Hedge Funds to Expand Risk Management Practices
Public pension systems are straying from the tried and true strategy of “little risk, guaranteed return” and opening up to the “high risk, high return” world of hedge funds. The reason behind the trend: no one expects the public equity market to return what it was going forward and pension funds must continue to generate the annual returns necessary to meet their obligation to retirees. Despite near record inflows in the second quarter however, the collapse of the subprime lending market is taking a toll on the industry. As a result, pension funds are bracing for heavy losses at funds that specialize in credit strategies. Now with the coming wave of retiring baby boomers, pension officials must carryout more effective due diligence, making absolutely sure that they have done everything possible to avoid a hedge fund meltdown. Executive recruiting firm, A.E. Feldman, says investment professionals with expertise in valuation and risk management are in a key position to benefit from the current environment.
The Massachusetts state pension system lost $30 million following this week’s collapse of Sowood Capital Management LP. The Boston-based hedge fund informed investors that a 57% loss in July wiped out half of its $3 billion in capital. Harvard and several other university endowments have also been flocking to riskier investments like hedge funds and private equity in recent years. Harvard also lost about $350 million last month through an investment in Sowood, according to The Wall Street Journal, although the $350 million loss is fairly small for the University’s $29 billion endowment.
Sowood was invested in corporate bonds and related securities that have been weakened by failures in subprime mortgages. The fund borrowed heavily to buy its investments and could not meet its obligations to lenders when the value of its holdings plummeted. Bear Stearns this week also notified clients that their investments in two prominent hedge funds were worth just pennies on the dollar. The funds had made bets on risky bonds backed by subprime mortgages.
Still, hedge funds enjoyed a near-record second quarter, attracting $58.7 billion in new assets according to Hedge Fund Research (HFR). The industry now oversees a staggering $1.74 trillion, a 22% increase from the end of last year. Hedge funds betting on falls in bonds linked to U.S. subprime mortgages raked in returns of almost 40% last month as they profited from the crisis. And going forward, it appears as if the subprime meltdown will not deter institutional investors from investing even more in hedge funds.
Institutional investors are expected to triple their hedge fund investments to $1 trillion by 2010, up from about $360 billion as of the end of 2006. Moreover, pension funds hungry for returns that aren’t strictly correlated with the S&P 500 will account for a whopping two-thirds of new institutional money flowing into hedge funds, according to a study by the Bank of New York and consulting firm Casey, Quirk & Associates.
Now, with a wave of baby boomers set to retire in coming years, pension fund managers say they are proceeding with caution. Those with large exposures to hedge funds say their risk is spread out over many funds with varying investment strategies. Larry Swartz, executive director of the Fairfax County pension funds’ board of directors told the Washington Post, “This is not all about reaching for return. It’s about developing a smoother return stream and managing the level of volatility in the retirement system year to year.”
By the end of June, the average hedge fund was up 8% according to HFR. But some managers are predicting that July and August will tell a different story. The fear is that there are more hedge fund disasters waiting to happen. Many experts say due diligence and transparency are three words that have been forgotten, until now. Failure on the part of pension plans to rigorously review risk management and valuation practices could mean financial ruin for many retirees. Pension officials may be forced to question whether the risks associated with hedge funds are appropriate considering the sole purpose and legal obligation of pension funds is to pay out predetermined benefits to retired workers.
The bottom line: pension fiduciaries must make absolutely sure that they have done everything possible to avoid a hedge fund meltdown. Money managers will spend $7.4 billion on in-house research in 2011, up 28 percent from 2006, according to Integrity Research Associates. And investment professionals looking for hedge fund jobs or public pension fund opportunities may benefit from this trend. Management consulting firm, A.E. Feldman, says demand is growing for investment professionals with expertise in valuation and risk management.
