© Copyright 2002 Rogers Media. The following article first appeared in the April 2002 edition of BENEFITS CANADA magazine.

The period from Aug. 31, 2000 to Sept. 30, 2001 was extraordinary by any measure. The Toronto Stock Exchange (TSE) 300 total return index declined more than 38%. The Standard & Poor's (S&P) 500 total return index dropped 30.5% and the Nasdaq composite index plummeted by more than 70% as irrational exuberance gave way to a more sober view of the markets. As a result, most pension funds suffered significant valuation declines. Future equity market return expectations have since seen substantial downward revisions.

Excessive valuations, a slowing economy, declining earnings expectations and the tragic events of Sept. 11 dealt a severe blow to many of the world's stock markets. Market losses were accompanied by a level of volatility not seen since 1987.

This turmoil has made for a fitting test of the hedge fund industry, which purports to preserve capital in negative markets, generate absolute returns and hedge away market volatility. In fact, the prolonged bear market is likely the first real test of the industry's mettle since it achieved critical mass over the past eight years.

There are many different hedge fund strategies. Overall, returns on these investments were positive during the recent bear market, although somewhat lower than their historical long-term average. From Aug. 31, 2000 to Sept. 30, 2001 the Credit Suisse First Boston (CSFB)/Tremont Hedge Fund index (an asset-weighted benchmark of hedge fund performance) posted a cumulative net return of 1.7%--outperforming the U.S. equity market by more than 32% and the TSE 300 by nearly 40%.

A number of factors explain the significant gap. Flexible investment policies, the ability to hedge market exposures and a propensity to make tactical use of cash helped hedge fund managers avoid much of the equity market's turmoil. The industry posted a modest loss of just 0.87% in September. As well, the volatility and correlation of hedge fund returns with traditional equity benchmarks was relatively low. If the bear market of 2000/2001 was a good stress test, the hedge fund industry passed it with a reasonably good grade.

GROWING INTEREST
The performance of hedge funds over the past two years has prompted two large American pension funds, General Motors Corp. and Nestle USA, to increase their hedge fund allocation. In general, the suitability of hedge funds for pension portfolios depends largely on the long-term objectives of the pension fund and its asset mix. Pension managers must consider whether the risk and return characteristics of these investments are appropriate to their fund. The investment committee must also be comfortable with them.

After the initial groundwork is laid, pension managers must identify an appropriate percentage allocation. There are a number of ways to approach this task. One is to look, retrospectively, at how hedge funds would have impacted the portfolio.

Consider a portfolio comprised of just two asset classes--the TSE 300 and the Scotia Capital Universe (SCU) Bond index. During the eight-year period ending Dec. 31, 2001, the TSE returned 9.4% annualized with a volatility of 17.6%. The SCU index returned 7.8% annualized with a volatility of 5.3%. These two asset classes can be used to construct a simple model of a portfolio comprised of 60% Canadian equities and 40% Canadian bonds.

Impact of hedge fund allocation
The addition of hedge funds to a typical pension portfolio would have decreased risk and boosted returns over the past eight years.

Source: Tremont Investment Management Inc. and Scotia Capital.

Efficient frontier
An optimized asset allocation calls for a high allocation to hedge funds even with conservative return
assumptions.

Source: Tremont Investment Management Inc. and Scotia Capital.

Over the past eight years, a 30% allocation to hedge funds would have increased the annualized return by 0.8 percentage points and decreased the annualized volatility by 1.4 percentage points. It is noteworthy that volatility is reduced as return is increased. The benefits increase along with allocation (see "Impact of hedge fund allocation," above).

Hedge funds tend to have a potent effect on portfolio volatility because the correlation between their returns and those of other asset classes is low. Over the past eight years, hedge fund correlation with the S&P 500 and the TSE 300 was 0.5 and 0.6, respectively. In contrast, the correlation between the S&P 500 and the TSE 300 was 0.8. (The correlation coefficient is a measure of return relationship. A correlation of one indicates a perfect positive relationship. Low correlation provides a superior diversification benefit.)

While investment professionals have observed increased correlation among global equity markets during times of crisis, hedge funds have continued to demonstrate a low return correlation, bucking the trend when investors have needed diversification most.

Another approach to identifying an appropriate hedge fund allocation is to use portfolio optimization. This technique analyzes risk return and correlation expectations to identify various asset mix combinations that can maximize expected future returns for different risk levels. The analysis is sensitive to input assumptions, but it provides insight into allocation.

An optimization process using the three-asset class portfolio described earlier (TSE 300, SCU Bond index and hedge funds) provides a surprisingly high allocation to the hedge fund asset class--even in the face of conservative risk and return assumptions.

This analysis uses historical data for volatility and correlation assumptions.

Disclosure and transparency
Striking a balance between comfort and compromise.
 

Hedge funds provide varying degrees of disclosure and transparency that differ from traditional investment vehicles--and for good reason. Concerns about transparency and disclosure can be addressed by knowing why these protection measures exist.

A few hedge funds offer total transparency, but most will provide only limited disclosure of positions and trades. The concept behind limited transparency and disclosure is that if a hedge fund manager has an investment strategy that generates excess risk-adjusted returns it would be unwise, if not foolish, to give it away through full disclosure or to allow it to be reverse-engineered through complete transparency. Simply put, returns from successful hedge funds will diminish if their strategies are known and fully exploited by the market in general.

Disclosure of short positions is a particularly sensitive issue. Investors should be leery of a hedge fund that provides current information on short positions. The information can be used against the hedge fund in a number of ways. Corporate managers may cut off the flow of information to the short hedge fund manager, and the market may bid up short positions to force the hedge fund to liquidate the position. This is sometimes referred to as a 'short squeeze.'

Institutional investors should work with hedge fund advisers who can provide sufficient transparency and disclosure to satisfy their concern without compromising the proprietary nature of the strategy. A focus on risk and risk factors is more important than an analysis of individual positions.

Future return expectations are more difficult to formulate, and more controversial. To be conservative, assume a 6% bond return, a 12% equity return and an 8% hedge fund return.

The allocation to hedge funds based on the optimization approach varies depending on the portfolio's risk and return objectives. For example, for a return target of 9%, an optimizer would allocate 40.2% to equities, 30.4% to bonds and 29.4% to hedge funds. For a 10% return requirement, the hedge fund allocation jumps to 33.3%.

While this analysis is dependent on input assumptions, it does illustrate how attractive hedge funds can be as an asset class in a diversified portfolio. The optimization process makes substantial allocation to hedge funds even with conservative return assumptions because hedge funds offer low correlation and enhanced diversification. The addition of other asset classes to this analysis would dilute the role of hedge funds, but it is likely that hedge funds would continue to earn a material place in a pension portfolio.

What minimum return expectation for hedge funds would dictate a material hedge fund allocation in the efficient portfolio? Not much. Hedge fund volatility and correlation numbers are so low that it is only necessary to expect hedge fund returns to be marginally in excess of bond returns.

While quantitative analysis and past performance may warrant a higher allocation to hedge funds, few pension funds begin with such large investments. It is more common for institutional investors to take a gradual approach to increasing allocation, particularly where a new asset class is concerned. Typical allocation in the area of alternative investments begins in the neighbourhood of 1% to 5%. In light of strong historical performance and the positive impact of hedge funds in an optimized portfolio, these numbers speak volumes. BC

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