Treasury Official: HF Institutionalization Good

ATLANTA (HedgeWorld.com)--Growing pension fund investments in hedge funds can, if properly structured and carried out, benefit not only the pension funds but the hedge fund industry and the investment community at large, U.S. Treasury official Emil Henry told attendees at a conference sponsored by the Federal Reserve Bank of Atlanta Tuesday [April 18].

Mr. Henry, the assistant secretary for financial institutions at the Treasury, said as more pension funds invest in hedge funds, the hedge fund industry is being forced to improve its risk management processes. That can serve to reduce systemic risk and improve reporting and transparency. At the same time, pension plan fiduciaries are becoming more aware of alternative investments and their role in portfolio construction, which benefits the entire investment community.

Among the benefits to pension funds, properly structured hedge fund investments can provide further diversification, an element of non-correlation with traditional markets and potentially lower portfolio volatility, Mr. Henry said. "Exposures to hedge funds should raise the sophistication level of our pension fiduciaries and that must bring with it a modicum of societal good and further risk education."

Of course, hedge funds aren't all peaches and Cherokee roses. Hedge funds' use of over-the-counter derivative markets, and especially credit derivatives, pose financial stability issues, Mr. Henry said. In his speech, he raised several questions the Treasury Department needs to monitor, among them:

  • Model risk, or the potential for some credit derivative transactions to become so complex that internal calculations like Value at Risk are ineffective at measuring the true risk. Mr. Henry cited the unexpected correlation in the summer of 2005 of certain collateralized debt obligation trades that weren't supposed to be correlated at all. "Many risk management models were just plain wrong," he said.
  • Do the largest financial institutions properly value and disclose their derivatives exposure?
  • Can the settlement infrastructure handle the current volumes?
  • Can regulators keep pace with new structures?

Another question, unposed and unanswered in Mr. Henry's speech, is, what about fraud? Mr. Henry delivered his speech just a few miles from the former headquarters of the now-defunct International Management Associates, where now-fugitive hedge fund manager Kirk S. Wright bilked dozens of wealthy African-American investors, including a handful of former National Football League players, out of $150 million or more in assets.

Mr. Henry mentioned the possibilities of "fraud or incompetence" only in the context of pension funds being cautious about investing in hedge funds partly out of a desire to avoid so-called headline risk, or investing in a manager that blows up spectacularly, splashing the pension fund's name across the front pages as one of the prominent investors.

In constructing a "party" analogy for how different kinds of investors have come to hedge funds, Mr. Henry said individual investors usually show up at the party first because they make decisions more quickly than institutional investors, often investing based on the recommendations of friends, and because they have less fear of headline risk.

Next to arrive are the endowments, mainly because their trustees are usually the same wealthy individuals who are already happily invested in the funds. After the endowments come the corporate pension funds. "Because of their institutional risk aversion and inertia, they require full validation of an investment space before getting involved," Mr. Henry said. "The risk of being wrong (losing money) and the potential for headline risk simply eclipse the incentive to deliver excess return or alpha that might present itself in an alternative asset."

And finally, the public pension funds come in. They are the most conservative, and by the time they arrive the party has been under way for a while and guests are picking over the remains that have been passed over by others. "Questionable judgments are likely being made at this time," Mr. Henry said. "Right now, hedge funds receive capital from all these sources."

Pension funds were finally influenced to explore hedge funds because of the superior risk-adjusted returns they provided during the market downturn of 2000?? 1/2 2002, Mr. Henry said. Instead of suffering, hedge funds flourished. By extension, so did their investors. "Forward-thinking" endowments that had put up to a quarter of their assets into hedge fund strategies, "turned in terrific results," Mr. Henry said. "They did not shoot the lights out, but just by posting positive performance in a time of such wrenching dislocation, they made clear the possibilities of hedge funds. Pension funds, by contrast, with traditional stock and bond exposures suffered greatly."

Although the hedge fund party may be in its latter stages, it could become a safer party with the arrival of the latest guests. "Pension funds demand institutional oversight of their capital," Mr. Henry said. "So, with increased investment from institutions, there is much to give us comfort that the business of hedge funds has been institutionalizing in response. And such institutionalization has served to mitigate risk on many levels."

Funds of hedge funds, in particular, have helped to drive this institutionalization through the demands they make of hedge fund managers, including extensive due diligence, verification of documented risk management processes and an insistence on transparency. Funds of funds have been popular among pension funds making their first hedge fund investments because such funds provide diversification, outsourced risk management and access to closed funds, Mr. Henry said.

"I think it is safe to say that as pensions continue to invest in hedge funds, the industry will further adjust and further impose upon itself an institutional risk management regime which should--at some level--mitigate risk," Mr. Henry said.

CClair@HedgeWorld.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.

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