Public pension funds dont like drama. For this reason they often regard hedge funds with a wary eye. Although such investments can generate enviable returns, they can also produce headline-grabbing losses that public plans like Stockholm-based AP7 would prefer to avoid.
In 2007, AP7 the biggest defined contribution fund within Swedens pension system lost some 6.5 million kronor ($1 million) when two Bear Stearns Cos. credit hedge funds suffered huge losses in their subprime mortgage portfolios. AP7s investment had been made through a fund of hedge funds managed by EIM Group out of Nyon, Switzerland. To make matters worse, EIM had also been an investor in Amaranth Advisors, the ill-fated Greenwich, Connecticutbased firm that lost more than $6 billion in September 2006 as a result of a bad bet on natural gas.
One thing that we have experienced during the years weve been invested in funds of hedge funds is that when underlying hedge funds run into trouble, the media risk is quite high, says Richard Gröttheim, 48, chief investment officer of AP7, which has some Skr1.6 billion of its total Skr82 billion in assets invested in funds of hedge funds. Even though its a small part of the portfolio, and even if you have a diverse fund-of-funds portfolio, it can be tough to deal with that issue.
Gröttheim and AP7s nine-member investment board are trying to harness the benefits of hedge funds noncorrelated returns and leave the drama behind. Six months ago they began to reevaluate the plans funds of funds, and they decided to look at replacing them with hedge fund replication strategies. Hedge fund clones seek to reproduce the returns of hedge fund benchmarks like the HFRI composite index a basket of more than 2,000 funds typically using a combination of index futures on stocks, bonds and other securities. They also charge significantly lower fees than do actively managed funds. The approach appealed to the AP7 board, which plans to hire two or three firms by this summer to manage the replication strategies. The goal: to move AP7s entire hedge fund allocation from funds of funds into clones by the end of the year.
Gröttheim joined AP7 as CIO and executive vice president in 2000, when the plan was created as part of the nationwide pension system reform that Sweden had begun in 1998. Previously head of the monetary and foreign exchange policy department at Sveriges Riksbank, Swedens central bank, he spearheaded AP7s move into hedge funds in July 2002, when the plan hired EIM and Stamford, Connecticutbased K2 Advisors to each manage 2 percent of its total assets in fund-of-hedge-funds portfolios. In March 2006 before the troubles at Amaranth and Bear Stearns AP7 put the two firms on a watch list for possible termination, largely because of disappointing returns on the part of hedge funds in general.
In May 2007 the board opted to decrease the plans hedge fund allocation to 2 percent and increase its private equity allocation from 4 percent to 6 percent (it was increased again in January 2008, to 8 percent). The bulk of the portfolio is in equities 52 percent in global equities, 20 percent in Swedish equities and 10 percent in emerging markets. The plans 10 percent fixed-income allocation includes 4 percent in Swedish bonds, 4 percent in foreign bonds and the 2 percent hedge fund allocation.
But not everyone is as confident as Gröttheim in the merits of replication strategies. U.S. investors have been less likely than their European counterparts to embrace the product, says James McKee of Callan Associates in San Francisco. He suspects the divide exists because Europeans demand that their assets be always available. But investors should be aware, he adds, that these products could have difficulty predicting market turning points.
Its hard to replace the experienced hand of a hedge fund manager, who has incentives to preserve capital, with a quantitative model, says McKee.
Gröttheim says he has heard the argument that hedge fund clones havent been tested in enough market conditions to ensure their reliability. He counters that the volatile markets during the past year have offered ample testing.
Its not a worry, he says. Many of these products have been doing quite well, even over the course of this year.