Moody's Report: With Growing Pension Popularity, Hedge Funds Must Alter Strategies

(March 23, 2011) — A recent report by Moody’s Investors Service shows that hedge fund managers will be forced to reduce their fees and risk tolerance while altering their business strategies as pensions increase their allocation to the sector.

“This shift in thinking and the need for alpha-producing strategies in addition to investors’ improved understanding of alternative investments has increased the attractiveness of hedge funds vs. traditional long-only investments,” said the report, obtained by aiCIO. “The size of the investment pool controlled by institutional investors is so large that even a small percentage increase in allocations to hedge funds could have a profound impact. The US pension fund industry alone controlled over $15 trillion, as of December 2010, according to estimates from Towers Watson, nearly 10x the size of the global hedge fund industry.”

Moodys’ research asserts that the financial downturn will cause several structural changes among hedge fund industry stakeholders, such as pensions and banks. While cautioning that existing operational staff would likely be stretched, Moody’s predicts that in response to institutional investors increasing their allocation to hedge funds, fund managers will need to increase their investor relations teams, improve reporting systems, and adjust their procedures to meet client demands. Furthermore, the ratings agency claims that increased allocations to hedge funds by pensions and other institutional investors could cause hedge fund managers to make more conservative investment decisions, which could “change the flexible and entrepreneurial nature of the hedge fund industry and would have far-reaching consequences.”

A report issued earlier this month by Preqin supports Moody’s findings that the hedge fund industry is gaining traction. Despite negative returns over a three-year timeframe, public pensions have increased their allocations to hedge funds. Nearly 300 public pension plans worldwide now invest in the asset class, a 51% increase over the past four years. Preqin’s database of institutional investors shows that 295 government pension funds worldwide were invested in hedge funds in the first quarter 2011, compared to 196 plans as of Dec. 31, 2007. Additionally, the research indicates that another 49 public plans are seeking to make their first hedge fund allocation within the next year.

Hedge funds have become more popular among public pensions than private equity, according to Preqin’s report. In total, the amount of public pension assets currently invested in hedge funds is $127.3 billion.

Overall, the leading 10 public schemes allocating to hedge funds have assets under management of $836 billion. “Public pension plans are one of the most influential groups of investors and their increased uptake of hedge funds is shaping the new institutional era of hedge fund management,” wrote the report’s author, Amy Bensted, Preqin’s manager of hedge fund data.