For Mounting Pension Funding Deficits Faced By Many U.S. Plan Sponsors, Hedge Funds Can Be An Important Part Of The Answer
Pension Quandary: Plans Now Need Bigger Investment Returns to Pay for Future Obligations, but Traditional Growth Assets Like Equities are Risky and Overvalued; A Low-Beta, High-Alpha Hedge Fund Allocation May be the Antidote
BOSTON (June 7, 2016) – The funded status of U.S. pension plans has continued to fall in recent years, with various industry reports citing drops of more than 20 percentage points since 2013. The reason: lower interest rates and rising life expectancies, which have caused benefit liabilities to grow faster than plan assets.
But pensions’ traditional growth sources, such as long-only equities, can be risky – and relying on them to close funding gaps is doubly problematic today as developed market equities are overvalued, especially in the U.S. And lower funding levels do not necessarily translate to greater risk tolerance on the part of plan sponsors.
Part of the solution may lie in cultivating a select group of hedge funds that may help plans generate excess returns over market benchmarks – alpha – and simultaneously reduce risk, according to “Hedge Fund-ing the Pension Deficit,” a report from global investment advisor Cambridge Associates.
Hedge Funds May Reduce Risk and Provide Alpha, Despite Previous Pension Fund Experience
“For some pension sponsors, the hedge fund solution may sound counter-intuitive, based upon their earlier experiences with hedge funds. After the financial crisis, many sponsors went into hedge funds that had done well during the crisis – but they were essentially too late. They were chasing what had worked in the last cycle, but they were actually in a different cycle. As a result, they saw poor risk-adjusted returns,” said report co-author and Cambridge Associates Managing Director Joseph Marenda.
“A carefully selected group of hedge funds, diversified across different strategies, may produce alpha and play a key role in risk reduction and return enhancement – not just in bull markets but across all market cycles,” he said. According to the report, Cambridge Associates clients’ hedge fund programs outpaced global equity markets by 48 percentage points cumulatively over the last 15 years, net of fees, with one-third the volatility of public markets.
“Getting the hedge fund component of a pension portfolio right may sound complicated – particularly for a pension plan struggling with a sizable funding deficit. But it is not as complicated as a sponsor’s life would be without that hedge fund component at an inopportune time. When business conditions, the stock market, and interest rates are all in decline and working against you simultaneously, sponsors might have to direct more money to the pension. In isolation, any of these can be painful. In concert, it’s a perfect storm.”
Getting the Hedge Fund “Mosaic” Right
It would be a mistake to assume that just any hedge fund collection would suffice, Marenda says. The challenge is to find individual funds that are suitable and get the combination right within the allocation. For a single pension fund, there may be only 15 hedge funds that would make sense, he says.
“Building a hedge fund allocation is something like making a mosaic. Each piece has to complement the other pieces. And when you put it together, it actually makes a very nice picture, because each manager or fund is doing something slightly different that contributes to the portfolio construction. This means that all the risks aren’t going in the same direction,” he said.
He added, “For instance, strategies that may appear volatile in isolation, such as managed futures and global macro, can be strong diversifiers in the context of a typical pension plan portfolio due to low – or nonexistent – correlation with traditional asset classes.” Other hedge fund strategies that may work well in combination and within a pension portfolio include opportunistic strategies such as multi-strategy and arbitrage funds, as well as high conviction, low beta long/short equity funds, the report says.
Hedge Fund Manager Selection: Art and Science
A critical component to getting the mosaic right is hedge fund manager selection. The significant performance dispersion across hedge fund strategies and managers makes careful selection critical. According to the report, of the 11,000 hedge funds on the market, fewer than 5% merit institutional capital.
Marenda said that several indicators, beyond past performance, can be useful in determining whether a fund or manager is worthy of further review – and some are counter-intuitive. For instance, slower rather than rapid growth of new assets (i.e., investors) is a positive; younger managers may do better than more established ones; and smaller and new funds may present advantages.
“Choosing managers and creating a program that truly benefits a pension portfolio is as much art as science. The science part includes having the necessary analytics as well as the right framework and overall guidelines. The art involves understanding the human component of a hedge fund. If you know the people running the investments, how they think and how they manage their risk profiles, there is a much greater likelihood that you will be successful in building a winning portfolio,” he said.
About Cambridge Associates
Founded in 1973, Cambridge Associates is a provider of independent investment advice and research to institutional investors and private clients worldwide. Working alongside its early clients, among them several leading universities, it pioneered the strategy of high equity orientation and broad diversification, which since the 1980s has been a primary driver of performance for these leading fiduciary investors. Cambridge Associates serves over 1,000 global investors and delivers a range of services, including investment advisory, outsourced investment solutions, research and tools, and performance monitoring, across global asset classes. Cambridge Associates has more than 1,200 employees serving its client base globally and maintains offices in Arlington, VA; Boston; Dallas; Menlo Park and San Francisco, CA; London; Singapore; Sydney; and Beijing. Cambridge Associates consists of five global investment consulting affiliates that are all under common ownership and control. For more information about Cambridge Associates, please visit www.cambridgeassociates.com.
This press release is provided for informational purposes only and is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This release is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Past performance is not a guarantee of future returns. Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index.
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