Over the past couple of years hedge funds and institutional investors have not always seen eye to eye. Hedge fund managers have been perceived to be too reckless, too expensive, and not transparent enough. Pension Funds Insider investigates whether pension funds can rely on a change of attitude from managers

"Hedge funds were very unregulated at the start of the crisis, they were in a very different position back then and basically got offered money and rejected people," says Martin Botha, director of buy-side solutions at Algorithmics, a software developing firm for risk management. "But with Madoff and the crisis hedge funds have now become part of the overall financial environment."

Nevertheless, investors remain wary of hedge funds. A fear, some say, that is not entirely justified.

"Hedge funds prior to the crisis got the blame already, but they didn't do anything (wrong)," says Mark Hewlett, managing partner at Anello asset management. "They outperformed other asset classes and always did alternatives exceed what they said they would deliver."

He says the problem is that investors "just do not think outside the box".

One investor who did 'think outside the box' was the Rabobank pension scheme. In 2009, it decided to withdraw completely from its fund of hedge funds investments, in which it had €383m.

The scheme wrote in its annual report: "Due to the crisis and the subsequent recession the portfolio of the fund has been drastically changed. It has been decided to stop entirely with investing in fund of hedge funds," "The most important reasons were that we had doubts about the added value in the light of the diversification we are seeking and the lack of transparency of the hedge fund industry in general."

The Rabobank is however currently still active in regular hedge funds. René Loman, press officer of the Rabobank Group, explains: "We still invest in hedge funds. During the crisis these funds have done exactly what they were meant to do: protect the coverage ratio." In the Netherlands, a minimum coverage ratio of 105% is demanded by the regulators.

"Hedge funds are facing a new order where the balance of power is shifting firmly to pension funds," says Bob Weare, marketing director at Algorithmics. "In future, to attract and retain investor capital, hedge funds will need to play by the rules of pension funds rather than their own. This means having in place robust risk systems and the willingness to provide greater risk transparency."

Transparency

Transparency seems indeed the factor that needs to be most improved. And according to Botha, that is exactly what is being done now. "The regulators do nothing else than promoting transparency, but investor confidence needs to be regained first," he says.

Botha says that a recent study carried out by Algorithmics saw that 84% of asset owners will demand more transparency than is currently the case. "They really want the same level of transparency for hedge funds as they see elsewhere in the market."

Peter Astleford, a partner at Dechert LLP, a law firm specialising in hedge funds, says that European managers are now far more transparent then they were.

He also says that there are differences between the two major markets, with US hedge funds remaining far less transparent than their European counterparts.

"The US funds are more opaque. Madoff was an example of an opaque fund, there just wasn't enough due diligence. Institutional investors in general just do not pay enough attention," he says. 
 
"With the older established funds you have to be more careful then with the new funds. The older ones have not been looking for new investors because they were closed for a long time," Astleford says. "They know little about the new ways, the new demands regarding transparency, because they have not had to deal with them yet."

Gary Goldberg, Capco's director, doesn't agree with Astleford. He says that large hedge funds which are already registered are "used to regulations".

He foresees a trend in the market that will lead to bigger funds. "We will see a lot of cases of consolidation. Bigger funds will control the market. They like institutions as investors and will be able to accommodate their demands."

His views are confirmed by Botha. "Active fund management is almost back at pre-crisis levels. The smaller hedge funds are struggling because they do not comply with what the pension schemes now want."

Legislation

The lawmakers may also have helped pension funds to improve their monitoring processes. In Europe, there is the Alternative Investment Fund Managers Directive (AIFMD) and in the US the Dodd-Frank reforms are taking place.

The AIFMD is aimed at managers of alternative investment funds, such as hedge funds. It was established after the G20 had agreed that the status quo was no longer acceptable and will probably come into force for all funds in 2013.

Given the counter-party risk involved with alternative investment, the directive is meant to 'rigorously' monitor and control the market. A fund will receive a passport under the directive, which will act as a licence for it to trade all over Europe, letting investors know that it is transparent, properly supervised, and protects investors whenever possible.

In the US, new rules on hedge funds were adopted last July as part of the Dodd-Frank Act. Hedge funds managers will now need to be registered and report with the Securities and Exchange Commission.

"Pension funds who have the manpower to do due diligence should go direct, for them hedge funds are suitable. In other cases managed accounts are perhaps more appropriate," explains Goldberg.

Managed accounts, he says, provide full transparency as a platform where investors have far more control over where their assets are invested.

Hewlett agrees with Goldberg and says that with managed accounts "there is nowhere to hide" for managers. 

UCITS and a closed shop

Other vehicles have ramped up security for investors. These include UCITS (Undertakings for Collective Investment in Transferable Securities Directives). These enable collective investment schemes to operate freely throughout Europe and hedge funds have looked at setting UCITS up in order to provide investors with the security that they require – as well as gain access to markets where hedge fund investment is tightly regulated.

"UCITS came into the world due to increased transparency demands," says Astleford. "It is a case of pan-European one-size fits all. But the disadvantage is that one size fits all means that it is pushing up costs and it will restrict the availability of non-European funds."

He says the danger is that many non-European hedge funds will regard the EU market as one that 'they do not need anyway'.

"Funds will be largely bought up by insurance and big private pension providers. Which means less choice, which means less performance. It would inevitably mean less innovation, less new managers, less business and a favour towards big investors," he claims.

Negatives aside, they do bring an extra layer of security, which is especially suitable to institutional investors who are very risk averse. Hewlett is no fan: "A lot of pension schemes buy into UCITS. They have a wider use of techniques but are still constrained. They are very much benchmarked and this takes the uniqueness of the product away. The selling point has always been the non-correlation."

"My biggest fear," says Hewlett, "is that pension schemes and other institutional investors choose the big funds again. They are obsessed with size. But what happens then is that they think it is safe when the fund is big enough and do not carry out enough due diligence. Then we get affairs like we have seen with Madoff."

Astleford says the problem with bigger funds is that they are harder to manage. "The average size has gone up. Larger equity means more risk management. What you ideally want is new, small funds, £500m to £2bn. It is really hard to follow a big fund of let's say £20bn to £30bn."

This is confirmed by GLG Partners, which reported this week (18 April) that it is preparing to close one of its largest funds to new investors. There are concerns about the ability of the large hedge fund to deliver the expected returns.

The fund will shut when it grows beyond $1bn which is expected to happen in the next couple of weeks. The move stresses a huge difference in attitude compared to pre-crisis times when the fund was confident with running more than $3bn in investments.

Fees

At the EDHEC-Risk Alternative Investment conference held in London earlier this month, the big debate centred around hedge fund fees. Overall, investors are finding that the '2 and 20' rule is quite a high price to pay.

Carrie Lo, investment manager at the California State Teachers' Retirement System (CalSTRS), the second-biggest US public pension fund, said that although "hedge funds are nothing compared to Goldman Sachs'  investment managers", rewarding them only made sense if things were going well.

Another view, voiced by Simon Fox, a principal at Mercer, was that investors "felt ripped off".
"If you have fund of funds then you can negotiate your fees down, with hedge funds I would like to see lower fees. Fees of 20% on excess value would probably be ok for 40% of the audience."

John Wilkinson, vice president at LGT Capital Partners says the fees are not what investors should look at, the net returns are more important. "The net return is effectively what can be added to the pension scheme." He also says that the higher the return is the higher the fees will be. "You get what you pay for. If you want to minimize fee structures then you need to go for a passive solution."

But according to Hewlett the industry has taken notice on this point – although not everyone has gone along yet. "We see more and more different structures now. 1.5 and 15, or in the States we even see 40% to 60%."

The fees make little difference and lowering the fees will possible only backfire, predicts Astleford. "Hedge funds are either loved, which is when people are glad to get into the fund, and then paying the fees is not a problem. Or investors do not trust them. In that case then lowering the fees would not make a difference, if anything they would trust them less."

"Trustees have fiduciary responsibilities. When they come to hedge funds they have a 100 today and want to change that into a 110 tomorrow, it is what they expect of them," Astleford says.

"Hedge funds need to increase that money. And as an asset class they perform better than real estate or global equity. Pension funds trustees go elsewhere if they want safety. Hedge funds give them what they need and want when it comes to high returns and liquidity."

Goldberg keeps it simple: "We live in a capitalist market and hedge funds are a part of this – in fact they stress the fact that we do."

azeevalkink@wilmington.co.uk

First published 19.04.11