UK pension funds “reluctant” to invest in hedge

The BP Pension Fund covers the pension arrangements for the majority of BP’s UK employees. The fund uses a mix of joint ventures and outsourced products for small-cap equities, corporate bonds, property and private equity investments but has no exposure to hedge funds.

The asset allocation of the fund includes 78% equities, with 36% allocated to UK equities and 42% overseas equities; 15% bonds; 4% property; 3% cash and other assets. The bulk of the assets are invested by the in-house team.

It was suggested to Sally Bridgeland, BP Pension Trustees’ ceo that plenty of the 'smart guys' were benefitting from hedge fund investment strategies, and therefore was she not concerned that BP could be missing out?

Bridgeland said: “What we are doing suits the way we are resourced and the skills that we have got. We do have a permanent trustee and an in-house team but they are not necessarily experts in that particular subject.

“Our private equity portfolio – which we started in 2000 – was very much driven by the passion our investment team had at the time. If we were to recruit somebody with knowledge of hedge funds it might be different. There are reputational and operational issues to take into account when coming to those decisions and certainly our sponsor is comfy with the main part of our risk being the equity market risk.”

Performance in 2007 was 8.6% compared to a benchmark of 6.6% but the fund has been badly hit by in 2008 by equity market volatility with performance currently down “between 20 and 30%.”

However, Bridgeland said: “In absolute terms am I happy with the performance? Well, I haven’t lost any sleep over it. The reality is that a pension fund is set up by a company to look after pensions and while the company is still committed to financing and providing those pensions that is the most important thing to me as a trustee. I have thought about moving away from commodities at a time when our sponsor might be more vulnerable to the ups and downs of the commodities market.

“Not only are we concerned with providing diversification, it is about diversifying our assets a bit away from our sponsor: to give us that insurance against the sponsor’s business pressure, so that you would hope that the cash is available when you need it.”

Avoiding investing in energy makes sense given that BP's business is energy, but Bridgeland is also reluctant to bring in specialist consultants to offer advice on investment strategy:

“Paying fees is money out of the system forever. The company and the trustees are comfortable taking equity risk. It is a very simple low cost approach. Our guys are not trying to shoot the lights out but they have consistently over a ten-year period outperformed by half a percent. Ok, that is not very much but on the size of assets that we’ve got that is quite a few millions.”

Vanessa James is investment director at the London Pension Funds Authority where she is responsible for advising the board on all aspects of investment strategy and implementation.

She has thirty years experience in the fund management industry, rising from a UK equity fund manager through to director at three major asset management companies.

The LPFA does also not invest in hedge funds, and James explained why:

“There is an issue about the people that are investing on behalf of the pension schemes understanding exactly what the hedge fund is doing, which is to generate performance. I cannot tell you long it has taken me to get people to understand what swaps are and what goes on behind the LDI matching part of the portfolio that we have.”

James argued that there is still a steep learning curve for pension trustees, with regard to hedge funds:

“You should not underestimate the fact that unless people think there is an absolutely compelling reason about why they must get to learn about hedge funds and learn thoroughly what the fund manager is doing they are not going to touch it. And so to go from a position of where there are no hedge funds in the portfolio to some would require a huge piece of work.

“You could get a number of analysts to help you, but there are only three of us that work permanently on the pension investment side and we have lots of governance to get through to get things accepted. And I have to say that given the state of the market over the last year there is no less chance of me getting through a trustee committee with the complexity of hedge funds now than I would have had a year ago.”

James also questioned the proposition that investing in hedge funds is not that different from equities, because it was simply a way to manage risk better.

“I am not even sure that you are managing risk better because I think that there is a whole raft of risks that we all have to start thinking about that we did not really understand fully how to sort out.

“There were risks in who our LDI strategy swaps were transacted with. There were risks in our stock lending portfolio as to how the person who did the stock lending portfolio managed the platform. Fortunately we were not one of the groups that lost money in Iceland.

“But there are risks when you have your cash managed, and people are going to be far more worried about those sort of risks that they did not realise even existed. And that is what the chat has been about recently rather than being in a hedge fund. If I was to say to our chairman ‘this hedge fund has only gone down by about 5% and the market has gone down 20%’ he would say ‘we should have been in cash then’.”

The LPFA fund is split into two – with one third of the assets in one fund and two-thirds in the other.

The first fund is cashflow matched and each of the fund managers has an alpha generation target. The portfolio of the second fund is 55% global equities including less than 10% UK equities (split between two active managers and one passive manager); 12% target return, 7% global property; 5% private equity, 5% infrastructure, and 1% commodities.

James said: “Target return is the closest we have come to going for anything that looked like hedge funds but it charges a fraction of the fees. Our portflolio is diversified but as yet there are no hedge funds.”

She acknowledged that there is a persuasive argument for investing in hedge funds:

“You can see looking at the different types of alpha and beta that we have already in our active portfolio that there might be a case for putting some in hedge funds that successfully exploit sources of alpha that are not being exploited elsewhere.

“Theoretically I can see that there is a space for it but from me having that thought to getting something in the portfolio I would estimate would take about eighteen months because of the type of governance that we would have to go through. I am sure we could get people from the hedge fund industry to come in and talk to the trustees but they are not coming in with a blank sheet of paper. They really do not like complexity.”

There appears to be a cultural gap in understanding between the hedge fund industry and some UK pension funds. Both the BP Pension Fund and the LPFA fund feel they can tolerate a high degree of volatility and believe equities can deliver higher return in the long term than hedge funds.

It is a difficult asset class to research with a small staff, and the fund of hedge funds route often favoured by institutional investors is an expensive one that remains a concern for trustees.