Using hedge funds as a pension diversifier
South African hedge fund organisations are engaging National Treasury and the Financial Services Board to regulate their industry, with a view to increase the future role of these funds in the pension funds space. Last Thursday we attended Blue Ink Investments’ Exploring the hedge conference to find out more. The most thought provoking presentation was undoubtedly that of independent actuary, Rob Rusconi, who investigated how hedge funds could be used in the pensions fund environment.
“The claim of the hedge fund is an ability to pull the [investment] curve out by offering better return at the same level of return, or lower risk at the same expected level of return,” said Rusconi. This return is boosted further by the use of leverage. In the broadest terms a hedge fund is a diversifier and the hedge fund manager’s task is to “to provide returns from alternative sources, derived from alternative sources of risk.”
Concerns with local pension fund environment
As hedge funds eye a bigger role in the pension space it becomes important to revisit some of the shortcomings in the existing system. Rusconi began his presentation with five major pension industry concerns. “The classic principle / agent conflict: confusion between those who own the assets and those who serve these owners,” remains a major bugbear, said Rusconi. He reiterated that fund managers are the servants of the funds, that trustees act as intermediaries, and that the members remain the true owners of the fund. Confusion in this area has resulted in the complex structures we see in the industry today.
The value chain has become so complex that trustees no longer understand what they are purchasing. “Members of the chain are often serving one another, not the end client,” said Rusconi. Under these conditions the potential for misalignment of motives (between fund managers, trustee and client) is extremely high. Rusconi has no problem with the complexity of the industry serving the client, but questions the dynamics within the supply chain! Another major problem in the local pension fund industry is the allure of the past. Rusconi believes that we are all slaves to behavioural finance and tend to support our decisions regardless of the cost. “The human flaw is to trust apparent expertise and to believe personal judgment,” said Rusconi. The best example of this is that last year’s top performer inevitably becomes this year’s manager of choice! As a more dramatic example, Rusconi trashed the active manager debate, saying that active managers in aggregate return zero against the market, negative after fees.
Conflict of interest is endemic in South Africa’s financial services environment. “The absence of independence fundamentally gnaws away at the integrity of the system and the ability of the system to allocate capital efficiently,” said Rusconi. Too many in the industry are receiving and using advice from people who are seriously conflicted! He also expressed concern that the data available in the industry was used to the advantage of the supplier rather than the customer.
Challenges the hedge fund industry needs to overcome
With these concerns out in the open, Rusconi mentioned the core challenges that hedge funds faced as they entered the pension fund environment. Top of the list was the so-called assessment challenge. “The challenge to the pension fund is in knowing what they are buying when they sign on the bottom line for a hedge fund investment,” said Rusconi. He says pension fund trustees will have to approach the hedge fund industry slightly differently because of the focus on diversifying resources of return. The South African hedge fund universe is dominated by equity-based market neutral or long-short funds. And this means there is “limited within-class diversification.” It is difficult for pension fund managers to create diversification of strategies within the hedge fund section of their portfolio.
The “potential for poor performance” that exists in the long-only space exists in hedge funds too. Rusconi says pension fund must recognise the risk inherent in these products before investing in hedge funds. “I am concerned about layers in the simplest of assets,” said Rusconi, before taking a swipe at hedge funds for the same transgression. He acknowledged that the natural components of a hedge fund would create higher fees due to the types of financial instruments used and the frequency of trades. But it remained important to assess the reward in relation to the added fees. Rusconi questioned whether the so-called Fund of Hedge Funds offered value in excess of the additional costs. “We need to be careful as investors to make sure that what we are getting is worth at least what we are paying for it,” said Rusconi.
A fund manager who diversifies and provides performance in excess of the risk free rate should be rewarded, provided the performance exceeds an appropriate benchmark. Rusconi is happy with the straight annual fee (between 1% and 1.5% on assets under management) charged by most local hedge funds. But he has a “serious concern with the basis for performance fees.” The capital preservation argument offered in support of the risk-free performance hurdle (cash) is moot as pension fund managers need at least inflation plus a few percent. Rusconi also questioned the practice of funds that pay their performance – after clearing the hurdle – from zero!
A powerful marginal contributor
Rusconi believes hedge funds have a part to play in the pension funds space. “The hedge fund is a powerful marginal contributor to the performance of a fund,” said Rusconi. He called on hedge fund managers to make sure they make “effective” marginal contributions and urged them to be clear on their benchmarks and product offering.
Editor’s thoughts:
Current regulation prohibits pension funds from investing more than 2.5% of their assets in hedge funds. Would you support regulations that allow this cap to be raised? Add your comments below, or send them to [email protected]
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