As institutions push hedge funds for transparency, Canadian investors will benefit.

Hedge funds, once the exclusive domain of the very rich, have gained a sizable following among institutional investors, which currently own some 25% of global hedge fund assets. While institutions in the U.S. have stepped up their allocations to hedge funds, those in Canada have shown little inclination to do so thus far.

But this trend may be changing. Canadian pension funds, like those in other parts of the world, are under sharp pressure to meet their institutional liabilities and are adopting liability-matching benchmarks in step with institutions elsewhere. Interest in absolute return-oriented investments such as hedge funds would be a natural outgrowth of this trend.

To date, two main factors have inhibited institutional interest in hedge funds in Canada. First, some of the country’s largest pension plans have been running hedge fund-like strategies of their own for years, managing short-equity portfolios and using derivatives, for example, to adjust the risk/return characteristics of their overall portfolios. These institutions have seen little reason to hire outside managers to do what they can already do themselves. Secondly, despite growth of 25% to 28% in Canada’s domestic hedge fund industry last year, most of the newer players do not have institutional investors in their sights. Many are pursuing commodity-based strategies that are unlikely to appeal to pension fund boards with a traditional focus on equity and fixed-income investing.

But this local trend is unlikely to affect Canadian institutions for long. While there are about 250 hedge funds in Canada, there are more than 8,000 in the U.S. Many of the U.S. funds are actively seeking increased participation from institutions—in part, by providing the kind of transparency, or clarity of information, about their structure and operations that institutional investors require. As Canadian pension funds survey the investment landscape, they may find that hedge funds have come to resemble traditional long-only managed funds to an unexpected degree.

Wealthy individuals—always the main investors in hedge funds—appear to be comfortable with having people they trust monitor a portion of their personal wealth. They have generally been content with two- or three-year lock-up periods and monthly valuations. But institutional investors are in a fundamentally different position. They have wide-ranging responsibilities to boards of trustees, to plan sponsors and, of course, to beneficiaries—and they are accountable to all of these entities. Moreover, they risk public exposure if the assets are mismanaged. Consequently, institutional investors are active overseers of performance on a short-term basis, and they have a large appetite for understanding risk/return ratios and rewards. They are looking to alternative investments such as hedge funds not to protect their wealth but to manage asset-liability mismatches.

Need for More Information

Eager to attract institutional assets, hedge funds are under pressure to value their portfolios with greater frequency. The industry has come a long way, from a full net asset value calculated once per month to providing weekly valuations, and there is now talk of daily valuations. Risk reporting, which used to mean looking at a limited number of variables that might affect the performance of the portfolio once a month, is also being done more thoroughly and frequently with information such as exposures and estimates of return. Increased frequency is a major driver on the hedge fund manager side.

Institutional investors want the same comfort level from hedge funds that they enjoy on the long-only side, for which they receive portfolio information daily. And, if they reside in a different time zone than the hedge fund manager, they want reporting from where they are, not from where the hedge fund manager is.

The demand for more timely and complete information is partly the result of a shift by institutional investors from fund of hedge fund investing to direct investment in individual hedge funds. In the beginning, hedge fund of funds provided a way for many pension funds and endowments to make their first foray into hedge funds. For these investors, owning a single, professionally managed portfolio diversified across multiple hedge fund investments was viewed as a way to minimize the risks of the asset class. Today, investors often manage their hedge fund portfolios themselves by investing directly in individual funds. Canadian institutions may follow this same trajectory when they begin allocating money to hedge funds, or they might bypass the fund of funds stage altogether.

New Concerns

As they evaluate individual hedge fund managers, institutional investors now find themselves focusing as much attention on investment processes as on investment philosophy. Understanding and validating the procedures and controls implemented by the managers is essential to mitigate the operational risk of investing in a fund. Public institutions are also concerned about the market risk inherent in various hedge fund strategies, and some may want to increase their allocation to hedge funds only if they can provide their oversight boards with more information on how the portfolio of differing strategies was put together. On the non-investment side, these investors also have to worry about headline risk—the possibility that lax controls and procedures or poor performance by a hedge fund in the portfolio will draw headlines, causing regulatory scrutiny and public outrage.

Assuaging these concerns about operational, market and headline risk calls for substantial investments in technology and intellectual capital. Rather than developing in-house capabilities, many institutional investors are turning to independent providers for help with monitoring their hedge fund portfolios. Such providers may also offer additional services, such as risk management, valuation, investor reporting, custody and cash management.

Today, a pension plan can tap into an independent provider’s platform to gather vast amounts of data on hedge fund and strategy performance, as well as on market value and holdings. Using this platform, pension plans can perform independent valuation, stress testing and what-if scenario analysis and monitor their current portfolios, including historical risk and return characteristics by manager and strategy. More importantly, investors can see how their portfolios’ risk/return characteristics would change if they chose to allocate assets to new managers or strategies currently under consideration. This service helps investors maintain greater insight into their investment processes, maximize the efficient frontier of their portfolios and implement the appropriate controls.

As relatively late arrivals to hedge fund investing, Canadian pension funds stand to benefit from the technologies and service platforms already in place. Using the tools available, they will be able to view allocations to hedge funds not simply as risks taken in the hopes of expected returns, but as risks systematically integrated into the management of their portfolios. Given the degree to which hedge fund investing can now accommodate the valuation, reporting and risk management requirements of institutional investors, it’s likely that Canadian pension funds will soon start making greater allocations to this fast-growing asset class.

Gary Enos is executive vice-president at State Street.

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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the Spring 2008 edition of INNOVATE magazine, published by BENEFITS CANADA.


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