British Pension Funds Double Their Hedge Fund Holdings

A recent study has shown that U.K. pension funds almost doubled their investments in hedge funds in 2011.


Hedge funds had a poor year in 2011, but this did not deter Britain’s cautious pension fund sector from continuing to ramp up its investment in this adventurous asset class.

The average share of U.K. defined benefit pension fund assets invested in hedge funds jumped from 2.6 percent to 4.1 percent last year, according to the recently published annual survey by the National Association of Pension Funds (NAPF). Since 2009 it has more than doubled from only 1.8 percent. Last year close to one third of pension funds had money in hedge funds compared with only one quarter two years before.

This may seem to sit oddly with pension funds’ trend towards “derisking” — trying to reduce the likelihood that they will not be able to pay future liabilities through a range of strategies that include cautious investment. Derisking has prompted them to cut equity allocations and increase their weighting in bonds to lessen the risk of large falls in their overall portfolio. In 2006, an average of 60 percent of their money was in equities, with 28 percent in fixed income. By 2011 the equity weighting was only 42 percent, with bonds up to 33 percent.

Yet some trustees see investing in hedge funds as compatible with derisking. Craig Stevenson, London-based senior consultant in hedge fund research at Towers Watson, a consulting company that advises many pension funds, says, “There has been an increasing realization of the role that hedge funds can play in clients’ portfolios: They offer lower correlations and diversification.”

U.K. pension investors in hedge funds now range from BT, the telecoms company with the largest private sector defined benefit scheme in Britain, to the much smaller schemes of London boroughs such as Enfield.

In many cases, pension schemes have boosted their exposure to hedge funds by shifting money away from conventional equity investment. One of their preferred hedge strategies is long-short equity — allowing them to seek a purer form of alpha than long-only investment in a broad range of stocks. The search for alpha has also made some keen on credit long-short strategies, with global macro — bets based on broad economic themes such as euro zone weakness — popular as well.

But Britain’s pension fund managers are a cautious breed. They have set a high bar for this asset class — exercising the same methodical due diligence that they do for their other investments. Hedge funds can be secretive, but pension funds reject those that are not sufficiently transparent about their investment allocations. U.K. pension schemes also take a dim view of those fund-of-funds whose role as trusted gatekeepers came into question because they had invested in Bernie Madoff’s Ponzi scheme, which collapsed in 2008. Moreover, pension funds’ current appetite for investments that they can exit quickly has made many reluctant to put money in illiquid absolute-return strategies such as distressed debt — though others are happy to make some illiquid investments as long as they are matched by more liquid plays through other hedge funds.

Those skeptical about the wisdom of pension funds’ increased investment in hedgies point to their mediocre 2011 performance. The median fund lost 2 percent, according to the HedgeFund Intelligence global composite index published by AR, Institutional Investor’s sister magazine specializing in the industry. But long-only equity investing did even worse, with the FTSE 100 index of U.K. stocks down 5.5 percent, and global stock market capitalization down 12.1 percent according to Bloomberg data. In 2011, it was the dullest, least adventurous pension fund investment that fared among the best of all: the return on U.K. gilts was 17 percent, with the yield on the ten-year falling to a record low as the year closed.

But Robert Howie, London-based European head of alternatives research at Mercer, a consulting company, says it is important for pension schemes to look beyond last year’s often unimpressive returns when deciding whether or not to invest in hedge funds. “As a human being it’s easier to invest in something that’s just had a really good run,” he says. “But often that’s the worst thing to do. I would prefer to look at each investment from a clean-sheet-of-paper, fundamentals perspective. Will its strategies work for the next three to five years?”

Nick Spencer, director of consulting for Europe, the Middle East and Africa at Russell Investments, sees even greater interest in this asset class in the future. He says U.K. pension schemes have been increasing their allocations to hedge funds “fairly steadily” since 2005. Looking at total hedge fund asset allocation as a proportion of their overall portfolios, “some pension funds are moving significantly beyond the 5 percent mark” — drawn, he says, by a desire to increase the diversification of their investments.