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HEDGE FUNDS - FACING THE FUTURE

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Hedge funds are a respected alternative investment, so why do local authorities seem unable to see past their alleg...
Hedge funds are a respected alternative investment, so why do local authorities seem unable to see past their allegedly risky image, asks Lewis Williamson

'To hedge your bets' has always implied a way of safeguarding one's position in the face of uncertainty.

Hedge funds grew out of a desire to bet against markets and reduce volatility in an uncertain investment world. They also have the potential advantage of delivering healthy returns.

But no investment is risk free - a truth made plain

in 1998 when the near-collapse and the officially-orchestrated rescue of Long-Term Capital Management by a lifeboat of private financial institutions sent shock waves around the global financial community, severely damaging the reputation of hedge funds. But a few years on there is growing interest in this type of investment.

Hedge funds bet against the market, buy and sell undervalued shares and bonds, and 'clones', such as futures and options.

According to Magnum Funds, which specialises in hedge funds, there are at least 14 distinct investment strategies, each offering different degrees of risk and return. A macro hedge fund invests in stock and bond markets and other investment opportunities, in the hope of profiting on significant shifts in such factors as global interest rates and countries' economic policies.

A macro hedge fund is more volatile, but potentially faster growing than a distressed-securities hedge fund that buys the equity or debt of companies about to enter or exit financial distress.

An equity hedge fund may be global or country specific, hedging against downturns in equity markets by shorting overvalued stocks or stock indices. A relative value hedge fund takes advantage of price or spread inefficiencies.

Such tactics can prove very successful, especially in a bear market. Only last month Britain's largest manager of hedge funds, Man Group, announced it had seen strong demand, as investors turned to an alternative product that offered the opportunity of making money whether stockmarkets are rising or falling.

Mike Taylor, director of finance at Surrey CC, says the funds can offer absolute returns in excess of interest on any security. 'You won't necessarily get stellar returns, but you can be confident of consistent returns,' he says.

Despite this potential for reducing volatility and delivering growth, councils remain wary of hedge funds.

A PT/Goldman Sachs survey of council attitudes towards hedge funds found extreme antipathy to the idea of dabbling in this form of alternative investment - suggesting hedge funds may suffer from something of

an image problem.

Nearly half of the UK's 98 council pension funds responded to the survey, but only one said it intended to start investing in hedge funds in the future. Some 70% of respondents had no intention of moving into hedge funds, while 28% of funds did not know whether they would try hedge funds in the future. Hardly a gold rush, then.

But the survey also highlights that councils are not unaware of hedge funds' potential. When asked what factors would persuade them to invest in hedge funds, almost half were interested in returns uncorrelated with other markets - clearly one of the fundamental attractions of a hedging strategy.

A quarter of respondents gave absolute returns as a prime motive, while just under a fifth said high potential returns would persuade them to go for hedge funds.

So what are the factors putting councils off hedge funds? The most commonly cited reason for not investing in hedge funds was the issue of risk. Half the survey respondents expressed concerns about risk. But this perception did not stem from poor publicity surrounding the Long-Term Capital Management affair: under 4% cited the press coverage as a dissuading factor.

Yet according to Mr Taylor, there may still be a suspicion that hedge funds are run by 'American wide boys'. He believes that citing risk as a reason not to go for hedge funds could also be indicative of a lack of understanding. 'They can actually offer a greater ability to control risk than other types of investment,' he says.

The second most common reason for not investing in hedge funds was the lack of comparative data on performance. The third was simply lack of knowledge.

Mr Taylor says a large part of the problem is that trustees need to be trained in the complexities of investment strategy, and hedge funds are probably the most complex of all.

'The problem with local authority funds is that the trustees change on a relatively frequent basis and you have to take them all through a training programme. You have to take them right from the basics, and hedge funds are the end of the book, as far as I'm concerned.'

Other common explanations included the small size of particular funds making an allocation to alternative investments difficult. High fees and lack of transparency were also cited, and there were claims of excessive complexity and a poor return-to-risk ratio.

Despite the lack of enthusiasm for hedge funds, more than half of respondents had asked their consultants, advisers or fund managers for more information.

Of course, for many council funds, decisions on whether they should consider exposure to alternative investments will be based on an analysis of their liability profile. Indeed, some 62% of councils said they had carried out an asset/liability modelling study of their fund. But more than a third had not - a striking number given that asset/liability modelling allows a fund to determine what investment strategies to adopt based on an analysis of how much it will have to pay out in pensions.

Mr Taylor says he is surprised such a large proportion of respondents have yet to carry out an asset/liability study: 'Much of what the Myners report said and the CIPFA code of practice on pensions says is that you must understand your liabilities before you do your investments. If you have not done an asset/liability study you can't really determine your asset allocation model.

'If you haven't done an asset/liability model you are benchmarking against the average of all funds, none of which are going to have the same liability profile as you.'

Speculating on what type of vehicle would be used if they were to invest in hedge funds, four out of five respondents would opt for an external fund of funds. The other 20% would go for externally managed hedge funds. No-one appears to think internally managed hedge funds would be a good idea.

As for tactics, there was a wide variety of responses, with the most popular options being multi-strategies, long short equities and equity market neutral.

It is clear that most councils remain sceptical about the merits of hedge funds. Mr Taylor believes several things need to occur for the average council pension fund to start investing in hedge funds.

The treasurer needs to be fairly bullish and have the confidence to put to his investment trustees that it is worth doing. The investment consultants have to agree it is a sensible strategy, and the trustees themselves have to want to take the step.

Given that markets are just as likely to go down as up, it does not seem too sensible to reject alternatives to traditional long investing. If trustees can be convinced of this, there is real potential for hedge funds to grow.

Hedge Fund Survey Results

Do you intend to start investing in hedge funds in the future?

Yes 2%

No 70%

Don't Know 28%

Have you carried out an asset liability modelling study of your fund?

Yes 62%

No 70%

Don't Know 3%

What factors would persuade you to invest in hedge funds?

High potential returns 19%

Absolute returns 25%

Returns uncorrelated 49%

with other markets

Other 7%

What are the main factors dissuading your fund from investment in hedge funds?

Lack of knowledge 13%

about hedge funds

Lack of comparative 21%

data on performance

Risk issues 50%

Press coverage surrounding 4%

the LTCM affair

The size of your fund 12%

(too small)

Have you asked your consultants, advisers or fund managers for more information on hedge funds?

Yes 57%

No 40%

Don't Know 3%

If your fund were to invest in hedge funds, which vehicle would you choose?

Externally managed hedge funds 21%

External fund of hedge funds 21%

(Internally managed hedge funds 0%)

If your fund were to invest in hedge funds, which of these strategies would you use?

Long short equity 15%

Equity market neutral 15%

Multi-strategies 16%

Convertible arbitrage 8%

Macro funds 8%

Fixed income arbitrage 3%

Sector funds 6%

Market timing 6%

Short selling 8%

Distressed securities 6%

Emerging markets 6%

Merger arbitrage 8%

Growth funds 8%

Event driven 8%

Distressed high yield 6%

Opportunistic/special situations 8%

Other 6%

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