Funds Some Issues for Pension Fund
Smithers & Co
It is widely, if not universally, agreed
that the world is experiencing a period
in which intentions to save tend to outrun
intentions to invest. Alan Greenspan and
Ben Bernanke, who is Chairman of the US
President's Council of Economic Advisors,
are among those who have pointed to this
probability. If economic policy did not
counteract this, the result would be a world
recession. Fortunately this has so far been
avoided or at least postponed by the easy
fiscal and monetary policies.
The result is that all major economies
have large budget deficits and interest
rates are exceptionally low in both real
and nominal terms. The world is awash with
money and this has driven up the price of
assets, be they bonds, houses, other properties
or equities. This has had the desirable
result of depressing the wish to save, but
it has created a grave problem for pension
funds. It is likely that returns from investing
in these asset classes, which have been
the traditional universe for pension funds,
are likely to be extremely poor.
This is an extremely uncomfortable prospect
for the sponsors of pension funds and for
their advisors and fund managers. This discomfort
creates problems. Telling plan sponsors
that they should increase their pension
contributions and hold cash in the fund
is a rational and intellectually honest
response, but it puts businesses and careers
at risk. The demand for other answers is
therefore massive, and demand produces its
supply. In financial services, even more
than in most industries, it might be said
that "where there's a will there's
a way." There is of course the risk
that the old adage of Addison Mizner will
be even more apposite. As he wrote in his
cynic's calendar "where there's a will
there's a lawsuit".
The two most popular routes for escape
from the probability of low medium-term
returns from traditional assets are to invest
in private equity or hedge funds. In this
article I shall concentrate on the latter
and I must declare an interest. I number
many hedge funds among my clients and I
am therefore likely to see virtues in them.
My fear is that if any of them read this
article, they will not think that I have
Hedge funds undertake a much more varied
range of activities than traditional long-only
managers. It has been said, unkindly but
by members of their own community, that
"hedge funds are not an asset class,
they are a charging mechanism". Hedge
fund managers charge a lot. It is true that
their charges are generally linked to performance.
But if all funds were "hedge"
the total payments made by investors would
rise. In aggregate, therefore, they can
only benefit investors if they either outperform
the "unhedged" or improve aggregate
There is a case that they can do both.
(I should, however, remind you here of my
bias.) But there must be grave doubts as
to whether they can do so. (Am I biased
enough?) I see the major threats to the
positive case as being first, whether the
"industry" becomes large and second,
whether charges are not so large than any
aggregate benefits fall on the managers
rather than on their investors.
One type of hedge fund is "long/short
equity". These differ from long-only
funds in being able to seek absolute or
relative outperformance by selling over-priced
shares short, rather than simply not holding
them. The case for this type of fund is
that if some managers are capable of superior
share selection, they will be able to create
more value from this if they can short stocks.
Another way of putting this would be to
point out that information costs money and
that if fund managers can go short as well
as long, the information that they have
will not cost any more, but will have greater
As I see it, there are three problems with
this. The first is whether superior fund
managers can be selected. The second is
whether their superiority will survive the
growth of the industry. The third is whether
the cost to the investor will be 100% or
more of any added value.
In an efficient market, a group of investors
who managed funds which were in aggregate
market neutral would achieve in aggregate
the same return as would be available on
cash, before expenses. Such funds would
then be an expensive way of holding cash.
I think there are three conditions necessary
to avoid this. Firstly, the market must
not be fully efficient by enough for past
performance to be a guide to the future.
Secondly, the money that these managers
manage must not grow to the point where
the market becomes efficient. Thirdly, the
managers must leave something for the investors.
But long/short equity is by no means the
only strategy open to hedge funds. Another
is investing in types of assets which have
traditionally been the main activity of
It is obviously impossible to make a return
above the risk-free rate without taking
risk and only necessary to say so because
the point seems so regularly overlooked
by optimists. The way that banks remain
in business is by taking two sorts of risk,
which have the advantage that they are probably
less risky taken together than they are
Banks take credit risks by lending money
to people and companies who can go bankrupt.
If they select them well, the banks will
make more money by charging a premium over
their cost of borrowing, than they will
lose from the periodic bankruptcies. Banks
also buy bonds. This is a different sort
of risk. They usually make more money from
holding bonds, even "risk free"
ones, than they have to pay out to their
depositors. But as the interest on these
bonds is fixed until they mature, they will
lose if the cost of money on deposit rises.
These two risks are nicely balanced. The
economy goes up and down; in good times
interest rates go up and bankruptcies go
down, and vice versa. Thus the banks tend
to make more money from holding bonds in
bad times and less money from lending.
In recent times, however, banks have increasingly
sold off their credit risks to other investors,
with hedge funds being very important. This
process has sparked off a whole new product
for the securities industry called CDOs
or CLOs. These are Consolidated Debt or
Loan Obligations. These are just packages
of debts and they can be sold off in tranches,
so that the buyer can take the top risk,
which occurs when any of the borrowers stop
paying, or the less risky bits, which will
only have problems if lots of borrowers
are in trouble.
One feature of this process which has,
I think, received too little attention is
that when profits are made by banks by taking
credit risks, these profits are liable to
corporation tax. But if the profits are
made by pension funds, either by direct
investment or via hedge funds, no such tax
If, as seems likely, part of the business
of hedge funds consists of reducing governments'
revenue from corporation tax, then hedge
funds will be able in aggregate to improve
aggregate returns. To do this they need
a patsy and that patsy will be the tax system.
It is generally believed that pension funds
were robbed by Gordon Brown when he abolished
ACT. In a small way at least, hedge funds
might provide a route for pension funds
to get their own back.
Banks, as a result of regulation, are implicitly
and in some countries explicitly guaranteed
by governments. This lowers their borrowing
costs, which in turn makes it unlikely that
they will not continue to be the main intermediary
between lenders and low risk borrowers.
But the tax advantages will probably be
the dominant long-term determinant of who
undertakes the more risky elements of lending,
because these require a high element of
equity, where the cost is heavily influenced
We should therefore expect the risky elements
of lending to be increasingly owned by investors
who, unlike the usual practice of banks,
"mark to market". This is likely
to make risk margins more volatile.