Sunday, November 27, 2005

Pension Fund Hedging

A NY Times article this morning pointed out the interest and issues associated with Pension Fund Investments in Hedge funds. Pension fund interest and actual $ commitments in hedge fund investing is clearly growing and investment providers are responding to the interest by developing and marketing their own hedge funds products...primarily fund of funds or "near" hedge fund products which use long -short and portable alpha strategies.

While not all hedge funds strategies are as inherently risky as others, the generic issues with hedge funds from a fiduciary perspective are their high fees, lack of transparency/disclosure and potential risks that may not be well understood or quantified by either the investors or managers. Of particular interest to plan fiduciaries should be the DOL's lack of specific guidance in this complex area. They refer to the 1996 letter to the Comptroller of the Currency as their position paper on the hedge fund issue. While the letter refers to derivatives, it obviously extends to hedge funds strategies, many of which use derivative instruments.

"In determining whether to invest in a particular derivative, plan fiduciaries are required to engage in the same general procedures and undertake the same type of analysis that they would in making any other investment decision. This would include, but not be limited to, a consideration of how the investment fits within the plan's investment policy, what role the particular derivative plays in the plan's portfolio, and the plan's potential exposure to losses. While derivatives may be a useful tool for managing a variety of risks and for broadening investment alternatives in a plan's portfolio, investments in certain derivatives, such as structured notes and collateralized mortgage obligations, may require a higher degree of sophistication and understanding on the part of plan fiduciaries than other investments. Characteristics of such derivatives may include extreme price volatility, a high degree of leverage, limited testing by markets, and difficulty in determining the market value of the derivative due to illiquid market conditions"

Based on this language, Plan fiduciaries have a high standard of analysis and evaluation to ensure hedge funds are prudent investments for their plans. These standards can only realistically be met with fully transparent hedge funds and sophisticated investment Trustees. Fiduciaries liabilities are increasing as these conditions are not keeping pace with the growth of hedge fund exposure in pension plans.

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