18th September 2006

"Wise to wise up on hedging - THE LAST WORD: JOHN AUTHERS: Yes, asset managers and plan sponsors need to talk the same language, but sponsors really need to open their minds."

By John Authers

"There is a disconnect between the wishes of fund managers and their biggest institutional clients. That shines through from the latest exhaustive survey of opinion in the global asset management industry by Create, the UK consultancy.

According to the survey, by Professor Amin Rajan and others, clients want to "go back to basics". Meanwhile, the industry is keen to offer them ever more complicated concepts borrowed from the hedge fund world.

The difference is clearest when asset managers and defined benefit plan sponsors were asked the five asset classes that would be most suited for their needs over the next five years. The list is almost completely different (both agree that private equity comes in fifth).

The plan sponsors want something that does not sound wildly different from the portfolios Foreign & Colonial must have been managing a century ago - global equities, emerging market equities, real estate, and then manager of manager mandates.

Asset managers, on the other hand, thought the sponsors would want, in order, liability driven investments, portable alpha, hedge funds, and structured products involving derivatives.

There are two ways of explaining this division, with the truth probably lying somewhere in the middle. The first is the industry is still trying to make the job of investment management needlessly complex, a ruse of salesmen throughout the ages.

Rather than putting extra buttons on the front of stereo equipment, on this interpretation, they are offering high-falutin' hedge fund strategies when an old-fashioned "buy-and-hold" equities strategy would be fine. After all, how different is a "liability-driven investment" - one designed to aim for a pay out at a specific date in the future - from what life assurance actuaries have been doing for two centuries?

The second explanation is that the plan sponsors show an alarming lack of sophistication, and do not understand that intelligently run strategies using hedge funds could raise returns for their members while reducing risk. There is some regional variation in this, though, with the big pension plans in the US and the Netherlands showing a better understanding. Alarmed by under-funding, and by rules requiring mark-to-market valuations, it is possible that sponsors are erring too far on the side of caution and conservatism.

Some comments from trustees were truly jaw-dropping. One admitted that "we have not cracked the boring bits of derivatives", while another said that the risks associated with derivatives "make me blink".

The opportunities to use derivatives to hedge a portfolio - presumably the "boring" bit of derivatives, rather than the "exciting" use of them for speculating, which leads to LTCM or Orange County - thus appear to be passing many plan trustees by.

As Mr Rajan puts it: "Pension funds find themselves in such a big hole at the moment that they would rather not take a chance on anything. They want these products stress-tested."

The truth is somewhere in the middle. Sponsors should open their minds, while asset managers should communicate in language that bears a much closer approximation to English.

But the greatest concern must be the almost wilful ignorance of some plan sponsors. The latest data from Chicago-based Hedge Fund Research showed every hedge fund strategy it covered was in positive territory for the year by the end of August, even though major world stock indices such as the Nikkei and the Nasdaq Composite were in negative territory for the year at the time.

A fund that remains fully invested in equities, with no hedging through selling short or through derivatives, begins to look now like an uncomfortably exposed investment.

Outside the US (and maybe the Netherlands) it is worrying that plan sponsors, and the small group of pension consultants who operate as their gate-keepers cannot yet see this."