Hedge funds and Private Equity - PES

130
4.2 The issue of pension funds
The privatisation of pension systems in many countries, ‘legitimised’ by increasing demographic
pressures on public systems, means that workers are increasingly being called upon to
save for their retirement through various forms of pre-funded schemes governed by private
pension funds. In some countries these pension funds are major players on the capital markets.
In the US, the UK and Canada, pension funds hold on average 20% of the stock market capitalisation.
Privatisation reforms have often been accompanied by de-regulation of pension funds’ investment
policies to diversify – and hence mitigate – their market risks. Once bounded by strict
quantitative restrictions (for example a 20% limit to investment in equity), in most jurisdictions
pension funds are now free to determine the composition of their portfolio by asset classes as
long as they respect value-based “prudent person” standards.
In the face of demographic pressures also squeezing such funds, rates of return on ‘safe’ investments,
such as government bonds, that are very low and, in some cases, the severe losses that
were incurred in the 2001 downturn, pension funds are increasingly looking to gain higher rates
of return and to seek out ‘alpha returns’ in particular. Investment returns can be disaggregated
into two parts: returns that are generated by generic market movements, known as beta, and
residual returns that are attributed to the specific investment added-value, known as alpha. With
lower market ‘beta’ returns, investors need to extract more ‘alpha’ to meet their funding targets,
and for pension funds to match their liabilities. Alpha investment strategies are short horizon strategies
using various tactical asset allocation techniques (such as delta-tilt, cross-market & overlay,
flexible absolute returns, low liquidity & equity-tilt, long-only & long/short hedge funds, etc.)
As a result of the de-regulation of their investment policy and the search for ‘alpha’ returns,
pension funds are diverting part of their assets away from traditional bonds and equity investments
into new ‘alternative’, alpha-oriented investment vehicles such as hedge and private equity
funds (including funds of funds).
This raises two main issues:
Pension funds aim to generate a long-term flow of income from their accumulated capital in
order to meet their commitments – pay out pensions – also over the longer term. This
suggests that investment in short-term and highly risky forms of investment should, at most,
be a marginal activity for such funds, a little speculative froth on the top of a large cup of
sustaining liquid. As shown elsewhere in this report, however, there are systemic pressures
on fund managers pushing them to ‘go with the flow’ (herding) and not to let their returns fall
significantly below the current best performers in the industry. Yet if these ‘best performers’
are merely so in the short term because of a favourable run of speculative successes, there
will be a general pressure to take on higher risk. Moreover as pension fund money flows into
alternative investments, which are by definition niche markets, it is increasingly unlikely that,
as a whole, they will continue to be able to extract ‘alpha’ returns over and above the normal
market rates of return.
A second concern is that of a division between the interests of retired (or elderly) workers
whose pension funds are pushed to adopt alpha risk strategies, including investment in hedge
funds and private equity and younger employed workers who are facing cuts in pay and conditions
(threatening their own ability to save for their retirement) as a result of the self-same
activity (such as the negative effects of leveraged buy-outs on wages, employment and
working conditions). Such tensions are likely to exacerbate the already serious problem of
achieving inter-generational equity in designing and reforming public pension systems.