Remko van der Erf, senior portfolio manager at the Multi Management Team of Kempen Capital Management, argues that hedge funds may offer diversification benefits to pension funds searching for yield.
A number of large pension funds including CalPERS in the US, and PMT and PFZW in the Netherlands have recently announced their decision to redeem their hedge fund investments. This has triggered other pension funds to scrutinize their allocations. Why did these pensions redeem? What are their concerns and are these concerns justified?
Often heard considerations are fees, the desire to reduce complexity and the lagging performance of hedge funds in recent years versus a traditional mix of equities and bonds. Justifying the allocation in light of these arguments can be challenging for the boards of these pension funds. Kempen Capital Management (KCM) doesn’t believe in the added value of an allocation to the ‘average’ hedge fund, which tends to lack differentiating characteristics and is simply (far) too expensive. However, a disciplined and selective approach aimed at accessing both non-traditional risk premia and alpha –the purest measure of manager skill– can add value to a traditional portfolio of equities and bonds.
KCM has sympathy for concerns around fee levels in the industry while a skeptical approach to active management in liquid, developed markets is also healthy. Having said that, with regards to arguments around transparency, scalability, complexity, and the capacity to contribute to a pension fund’s long-term objectives, we arrive to a different conclusion. We also suspect that some of these arguments wouldn’t have been brought up if the performance of the redeeming pensions had been better. Conversely, for the largest Dutch pension fund ABP strong risk-adjusted returns in hedge funds form the basis for the constructive voice about these investments in its 2014 annual report where they defend the expenses incurred through their allocation to hedge funds.
So what are the main benefits of investing in hedge funds? In the context of a low-rate environment and compressed risk premia in traditional assets such as corporate bonds and equities, alternative, exotic sources of return in strategies like distressed debt, insurance-linked securities, MENA equities, and structured credit, if carefully selected, can actually help a pension to achieve its goals. As long as these strategies generate a return per unit of risk that exceeds plain vanilla risk premia, the diversification benefit is self-explanatory.
A crucial factor for anyone investing in hedge funds is to be very selective and to operate with a critical mindset. When implementing our hedge fund program we constantly keep in mind how it can help a pension fund to achieve its objectives believing that average is just not good enough.