Hedge Funds Are From Mars

Literally, hedge fund investing requires a different mindset, cautions Jeff Geller, a director in the investment group at Frank Russell, an investment advisory and asset management company. While institutional investments can be tracked, and their risks defined, by market benchmarks, hedge fund managers aim to make money every month regardless of market conditions. "They're not paying attention to tracking broad-based indices," says Geller, who is responsible for Russell's hedge fund programs. "It's a very different way of thinking about investing and how you're evaluating the managers."

In addition to the range of different strategies they pursue, hedge fund managers have access to some tools that regular fund managers do not, like leverage and shorting–selling securities that they don't own. Given those differences, hedge funds are often viewed as an entirely different asset class whose returns have little correlation with the performance of stocks and bonds. Still, Louis Finney, a consultant at Mercer Investment Consulting, is skeptical about the amount of diversification hedge funds represent. Hedge funds are "more correlated with the markets than the ideal zero correlation," he says. "I've seen some studies put it as high as 60%, which lessens their attractiveness a whole lot."

Peng Chan, director of research at Ibbotson Associates, an investment consulting and management company, says pension plans should keep in mind the possible downside of hedge funds, including "the definitely higher potential of catastrophic risk," like what occurred at Long Term Capital Management, and the fact that their fees are higher than those of traditional money managers.

The challenges of investing in hedge funds are compounded by the fact that traditionally they have been much less forthcoming about their holdings than institutional fund managers. Tremont's Hock argues that what investors need isn't information about a hedge fund's holdings, but "100% risk transparency" in the form of data about its leverage and sector exposure, as well as the results of sensitivity and scenario analyses and stress testing. "We don't need to know that someone is short IBM," he says. "What's important is that there is shorting going on and, to the extent that it's going on, the liquidity of that investment and the sensitivity of that investment to others in the portfolio."

No New Investment Ideas

But Mercer's Finney contends that even comprehensive risk statistics could leave a pension fund vulnerable. For example, a plan sponsor might not realize that a hedge fund that it invests in has its 3% tech stock weighting in Microsoft, as does one of its institutional funds. "What if all the tech holdings are in Microsoft?" he says. "You find out at the end of the day that you really have a double weighting to Microsoft that you didn't realize. Without the exact security-level data, you can definitely run into problems."

With so much new money pouring into hedge funds, there are concerns that some hedge fund strategies may be tapped out and the stellar returns that many hedge funds posted during the 1990s may be a thing of the past. Finney says hedge funds in the future are likely to generate "a modest premium over Treasury bills," rather than "super rates of return."

Geller says that four or five years ago, investors in non-directional hedge fund strategies earned "high double-digit returns at low volatility levels." Today, it's more realistic to expect returns that are six to eight points above the return on Treasury bills, he says, adding that as the average returns on hedge funds look less exciting, "manager selection will become even more critical."

And how to pick the best managers? Myra Drucker, chief investment officer at General Motors Trust Co., a subsidiary of General Motors Asset Management (GMAM) that invests pension assets for other companies, says companies need to "understand what strategies the manager is pursuing and be sure those are strategies with which you are comfortable. Don't just look at past track records."

General Motors Asset Management has approximately $700 million invested in hedge funds, and its evaluations of hedge funds usually take several months. "Most time is spent assessing the caliber of the people, the intellectual process and the process of making the decision," Drucker says. GM looks at the fund's past experience to see if the manager follows the strategy he cites, and it also tries to assess "how much excess return they can produce and the volatility of that return."

She adds that it's "critical" that sponsors invest not in a single hedge fund, but rather in a diversified group of them. Given the amount of research involved in selecting just one hedge fund, let alone a group of them, pension plans usually don't go it alone. Many make their hedge fund investments through a fund of hedge funds, while others rely on an asset management firm.

"The benefit is diversity, and you also get the professional management from that fund of funds manager," says Ibbotson's Chan. "The fund of funds manager will interview the individual managers and determine the allocation. So there's an extra layer of due diligence."

But even investing in a fund of funds requires a careful selection process. Plan sponsors "should do their due diligence on the type of due diligence the fund of funds manager is doing," says Drucker. "They should understand the quality of the research that fund manager is doing and the quality of the monitoring." Otherwise, that seemingly attractive investment alternative can eat a plan sponsor alive.