Two apparently contradictory items of news were released at the end of January – on the one hand it was reported that hedge funds' saw their second worst year ever and on the other we read that a new survey shows pension funds' are still eager to increase their hedge fund holdings.

Meanwhile, the trickle of negative headlines surrounding hedge funds since the onset of the financial crisis shows no sign of abating. From scathing books to problems with illiquid assets, hedge funds are still many outsiders' bete noire. 

The survey from service providers SEI suggests that 38% of institutional investors plan further investments into hedge funds, as opposed to just 15% who plan to lower them. This comes after UK pension funds have already more than doubled their overall exposure to hedge funds from 1.8% to 4.1% between 2009 and 2011, according to the National Association of Pension Funds.

So how exactly have the much-vilified hedge funds defied the crisis and poor returns to woo pension funds in record numbers?

Making a move 

One answer seems to be that hedge funds are making a greater effort to win pension fund investments, recognised within the hedge fund industry as its 'institutionalisation'. 

John Belgrove, a principal at consultancy firm Aon Hewitt explained to Pension Funds Insider: "After the crisis a lot of hedge funds woke up to the value of having long-term investors like pension funds rather than attracting hot money which was being withdrawn at the height of the financial crunch."

Attempting to win pension funds as clients has seen hedge funds respond to trustees' concerns over transparency and high fees, says Belgrove. Indeed, the SEI survey showed that the number of hedge fund investors listing transparency or fees as their chief concern dropped dramatically over 2010, from a combined total of 35% to 22%.     

Phil Masterson, senior vice president of SEI, argued that hedge funds have made great efforts to build trust with investors since the financial crisis.

While speaking to Pension Funds Insider Masterson said that these efforts also include new ways to verify assets, clearer pricing structures and open-risk protocols.

Masterson described the recent courtship of pension funds by hedge funds as: "A mutual discovery process, where the investor, ideally, gains a clear picture of the hedge fund's strategy and the investment manager has a clear understanding of what the investor's objectives are.

"In that way you can avoid disconnects like some of the liquidity mismatches experienced by some investors in the wake of the financial crisis."

Building a future together

The friendly overtones that hedge funds have made towards pension funds seem to be fuelling trustees' recognition of the potential of the asset class in helping to solve their deficit problems.

The majority of pension funds are either carrying large deficits or otherwise causing their sponsor companies headaches by their huge financial volatility.

This volatility has made an even bigger stain on company balance sheets under mark-to-market accounting rules that are now standard.

The greatest attraction of hedge funds seems to be that their unique investment techniques claim to battle the source of this volatility. This involves hedging against the equity risk that has seen ballooning deficits in the last ten years and fighting the inflation or interest rate risks that can see the liability of future benefits shoot up to.

Belgrove says that "hedge funds are suitable investments for pension funds looking to reduce their risks and close their deficits in a measured way".

An increasing number of pension funds are currently trying to remove risk from their portfolios by following 'liability-driven investing' that prioritises matching future benefit obligations and thereby reducing deficits.

The volatile business of investing in equities has become less popular under this approach. That has opened room for alternative asset classes like real estate, infrastructure and hedge funds, who aim to reduce volatility with techniques like going both long and short on stocks, and trying to make money from falling stock markets.

More than a few years ago hedge fund investing was virtually unknown amongst pension funds in the UK, which explains why its rise looks so dramatic from the statistics.

But why are pension funds still increasing their exposure to an asset class that lost 2.52% in 2011, according to the Dow Jones Credit Suisse Hedge Fund index?

Belgrove reckons that the best hedge funds for pension funds can be "reasonable winners in strong markets and not lose too much in really weak markets".

According to this outlook he says the 2011 returns "are not a bad result" in a year when major equity indices suffered greater drops (the FTSE 100 declined by 5.5%).

The poor returns of 2011 across hedge funds on the whole were tempered by some types of hedge fund investing performing better. "Macro performed relatively well but equity long/short suffered from its equity exposure, albeit it did not perform as poorly as pure equity investing," Belgrove says.

Masterson, however, feels that concern from institutional investors on poor performance is being felt by returns being indicated as the major concern in the SEI survey.

He said: "While the poor performance in 2008 was generally accepted in the context of the economic crisis and relative outperformance of hedge funds, this leeway no longer being granted, and investors are focusing on performance of hedge funds in their portfolio."

Belgrove is critical of the mistaken assumption that hedge funds always deliver returns. Some blame the hedge fund industry for blatantly promoting this idea, by labelling their funds 'absolute return' for instance, a phrase Belgrove finds "unfortunate".

A match made in heaven?

Consultancy firms like Aon Hewitt emphasise the need for pension funds to tread extremely carefully in finding the right hedge fund to invest in.

"In our opinion most hedge funds are not up to the job but many are outstanding," says Belgrove.

The resources needed to find the right hedge fund perhaps means that poor reputation of the more maverick funds has hampered the take up of the asset class on the whole. Pension funds are clearly still wary of getting ripped off by the wrong hedge fund.

Belgrove says: "Hedge funds carry a higher monitoring burden which requires a lot of effort and work from trustees. That has led to the larger pension funds tending to be bigger players in hedge fund investing."

Masterson says: "Diversification is still seen as a very valid strategy for a pension fund, but is increasingly accepted that you need a broad set of sources of that. This can be found in the diverse hedge fund environment, and investors need to carefully analyse where and in what circumstances a hedge fund can fulfil their objective whether it be non-correlated returns or excess returns."

Analysing the exact risks of a particular hedge fund is a difficult element of this selection process, although the same is true of any asset class.

Nonetheless, the freedom of hedge fund managers to apply innovative investing techniques is being accepted as a freedom pension funds need to tap into in order to claw back some of their deficit and reduce their sponsoring company's pension risk.

Many pension funds that have already invested in the asset class are confident enough with the world of hedge funds to have largely ditched fund-of-fund investing in favour of more direct allocations. The SEI survey found that 40% of institutional investors with hedge fund holdings now invest solely in single-manager funds, up from 24% a year previously.

So while scepticism abounds, convincing pension funds to see them as a reliable destination for a reasonable chunk of their assets is no mean feat on behalf of hedge funds during some of their industry's more difficult times.

dbillingham@wilmington.co.uk