US Pension Funds searching for higher returns in Alternatives

US Pension Funds searching for higher returns in alternatives:  A high risk, low reward strategy?

“We can’t put it (funds) in Treasury notes and bonds; that’s just not making any money,”…This comment by a Pension Fund Manager justifies the flight by some of the US pension funds in to HFs asset class in last three to four years. 

According to a recent market survey, Investment in hedge funds (total hedge funds and hedge funds-of-funds) among the 200 largest U.S. retirement funds jumped to 20.3% to $134.7 billion.

One point of view is that this ‘flight to alternatives’ (higher allocation to HFs, PEs, Alternatives) was more of a knee-jerk reaction to the credit crisis of 2008 and the consequent financial market collapse.  To understand the real picture you have to stack up the returns from Hedge Funds as an asset class among other asset classes over a longer period –at least 10 years.

Our analysis shows that Hedge Funds as an asset class outperformed S&P 500 only in two out of the last ten years and if you compare the performance with  Non-US equities (HFs being a riskier asset class), it outperformed Non-US equities in only three of the last ten years.  Refer to comparative asset class analysis below.

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US Pension funds are adopting aggressive investment strategies by higher allocation to Hedge Funds.   This trend is driven by a desire to generate higher returns (given the funding gaps).  The decision is also fueled by the fact that currently investments in HF’s form a small component of aggregate asset allocation (it currently stands at around 2.5% of total allocation).  If you compare this with some of the top Canadian pension funds the comparable percentage is about 3.5 % of total asset allocation.

However, these funds need to be cautious given that the high cost incurred in investing in HF’s is not necessarily backed by higher returns. In 2012, the HF industry generated returns of around 8.5%, which is way below S&P 500 returns of around 13.4%.  And finally, the expectation of high returns from Hedge Funds comes at a significantly higher cost.  Typical, external Manager fees for Hedge Funds asset class is approx. 5 times compared to domestic equity assets and around 8 – 10 times compared to various sub segments of fixed income asset classes.

It is clear that betting on riskier funds does not necessarily yields higher returns.