Institutional investors making big splash in hedge fund pool

April 12, 2006

Long considered an elite investment for high net-worth individuals, smaller private banks and certain institutional investors, the hedge fund market has grown up from a multimillion-dollar cottage industry one where assets total more than $1 trillion. "And the bulk of the growth in the past five years has been attributable to the entrance of institutional investors into the space," said David Friedland, president of the Hedge Fund Association.



Virtually unregulated, hedge funds have minimum investment requirements, typically ranging from $250,000 to $1 million. By law, a maximum of 100 investors is allowed in a hedge fund, accounting for those high minimum investments. And hedge funds have fewer reporting requirements, making them less transparent than traditional investments and adding to their reputation for secretive trading strategies.


Like traditional funds, investors pay an annual service fee, but unlike traditional investments, investors also pay a percentage of the gains. "Usually it's 2 and 20," said Herbert Kaufman, finance professor at the W. P. Carey School of Business, "which means 2 percent is the annual service fee, plus 20 percent of the gains. And because they have such reputations, there are hedge fund managers who have been able to take substantially more than 20 percent of the gains."


Hedge funds have been getting a lot of press these days. Because institutional investors need higher returns than they have been earning in order to meet their actuarial projections, they have been allocating portions of their pension funds to alternative investments including hedge funds -- chasing higher returns in what some view as risky investment classes.


That perception that hedge funds are risky may stem from the fact that hedge funds are not as liquid as stocks. Investments are subject to a lock-up period, during which principal and any gains cannot be accessed. Lock-up periods can range from one to 12 years.


Why the migration to hedge funds?


"Pension fund managers are in sort of a desperate situation right now," Kaufman said. These managers need returns on investments based on an actuarial assumption to their pension obligations -- frequently about 8 percent. "And those equity and bond returns, their traditional portfolio holdings, have evaporated in this environment," he said. "So they looked for alternative investments to raise their overall returns to their assumed 8 percent, which they hadn't been able to achieve."


Pension funds usually invest a small portion of their portfolios -- often 10 percent or even less -- in hedge funds and other alternative investments such as private equity funds. Kaufman said that overall, pension fund managers are not at risk when investments are made in hedge funds or other alternative investments. "But they are more at risk than they were when they didn't risk any of it in these alternative investments," he added. "To the extent alternative investment allocations keep expanding, however, there may come a time when increased alternative investment allocations can become very worrisome."


If a pension fund's investments are locked up in a hedge fund strategy that isn't yielding the needed returns, the fund manager must wait until the redemption period to cash out and move those monies to another investment with higher anticipated returns.


Longer lockups yield higher returns


Yet waiting out a lock-up period often results in stronger returns, according to George Aragon, assistant finance professor at the W. P. Carey School of Business. In a forthcoming article in the Journal of Financial Economics, titled "Share Restrictions and Asset Pricing: Evdence from the Hedge Fund Industry," Aragon studies the share restrictions that are imposed by funds that limit the liquidity of fund investors.


Using a database of 3,000 hedge funds. Aragon compares investment returns, based on hedge funds' lockups, redemption notice periods, and minimum investment amounts. He finds that, on average, returns are higher for funds with greater share restrictions.

For example, funds with a one-year lock-up period earn roughly 4 percent a year more than those funds without a lock-up period. "I think that's economically important," he added.


Aragon also finds that share restrictions are more often required by funds that pursue strategies involving illiquid assets. "A fund that holds illiquid stocks can earn high returns," Aragon said, "but its profitability depends crucially on its investment horizon. When transactions costs are large, it is important to have a long-term horizon. Share restrictions lead to lower trading costs, and thereby allow funds to efficiently manage illiquid assets. In turn, these benefits are captured by fund investors as compensation for the lock-up period."


More predictable returns


Because they are often less aggressive and more predictable in their returns than traditional equity investments, Friedland feels that investing in hedge funds actually lowers a pension fund's risk profile. Friedland is also president of Magnum U.S. Investments, a fund comprising investments in 40 different hedge funds.


Friedland observed that some college endowments -- such as Harvard and Yale, among the wealthiest university endowments -- invest as much as 30 to 40 percent of their portfolios in hedge funds and other alternative investments. "Depending on what the investor's liquidity needs are," he said, "something in the 15-to-30 percent range makes perfect sense. If you look at those who have been most successful in building their endowments, they have higher allocations to hedge funds and have been very successful with that."


California seeks long-term returns


The nation's biggest public pension fund, the $207 billion California Public Employee Retirement System, doubled its investment in hedge funds to $2 billion in late 2004, about 1 percent of its total assets. With an eye toward gaining long-term returns, the board expected the investment expansion to provide greater diversity for the global equity portfolio. Along with those better returns, CalPERS reported that with the first round of investments, volatility in the hedge fund portfolio was only one-fourth of the volatility in the retirement system's U.S. stock portfolio, though, of course, over a very short period of time.


The CalPERS experience demonstrates that when pension fund managers use a disciplined approach to investing, and when they understand the strategies that are being used in the funds where they invest, they can build a low-volatility, lower-risk portfolio with hedge funds than with any mutual funds or equity investments. "That's because of the ability of hedge funds to use risk-reducing techniques, such as shorting, arbitrage and lowering their equity exposure," Friedland said.


Hedge funds flooded by investments


In the ongoing search for the returns they need to efficiently manage their portfolios for the next decade and beyond, pension fund managers have clamored for hedge funds' characteristically big returns. That flood of capital is expected to top $300 billion by 2008.


"Unfortunately," Kaufman said, "what that has meant is that the returns that were out there for hedge funds when they were dealing with a few billion dollars have been substantially reduced. Currently they're competing for the same deals, but the funds are now in the tens of billions of dollars, so the overall return on hedge funds has substantially declined. As an economic argument, you'd expect that as there's more money chasing the same deals, those deals would yield less as returns are competed away."


Therein lies the conundrum. When annual management and hefty percentage-of-the-profit fees are factored in, Kaufman said that the return in hedge funds, "at this moment in time, doesn't appear to be there. When a fund is yielding 30 percent and after paying 7 or 8 percentage points you're netting 22 percent -- but everything else you're doing is netting 7 percent -- you're pretty happy. But when you're doing 7 percent a year and you're only netting 4 percent out of that, you're not. And that's the situation with regard to many hedge funds now. Pension fund managers hope that what they're seeing is just an aberration in returns."


Too much money chasing too few deals


Aberration it may be. Friedland said that the flood of capital has caused overcapacity in some hedge fund strategies, which, in turn, has caused deteriorating market conditions. "What I mean by that is it's a lack of market investment opportunity, coupled with increased monies facing those investing opportunities that lead to a reduction in overall returns in that particular area. When you've got more and more dollars chasing fewer and fewer deals, the spread tends to narrow and the risks tend to increase. You'll find that there will be a lowering of return expectations in some of those strategies, because of that."


That leads to investors pulling capital from poorly performing strategies, as they did last year in convertible bond arbitrage. "Nobody was looking at that space at the end of last year," Friedland said. "But that doesn't mean it's not going to do well over the next couple of years. In fact, money's been coming out of that sector and it has been one of the hottest sectors over the past four or five years."


Pension fund managers have a lot of information to sort through when considering investing a portion of their portfolios in hedge funds. Aragon said if he was a hedge fund investor, he would want as much transparency as possible, up to a point: "For competitive reasons," he said, "it may not be in the investor's interest for a fund to maintain a practice of full disclosure. However, I would expect any potential hedge fund investor to use basic due diligence when selecting new managers. In general, useful information is publicly available."


Bottom line:


  • The chase for higher returns has led institutional investors, including pension fund managers, to alternative investments -- including hedge funds
  • The flood of capital into hedge funds from institutional investors is expected to top $300 billion by 2008
  • Returns are higher for hedge funds with greater restrictions: funds with a one-year lock-up period earn roughly 4 percent a year more than those funds without a lock-up period
  • Annual management and hefty percentage-of-the-profit fees are cutting the expected high return in hedge funds