By Penny Aitken
How much exposure should pension funds have to alternative investments? This question is mired in complexity as each pension scheme will have its own unique set of parameters and obligations that will influence their asset allocation. Therefore before trying to assess the optimal level of any alternative exposure one should try to better understand the specific risk profile of a scheme’s current portfolio composition as well as its long-term objectives.
Why would a scheme want to do this? In brief, to help manage and diversify existing risks and layer-in multiple sources of idiosyncratic performance that will not necessarily correlate with traditional asset exposures over an investment cycle and provide additional sources of risk-adjusted return. Finding, measuring and monitoring hedge funds that can consistently deliver alpha is key. Gathering evidence, both statistical and qualitative, is vital in this process.
Measuring risk and alpha varies firm to firm. The challenge is to find a way to differentiate market factors from idiosyncratic returns. There are tools that can measure and plot this over time to gauge the manager’s skill, as well as run historic simulations across historic stress periods. Such tools provide us with the ability to decompose and understand hedge fund risk factors and enable investors to minimise risks and maximise returns. There is another significant obstacle though. The hedge fund universe is vast and spans a wide range of geographic locations, regulatory jurisdictions, complex investment strategies and firms at different stages in their lifecycle. The resources required to undertake dedicated, insightful and diligent ongoing analysis of this universe remain significant and this commitment continues to rise as technological, regulatory and compliance demands all grow.
Therefore the question of how best to approach hedge fund investment depends on any pension scheme’s ability and preference on how to resource this. This falls down to some simple questions, including do they have the investment and risk expertise as well as the systems and technology to enable them to filter the global opportunity set in hedge funds and do they have the expertise across asset classes, strategy and geography?
Other questions to ask include do they have the infrastructure to cope with the heterogeneous reporting universe and to monitor on an ongoing basis investment and operational risk factors and do they have experienced professionals to guide them around common and historic pitfalls?
Elsewhere, pension funds need to consider whether they have the statistical, legal and audit expertise to guide them through the labyrinth of documentation and data involved in any investment and the tools to be able to identify and monitor funds exhibiting skill not luck and those with characteristics that can diversify their risk not augment it.
Certainly intermediaries such as fund of funds have come under scrutiny and criticism in recent years. Much of this rightly questioned the skill of some of these intermediaries and their business model as many failed to manage or meet their investors’ expectations. For intermediaries to earn their role and evolve, they need to demonstrate their value add and adapt their approach and business model to facilitate a better service offering to investors.
Penny Aitken is partner and head of research at FQS Capital
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