Hedge funds on the road to greater respectability

In January, the company said it was considering its first investment in hedge funds, after receiving clarification from Revenue & Customs that the asset class will be treated as a mainstream investment for tax purposes.

Dana Ward, a partner at tax adviser Grant Thornton and a member of the Alternative Investment Management Association, said: “It is a good outcome that investment in hedge funds is not regarded as trading activity. It would have only acted as a deterrent to pension schemes.”

Confusion over tax treatment is one problem trustees face when debating hedge fund investment. However, a more fundamental concern about whether these largely unregulated vehicles are appropriate for the nest eggs of primary school teachers and firemen – especially given some of the more egregious hedge fund collapses – lie at the heart of trustees’ concerns. The high fees, the lack of transparency, difficulties in monitoring hedge funds’ secretive trading activities and long lock-in periods are further deterrents – particularly for public sector schemes.

Such barriers, coupled with what Paul Myners – who chaired a Government inquiry into institutional fund management – calls “scaremongering in the press”, obscure the fact that hedge funds have built an impressive record of riding market volatility since the early 1990s. The consequence is that there are few countries – even the US, UK, the Netherlands and the Nordic countries – where hedge funds account for more than 1% to 2% of pension fund investment.

Richard Grottheim, chief investment officer at Swedish fund AP7, which invests 2% of its assets in funds of hedge funds, said: “There has been a false perception among European pension funds that hedge funds are riskier than they are. If you create a well-diversified portfolio of hedge funds, the risk is lower than equities.”

Several significant changes have occurred in the past year – including a code of conduct from the Hedge Fund Working Group, which was set up to examine voluntary standards for the industry. Its comply-or-explain standards include that managers should adopt “an independent process for valuing their portfolios” and introduce robust governance and comprehensive risk-management procedures. These measures have already improved institutional perceptions of the sector. Hedge funds have been slowly shedding some of their Wild West image and entering the investment mainstream.

The largest hedge fund managers and fund of hedge fund managers have realised that to win institutional mandates, they have to institutionalise their businesses. Andrew Shrimpton, a partner at Kinetic Partners, an advisory firm specialising in the investment industry, said hedge funds had been working hard to sort out their operational infrastructure by investing in their back and middle offices, administration, the settlement of trades, calculation of net asset value and fund accounting.

Shrimpton said: “The big hedge fund managers want to go after institutional money and are building platforms that look just like those of any other institutional asset manager.”

The period of high volatility in equity markets is also working in hedge funds’ favour, where many rode out the credit crunch-inspired storms better than some other instruments including structured investment vehicles and collateralised debt obligations.

Kathryn Graham, head of hedge funds at Hermes Pensions Management, which manages the £38bn BT pension scheme, said: “If anything, market instability is going to increase investor appetite for hedge fund investment. The low risk, low volatility nature of the bulk of the hedge fund universe is coming to the fore again. However, I agree that transparency needs to improve.”

In 2006, Hermes doubled the BT fund’s allocation to hedge funds and other alternative assets from 7% to 15% of assets, or £5.7bn. The pension scheme buys hedge funds directly rather than using funds of funds, which is an approach used by other UK pioneers such as retailer J Sainsbury and railway scheme Railpen.

The latest survey from Baring Asset Management suggests enthusiasm for the asset class is picking up, at least among UK pension funds. In 2006, 17% of UK schemes were investing in hedge funds, according to Baring’s research. That had risen to 48% last year.

Brad Ziff, director of hedge funds advisory at management consultant Oliver Wyman, expects UK and European pension funds to increase their overall allocation to hedge funds as economies and investors become more comfortable with them.

However, there is still the issue of fee levels. Most UK and European pension funds are more comfortable with using funds of funds than doing direct investment, which is favoured only by the largest pension schemes such as the Netherlands’ ABP and PGGM.

What leading fund of fund providers, such as UBS, Union Bancaire Privée, HSBC, Permal, GAM and Grosvenor Capital, provide is reassurance. Their 100-member teams assess, select, monitor and perform due diligence on underlying funds. Even so, there is concern among investors and consultants that fund of hedge fund fee structures – an additional 1% management fee and an additional 5% performance fee over and above the underlying hedge fund fees – will come under pressure.

Robert Howie, principal for hedge fund research at investment consultant Mercer, said: “We have seen some clients successfully negotiate down fees for funds of hedge funds. Ultimately it is market forces that will determine fees. I would certainly like to see a restructuring of fees.”

Grottheim, who has cut AP7’s hedge fund allocation from 4% of the portfolio to 2%, believes fee compression is probably inevitable – particularly given that alpha remains elusive for many funds. He said: “I have said I think fees are too high: especially in the past five years, when returns, even among first-quartile funds, have been disappointing. The debate on whether hedge funds deliver alpha is important. Can you get hedge fund beta through cheaper instruments?”

Hedge funds that are committed to the institutional market must continue to enhance transparency, without necessarily giving away shorting plans, according to investors.

David McCourt, policy adviser at the NAPF, said: “Hedge funds have been demystified because they are not so new any more. However they will have to keep up the educational drive and keep it fresh.” He believes persuading fund of fund managers to meet trustees and talk about what they do can help enormously.

Ros Altmann, an independent pension consultant, said: “Until now, many pension fund trustees have been reluctant to engage – partly because of the complexity but also because of a perception of hedge funds as high-risk, high-fee vehicles.”

She believes hedge funds and other alternative assets should be a mainstream part of pension fund asset allocation. “The sooner trustees and their advisers wake up to the opportunities, the better,” she said.