Cautious investors may tame hedge funds, at a cost

Date: Wednesday, August 22, 2012
Author: Anjuli Davies and Tommy Wilkes, Reuters

* Institutions now account for 2/3 of hedge fund assets

* Institutions push hedge funds to curb risk-taking

* Many want funds to cut leverage, protect against losses

* Some steer clear of short-selling

An academics' pension fund, the Church of Sweden and a biomedical charity are among conservative investors breaking with tradition and piling into hedge funds who are willing to curb their highest-risk bets to attract their cash.

Five years into the financial crisis, volatile markets and rock-bottom interest rates have crushed the returns of charities and pension funds, making it harder to meet their liabilities in paying for their members' retirements.

So many are now pinning their hopes on hedge funds to preserve, as well as grow, their money.

"We invest in hedge funds to diversify and reduce risks, we are not looking for them to shoot the lights out," Mike Taylor, chief executive of the London Pensions Fund Authority (LPFA), said.

Institutional investors like the LPFA, which runs 4.2 billion pounds ($6.6 billion) for state workers in the UK's capital, now account for two-thirds of hedge fund assets compared with less than a fifth in 2003, according to Deutsche Bank estimates.

Many funds are willing to adapt their higher-risk trading strategies to suit these more cautious institutions, because they usually invest for longer than the high-rolling wealthy individuals who once provided the bulk of their firepower.

But in demanding downside protection from their new funds, instead of high-risk strategies that can produce big returns - or similarly large losses - the investors could end up disappointed with how the hedge fund of the future performs.

LESS RISK, LOW LEVERAGE

The shift in the investor base has already influenced the popularity of different hedge fund strategies.

The reputation of the long-short equity fund, one of the most commonly used hedging strategies which rests on betting on some stocks to fall as well as some to rise, plunged after many managers failed to shield investors from stock market losses, boosting the appeal of rival strategies viewed as less volatile.

A category known as CTA (for commodity trading advisors ) for instance, which are computer-driven funds designed to latch on to trends in futures markets, has almost doubled in size between 2008 and the end of 2011 to $188 billion, according to industry tracker Hedge Fund Research.

Some, such as Michael Powell, head of alternatives at Britain's 32 billion pound Universities Superannuation Scheme (USS), argue the returns from such strategies are more dependable than a one-way bet on the stock market.

" For USS , hedge funds are less risky than equities. The volatility of our hedge fund programme is less than a third of that of public equities," Powell said.

Other investors place outright bans on investing in those they deem too daredevil.

The Wellcome Trust, a London-based charity which funds biomedical research and had almost 2.5 billion pounds invested across 38 different hedge funds last year, avoids those which use substantial debt or leverage to magnify their return on equity.

Hedge funds keen to reel in these more mainstream backers appear to have got the message.

Fund leverage has barely budged despite growth in the industry i n recent years and remains around 3.5 times net asset value, reflecting a drop both in demand to borrow and bank appetite to lend, the Financial Services Authority said in a paper published earlier this year.

Managers might also be tempted to scale back bolder bets because they are aware that their new investor base is less tolerant of high risk-taking, says Damien Loveday, global head of hedge fund research at consultancy Towers Watson.

SHORT-SELLING

As well as demands to mitigate risk, the more ethically-minded investors even go as far as to stay clear of funds which engage in certain activities, such as speculating on falling share prices or betting on the rising cost of food staples like corn, rice and wheat.

Robert Howie, a research director at Mercer, which advises investors on their hedge fund investments, told Reuters some pension funds require managers to carve out parts of their strategies into separate accounts.

The Church of Sweden for example invests in fixed income-focused managers but tends to avoid equity hedge funds, because of short-selling concerns and the high turnover of positions which clashes with its long-term investment approach.

The Church of England's 1.1 billion pound pension fund, which has invested in funds run by Winton Capital, Bridgewater and BlackRock, screens managers according to strict ethical criteria, such as excluding investments in firms involved in gambling, pornography and military products.

Cutting risk and keeping more of their assets in cash has helped hedge funds avoid some of the big falls seen in bonds and equities, but it has also meant many lag when markets recover.

The average hedge fund was up 1.87 percent for the first six months of 2012, Hedge Fund Research shows, below a 7.6 percent gain in the MSCI World Index, a measure of world equity prices.

"One of the attractions of hedge funds is their flexibility; their ability to short-sell and use leverage where appropriate," Mercer's Howie said. "To some extent, those investors are shooting themselves in the foot."