Since the financial crisis, pension plans across the country have fought a long battle to improve their funded status. Many have. Some are well on their way to a derisking path. Regardless of funded status, however, with U.S. equity markets at all-time highs due to the longest bull market in U.S. history, plans should be seeking ways to protect their funded status from an inevitable recession or market correction. The difficulty facing trustees is how to do so while still benefiting from today's favorable economy--and without increasing their plan's risk profile.
If implemented effectively, a hedge fund allocation can play a valuable, additive role in addressing this challenge. Hedge funds have provided attractive long-term returns that have lower volatility than, and lower correlation to, equities. These attributes have made hedge funds useful regardless of plan type or status, provided that (1) the hedge fund allocation was sized appropriately and (2) the strategies and specific hedge funds were selected carefully to achieve the desired benefit. The hedge fund allocation should complement, and must be considered in the context of, the total portfolio and its objectives.
Understanding hedge funds and their role in a plan's investment strategy is critical before implementing an allocation. Trustees should consider issues such as high fees, transparency, illiquidity and sources of return that accompany many hedge funds.
Hedge Funds: An Overview
The term hedge fund describes a legal structure and little else today. Indeed, the hedge fund universe includes a huge number of strategies, the widest of any traditionally defined asset class. For example, purely equity-focused strategies, whether investing in the United States or any geographic area, are called long/short funds. Event-driven funds invest only in companies that are going through some sort of corporate "event" such as a merger transaction or asset sales. Some funds, including global macro or systematic trend, pursue strategies that invest in the foreign exchange markets, commodities, sovereign bonds, equity indexes, or derivatives and futures in countries around the world. Distressed funds invest primarily in the bonds or equities of companies in financial distress or that have filed for bankruptcy. Other funds combine several or even all of these strategies into a single entity. These examples are just a few of the myriad investment strategies commonly labeled as a hedge fund.
Combining funds that pursue different strategies into a well-planned hedge fund allocation should reduce total portfolio volatility because hedge funds typically have lower volatility than equities. The plan also should gain exposure to investments and strategies that its other investments miss, thus gaining greater investment diversification for the total portfolio. As a result of the lower volatility, broader investment strategy and increased diversification, the plan should experience smoother total portfolio returns over time.
The fluid nature of some hedge fund strategies and their ability to actively manage exposures and to opportunistically shift positioning toward less exploited areas also can help protect portfolios and, potentially, achieve returns unavailable through other investment strategies.
The Pension Plan Dilemma--A Role for Hedge Funds?
Over the last decade, the global financial crisis, market volatility, changes in the discount rate and mortality assumptions have played havoc with funded status for many defined benefit plans, including multiemployer, single employer and public employer plans. This funded status volatility has placed an added strain on corporate financial statements and on municipalities and states, making the jobs of plan trustees much more difficult.
Regardless of funded status, plans with high equity allocations are particularly sensitive to any decline (also called a drawdown) in the equity markets. While the definition of an equity market correction is a decline of 20% or more from the market's peak, a decline of even 10% can be very damaging to a plan and erase years of hard work. Since 2001, there have been 12 market drawdowns where the MSCI All Country World Index lost at least 8% in a single month, although it has been an astonishing six years since the last drawdown of this magnitude.
The dilemma for most plans is how to achieve their funded status goals in a way that marries their need for excess return with their limited risk tolerance.
A carefully selected group of hedge funds could help plans generate excess returns while significantly reducing volatility relative to traditional growth assets such as long-only equities, which often dominate pension plan growth portfolios.
Controlling equity market exposure is especially important for pension plans because stock market declines often coincide with periods of decreased economic activity and financial stress, making it difficult for...