Head to head: Do hedge funds make sense for Canadian pension plans?

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Wooden Podium Tribune Rostrum Stands with Microphones on the floor © Alexander Kharchenko / 123RF Stock PhotosWhile some pension fund managers swear by hedge funds, others would never sink in a single cent. After the 2008 financial crisis turned some investors sour, is it time to give hedge funds a second chance?

Colin Spinney, treasurer at Dalhousie University:

The Dalhousie pension plan once had a stand-alone allocation to hedge funds, or absolute return strategies. It had the following objectives: an annual real return of six per cent, volatility of between six and eight per cent and less than a 0.4 correlation to equity markets.

Essentially, we were looking for equity-like returns with bond-like volatility with little correlation to stocks. When we made our allocation with a number of strategies, these objectives were being met. Then the financial crisis hit. Drawdowns were less than equity markets, but correlations were up and the resulting hit to returns was still significant.

When Dalhousie first made these allocations, backing instruments such as treasury bills had real interest rates that were contributing to the real-return target. But with quantitative easing, negative real returns appeared, requiring higher returns to attain our six per cent real target. With the continuing negative real rates, our objective appeared to be an unrealistic ask.

In addition, the Hedge Fund Research Indices asset-weighted composite index and Credit Suisse Group’s indices of the major hedge fund categories were reviewed for the period of 1994 to 2014. Results for those 20 years looked satisfactory, but there was evident deterioration over time when we compared the period between 1994 and 2004 to the one between 2004 and 2014.

So, in 2014, a decision was made to eliminate the allocation to hedge funds as a stand-alone; instead, we increased allocations to private equity and real assets. This wasn’t a reflection on our managers, but rather our belief that our objectives were no longer reasonable. The plan’s funds still use some hedge fund strategies as an overlay, but not as a stand-alone.

Ruo Tan, president of Segal Rogerscasey Canada:

Pension plans across Canada face challenges on multiple fronts: funded status, longevity risk, market volatility due to geopolitical issues, record equity market highs, liquidity of investments, low interest rates and the prospect of the next recession.

Plan sponsors have to decide how to manage their plan’s risk budget while benefitting from the still-growing economy and available investment opportunities. They can address these challenges by skillfully implementing a hedge fund allocation.

First, carefully selected hedge funds can have lower volatility than equities and, more importantly, lower correlation to equity markets. This provides a downside protection in the event of a stock market correction. The selected hedge fund allocation can improve a plan’s asset drawdown in a recession, as demonstrated in the 2008 financial crisis, which helps protect a plan’s funded status and achieve a quicker asset level recovery later.

Next, some hedge funds have the flexibility to opportunistically invest in less traditional areas and this gives them an edge over traditional investment strategies. These hedge funds can protect asset value and achieve returns unavailable to other options. To generate alpha regardless of market beta, they can take full advantage of market trends, investor behaviour, mis-pricing opportunities, special events, currency, multi-strategy, derivatives, various country markets, leverage and arbitrage.

A well-constructed hedge fund allocation can enable a pension plan to enjoy the volatility/drawdown improvement without significantly compromising overall liquidity and enhanced risk-adjusted returns. Also, when it comes to hedge funds, governance and transparency have improved since 2008. And the liquidity of hedge funds is generally better than real asset investments and private equity programs.

This article originally appeared on CIR’s companion site, Benefitscanada.com. Read the full story here.

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