Pension funds allocations to hedge funds: an empirical. analysis of US and Canadian de ned bene t plans

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1 Pension funds lloctions to hedge funds: n empiricl nlysis of US nd Cndin de ned bene t plns Vincent Bouvtier y Sndr Rigot z August 2011 Abstrct This pper investigtes the chrcteristics of US nd Cndin pension funds tht llocte ssets to hedge funds. The typicl pension fund tht invests in hedge funds is lrge sophisticted pension fund tht diversi es its portfolio cross numerous clsses of investments, privte equity in prticulr, uses core-stellite orgniztion nd hs ccess to low delegtion costs for lterntive ssets. Moreover, we nd tht pension funds investing in hedge funds signi cntly obtined higher globl returns. JEL clssi ction: G23 Keywords: pension funds, hedge funds, sset lloction, diversi ction We would like to thnk Michel Agliett nd Gunther Cpelle-Blncrd for helpful remrks nd suggestions. The usul disclimer pplies. y EconomiX, Université de Pris Ouest - CNRS, 200 Avenue de l République, Nnterre Cedex, Frnce. E-mil: vbouvtier@u-pris10.fr z CEPN, Université de Pris Nord - CNRS, 99 venue Jen-Bptiste Clément, Villetneuse, Frnce. E-mil: sndrrigot@club-internet.fr 1 Electronic copy vilble t:

2 1 Introduction Since 2000, institutionl investors hve been improving their portfolio diversi ction nd llocting more funds to lterntive ssets. 1 In prticulr, hedge fund investments becme signi cnt sset clss in the portfolios of numerous institutionl investors. In 2007, institutionl investors ccounted for more thn 50% of hedge funds in ows for the rst time (Mc Kinsey, 2007); the lrgest shre of hedge funds cpitl hs historiclly come from high net worth individuls (Prequin, 2009; US GAO, 2008). Pension funds nd funds of funds re the min contributors to this chnge in the client structures of hedge funds. 2 In this pper, we investigte the chrcteristics of pension funds tht invest in hedge funds. The growing interest tht pension funds hve tken in hedge funds occurs in globl context. After the stock mrket crsh of nd the decline in long term interest rtes, pension funds hve been looking for sources of higher returns. 3 Consequently, pension funds stedily reorgnized their mngement to improve their strtegic sset lloction. They employ core-stellite orgniztion, which comes from sset-libilities mngement (Shrpe nd Tint, 1990). This structure is known to be n e cient strtegy for portfolio diversi ction through ctive mngement (Amenc et l., 2004). It consists of de ning strtegic sset lloction nd dividing ssets between two components: core nd stellite. The rst (75%-90%) ims to mtch the libilities of pension funds vi immuniztion techniques. The objective is to void risks relted to the vribility of the ssets of pension funds. The core is generlly invested in trditionl sset clsses in liquid mrkets (lrge cps, bonds, etc.) nd the ssets cn be mnged in either n ctive or pssive wy, s well s internlly or externlly. The second component (10%-25%) is lmost exclusively invested in lterntive ssets (rel estte, hedge funds, privte equity, infrstructure, etc.). The stellite looks for higher performnce (by generting positive lph returns) nd better diversi ction of risk (by improving bet). 4 In ddition, stellites re exclusively mnged externlly becuse 1 Alterntive ssets re mde up of privte equity, rel ssets nd hedge fund investments. 2 Funds of funds re collective investment vehicles tht llocte ssets to severl hedge funds to bene t through diversi ction of bene ts. As generl rule, they re mnged by privte bnks, mutul funds or institutionl sset mngers. 3 The high returns erned by hedge funds in ber mrkets between 2001 nd 2003 explin the importnce of hedge funds in ows over these yers. 4 Alterntive investments llow portfolio diversi ction becuse their return drivers di er from the equity 2 Electronic copy vilble t:

3 these ctive investments require speci c expertise tht pension funds do not hve in-house. The hedge funds industry, with its objectives of high nd llegedly uncorrelted returns, seemed therefore prticulrly ttrctive for the stellite component. Regultors viewed hedge funds s hving positive in uence on nncil mrkets (Dnielsson nd Zigrnd, 2007). However, their light regultion nd their speci c governnce rise issues beyond those posed by trditionl investments. These issues include risks nd chllenges relted to vlution, leverge, liquidity nd the opertionl risk of hedge fund investments (US GAO, 2010). Indeed, investors in hedge funds hve limited informtion on the vlution of nd the ssets underlying their investments. Hedge funds re engged in complex investment techniques tht cn involve vrious nncil instruments for which there is no benchmrk nd no mrket. In ddition, hedge funds often hve brod ltitude to use leverge, which mpli es both potentil gins nd losses. As result, some of the most successful hedge fund strtegies disply vulnerbility to extreme losses, i.e., negtive skewness nd very lrge kurtosis (Amin nd Kt, 2002; Agrwl et l, 2004; Khnniche, 2008). Hedge funds lso hve speci c rules tht limit n investor s bility to redeem n investment for de ned period of time; generlly corresponding to one yer lockup period. Additionlly, hedge funds impose higher fees. 5 As result, investors need to ern higher gross return to chieve higher net return (Ackermnn et l., 1999). Finlly, hedge fund s ctive or risky trding ctivity my result in losses due to opertionl filures such s trding errors or outright frud (opertionl risk). The prticulrs of hedge fund investments -relted minly to vlution, leverge, liquidity nd opertionl risk- imply tht mny pension funds do not hve the necessry bilities or incentives to invest in this ctegory of lterntive ssets. Investments in hedge funds should, for exmple, be mde by those with the skills required to select hedge funds mngers nd require su cient brgining power to negotite contrctul terms relted to fees nd informtion disclosure. Attention hd incresingly focused on the mngement nd investment prctices of pennd bond mrkets drivers (Schneeweis, Kzemi nd Mrtin, 2001). 5 Investors re chrged 3 types of fees: mngement fees (1%-2%), performnce fees (15%-20%) nd erly termintion fees (1%-2%) in the event of n erly liquidtion. 3

4 sion funds. However, few studies focus on pension funds contrctul delegtion to their hedge fund mngers. This pper ims to bridge this gp through the use of n originl nd representtive dtbse from CEM benchmrking. This dtbse concerns the investment strtegies of US nd Cndin De ned Bene ts pension funds, over the period The rst im of this rticle is to nlyze the extent to which US nd Cndin pension funds llocte to hedge funds nd to identify the min chrcteristics of the pension funds investing in hedge funds. Second, we investigte the implictions of llocting pension fund ssets to hedge funds. More precisely, we propose to evlute the bene ts of hedge fund investments with respect to returns nd to question to wht extent pension funds hve tckled speci c gency problems in their delegtion to hedge funds. The reminder of the pper is orgnized s follows. Section 2 presents the dt nd descriptive sttistics. Section 3 ssesses the chrcteristics of the pension funds llocting to hedge funds. Section 4 investigtes the reltionship between pension funds globl returns nd their lloction to hedge funds. Section 5 concludes the pper. 2 Dtset nd descriptive sttistics We use the CEM benchmrking dtbse, which provides dt on individul de ned bene t pension plns from the US nd Cnd from 1990 to The dt include ssets under mngement (in millions of dollrs); costs nd returns, which re vilble by sset clss nd by the nture of their delegtion (ctive/pssive nd externl/internl). 6 In ddition, the dtbse provides the policy sset lloctions (in %) (i.e., strtegic sset lloctions, de ned before buy nd sell decisions) nd their expected return by sset clss s well s other informtion regrding globl costs (custody, consulting nd oversight). The dtbse lso indictes whether the fund is publicly or privtely owned. According to Mc Kinsey (2007), OECD (2008) nd US GAO (2008), US de ned bene t (DB) pension funds were vlued t $4,250 billion in Assets under the mngement 6 Totl ssets re disggregted into 7 clsses: equity, xed income, rel ssets, privte equity, hedge funds, csh nd tcticl sset lloction (TAA). In ddition, for ssets under mngement, equities nd xed income ssets re lso disggregted into subclsses. 7 More precisely, totl ssets mnged by US pension funds mounted to $9,500 billion in 2007 nd 4

5 of the US pension funds listed in the CEM benchmrking dtbse ccounted for $2,500 billion in 2007, i.e., round hlf the vlue of US DB pension funds in terms of ssets under mngement. Concerning Cnd, more thn 93% of pension funds were de ned bene t in 2004, while their ssets under mngement mounted to bout $700 billion in 2006 (OECD, 2007). The CEM benchmrking dtbse seems to be representtive, s it reports tht $460 billion of ssets were under mngement in We focus our empiricl nlysis on the period from 2000 to 2008 becuse pension funds begn llocting to hedge funds in More precisely, we hve n unblnced pnel of 1,973 observtions for 407 pension funds, mong which 86 invested in hedge funds for t lest one period. Concerning the geogrphic distribution, 274 pension funds in our dtset come from the US, nd 72 of these US pension funds invested in hedge funds for t lest one period. To our knowledge, the informtion provided by the CEM benchmrking dtbse concerning lloctions to hedge funds hs rrely been used in relted pension fund studies. 9 In this section, we present generl descriptive sttistics concerning pension funds lloctions to hedge funds. In ddition, we suggest severl chrcteristics of pension funds tht could be relted to the decision to invest in hedge funds. 2.1 Alloction to hedge funds Tble 1 shows the verge portfolio lloction for the full smple nd for the subsmple of pension funds investing in hedge funds. In the full smple, equities re the primry ssets nd ccount for pproximtely 60% of the portfolio, followed by xed income ssets, which represent pproximtely 30% of the portfolio. The reminder of the portfolio is llocted to lterntive ssets, minly rel ssets (pproximtely 4%) nd privte equity (pproximtely 3%). Alloctions to hedge funds only represent 0.61%, indicting both tht numerous pension funds do not invest in hedge funds nd tht pension funds consider the three ctegories pproximtely hlf of those ssets were mnged by DB pension funds. 8 There is no distinction in the dtbse between lloctions to hedge funds or to funds of hedge funds. 9 For exmple, French nd Kenneth (2008) compre the fees, expenses nd trding costs society pys to invest in the U.S. stock mrket long with n estimte of wht would be pid if everyone invested pssively. Buer, Cremers nd Frehen (2010) document the performnce nd costs of the domestic equity investments of lrge smple of US pension funds (smll-lrge size) in comprison with mutul funds. 5

6 of lterntive ssets di erently. Focusing on the subsmple of pension funds investing in hedge funds, Tble 1 highlights how the portfolio lloction is modi ed when pension funds decide to invest in hedge funds. The verge lloction to hedge funds jumps to 4.57%. The lloction to other lterntive ssets lso increses. Rel ssets nd privte equity represent 6.16% nd 4.98% of totl ssets respectively. These relloctions re mde through reduction in equities, which ccount for 52.52% of totl ssets. To illustrte more precisely the pension funds lloctions to hedge funds (HF i;t ), Figure 1 represents the percent distribution of HF i;t for the subsmple of pension funds investing in hedge funds. For more thn 50% of these pension funds, investments in hedge funds represent less thn 3% of totl ssets. However, severl pension funds re investing more thn 10% of their totl ssets in hedge funds with mximum of 36.69%. In the US, the federl government does not speci clly limit or monitor privte sector de ned bene t plns investments in hedge funds, nd stte pproches to public pension plns vry. 10 Under the Employee Retirement Income Security Act (ERISA) of 1974, duciries (pension fund dministrtors) must comply with stndrd of prudence (including the diversi ction of ssets nd minimizing the risk of lrge losses), but there is no explicit restrictions on lloctions to hedge funds. The prudent mn stndrd does not explicitly prohibit investment in ny speci c ctegory. An unsuccessful individul investment is not considered per se violtion of the prudent mn stndrd. Tble 2 gives brekdown of the number of pension funds by yer in the full smple. In ddition, Tble 2 displys the proportion of pension funds investing in the three ctegories of lterntive ssets nd the verge lloction. The number of pension funds investing in hedge funds hs incresed over the yers. From 2000 to 2008, the percent of pension funds investing in hedge funds incresed from 1.35% to 25.42%. However, the verge lloction hs not incresed over time. Rel ssets nd privte equity re more commonly mnged by 10 We cn clssify pension funds by two criteri tht cn be mixed: the rst is concerned with bene ts, which cn be de ned or not; the second reltes to sponsorship, which cn be privte or public. A de ned bene t (DB) pln promises prticipnts speci ed monthly bene t t retirement. In this context, pln sponsors ber the investment risk. On the contrry, de ned contribution (DC) pln does not promise speci c mount of bene ts t retirement. In ddition, public nd privte DB plns re not subject to the sme regultory frmework. The federl government monitors privte sector DB pln investments nd stte governments monitor the investments of public DB plns. 6

7 pension funds. From 2000 to 2008, the percentge of pension funds investing in rel ssets incresed from 69.68% to 78.81%. Concerning privte equity, the percentge incresed from 51.13% to 63.98%. Similr to investments in hedge funds, the verge lloctions do not exhibit trend. The interest of pension funds in hedge funds my lso be highlighted by the strtegic lloction, lso known s the policy weight (P W i;t ). Tble 3 reports some descriptive sttistics for severl vribles used in our empiricl nlysis. The verge policy weight of hedge funds is higher thn the e ective lloction (HF i;t ) nd reches 1.03% in the full smple. Focusing on the subsmple of pension funds investing in hedge funds, the policy weight nd the e ective lloction seem very close on verge, t 4.62% nd 4.57% respectively. However, the policy weight nd the e ective lloction cn diverge noticebly. Severl pension funds investing in hedge funds report policy weight equl to 0, nd conversely, severl pension funds reporting positive policy weight do not invest in hedge funds. For exmple, the policy weight is equl to 0 for 36% of the subsmple of pension funds investing in hedge funds. 11 As result, the policy weight of hedge funds cn provide distorted representtion of the e ective investments pension funds mke in hedge funds. Therefore, we focus our empiricl nlysis on the e ective lloction (HF i;t ) rther thn on the policy weight (P W i;t ). 2.2 Sophistiction of pension funds Hedge funds represent one ctegory of lterntive ssets in which pension funds invest. Rel ssets nd privte equity re the two other ctegories. Privte equity funds re funds specilizing in funding innovtion vi corporte cretion (venture cpitl), growth of smll nd mid-sized rms (expnsion) nd the purchse of diverse rms (leverge buyouts). Rel ssets include rel estte investment trusts (REITs), rel estte, commodities nd infrstructure (minly for corportions o ering public services, e.g., nturl monopolies). Tble 3 reports the percentges of privte equity (P RIV i;t ) nd rel ssets (REAL i;t ) in totl ssets s well s the sum of these two components (ALT i;t ). The verge of ALT i;t 11 In ddition, considering the subsmple where P W i;t > 0 (315 observtions); the verge policy weight is 6.49%, the verge e ective lloction is 2.57% nd 46% of observtions in this subsmple hve n e ective lloction equl to 0. 7

8 is 6.45% in the full smple nd 11.15% for pension funds investing in hedge funds. The verges suggest therefore tht pension funds tht invest more in privte equity nd rel ssets hve the incresed incentives or skills to invest in hedge funds. The degree of sophistiction of pension funds cn be evluted more generlly through di erent indictors. De Dreu nd Bikker (2009) suggest tht the home bis in sset lloction revels the "degree of shortsightedness" of investors. Interntionl diversi ction in investment lloction could, therefore, be positively ssocited with the degree of sophistiction of pension funds. Interntionl diversi ction (F OR i;t ) is mesured by the percentge of foreign equities in the equity portfolio. Foreign equities represent 37.64% of the equity portfolio in the full smple nd 43.44% for pension funds investing in hedge funds (Tble 3). Pension funds with lower home bis tend to invest more in hedge funds. Policy weight could lso be informtive with respect to the identi ction of sophisticted funds. Figure 2 represents the percent distribution of policy weights for equities. Policy weights re frequently multiple of 5%. More precisely, the policy weight for equities is xed t 55%, 60%, 65% or 70% for more thn 40% of our smple. De Dreu nd Bikker (2009) suggest tht the use of these ttrctive numbers revels lck of sophisticted method of selecting investments. Indeed, sset lloction models should give n ccurte number, while rounding to the nerest 5% indictes the use of humn judgment. We crete the dummy vrible RND i;t ; which tkes the vlue one if the policy weight for equities is multiple of 5% nd zero otherwise. In the full smple, pproximtely 50% of the observtions round their equity policy weights. In the subsmple of pension funds investing in hedge funds, this percentge is reduced to 30%, which could indicte tht pension funds using n ccurte method to choose equity policy weights lso tend to invest in hedge funds. We consider nl indictor of sophistiction bsed on performnces in trditionl sset clsses, i.e., in xed incomes nd equities. All pension funds hold trditionl ssets, which cn be mnged ctively or pssively nd externlly or internlly. 12 According to the smrt money e ect, sophisticted investors mke smrt choices to identify funds tht subsequently perform well. As result, decisions mde by sophisticted pension funds should led on 12 Pssive mngement corresponds to indexed mngement nd externl mngement corresponds to delegted mngement to third sset mnger. 8

9 verge to better performnces in the core component. We compute dummy vrible SF i tht tkes the vlue one if the pension fund hs n verge return (net of delegtion costs) in the core component higher thn the verge obtined for the full smple. By de nition, pproximtely 50% of pension funds re clssi ed s sophisticted in the full smple using vrible SF i. 13 In the subsmple of pension funds investing in hedge funds, this percentge rises to 58%. The descriptive sttistics provide evidence tht funds tht re smrt in the core component lso tend to invest in hedge funds. 2.3 Portfolio mngement Portfolio mngement is noticebly di erent cross pension funds. Prctices regrding delegtion nd diversi ction cn highlight these di erences. Ownership nd size cn lso ect portfolio mngement, speci clly concerning preferences bout lloctions to hedge funds. The mngement cn be ctive or pssive nd externl or internl. In our dtset, pension funds generlly mnge their ssets through externl nd ctive mngement. Tble 3 shows tht the percentge of ssets under externl nd ctive mngement (EA i;t ) represents on verge pproximtely 70% of totl ssets, both in the full smple nd in the subsmple of pension funds investing in hedge funds. Consequently, the descriptive sttistics do not exhibit cler link between preferences regrding delegtion nd lloction to hedge funds. The degree of diversi ction is ssessed by the sum of the squres of the percentge sset lloctions (DIV i;t ). 14 This mesure is computed in the spirit of Her ndhl index. Tble 3 shows tht the vrible DIV i;t is on verge lower for pension funds investing in hedge funds (0.17) thn in the full smple (0.23). As result, pension funds pursuing higher portfolio diversi ction invest more in hedge funds. Pension funds re owned either publicly or privtely. In the full smple, 259 pension funds (out of 407) re owned privtely, i.e., pproximtely 60% of the pension funds in the 13 This is not exctly 50% becuse the dtset is not blnced. 14 Totl ssets re divided into 7 ctegories (equity, xed income, rel ssets, privte equity, hedge funds, csh, TAA) nd ech ctegory cn be subsequently disggregted into 3 dimensions t most: (i) subctegory (only for equity nd xed income); (ii) internl/externl delegtion; (iii) ctive/pssive delegtion. Subctegories refer to geogrphicl criterion (US, Cnd, EAFE, Emerging, etc.) or n sset speci city (high yield bonds, mortgge bonds, etc.). 9

10 dtset. A similr division is observed in the subsmple of pension funds investing in hedge funds, with 48 pension funds (out of 86) re owned privtely. Tble 3 reports descriptive sttistics for the subsmple of privte pension funds. These sttistics re similr to those obtined for the full smple, which suggests tht privte nd public pension funds shre severl chrcteristics. For exmple, lloction to hedge funds (HF i;t ) is on verge similr in the full smple nd in the subsmple of privte funds. When pension funds invest in hedge funds, the verge lloction is 4.57% in the full smple nd 4.33% in the subsmple of privte funds. The size of investors is frequently informtive for n understnding of investment policies. The verge of totl ssets for the pension funds in the full smple is $10,878 million. Pension funds investing in hedge funds re signi cntly lrger with n verge of totl ssets of $22,802 million. Therefore, size e ect could hve n e ect on the investments pension funds mke in hedge funds. 2.4 Costs nd returns Delegtion costs for lterntive ssets under externl nd ctive mngement (DCi;t AEA ) re prticulrly high. On verge, these delegtion costs re 1.77% in the full smple nd 1.84% for pension funds investing in hedge funds. Delegtion costs for equity (DC E i;t), the min sset of pension funds, re round 0.30%. Pension funds therefore fce delegtion costs 5 or 6 times higher when they decide to invest in lterntive ssets under externl nd ctive mngement rther thn in equity. In ddition, the stndrd devition of the vrible DC AEA i;t is high, suggesting tht pension funds do not fce similr conditions when investing in lterntive ssets. These prohibitive costs cn be explined by severl fctors. Most hedge funds strtegies use high trding volume with gret del of opertionl support nd incur importnt reserch (front o ce) costs. Moreover, hedge funds re often smll entities with few employees (Cumming nd Di, 2007). They re typiclly clled "boutiques". Hedge funds mngers re therefore more eger to concentrte their e orts on the front o ce tsks (to bene t from opportunities) thn dministrtive tsks. Hedge funds tend to delegte other opertions to specilized services providers (dministrtion, IT, bck o ce, middle o ce, complince 10

11 services, legl services, etc.). These services do not require the prticulr expertise of hedge funds mngers. They re more the business of investment bnkers. This incresing externliztion of supporting services/ctivities hs two consequences: n increse in the costs of delegtion mngement nd more di cult monitoring resulting from lengthening of the investment chnnel with more numerous intermedites (see KPMG (2008) for survey of hedge fund cost structures). Tble 3 shows tht the verge return from hedge fund investments (R HF i;t ) is 2.41%. However, the verge vlue results from voltile returns; the stndrd devition is very high. For exmple, the verge return reched 12.73% in 2003 nd fell to % in Chrcteristics of pension funds llocting in hedge funds The chrcteristics of the pension funds investing in hedge funds re identi ed with Tobit model. Numerous pension funds do not invest in hedge funds nd the Tobit model llows us to ccount for the censoring of the dt. We consider the di erent vribles stted in the previous section s explntory vribles. 3.1 Empiricl frmework We consider the following empiricl speci ction 15 : 8 < HFi;t if HFi;t > 0 HF i;t = : 0 otherwise (1) with: HF i;t = i + j;t + X 0 i;t + " i;t ; (2) where i N(0; 2 ) is time-invrint individul rndom e ect, j;t is country-nd-time xed e ect, X i;t is the regressor vector (including n intercept), is vector of unknown 15 The subscript i indexes pension funds, t indexes yers nd j indexes countries (Cnd or the US). For simplicity, the subscript j is used only for the country-nd-time xed e ect. 11

12 prmeters nd " i;t N(0; 2 ") is time-vrying idiosyncrtic rndom error. The regressor vector is given by: X 0 i;t = [P RIV i;t 1 REAL i;t 1 F OR i;t RND i;t SF i EA i;t 1 DIV i;t T Y P i SIZE i;t 1 DC AEA i;t R HF i;t 1 C] where C is the intercept nd T Y P i is dummy vrible tht tkes the vlue 1 if the pension fund is publicly owned nd 0 otherwise. Vribles P RIV i;t 1 ; REAL i;t 1 ; EA i;t 1 nd SIZE i;t 1 re included with lg to void simultneity nd endogeneity problems. Furthermore, we compute the vrince in tion fctors (VIF) to ssess whether there is collinerity problem between the regressors. The verge VIF is 1.30 nd the mximum is 1.78, which suggests tht the regressors re independent. The model is rst estimted with the rndom-e ects mximum likelihood estimtor (MLE). 16 This estimtor ssumes tht rndom e ects re independent of the regressors. This ssumption is relxed with the Mundlk (1978) correction, which supposes tht unobserved heterogeneity is function of the mens of the regressors. In second speci ction including the Mundlk (1978) correction, rndom e ects re de ned s: i = X 0 i +! i ; (3) where is vector of unknown prmeters nd! i N(0; 2!) is time-invrint individul rndom e ect: Eqution (3) llows us to tckle the correltion between unobserved e ects nd the regressors in the Tobit frmework. The estimted coe cients mesure the mrginl e ect of the independent vrible on the ltent vrible (HF i;t). We lso report the mrginl e ects for the expected vlue of the dependent vrible conditionl on it being uncensored. Considering the mrginl e ects of the regressors on the observed vrible (HF i;t ) llows for quntittive interprettion of the results. 3.2 Results Results re displyed in Tble (4). Speci ction (1:) corresponds to the estimtions of Eqution (2) with the rndom-e ects MLE. In speci ction (1:b), the Mundlk (1978) correction is included. Including the Mundlk correction does not modify the conclusions. 16 In short pnels, the xed e ects MLE is inconsistent (see Cmeron nd Trivedi (2005)). 12

13 First, lloctions to privte equity nd rel ssets do not ect the lloction to hedge funds in the sme wy. The results show positive nd signi cnt reltionship between privte equity (P RIV i;t 1 ) nd hedge fund lloctions, while rel ssets (REAL i;t 1 ) do not hve signi cnt e ect. More precisely, the estimted mrginl e ects in Tble (4) from speci ction (1:b) show tht 1% increse in the privte equity lloction leds to 0.059% increse in the hedge fund lloction. This result highlights the fct tht privte equity nd hedge funds hve similrities. More nd more hedge funds re turning to speci c investment style: event driven, which is strtegy very similr to tht used in privte equity. Indeed, event driven strtegies involve long or short term investments in the securities of corportions undergoing signi cnt chnge (e.g., spin-o s, mergers, liquidtions nd bnkruptcies). Such chnges often provide mngers with tngible ctlyst by which the mnger my be ble to perceive the expected chnge in vlue in the underlying security. Substntil pro ts my be generted by mngers who correctly nlyze the impct of the nticipted corporte event, predict the course of restructuring nd tke positions ccordingly. In 2010, the event driven strtegy ws tht used the most frequently by hedge fund mngers (HFR, 2010). The di erence between hedge funds nd privte equity is becoming incresingly blurred. Consequently, hedge funds nd privte equity occupy prticulr plce in the clss of lterntives. They re considered to be more risky strtegies thn rel ssets re. Pension funds tht invest in rel ssets re less interested in superior returns thn in protection ginst in tion becuse pension bene ts re in rel terms (Alestlo nd Puttonen, 2005). Rel ssets tend to be plced mong the trditionl sset clsses. According to the de nition used by CEM Benchmrking, rel ssets re included in rel estte nd infrstructure. These ssets incorporte bond nd stock chrcteristics becuse of rent nd right of use, respectively, nd by the vrition in sset vlue. Second, concerning sophistiction indictors, we nd positive nd signi cnt e ect for the vrible F OR i;t (relted to home bis) nd SF i (relted to performnce in the core component), while the use of ttrctive numbers in the policy weights (the vrible RND i;t ) does not hve signi cnt impct t the 10% level. As result, sophisticted pension funds chrcterized by lower home bis nd better performnce in trditionl ssets invest more in hedge funds. More precisely, the estimted mrginl e ects for speci ction (1:b) show 13

14 tht 1% increse in the proportion of foreign equities in the equity portfolio leds to 0.010% increse in hedge fund lloctions. Smrt pension funds, identi ed by the vrible SF i, invest 0.488% more in hedge funds. Additionlly, contrry to wht one might expect from the descriptive sttistics, unsophisticted pension funds tht round their policy weights re not signi cntly less involved in hedge funds. De Dreu nd Bikker (2009), who investigte strtegic bond lloctions (i.e., in unsophisticted ssets) for Dutch pension funds, nd tht this indictor is relevnt to explntions of the behvior of pension funds. Third, severl vribles relted to the portfolio mngement signi cntly ect lloction to hedge funds. Pension funds tht re more involved in externl nd ctive delegtion (EA i;t 1 ) nd more diversi ed (DIV i;t ) invest signi cntly more in hedge funds. For exmple, the estimted mrginl e ects for speci ction (1:b) show tht 1% increse in the proportion of ssets under n externl nd ctive delegtion leds to 0.016% increse in hedge fund lloctions. The positive e ect of vrible EA i;t 1 might result from the doption of core-stellite mngement by pension funds beginning in 2000 nd prticulr interest in hedge funds in the stellite component. Furthermore, we nd size e ect. The vrible SIZE i;t 1 hs positive nd signi cnt e ect. The estimted mrginl e ects for speci ction (1:b) show tht hedge fund lloctions increse by 0.342% when the log of totl ssets increses by 1. This result con rms tht mngement delegtion in lterntive ssets implies long nd costly process of selecting hedge funds or style of hedge funds. Lrge pension funds re therefore in better position to invest in hedge funds (Rigot nd Tdjeddine, 2010). Finlly, concerning ownership, the coe cient of vrible T Y P i is not signi cnt t the 10% level. The exible prudent mn rule is more nd more frequently pplied by public pension funds, even though some restrictive quntittive rules remin. This trend could explin why we do not nd di erences between the regultory frmeworks for public nd privte pension funds. Lstly, the descriptive sttistics showed tht delegtion costs for lterntive ssets under externl nd ctive mngement (DCi;t AEA ) re prticulrly high on verge. We nd tht this vrible hs negtive nd signi cnt coe cient. This result suggests tht costs mtter for lloctions to hedge funds. Conversely, pst performnce does not seem relevnt. The lgged return from hedge fund investments (R HF i;t 1) does not hve signi cnt e ect. The estimted 14

15 mrginl e ects in speci ction (1:b) show tht 1% increse in vrible DC AEA i;t leds to 0.105% decrese in hedge fund lloctions. Pension funds with lower mngement costs invest more in hedge funds. We cn presume tht some pension funds re more ble to negotite these costs for lterntive ssets. 17 Indeed, focusing on hedge funds, the contrct between hedge fund mngers nd their investors is speci c (concerning for exmple informtion disclosures, liquidity conditions nd performnce fees). There is no stndrdized contrct becuse hedge funds re not regulted like the other mutul funds. In the nme of the importnce of contrctul freedom, contrctul terms re minly de ned by co-contrctors. Consequently, the degree of trnsprency, liquidity nd the terms of performnce re the result of the blnce of power between hedge fund mngers nd pension fund dministrtors. In this contrctul frmework, some pension funds cn demnd more relevnt nd detiled informtion nd negotite contrctul terms relted to fees. For exmple, lrge pension funds nturlly hve greter brgining power (Rigot nd Tdjeddine, 2010). However, the subprime crisis hs reveled tht this blnce of power ws rther in the hedge funds fvor. Indeed, until the crisis, pension funds tended to trust their hedge fund mngers (e.g., they did not negotite contrctul terms or require the disclosure of informtion disclosures) s long s the hedge fund s performnce ws high nd decorrelted. This pssive behvior prevents pension funds from mking good risk evlution, nd my be prejudicil becuse pension funds re institutionl investors tht collect svings from employees ( nl investors) to py long term retirement bene ts. The lrge losses registered by pension funds in their hedge fund lloctions in 2008 hve induced mistrust nd hve incited pension funds to negotite lower fees, shorter lockup periods nd more informtionl disclosures s well s the use of independent service providers to monitor returns (Shbd, 2009). In conclusion, the typicl pension fund tht invests in hedge funds is lrge privte sophisticted pension fund tht diversi es its portfolio cross numerous clsses (in privte equity in prticulr), uses core-stellite orgniztion nd hs ccess to low delegtion costs for lterntive ssets. Now tht we hve identi ed the chrcteristics of the pension funds llocting to hedge funds, we cn consider the potentil bene ts of this lloction. 17 Bikker nd De Dreu (2009) nd tht economies of scle exist for lrgest pension funds with regrd to investment costs. 15

16 4 Returns nd lloction to hedge funds We investigte the reltionship between the globl returns obtined by pension funds nd their lloctions to hedge funds. First, we could expect direct e ect. Investments in hedge funds re mde both to generte positive "lph returns" nd for sset diversi ction, which could led to positive e ect on globl returns. However, the high costs tht pension funds incur by investing in hedge funds nd the reltively low lloctions to hedge funds might weken this reltionship. Indeed, hedge funds hve speci c governnce (i.e., contrctul terms) with their investors. Moreover, they purportedly generte lph returns vi complex strtegies nd the use of nncil instruments tht re not llowed for mutul funds, such s leverge nd short selling. Consequently, these investments re more risky nd more expensive. Second, we could lso expect n indirect e ect. As stted in the descriptive sttistics nd in the previous section, pension funds investing in hedge funds re more diversi ed, more sophisticted nd lrger. All the bene cil spects these chrcteristics hve on globl returns could be cptured through lloction to hedge funds. 4.1 Empiricl frmework We consider the following empiricl frmework: R i;t = ' 1 HF i;t + ' 2 T Y P i;t + j;t + i + u i;t (4) where R i;t is the globl net return obtined from the whole portfolio, j;t is country-ndtime xed e ect, i is time-invrint individul e ect nd u i;t N(0; 2 u) is time-vrying idiosyncrtic rndom error. 18 The Husmn test is implemented to determine if i should be considered s n individul xed-e ect or s n individul rndom e ect. Eqution (4) llows us to test if lloction to hedge funds hs signi cnt e ect on the globl return fter controlling for ownership (T Y P i;t ), country-nd-time ( j;t ) nd individul 18 More precisely, R i;t represents the verge return minus the verge cost obtined from the equity, xed income, rel ssets, privte equity nd hedge fund portfolios. 16

17 ( i ) e ects. Alterntively, Eqution (4) is estimted with the vrible hf i;t dummy vrible tht tkes the vlue 1 if the pension fund invests in hedge funds nd 0 otherwise insted of HF i;t : Bene cil spects on globl returns could be relted to the decision to invest in hedge funds rther thn the proportion llocted to hedge funds. Therefore, considering hf i;t insted of HF i;t llows us to identify if the e ect of hedge funds on globl returns is direct (i.e., relted to the proportion llocted) or indirect (i.e., relted to the decision to llocte). The distinction between the direct nd indirect e ects is lso ssessed with modi ction of the endogenous vrible in Eqution (4). We de ne Ri;t 0 s the net return obtined from the sub-portfolio excluding lloctions to hedge funds. As result, considering vrible Ri;t 0 insted of R i;t in Eqution (4) removes the potentil direct e ect of the lloction to hedge funds tht one might expect. A positive reltionship between HF i;t (or hf i;t ) nd Ri;t 0 could only be explined by n indirect e ect. Finlly, we consider the net return in the core component (Ri;t) c s n endogenous vrible to investigte whether pension funds investing in hedge funds outperform other pension funds, even in the core component. Indeed, the bility of pension funds investing in hedge funds to mke smrt choices in selecting funds lso concerns investments in trditionl ssets. 4.2 Results Tble (5) displys the results obtined with the rndom e ect estimtor. The Husmn test indictes tht this estimtor is consistent. Furthermore, controlling for ownership, countrynd-time nd individul e ects explin the reltively high R 2 vlue: Speci ction (2:) in Tble (5) shows tht lloction to hedge funds (HF i;t ) hs positive nd signi cnt e ect on globl returns (R i;t ). The estimted coe cient is In speci ction (2:b) the vrible hf i;t is used insted of HF i;t identify whether the e ect is direct or indirect: We lso obtin positive nd signi cnt coe cient. Globl returns re, on verge, higher for pension funds investing in hedge funds. More precisely, globl returns increse by %. The bene cil spects of hedge funds therefore seem to be relted to the decision to invest in hedge funds nd not especilly to the proportion of the lloction. In speci ctions (2:c) nd (2:d), vrible Ri;t 0 is used s endogenous vrible to con- 17

18 rm the importnce of the indirect e ect. The proportion invested in hedge funds nd the decision to invest in hedge funds both hve positive nd signi cnt e ect on the net returns obtined from the sub-portfolio excluding lloctions to hedge funds. In prticulr, net returns in the sub-portfolio (Ri;t) 0 is % higher for pension funds investing in hedge funds. Consequently, our results re primrily driven by n indirect e ect. Pension funds investing in hedge funds combine severl chrcteristics tht improve their returns. This e ect illustrtes positive spect resulting from core-stellite orgniztion nd from the sophistiction of pension funds. However, the bene t could be higher if pension funds were to dopt stronger governnce concerning hedge fund delegtion. For exmple, lrge pension funds should use their brgining power to require more disclosures to better evlute hedge funds risks nd lower performnce fees. This is lredy the cse for the biggest US DB public pension fund (ClPERS), which nnounced in 2009 tht it would only enter prtnerships with hedge funds under these renegotited conditions. Finlly, in speci ctions (2:e) nd (2:f), vrible Ri;t c is the endogenous vrible. The proportions invested in hedge funds (HF i;t ) do not signi cntly ect net returns of the core component (Ri;t). c However, we nd positive nd signi cnt reltionship between the decision to invest in hedge funds (hf i;t ) nd Ri;t. c Returns in the core component increse by % for pension funds investing in hedge funds. The incentives nd skills tht led some pension funds to invest in hedge funds therefore lso hve positive e ects on the pension funds bilities to outperform in trditionl ssets. The sophistiction of pension funds does not only mtter for the selection of funds specilizing in lterntive ssets but for the construction of the core component portfolio s well. 5 Conclusion Institutionl investors hve hd n incresing interest in hedge funds since the beginning of the 2000 s due to their promises of high nd decorrelted returns. In this pper, we investigte the chrcteristics of pension funds llocting to hedge funds, nd we question the potentil bene ts of these speci c lterntive investments. We nd evidence tht the typicl pension fund investing in hedge funds is lrge, sophisticted pension fund tht 18

19 diversi es its portfolio cross numerous clsses (in privte equity in prticulr), uses corestellite orgniztion nd hs ccess to low delegtion costs for lterntive ssets. Moreover, our results emphsize the bene cil spect of investments in hedge funds in terms of returns. This positive e ect is more due to the decision to invest in hedge funds thn to the size of the lloction or the return on the hedge fund investments. Consequently, this bene cil spect is minly driven by n indirect e ect. Pension funds investing in hedge funds combine severl chrcteristics tht positively ect their returns such s improved diversi ction. Recent nncil disturbnces hve shown, however, tht hedge funds re not unsinkble. Losses in hedge fund lloctions were higher thn those llocted to privte equity nd rel ssets. 19 Speci c gency problems in hedge fund delegtion nd certin pssivity in the behvior of pension funds could explin this lower performnce. Bene ts could therefore be higher if pension funds were to dopt stronger monitoring concerning their delegtion to hedge funds. Privte mislloctions induced by such informtionl symmetries my hve detrimentl consequences in the cse of pension funds becuse the retirement bene ts of millions of employees re t stke (the consequences include incresed contributions nd/or decresed bene ts). These issues relting to the lck of trnsprency in the hedge fund industry were so prominent in the crisis tht regultory uthorities decided to chnge hedge fund regultions. They recognized tht the opcity of hedge funds my led to predictble dmges: mislloctions t the micro level nd incresing nncil instbility nd systemic risk t the mcro level. For the rst time since the beginning of the hedge fund industry in the 1950 s, drft hedge fund drft regultions were promulgted in the Europen Union (EU) nd the US. The rst is speci c to hedge funds, while the second is prt of comprehensive US nncil reform. 20 In spite of di erences in hedge fund regultions between the US nd the EU (Rigot nd Tdjeddine, 2010), modi ction in investors behvior towrds hedge fund mngers is ll the more crucil, s pension funds continue to llocte to hedge funds. 19 In 2008, the returns on privte equity nd rel sset lloctions were between -5% nd 10%. 20 Directive of the Europen Prliment nd Council on Alterntive Investment Fund Mngers; (AIFM) Second Proposl with mendments November 2009 (Guzes report); Directive of the Europen Prliment nd Council on Alterntive Investment Fund Mngers (AIFM) Finl Proposl My 2010; US Tresury nncil regultion reform, Geithner Pln (June, 2009); Finncil reform, frmework for nncil stbility, Volcker pln (Jnury 2010); US Finncil reform bill, (July 2010) 19

20 References Ackermnn, C., McEnlly, R. nd Rvenscrft, D. (1999). The Performnce of Hedge Funds: Risk, Return, nd Incentives. Journl of Finnce 54(3), Agrwl, V. nd Nik, N. (2000). Generlised Style Anlysis of Hedge Funds. Journl of Asset Mngement 1(1), Agrwl, V. nd Nik, N. (2000b). On Tking the Alterntives Routes, Risk Rewrds, Performnce Persistence of Hedge Funds. Journl of Alterntive Investments 2(4), Agrwl, V. nd Nik, N. (2004). Risks nd Portfolio Decisions involving Hedge Funds. Review of Finncil Studies 17(1), Agliett, M. nd Rigot, S. (2009). Crise et rénovtion de l nnce. Pris: éditions Odile Jcob. Alestlo, N. nd Puttonen, V. (2006). Asset Alloction in Finnish Pension Funds. Journl of Pension Economics nd Finnce 5(1), Amenc, N., Curtis, S. nd Mrtellini, L. (2003). The Alph nd Omeg of Hedge Fund Performnce Mesurement. EDHEC, Working Pper. Amin, G. nd Kt, H. (2002). Stocks, Bonds nd Hedge Funds: Not Free Lunch! University of Reding, ISMA Discussion Ppers in Finnce Buer, R., Cremers, M. nd Frehen R. (2010). Pension Fund Performnce nd Costs: Smll is Beutiful. MPRA Pper No Bikker, J nd De Dreu, J. (2009). Operting costs of pension funds: the impct of scle, governnce, nd pln design. Journl of Pension Economics nd Finnce 8(1), Brown, S., Goetzmnn, W. nd Ibbotson, R. (1999). O shore Hedge Funds: Survivl nd Performnce Journl of Business 72(1), Cmeron, C. nd Trivedi, P. (2005). Microeconometrics: Methods And Applictions. New York: Cmbridge University Press. 20

21 Cumming, D. nd Di, N. (2007). A Lw nd Finnce Anlysis of Hedge Funds. Finncil Mngement 39(3), Dvis, E. nd Hu, Y. (2009). Should Pension Investing be Regulted? Rotmn Interntionl Journl of Pension Mngement 2(1), De Dreu, J.nd Bikker, J. (2009). Pension Fund Sophistiction nd Investment Policy. DNB, Working Pper 211. Fvre, L. (2006). The Bene ts of Hedge Funds: 2006 Updte. Center for Interntionl Securities nd Derivtives Mrkets, Working Pper. French, K. (2008). Presidentil ddress: The Cost of Active Investing. The Journl of Finnce 63(4), Fung, W. nd Hsieh, D. (2000). Performnce Chrcteristics of Hedge Funds nd CTA Funds: Nturl versus Spurious Bis. Journl of Finncil nd Quntittive Anlysis 35(3), Fung, W. nd Hsieh, D. (2002). Benchmrks of Hedge Fund Performnce: Informtion Content nd Mesurement Bises. Journl of Alterntive Investments 58(1), Khnniche, S. (2008). Mesurer le risque des hedge funds. Groupm-Asset Mngement, Working Pper. KPMG LLP. (2008). Hedge Fund Cost Survey. Finncil Advisory Services, September Mundlk, Y. (1978). On the Pooling of Time Series nd Cross-Section Dt. Econometric 46(1), OECD (2007). Pension Mrkets in Focus 4. OECD report, November OECD (200). Pension Mrkets in Focus 5. OECD report, December McKinsey & Compgny. (2007). The New Power Brokers: How Oil, Asi, Hedge Funds nd Privte Equity re Shping Globl Cpitl Mrkets. McKinsey Globl Institute. 21

22 Preqin Ltd. (2008). Overview of the Globl Hedge Fund Institutionl Investor Universe: Specil Report, November Preqin, Ltd. (2010) Preqin Alterntives Investment Consultnt Review. Rigot, S. nd Tdjeddine, Y. (2010). Emergence of New Regultion: Informtionl Disclosure Modlities in The Hedge Fund Opcity World. Interntionl Economics 123, Schneeweis, T. nd Mrtin, G. (2001). The Bene ts of Hedge Funds: Asset Alloction for the Instutitionl Investor. Journl of Alterntive Investments 4(3), Shdb, H. (2009). The Lw nd Economics of Hedge Funds: Finncil Innovtion nd Investor Protection. Berkeley Business Lw Journl 6(1), Shrpe, W. nd Tint, L. (1990). Libilities: New Approch. Journl of Portfolio Mngement 16(2), U.S. Government Accountbility O ce (GAO) (2008). Hedge Funds Regultors nd Mrket Prticipnts re Tking Steps to Strengthen Mrket Discipline but Continued Attention is Needed. Report to Congressionl Requesters, GAO , Jnury

23 Figure 1: Percent distribution of HF i;t for the subsmple of pension funds investing in hedge funds Percent Alloction in Hedge Funds Source: CEM benchmrking dtbse Figure 2: Percent distribution of the equity policy weight for the full smple Percent Equity Policy weight Source: CEM benchmrking dtbse 23

24 Tble 1: Averge portfolio lloction ( ) (% totl ssets) Equity Fixed Income Rel Assets Privte Equity Hedge Funds Other Full smple (1976 observtions) Men Stndrd Devition Min / Mx 0/ / / / / /39.82 Subsmple of pension funds investing in hedge funds (267 observtions) Men Stndrd Devition Min / Mx 0/ / / / / /19.58 Note: Ctegory Other merges lloctions in csh nd TAA. Source: CEM benchmrking dtbse. Tble 2: Brekdown of pension funds by yer No. of Pension Funds % investing in hedge funds Averge lloction % investing in rel ssets Averge lloction % investing in privte equity Averge lloction Note: Averge lloction is expressed in % of totl ssets. Source: CEM benchmrking dtbse. 24

25 Tble 3: Generl descriptive sttistics : men nd stndrd devition All funds HF i;t 0.61 (2.56) Full smple Funds with HF i;t > (5.55) Subsmple of privte funds All Funds with funds HF i;t > (2.16) 4.33 (4.13) P W i;t 1.03 (3.24) 4.62 (6.01) 1.27 (3.84) 5.76 (6.94) P RIV i;t 2.43 (3.68) 4.98 (4.14) 2.28 (3.55) 5.16 (4.40) REAL i;t 4.01 (4.24) 6.16 (5.05) 3.06 (3.77) 5.07 (4.46) ALT i;t 6.45 (6.48) (7.21) 5.34 (5.91) (6.91) F OR i;t (15.77) (17.12) (16.11) (13.12) EA i;t (26.75) (29.39) (26.11) (23.46) DIV i;t 0.23 (0.08) 0.17 (0.06) 0.24 (0.08) 0.19 (0.07) T A i;t (23162) (38083) 5495 (10829) (21206) DC AEA i;t 1.77 (2.03) 1.84 (1.19) 1.70 (1.63) 1.71 (1.31) DC E i;t 0.30 (0.15) 0.33 (0.20) 0.33 (0.14) 0.36 (0.15) R HF i;t 2.41 (13.91) 2.94 (13.97) No. funds Obs Note: Stndrd devitions re in brckets. Descriptive sttistics for vrible DC AEA i;t re computed for pension funds which invest in lterntive ssets under externl nd ctive mngement. Source: CEM benchmrking dtbse. 25

26 Tble 4: Alloction to hedge funds: estimted coe cients nd mrginl e ects (M.E.) Endogenous vrible : HF i;t (1:) (1:b) Coe M.E Coe M.E P RIV i;t 1 0:418 0:066 0:398 0:059 (0:158) (0:024) (0:124) (0:018) REAL i;t 1-0:101 (0:133) -0:016 (0:021) -0:125 (0:080) -0:018 (0:011) F OR i;t b 0:084 b 0:013 0:066 0:010 (0:037) (0:005) (0:025) (0:003) RND i;t -0:370 (0:626) -0:058 (0:098) 0:111 (0:539) 0:016 (0:080) SF i 2:845 0:447 b 3:317 0:488 (0:583) (0:091) (1:346) (0:198) EA i;t 1 0:067 0:010 0:112 0:016 (0:021) DIV i;t -18:062 (4:953) (0:003) -2:876 (0:787) (0:028) (0:004) -15:415-2:306 (4:883) (0:732) SIZE i;t 1 1:701 0:270 c 2:287 0:342 (0:367) T Y P i -0:253 (0:710) DC AEA (0:058) -0:040 (0:111) c i;t -0:582-0:092 (0::325) R HF i;t 1 0:037 (0:325) (0:051) 0:005 (0:004) (1:387) -1:232 (1:159) c -0:706 (0:222) 0:038 (0:029) (0:208) b c -0:183 (0:171) -0:105 (0:033) 0:005 (0:004) Country-nd-time e ect Yes Yes Yes Yes Mundlk s correction Yes Yes Obs Uncensored Log likelihood sttistic [p vlue] [0:00] [0:00] [0:00] [0:00] Pseudo R LR test [p vlue] 573 [0:00] 573 [0:00] 555 [0:00] 555 [0:00] Note:, b nd c indicte signi cnce respectively t the 1%, 5% nd 10% levels. Stndrd devitions re in brckets. Stndrd devitions reported in the tble correspond to the bootstrped stndrd devitions. 26