The future use of hedge funds within UK pension portfolios will depend on the experiences gained in the current challenging market environment. In this article we review reasons for including hedge funds in a pension portfolio and consider whether they have been met in a historical context. We conclude by discussing selected issues pension funds face when investing in hedge funds.
Why have pension schemes invested in hedge funds?
According to our experience, hedge funds primarily have been used as a tool to further diversify a pension scheme’s asset portfolio so as to reduce portfolio risk. This is attributed to two key factors:
• Hedge funds in general are expected to have a lower risk but similar return compared to equities
• Hedge funds are expected to have a lower correlation with traditional assets
Hedge funds have typically been funded by replacing part of the equity exposure of the scheme.
Analysis of past performance
We analysed return data from January 1995 until end October 2008. This time period includes the Asian crisis (1997) followed by the LTCM Hedge Fund collapse (1998), the bursting of the technology bubble (2001) and the recent equity bear market returns. We note that any historical review will strongly depend on the selected time period. Our calculations are based on the returns of the HFRI Fund of Hedge Fund Composite Index hedged in GBP(1).
The analysis reviews three pension schemes with different allocations. The three pension portfolios modelled were:
PS1: 70% Equity, 30% Bonds
PS2: 60% Equity, 30% Bonds, 10% Hedge Funds (in GBP)
PS3: 70% Equity, 20% Bonds, 10% Hedge Funds (in GBP)
• Over the selected historical period, hedge funds delivered equity-like returns with risk slightly below long term government bonds. If the recent bear market is excluded, hedge funds still had returns in line with equities (note that part of the hedge fund return measured in GBP was due to currency hedging) with significant lower risk (5.6% vs. 13.2%).
• Comparing PS1 against PS2 showed that pension funds which replaced their equity allocation with hedge funds had higher returns and slightly reduced risk.
• Comparing PS1 against PS3 showed that pension funds which replaced their bond allocation with hedge funds had higher returns albeit with a higher portfolio risk.
• This raises the question whether pension schemes should be looking to buy hedge funds from equities or from bonds. We will review this question in the penultimate sections.
Risk reduction benefits from holding hedge funds are also due to their correlation with traditional assets.
The HFRI FoF Index hedged in GBP had an average correlation of 0.63 with equities and close to zero with bonds over the analysis period. The average correlation of the index with a typical UK pension scheme asset portfolio (PS1) was 0.62 and thus much closer to the equity correlation than the bond one. It is the equity exposure which drives the correlation of a typical pension portfolio with hedge funds.
Overall the results support the view that hedge funds did have a positive diversification contribution over the analysed historical period, although a 0.62 correlation might appear on the high side since hedge funds are often thought of as having little market exposure. While some hedge fund strategies are indeed close to market neutral (such as relative value strategies) others are more directional in nature reflecting the heterogeneity of hedge fund strategies.
The historical review since 1995 confirms the expectations investors had put in hedge funds. But developments over the past year may have changed the perception of some investors and pension scheme trustees. The HFRI FoF index lost 18.5% from January 2008 to October 2008, a period where equity markets posted larger losses, implying a higher correlation than the historical average of 0.63.
At the same time, the index displayed negative monthly returns as large as 6.9% putting some question marks behind its low historical risk. This would be worrying news for pension schemes and trustees are rightly concerned as to whether any further surprises are in store.
Lessons from extreme events
The analysis so far has concentrated on average numbers, which does not necessarily reflect the impact of extreme events. Pension schemes in particular are very sensitive to extreme events. Calculations for funding and recovery plans are made at particular points in time, where some schemes may be unfortunate enough to have had significantly deteriorated funding ratios on the valuation date.
Two possible ways to review extreme events are to look at how the correlations have changed over time and to review downside risk measures such as the maximum drawdown the portfolio has experienced over time.
We analysed the returns of hedge funds against the return of a typical pension portfolio (assumed to be PS1) and calculated the implied 24 month rolling correlation. This correlation has historically increased during prolonged bull markets and during periods of market stress. Times when the 24 month rolling correlation spiked above 0.7 were the Asian crisis (1997), the collapse of LTCM Hedge Fund (1998), the beginning and the middle of the bull market in 2003 and 2005, the poor performance of quantitative managers in August 2007 and the most recent period of the 2008 liquidity crisis. With the exception of the 2003 bull market, these were all times during which equity prices fell meaningfully.
Historically, it appears that hedge funds delivered less diversification benefits in times when this benefit was most needed. The impact on funding ratios was often even more pronounced as the reduced diversification benefits during downturns coincided with increasing pension liabilities.
Possible causes for increase in correlation
We believe liquidity, or the lack thereof, has been the driver behind the historical spikes in correlation during times of negative equity market returns. We use the term liquidity to jointly refer to the cost and availability of funds. Funds can be obtained through borrowing or by selling some assets.
Liquidity is an interesting risk driver. Whenever liquidity is available in abundance its impact goes unnoticed, but the impact grows exponentially once it becomes scarce. The lack of liquidity affects equity and hedge funds through different channels but is a key reason behind the historically observed spikes in their mutual correlation.
Currently, hedge funds are facing the most challenging time so far. It is not only the lack of liquidity in many markets which is unprecedented, but the fact that the entire financial industry is on the same side of the equation, desperately looking for liquidity. During the LTCM crisis for example, many hedge funds were forced to de-lever, but their prime brokers and the banking system were not facing the same issues and were able to absorb this shakeout. Given the current lack of liquidity in the entire financial system, we should expect hedge funds to have a higher than usual correlation with a typical pension portfolio for some time.
Funding hedge funds out of bonds or equities?
Reviewing the downside risk measures such as the maximum drawdown (also listed in Table 1) we note that periods of large losses coincided with periods of spikes in correlation. Extreme events do matter and need to be reviewed when deciding about the appropriate hedge fund allocation in a pension portfolio.
The maximum drawdown refers to the maximum loss the portfolio incurred from its previous peak. It can be seen as the return generated if one was unlucky enough to hold the portfolio for the worst possible time period only.
Using the maximum drawdown as an example, adding 10% hedge fund exposure at the expense of equities would have reduced the maximum drawdown from -29.3% to -24.8%. If hedge funds had been financed out of bonds the maximum drawdown would have become more negative. The result is the same if we use other definitions of downside risk such as underwater period, Value at Risk or conditional Value at Risk.
So despite the spike in correlation and the resulting larger losses during market stress, hedge funds can still alleviate the ‘worst outcome’ in a pension portfolio if they are held at the expense of equity. If held at the expense of bonds though, returns can be increased but the magnitude of extreme negative outcomes will increase too.
What next for pension schemes?
From this historical review we conclude that hedge funds have had a positive impact as part of a pension scheme’s asset strategy. Portfolios which included hedge funds have attractive returns and lower risk historically compared to a typical asset allocation without hedge funds. In an asset-liability framework, where the pension liability is included and results assessed relative to the impact on funding ratio, the conclusions would have been similar.
Deriving the appropriate hedge fund allocation purely on ‘average’ risk and return numbers might lead to large hedge fund allocations. This may not be the appropriate solution for pension schemes which need to make allowances for their cashflow requirements. Any analysis for the pension scheme’s asset allocation involving hedge funds should incorporate extreme events and their impact on cash flows, funding ratio and the value of the asset portfolio.
Underfunded plans or plans with a weaker sponsor are more sensitive to deterioration in funding ratio. Ideally, these plans should substitute hedge funds for equity and not bonds in order to reduce their asset and funding ratio (shortfall) risk. Overfunded plans or plans with a strong sponsor (such as public plans) can consider substituting hedge funds for bonds and receiving an additional return at the cost of a higher funding ratio volatility.
Historic data can give valuable information. We would also recommend using forward looking risk modelling when setting policy strategies. A complete policy analysis for pension schemes should incorporate other alternative assets such as private equity and real estate.
NOTES
(1) Our calculations are based on the returns of the HFRI Fund of Hedge Fund Composite Index. The HFRI Fund of Hedge Fund Composite Index (HFRI) includes two layers of fees and is less prone to various data biases present in single hedge fund indices, which is more in line with the hedge fund portfolio of a UK pension scheme. On the risk side we note that the HFRI is more diversified and thus likely to display lower volatility compared to a typical UK pension hedge fund portfolio. No adjustments have been made to allow for the lower risk profile.
ABOUT THE AUTHOR
Vincent Couson is a member of the Asset Allocation and Currency investment committee within the Global Investment Solutions (GIS) team. He is responsible for advising the committee and clients on the strategic inclusion of alternative assets within multi-asset portfolios.
Ritesh Bamania is Head of Asset Liability Investment Solutions, UK, within the Global Investment Solutions (GIS) team. He is responsible for delivering Asset Liability Investment Solutions (ALIS) to UK clients. This includes the development and management of pension fund investment strategies that focus on the scheme’s funding ratio objectives.
