Pension funds attracted to long/short strategies

Date: Thursday, April 17, 2008
Author: Hedge Funds Review

Pension funds are rapidly and increasingly adopting long-short equity strategies. This is because of the value this strategy provides by differentiating market exposure (beta) and manager skill (alpha), according to the latest State Street Vision report.

The report, “The Pensions Industry — Bridging the Gap”, said the management of retirement assets in future will take advantage of this strategy.

Providing beta exposure for institutional investors will also become a basic service in the future, said the survey. Alpha managers are expected to earn even greater sums than at present.

Weaker active managers will no longer be able to charge for beta. The “battle for sustainable alpha” will be won by those with the most money, the report by the global advisory company concluded.

To help mitigate risk, pension funds are diversifying into sophisticated strategies such as absolute return, private equity and commodities.

The recent market turmoil and end of the bull market has made investors question the use of market indices as benchmarks. Hedge funds are now seen as a viable alternative of absolute returns.

The survey showed the long only tradition of pension fund managers is not the way to manage assets. UK managers have now embraced the concept of absolute returns, stated the report.

Hedge funds encourage institutional investors to seek the best strategies for making money wherever possible, said the report. Equity managers do not just hold stocks they like. They also profit by sharing shorting stocks they believe will depreciate.

Although the survey was carried out in June-July 2007, State Street said the credit crunch supports a change in how pension funds are changing their asset allocations.

The survey revealed almost 60% of defined benefit (DB) pension plans are using or seriously considering 130/30 funds. Although the research showed the distinction between exposure to assets ( in the form of beta) and exposure to strategies (in the form of alpha) will grow stronger, a large number of respondents said they would go into 130/30 funds. This showed a conflict with the trend to separate alpha and beta.

As greater wealth and the rising costs of provision feed into pension funds, new investable markets will have to be created. Derivatives will be to the fore in the future, said the report. Regulators, exchanges and banks will have to respond to this need and at the same time higher standards of custody, administration and functionality will be needed, the report pointed out.

The report also showed investment risk was top of the risk list for European respondents. Longevity risk was the second greatest.

Some DB schemes have solved the longevity risk problem by linking retirement age to longevity. This has led to insurance companies acquiring the liabilities and assets of plans.

These “buy-outs” have been rare with the large pension funds preferring to manage risks under new regulations or waiting until funding levels improved before considering buy-outs.

State Street believed this is likely to change and over the next 10 years, DB assets will increasingly move into the hands of insurance companies.

The survey showed institutional investors between 21% and 40% of their time managing risk rather than investment return.

State Street also pointed to the fact there needs to be greater acknowledgement of the challenges facing the retirement market. To meet these challenges, pension governance needs to be overhauled.

The report said governance is lagging behind investment strategy and asset class evolution.

Rising longevity and declining birth rates are becoming big issues with the ratio in Europe being 1:4 but expected to be 1:2 by 2050. For the world’s richest 30 countries, annual pension spend is $3.5 trillion — around 9% of GDP.

The survey was done during summer 2007 talking to North American and European asset owners  including corporate, endowment, non-profit and others.