Pension fund investment in alternative assets triples in three years

UK pension fund weightings in alternative assets (hedge funds, private equity and venture capital) have increased from 0.3%, by asset value, at the end of September 2002 to 1.0%, at 30 September 2005. This was after a period of eight years during which holdings in alternative investments remained fairly static.
This is one of the findings of a recent Mellon Analytical Solutions (MAS) study into some of the key issues associated with pension fund investment in alternative assets. This research covered individual years to September, ending with the year to 30 September 2005.

At the end of September 2005, the lion’s share of pension fund investment in alternative assets was through hedge funds and absolute return mandates. More money was invested in these sectors than in private equity and venture capital combined. By asset value, hedge funds/absolute return mandates represented 62.7% of specified pension fund investment in alternatives, while private equity and venture capital combined, accounted for 37.3%.

Performance and risk

The study found that, over seven years to 30 September 2005 (the longest available period), hedge funds outperformed Equities, Bonds, Index-Linked Gilts and Cash, but underperformed relative to Property.

Property returned 11.1% p.a. while the FTSE Hedge Fund index returned 10.1% p.a. in sterling terms. UK Index-Linked Gilts provided the next best return of 6.3% p.a., while UK Equities (5.3% p.a.), Overseas Equities (5.8% p.a.) and UK Bonds (5.5% p.a.) also beat Cash (4.6% p.a.) over the period. Overseas Bonds produced the poorest return of 4.5% p.a. over seven years.

Hedge funds demonstrated less risk than Equities, Bonds and Index-Linked Gilts, but were more volatile than Cash and Property.

Over seven years to 30 September 2005, Overseas Equities was the most volatile asset class followed by UK Equities. The standard deviation of quarterly returns for Overseas Equities was 20.0% p.a. against 16.4% p.a. for UK Equities. By comparison, the standard deviation of the hedge fund index was 3.8% p.a.

Alternative assets v UK Equities

The research also looked at how closely returns for different asset classes were correlated with UK Equities, the single biggest asset class for UK pension fund investment.

MAS found that hedge fund returns were more closely correlated with UK Equities than were any of the other asset classes, except Overseas Equities. However, any reduction in equity holdings within a pension fund coupled with a corresponding increase in hedge fund investment would have increased overall return and reduced overall risk. This is because hedge fund returns were less volatile and produced more consistent performance.

Daniel Hall, MAS’ Publications and Statistics Manager said, “It is often said that hedge fund investment reduces fund risk due to low correlation with equities. In fact, the data shows that hedge funds have been more closely correlated with equities than any other asset class. However, hedge funds would still have had a diversifying influence, reducing overall fund risk, due to a more consistent performance and lower volatility.”

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