From the November 2013 issue of Investment Advisor • Subscribe!

Can Hedge Funds Save Troubled Pension Funds?

Struggling pension funds should look to hedge funds’ superior risk management techniques for an example

A new vision of hedge funds is emerging in which they could have a much bigger role to play in portfolio management. Under the new scenario, the conventional image of a hedge fund as two guys with a terminal, swinging for the fences, is passé. While a lot of attention has been paid to what hedge funds have done wrong, too little attention has been paid to what they have done right, which is to strive to help investors avoid losses. That’s because without much fanfare, the largest hedge funds have evolved into the world’s most sophisticated risk management vehicles.

According to this perspective, the traditional 60% stocks/35% bonds/5% cash portfolio is beginning to resemble a car that has only one gear—forward. In hedge funds, by contrast, investors see the equivalent of a car that can go forward, backward, sideways, up and down.

Instead of allocating 10% of their portfolios to hedge funds, some pension funds are using them across all of their portfolios’ asset classes. The Employees Retirement System in Texas, for example, recently decided to integrate hedge funds across its entire $24.9 billion portfolio. The move was particularly notable because the Texas Retirement System only began investing in hedge funds in 2011, according to Institutional Investor magazine. Similar actions were taken in the Teacher Retirement System of Texas and the Virginia Retirement System.

In Geneva, the head of the pension fund for CERN, the world’s largest particle physics laboratory, is running its 4-billion Swiss Franc ($4.37 billion) portfolio as if it’s one big global macro fund. Theodore Economou, CEO of the CERN Pension Fund and the person behind the so-called CERN Model, thinks all pension funds should adopt CERN’s approach. If they can’t, Economou has proposed a radical solution: turn the entire pension portfolio over to a large hedge fund that can.

Integrating hedge funds across an entire portfolio may sound as if chief investment officers want to put their portfolios on steroids. In fact, their motive is just the opposite. They’re making the judgment that hedge fund managers are no longer a one-off entity to which you might allocate a small slice of the portfolio. Rather, they are relying on hedge funds to deliver a sophisticated set of tools to each of their asset classes.

Worried about a possible slowdown in China? The CIO of a traditionally-run portfolio might lighten up on the suppliers of raw materials and commodities to China. In the new scenario, the CIO might rely on its global macro hedge fund to manage the portfolio’s exposure to China by buying credit default swaps on oil-and-gas company debt. If China’s growth slows, so will the demand for energy, which in turn may make the oil-and-gas company’s debt riskier.

The point is pension funds cannot afford another 2008. In order to be more conservative, pension funds need to be less traditional, as Economou put it in a May interview with Hedge Funds Review. They have to avoid that level of losses, and to do that, they need to control risk. With that in mind, if hedge funds possess the best risk management techniques, why limit them to only 10% of the portfolio? If pension funds and hedge funds work together, Economou thinks the hedge fund industry has the potential to grow five or 10 times larger than it is today.

“The opportunity lies in hedge funds starting to see pension funds differently and reflecting on how their skill set cannot just be complementary to an existing portfolio, but can contribute to solving the entire daunting challenge that most pension funds are facing,” Economou told Hedge Funds Review.

The ability to control risk goes a long way in explaining why big hedge funds have been getting bigger, even though small hedge funds have generally outperformed larger ones, according to a 2011 survey from PerTrac. Most industry experts would probably agree that not only do large hedge funds have the most sophisticated risk management systems, but they also offer better liquidity and the ability to handle huge allocations from institutions. This doesn’t mean that the small, emerging hedge fund is going to disappear, but it may lead to a bifurcation of the industry in the future, with one set of hedge funds for the big investors and one set for smaller investors.

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