the oldest hedge fund investment
strategy. It is easy to understand and is accessible to fund managers. Equity hedge strategies
usually involve buying particular stocks and at the same time shorting stocks within the same
industry or stocks whose price is expected to fall. This strategy aims to maximize the stock
selection effect regardless of market movements.
Equity hedge strategies enable hedge funds to sustain investment returns within a certain
range by maintaining both long and short positions. Accordingly, funds can protect downside
2) HFRI, Hedge fund industry report.
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Capital Market Opinion
risk within their portfolios from a risk management perspective. On the other hand, in a bull
market, hedge funds using equity hedge strategies are expected to underperform the market
index or general equity funds. In practice, however, observations from hedge funds’ historical
performance shows that equity hedge strategies provide stronger downside risk protection than
expected and are very responsive to stock market rallies. Equity hedge funds represent about
28 percent of the global hedge fund market, indicating that the equity hedge strategy is most
commonly used. Among different types of hedge fund strategies, this strategy has a relatively
high correlation with publicly offered stocks. In the event of a market downturn such as a
financial crisis, equity hedge investing tends to move together with the stock market, meaning
that this type of hedge fund strategy would not respond effectively to the demand of pension
funds seeking diversification or protection against possible losses during a crisis.
Second, the event-driven strategy is one where fund managers seek returns on investment
from companies in special situations that directly affect corporate value. Special situations
include bankruptcy, mergers and acquisitions (M&A), and restructuring. For example, in the
case of a potential acquisition, event driven investors purchase the stock of the company to be
acquired and at the same time short-sell the stock of the acquiring company. Similar to equity
hedge investing, event driven investing is highly correlated with the stock market.3)
Third, relative value strategies take advantage of relative differences in prices between assets
(relative value arbitrage). For example, fund managers purchase undervalued credit bonds when
credit spreads are abnormally wide and short-sell government bonds with the same duration at
the same time. With the exception of aggressive short-selling strategies, fund managers are also
very familiar with this type of strategy. Since main investment assets are bonds, strategies in this
category have relatively low correlation with the stock market.
Last, the macro investing strategy has the lowest correlation with the stock market among
hedge fund strategies because it is based on macroeconomic outlooks for particular countries or
economic blocs. Hence, hedge funds utilizing a macro strategy can maintain impressive absolute
returns despite the impact of a financial crisis. Most macro strategies, including commodity
trading advisory (CTA), take a financial engineering approach on the basis of extensive data. For
example, a global macro strategy identifies discrepancies in macro variables which encompass
3) According to HFRI’s 2010 Global hedge fund industry report, performance statistics over latest five years, including 2008, the year
of the financial crisis, show that hedge funds using equity hedge strategies (highly correlated with the stock market) posted 4.5
percent rate of returns whereas those using macro strategies recorded 7.5 percent in returns.
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Capital Market Opinion
both quantitative indicators (e.g., a country’s macroeconomic indicators) and non-quantitative
indicators (e.g., political conditions). Many skilled and experienced professionals are required for
hedge funds to use this strategy. As a result, it is the least common strategy among hedge funds.
Nevertheless, the cumulative performance (returns) of hedge funds using this approach is the
strongest during drastic market changes such as a financial crisis.
When comparing hedge fund performance according to fund management approaches and
investment strategies, we should note that such analysis is mostly based on hedge fund indices.
As widely known, hedge fund indices fail to meet requirements for stock market indices in
general. Due to the nature of the private placement market, all hedge fund indices are calculated
using unaccredited data by index providers having their own criteria. Thus, it cannot be free from
so-called survivorship bias4) or selection bias.5) The biggest problem with hedge fund indices is
that they cannot satisfy the “investable” asset requirement, which is the most important for a
benchmark index, because hedge funds by nature rely on managers’ skills and ability rather than
the market. This means that the index of particular investment strategy does not represent the
appropriate market.
Hedge fund investment by pension funds in Korea
In Korea, public pension funds are known for investing in safe assets, mostly fixed-income
securities. The biggest challenge facing domestic public pension plans is to increase investment
returns to their required return levels in the low interest rate environment. Along with that,
in times of macroeconomic crisis such as a global financial crisis, pension funds have difficulty
controlling total risk in their portfolios because correlation between asset classes increases
drastically. Under such circumstances, not only domestic but also global pension funds are
increasing their allocations to alternative assets in order to generate more returns and diversify
their portfolios. It is notable that pension funds are increasingly interested in hedge funds for
capital preservation and portfolio diversification purposes in times of crisis.
According to research by Preqin (2011), the leading provider of information and index
calculation in the field of alternative investment, 61 percent of institutional investors including
pension funds responded that the biggest reason they consider investing in hedge funds is
4) This occurs because indices include only funds currently under management, and exclude funds that are no longer operating
because of poor performance.
5) This occurs because it is based on voluntary reports by fund managers. Fund managers may selectively report good performance.
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Capital Market Opinion
portfolio diversification. The remaining 36 percent replied that they felt the need to seek
absolute returns regardless of market conditions while going through the financial crisis.
Interestingly, only one percent said they considered hedge fund investment to increase total
returns. The research shows that most institutional investors do not perceive hedge funds as
high risk, high return assets.
Primary investors in the hedge fund sector have changed from high net worth individuals to
institutional investors since the financial crisis.6) Among institutional investors, pension funds are
investing more in hedge funds. 2010 UNPRI survey shows that global pension funds increased
investments in hedge funds from 3.6 percent of their portfolios on average in 2007 before
the crisis to 3.9 percent in 2010 after the crisis. In case of Korean pension funds and sovereign
wealth funds, Korea Investment Corporation (KIC) invests in hedge funds as part of alternative
investments. Besides, Korea Post and Military Mutual Aid Association show strong interest in
hedge funds. The National Pension Service, the flagship pension plan, considered hedge fund
investment in 2008, but is still assessing the feasibility of investing in hedge funds.
Although Korean hedge funds were launched recently, most pension funds consider first
investing in offshore hedge funds because they are keen on hedge funds’ past performance, and
then expanding their investments to the domestic market after Korean hedge funds build track
records and local fund managers prove their performance.7)
Meanwhile, domestic hedge funds in their infancy expect investment from institutional
investors rather than individuals because a virtuous cycle will be created if pension funds
equipped with strong due diligence and fund-raising capabilities participate in the hedge fund
market. Thus, public pension plans need to run pilot-tests by allocating small amounts of capital
to hedge funds in order to nurture Korean hedge funds and help them build track records.
As for overseas pension funds investing in hedge funds, most of them outsource fund
administration to third-party managers because of expertise. When it comes to the outsourcing
method, pension funds have started to invest in FoHF mainly managed by large fund
administrators.8) After the funds have accumulated their own expertise and experience in hedge
6) In the global hedge fund market, high net wealth investors took up 54 percent in 2000 but decreased to 24 percent in 2010. FoHF
as a percentage of the market rose from 17 percent to 31 percent.
7) Preqin (2011) finds that 62 percent of institutional investors request at least three-year track records when they select hedge fund
managers.
8) One large fund management company is Blackstone Alternative Asset Management.
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Capital Market Opinion
fund strategies, they increase the proportion of single funds managed by smaller specialized
asset managers employing particular strategies. When pension funds have sufficient experience
in hedge fund investment and increase hedge fund assets to a significant level, then they will
add in-house fund managers by using their talent or taking over existing fund management
companies.
For large pension funds that can allocate sizable capital to hedge funds in the early-stage
investment, these funds should consider first investing in the hedge fund market through FoHF
and at the same time strategically exploring a handful of single funds. In this case, pension
funds can employ the concept of optimal asset allocation among various hedge fund strategies
for entire portfolios and maximize the diversification effect by relying on leading hedge fund
advisers.9)
Equity hedge strategies are most recommended for pension funds when they start hedge
fund investing because it is accessible and easy to understand. However, there may be mixed
views on whether equity hedge strategies are most appropriate even for large pension
funds whose AUM exceed a certain level, in making the first hedge fund investment. This is
because large pension funds should mull over various factors including initial asset allocation
size, correlation with asset classes in existing portfolios, investment purpose (portfolio
diversification), and reputation risk. Given the maximization of the diversification effect and the
ease of establishing related systems depending on size, macro investing strategies rather than
equity hedge strategies are more suitable for pension funds to meet the purpose of hedge fund
investment.
Meanwhile, reputation risk is cited as the biggest obstacle for public pension systems to
invest actively in hedge funds. Like UCITS hedge funds,10) a hedge fund’s transactions and asset
holdings can be periodically reported via managed accounts, to ensure transparency of fund
administration. Above all, transparency is important for FoHF, which can be the first hedge fund
investment by Korean pension funds. And pension funds and third parties need to keep a close
eye on their investments as part of ex-post risk management.
9) The Dutch ABP set up its subsidiary, New Holland Capital, for hedge fund investment.
10)This term refers to hedge funds subject to the UCITS-III (The Undertaking for Collective Investments in Transferable Securities
Framework, third version). Monthly or weekly exit from investment is allowed and separate risk regulations are applied to those
funds.
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