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

Transcription

1 Pension funds lloction to hedge funds: n empiricl nlysis on US nd Cndin de ned bene t plns Vincent Bouvtier y Sndr Rigot z Preliminry drft Jnury 2011 Abstrct This pper investigtes the chrcteristics of US nd Cndin pension funds llocting in hedge funds. The typicl pension fund which invests in hedge funds is lrge sophisticted pension fund which diversi es its portfolio in numerous clsses, in prticulr in privte equity, uses core-stellites orgniztion nd hve ccess to low delegtion costs for lterntive ssets. Moreover, we nd tht pension funds investing in hedge funds obtined signi cntly higher globl returns. JEL clssi ction: G23 Keywords: pension fund, hedge fund Remerciements y EconomiX, Université de Pris Ouest - CNRS, 200 Avenue de l République, Nnterre Cedex, Frnce. E-mil: vbouvtier@u-pris10.fr z EconomiX, Université de Pris Ouest - CNRS, 200 Avenue de l République, Nnterre Cedex, Frnce. E-mil: sndrrigot@club-internet.fr 1

2 1 Introduction Since 2000, we observe huge expnsion of the hedge fund industry. The globl hedge fund industry grew t record pce from n estimted $491 billion in 2000 in ssets under mngement to pek of $1.93 trillion in mid-yer This growth cn be explined by severl demnd nd supply resons: dvnces in technology, the derivtives revolution, poor equity mrket performnce, low interest rtes nd the pension plns troubles meeting their libilities. The lst one relted to the chnge in clients structure of hedge funds 1 seems to be mong the most importnt fctors. Indeed, since 2000, there is considerble nd growing number of institutionl investors which hve invested in lterntive ssets nd in hedge funds in prticulr 2, while 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 3 registered the highest nnul growth rte. This trend my be explined by the fct tht pension funds hve been looking for higher sources of return nd for better portfolio diversi ction fter the stock mrket crsh in nd the decrese of longterm interest rtes. Pension funds tried to diversify their portfolios to void substntil losses during lrge downturns in the equity nd bond mrkets, s for exmple, the Asin crisis in 1997 or the new economy bubble crsh in During those phses, lterntive investments re supposed to diversify portfolios, becuse their return drivers di er from the equity nd bond mrkets drivers (Schneeweis, Kzemi nd Mrtin, 2001). The hedge funds industry seemed prticulrly ttrctive becuse of its objectives of high nd llegedly uncorrelted returns. Bene ts of investing in hedge funds my come from "lph return" or decrese in "bet". Fung nd Hsieh (2000) s well s Amenc, Curtis nd Mrtellini (2003) summrize the resons for investing in hedge funds. The rst reson ddresses the hedge fund mngers exibility 1 For the rst time in 2007, institutionl investors ccounted for more thn 50% of hedge funds in ows (Mc Kinsey, 2007). 2 Contrry to privte equity nd rel ssets investments, hedge funds lloction hs only ppered in the 2000 s. 3 Fund of funds re collective investment vehicles which llocte ssets to severl hedge funds in order to get bene t through diversi ction of dvntges. As generl rule, they re mnged by privte bnks, mutul funds or institutionl ssets mngers. 2

3 due to their less regulted investment vehicles to exert their skills nd expertise in the ttempt to generte positive "lph returns". The second reson focuses on the low correltions of hedge fund returns with trditionl sset clsses. The risk premiums of hedge funds strtegies re in generl wekly correlted with equity or xed income risk premiums. More precisely, hedge funds hve been described s skill-bsed investment strtegies. In other words, their returns re obtined from the unique skill or strtegy of the trder. However, Fung nd Hsieh (2002) show tht hedge funds returns re lso driven systemticlly by mrket fctors such s chnges in credit spreds or mrket voltility, rther thn exclusively by n individul mnger s lph. As result, hedge funds returns re combintion of mnger skill nd n underlying return to the hedge fund strtegy or investment style itself (Fvre, 2006). In ddition, higher investment returns of hedge funds re lso explined by the higher risk of investment strtegies. Indeed, to perform systemtic return, hedge funds re engged in broder set of sophisticted strtegies (using leverge nd innovtive - nncil instruments like short selling) thn more restricted sset mngers (mutul funds). Moreover, hedge funds enjoy very exible regultory frmework in terms of investment ctivities nd disclosure requirements. Finlly, they enjoy exible governnce concerning delegtion contrct provisions becuse of high fees, lock up periods, lck of privte nd public informtion (Shbd, 2009). In theory nd prctice, the bene ts of hedge funds re lmost lwys explined by shift in the e ciency line in men-vrince environment. The superiority of hedge funds over trditionl investments, such s bonds nd equities, is justi ed by their better riskdjusted returns (Fvre 2002). Consequently, institutionl investors consider two vribles to evlute bene ts of hedge funds: return nd stndrd devition vi Shrpe rtio s n indictor of risk djusted return. Over the period , Shrpe rtios seem very ttrctive (Khnniche, 2008, 2010) in comprison with stocks nd bonds indices. These results re in line with some empiricl investigtions regrding the performnce persistence of hedge fund mngers. For exmple, Agrwl nd Nik (2000, 2000b) nd evidence for performnce persistence. However, cdemic literture showed mixed results: Brown, Goetzmnn nd Ibbotson (1999) nd contrry picture. The di erences in the conclusion cn be ddressed to di erent dtbses, investigtion periods, performnce mesures nd 3

4 sttisticl methodologies. The growing interest of pension funds for hedge funds hppens in more globl context. Pension funds stedily reorgnized their mngement in order to improve their strtegic sset lloction (policy lloction). They implement core-stellite orgniztion which comes from sset-libilities mngement (Shrpe nd Tint, 1990). This orgniztion is known to be n e cient strtegy to diversify portfolio by ctive mngement (Amenc et lii, 2004). It consists in de ning strtegic sset lloction nd to divide ssets in two components: core nd stellite. The rst one (75%-90%) ims t mtching libilities of pension funds vi immuniztion techniques. The objective is to void risk relted to the vribility of the sset of pension funds. The core is generlly invested in trditionl sset clsses in liquid mrkets (lrge cps, bonds... ) nd ssets cn be mnged in n ctive/pssive wy, s well s internlly nd externlly. The second one (10%-25%) looks for higher performnce (by generting lph positive returns) nd better diversi ction of risk (by improving bet). This component is usully invested in lterntives ssets (rel estte, hedge funds, privte equity, infrstructures... ) which require very ctive mngement vi sophisticted strtegies. Among these stellites, hedge funds hve known n incresing success during the lst decde. Stellites exclusively use externl mngement becuse this ctive investment requires speci c expertise given the bsence of benchmrk nd liquid mrkets. Delegtion hs incresed in the sme time institutionl ssets were invested in nontrditionl sset clsses. The core-stellite orgniztion contributes to the sophistiction of pension fund lloction. However stellites mngement which is lwys delegted requires stronger governnce. Indeed, becuse externl mngers use sophisticted strtegies nd there is no benchmrk nd no mrkets, the monitoring of risk is more di cult for pension funds. In hedge funds, for instnce, mngers re often less regulted thn mngers of trditionl sset clsses which cn lso led to higher risk exposures. Until the nncil crisis of 2008, this legl regime ws ccepted by pension funds, in exchnge of diversi ction nd higher returns, s well s by mrket supervisors s wy to promote informtionl e ciency, nncil innovtion nd liquidity in mrkets (Dnielsson 4

5 nd Zigrnd, 2006). This point of view is in fct in line with the one of pension funds supervisors. Indeed the federl government does not speci clly limit or monitor privte sector de ned bene t plns 4 investment in hedge funds nd Stte pproches to public pension plns vry. Under the Employee Retirement Income Security Act (ERISA) of 1974, duciries (pension fund dministrtors) must comply with stndrd of prudence (including diversifying ssets nd minimizing the risk of lrge losses), but there is no explicit restrictions on the lloction to hedge funds. The prudent mn stndrd does not explicitly prohibit investment in ny speci c ctegory of investment. An unsuccessful individul investment is not considered s per se violtion of the prudent mn stndrd. This is the pln duciry s overll mngement of the pln s portfolio which is evluted under the stndrd 5. However, ERISA my indirectly limit pension pln s bility to invest in speci c hedge funds. If the ggregte investment by bene t pln investors in the equity interest of prticulr entity is "signi cnt" (>25%) nd tht equity interest is not publicly-o ered security, issued by registered investment compny, such s mutul fund, then the person who exercises mngement uthority over the entity now deemed to hold pln ssets will become subject to ERISA s duciry stndrds. This duciry responsibility requires them to ct prudently in mnging pension pln money. Consequently, in order to void being deemed pln duciry (nd ssuming ll of the libilities tht ccompny tht sttus), mny mngers of hedge funds 6 crefully monitor the level of investments in the hedge fund by bene t pln investors to ensure tht their ggregte investment remins below the 25 % threshold. The Pension Protection Act of 2005 proposed number of chnges to the US privte pension regultion. 4 We cn clssify pension funds by two criteri which cn be mixed: the rst one is linked to bene t which cn be de ned or not nd the second one is relted to the 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. Federl government monitor privte sector DB pln investment nd stte lw monitor DB public investments. 5 In ddition, the stndrd focuses on the process for mking investment decisions, requiring documenttion of the investment decisions, due diligence, nd ongoing monitoring of ny mngers hired to invest pln ssets. 6 Hedge funds generlly re not publicly-trded, not registered investment compnies, nor operting compnies. 5

6 The mesure llows for up to 50% of hedge fund s ssets to be from ERISA-governed plns. While Sttes generlly impose prudent mn stndrd similr to ERISA s on pln duciries, some Sttes still hve policies tht restrict or prohibit by lws pension pln investment in hedge funds or privte equity or some trding strtegies. According to PERAC (Public Employee Retirement Administrtion Commission), this limittion 7 exists becuse hedge funds re reltively new investments for pension plns nd becuse they require high levels of due diligence nd expertise tht my be excessive for smller plns. However, ccording to US GAO (2008), Stte regultion of DB public pension pln investments hs become generlly more exible such s doption of the prudent mn stndrd. Even if hedge funds re considered by supervisors to hve globlly positive in uence on nncil mrkets, the light regultion of hedge funds nd their speci c governnce rise issues beyond those posed by trditionl investments funds. These chllenges include issues with lck of trnsprency, liquidity, pricing, fees nd frud. Indeed, there is limited informtion on hedge fund s underlying ssets nd vlution. Hedge funds hve speci c governnce which limit n investor s bility to redeem n investment in hedge fund for de ned period of time (most hedge funds hve t lest one yer lock up period). Hedge funds impose higher fees 8 which require pln to ern higher gross return to chieve higher net return (Ackermnn et lii, 1999). They often hve brod ltitude to use leverge, which mpli es both potentil gins nd losses nd to engge in complex investment techniques tht cn involve vrious nncil instruments in vrious nncil mrkets. Hedge fund s ctive or risky trding ctivity my result in losses, due to opertionl filure such s trding errors or outright frud (opertionl risk). Moreover, simple men-vrince pproch hs drwbcks mong which the use of only two moments to evlute risk (Shrpe rtio). Some of the most successful hedge funds strtegies disply vulnerbility to extreme losses (negtive skewness nd very lrge kurtosis) which re not tken in ccount by pension funds (Amin nd Kt, 2002; Agrwl et l, 2004; Khnniche, 2008). The rst issue relted to the lck of 7 For exmple, public plns with less thn $25 million in ssets my invest up to 3% of ssets in privte equity nd plns with more thn $25 million my invest up to 5% of ssets in privte equity. PERAC requires plns of either size to obtin PERAC permission before investing in privte equity bove those levels. 8 Investors re chrged 3 types of fees: mngement fees (1%-2%), performnce fees(15%-20%) nd erly termintion fees (1%-2%) in cse of erly liquidtion. 6

7 trnsprency in hedge fund industry is crucil becuse they severely limit the opportunity for oversight. Asymmetricl informtion my induce non optiml individul lloction which could be detrimentl for investors. Indeed, pension funds re di erent from high net worth individul investors who invest with full knowledge of these vehicles judged s risky nd ccept the consequences in terms of losses. At the contrry, pension funds comprise pooled ssets, which re imed to support people s retirement nd millions of retired rely on pension plns for their nncil well-being. As pension funds ply n importnt role in nncil mrkets, there hs been incresing ttention focused on their mngement nd investment prctices nd on pension funds contrctul reltionship of delegtion with their hedge fund mngers. To better understnd this trend nd its implictions, the im of this rticle is rstly to nlyze to wht extent US nd Cndin pension funds llocte to hedge funds nd to identify the min chrcteristics of pension funds investing in hedge funds. Secondly, we investigte implictions for pension funds ssets (potentil bene ts nd chllenges) to llocte in hedge funds. We use unique nd comprehensive dtbse from CEM benchmrking compounded of de ned bene t pension funds over the period Our results show tht the typicl pension fund which invests in hedge funds is lrge sophisticted pension fund which diversi es its portfolio in numerous clsses, in prticulr in privte equity, uses core stellites orgniztion nd hve ccess to low delegtion costs for lterntive ssets. Moreover, we nd evidence of bene cil spect of hedge funds in terms of return. However, this positive e ect is more due to the decision to invest in hedge funds rther thn especilly to the vlue of the lloction or the return of the hedge funds investment. Consequently, this bene cil spect is minly driven by n indirect e ect. Pension funds investing in hedge funds merge severl chrcteristics which positively ect their returns. The reminder of the pper is orgnized s follows. Section 2 presents dt nd descriptive sttistics. Section 3 ssesses the chrcteristics of pension funds llocting to hedge funds. Section 4 investigtes the reltionship between the globl return of pension funds nd their lloction to hedge funds. Section 5 concludes the pper. 7

8 2 Dtset nd descriptive sttistics We use the CEM benchmrking dtbse which provides individul de ned bene t pension plns for the US nd Cnd from 1990 to The dt re relted to ssets under mngement (millions of dollrs); costs nd returns which re vilble by sset clss 9 nd by nture of delegtion (ctive/pssive nd externl/internl); policy sset lloction (%) (i.e strtegic sset lloction, de ned before buy nd sell decisions) nd their expected return which re vilble by sset clss; s well s other informtion regrding globl costs (custody, consulting, oversight). The dtbse lso indictes if the ownership is public or privte. According to Mc Kinsey (2007), OECD (2008) nd US GAO (2008), US de ned bene t (DB) pension funds ccounts for $4250 bilions in Assets under mngement by US pension funds vilble in the CEM benchmrking dtbse ccounts for $2500 billions in 2007, i.e. round the hlf 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 (OCDE, 2004). In 2006, the ssets under mngement of Cndin pension funds were bout $800 billions. The CEM benchmrking dtbse is very representtive since its ccounts for $750 billions in 2006 of ssets under mngement. We focus our empiricl nlysis over the period 2000 to 2008 becuse pension funds strted to llocte to hedge funds from More precisely, we hve n unblnced pnel of 1973 observtions composed by 407 pension funds mong which 86 invest t lest one period in hedge funds. Concerning the geogrphicl reprtition, 274 pension funds in our dtset come from the US nd 72 of these US pension funds invest t lest one period in hedge funds. To our knowledge, informtion provided by the CEM benchmrking dtbse concerning hedge funds lloction hs been rrely used 12 in relted pension fund studies. 9 The totl sset is disgregted in 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 disgregted in subclsses. 10 More precisely, totl ssests mnged by US pension funds represent 9500 bilions $ in 2007 nd round the hlf is mnged by DB pension funds. 11 There is no distinction between hedge funds nd funds of hedge funds lloction in the dtbse. 12 For exmple, French nd Kenneth (2008) compre the fees, expenses, nd trding costs society pys to invest in the U.S. stock mrket 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. 8

9 We present in this section generl descriptive sttistics concerning pension funds lloction to hedge funds. In ddition, we put forwrd severl chrcteristics of pension funds which 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 whole smple nd for two subsmples: the US subsmple nd the subsmple of pension funds investing in hedge funds. We cll this lst subsmple the initite subsmple. The portfolio lloction is very similr in the whole smple nd in the US subsmple. Equities re the min ssets nd ccount for round 60% of the portfolio; following by xed income ssets which reprensent round 30% of the portfolio. The remining of the portfolio is llocted to lterntive ssets, minly rel ssets (round 4%) nd privte equity (round 3%). In the whole smple nd the US subsmple, lloction to hedge funds only represents respectively 0.61% nd 0.72%, indicting both tht numerous pension funds do not invest in hedge funds nd tht the three ctegories of lterntive ssets re di erently considered by pension funds. Focusing on the initite subsmple 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 respectively 6.16% nd 4.98% of totl ssets. These relloction re mde through reduction of equities which ccount for 52.52% of totl ssets. To illustrte more precisely the pension funds lloction to hedge funds (HF i;t ), gure 1 represents the percent distribution of HF i;t for the initite subsmple. For more thn 50% of these pension funds, investment in hedge fund represents less thn 3% of totl ssets. However, severl pension funds re investing more thn 10% of their totl ssets in hedge funds with mximum t 36.69%. Tble 2 gives brekdown of the number of pension funds by yer in the whole smple nd in the US subsmple. In ddition, tble 2 displys the proportion of pension funds investing in the three di erent ctegories of lterntive ssets. The number of pension funds investing in hedge funds is incresing over the yers. From 2000 to 2008, the proportion of pension funds investing in hedge funds incresed from 1.35% to 25.42% in the whole 9

10 smple nd from 0.70% to 29.06% in the US subsmple. Rel ssets nd privte equity re more commonly mnged by pension funds but they lso represent n incresing interest for pension funds. From 2000 to 2008, the proportion of pension funds investing in rel ssets incresed from 69.68% to 78.81% in the whole smple nd from 76.05% to 83.13% in the US subsmple. Concerning privte equity, the proportion incresed from 51.13% to 63.98% in the whole smple nd from 62.67% to 72.67% in the US subsmple. The interest of pension funds in hedge funds could lso be highlighted by the strtegic lloction, lso clled policy weight (P W i;t ). Tble 3 reports some descriptive sttistics for severl vribles used in our empiricl nlysis. The verge policy weight to hedge funds is higher thn the e ective lloction (HF i;t ) nd reches 1.03% in the whole smple nd 1.25% in the US subsmple. Focusing on the initite subsmple, the policy weight nd the e ective lloction seem very close on verge, respectively 4.62% nd 4.57%. 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 initite subsmple observtions 13. As result, the policy weight to hedge funds cn provide distorted representtion of the e ective impliction of pension funds in hedge funds. We focus therefore 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 specilized in innovtion funding vi corportes cretion (venture cpitl), growth of smll nd middle corportes (expnsion) nd the purchse of diverse corportes (leverge buyouts). Rel ssets includes REITs, rel esttes, commodities, infrstructures (minly for corportes o ering public services, e.g. with nturl monopoly). 13 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. 10

11 Tble 3 reports the proportions 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 is 6.45% in the whole smple nd 11.15% in the initite smple. The sme gps re observed in the US subsmple. Averges suggest therefore tht pension funds which invest more in privte equity nd rel ssets hve more incentives or skilled to lso invest in hedge funds. The degree of sophistiction of pension funds cn be evluted more generlly through di erent vribles. De Dreu nd Bikker (2009) suggest tht the home bis in sset lloction revels the "degree of shortsightedness" of investors. The interntionl diversi ction in investment lloction could therefore be positively ssocited to the degree of sophistiction of pension funds. The interntionl diversi ction (F OR i;t ) is mesured by the proportion of foreign equities in the equity portfolio. Foreign equities represent 37.64% of the equity portfolio in the whole smple nd 43.44% in the initite subsmple (tble 3). Pension funds with lower home bis tend therefore to invest more in hedge funds. Policy weight could lso be informtive to identify 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 the lck of sophisticted method for the investment choices. Indeed, sset lloction models should give n ccurte number while rounding to the nerest 5% indictes the use of humn judgement. We crete the dummy vrible RND i;t which tke the vlue one if the policy weight for equities is multiple of 5% nd zero otherwise. In the whole smple, round 50% of the observtions re rounding their equity policy weight. In the initite subsmple, this proportion is reduced to 30% which could indicte tht pension funds using ccurte method to choose equity policy weight tend lso to invest more in hedge funds. 2.3 Portfolio mngement The portfolio mngement is noticebly di erent ccross pension funds. Prctices in terms of delegtion nd diversi ction cn highlight these di erences. The ownership nd the size cn lso ect the portfolio mngement nd more precisely concerning preferences in term 11

12 of lloction to hedge funds. The mngement cn be ctive or pssive nd externl or internl 14. In our dtset, pension funds minly mnge their ssets through n externl nd ctive mngement. Tble 3 shows tht the proportion of ssets under n externl nd ctive mngement (EA i;t ) represents in verge round 70% of totl ssets, both in the whole smple nd in the initite subsmple. Focusing on the US subsmple, the externl nd ctive mngement is slightly more importnt for pension funds investing in hedge funds. Consequently, descriptive sttistics do not exhibit cler link between preferences in terms of 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 ) 15. This mesure is computed in the spirit of Her ndhl index. Tble 3 shows tht vrible DIV i;t is lower in verge in the initite smple (0.17) thn in the whole smple (0.23). As result, pensions funds pursuing higher portfolio diversi ction invest more in hedge funds. Pension funds hve privte or public ownership. In the whole smple, 259 pension funds (over 407) hve privte ownership, i.e round 60% of pension funds in the dtset. The sme kind of reprtition is observed in the US nd initite subsmples with respectively 163 pension funds over 274 nd 48 pension funds over 86 with privte ownership. Tble 3 reports descriptive sttistics for the subsmple of privte pension funds. These sttistics re close to the ones obtined for the whole smple which suggests tht privte nd public pension funds shre severl chrcteristics. For exmple, lloction to hedge funds (HF i;t ) is similr in verge in the whole smple nd in the privte subsmple. When pension funds invest in hedge fund, the verge lloction is 4.57% in the whole smple nd 4.33% in the privte subsmple. The size of investors is frequently informtive to understnd investment policies. The 14 Pssive mngement corresponds to indexed mngement nd externl mngement corresponds to delegted mngement to third sset mnger. 15 Totl ssets re divided in 7 ctegories (equitiy, xed income, rel ssets, privte equity, hedge funds, csh, TAA) nd ech ctegories cn be desgregted subsequently t most in 3 dimensions : (i) subctegory (only for equity nd xed income) ; (ii) internl/externl delegtion; (iii) ctive/pssive delegtion. Subctegories refer to geogrphicl criteri (US, Cnd, EAFE, Emerging...) or n sset speci city (high yield bonds, mortgge bonds...). 12

13 verge totl sset of pension funds in the whole smple is $10878 millions. Pension funds investing in hedge funds re signi cntly lrger with n verge totl sset of $22802 millions. This lrger size of pension funds llocting in hedge funds is lso observed in the US subsmple. A size e ect could therefore mtter in the investments in hedge funds by pension 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 whole smple nd 1.81% in the initite subsmple. Delegtion costs for equity (DC E i;t), the min sset of pension funds, re round 0.30%. Pension funds support therefore 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 vrible DC AEA i;t is high, suggesting tht pension funds do not fce similr conditions to invest in lterntive ssets. We cn explin these prohibitive costs by severl fctors. Most of hedge funds strtegies use high trding volume with lot of opertionl support nd induce importnt reserch (front o ce) costs. Moreover, hedge funds re often smll entities with few employees (Cumming nd Di, 2007). We usully cll them "boutiques". Hedge funds mngers re therefore more eger to concentrte their e orts on the front o ce tsk (to bene t from opportunities) thn dministrtive tsk. Hedge funds tend to delegte the others opertions to specilized services providers (dministrtion, IT, bck o ce middle o ce, complince service, legl service... ). These services do not need 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 of costs of delegtion mngement nd more di cult monitoring becuse of the lengthening of investment chnnel with more numerous intermedites (for survey of hedge funds cost reprtition, see KPMG (2008)). Tble 3 lso reports the verge return from hedge funds investments (Ri;t HF ). This return is 2.34% in the whole smple nd 2.50% in the US subsmple. However, the verge vlue 13

14 result from voltile returns, the stndrd devition is very high. For exmple, the verge return reched 22.45% in 2003 nd fll t -14.5% in Chrcteristics of pension funds llocting in hedge funds Chrcteristics of 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 to tke into ccount this censoring in dt. We consider s explntory vribles the di erent vribles stted in the previous section. 3.1 Empiricl frmework We consider the following empiricl speci ction 16 : 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 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 EA i;t 1 DIV i;t T Y P i;t SIZE i;t 1 DC AEA i;t C] where C is the intercept nd T Y P i;t is dummy vrible which tkes the vlue 1 if the pension fund hs public ownvership 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 16 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 in the country-nd-time xed e ect. 14

15 ssess if there is collinerity problem between the regressors. The verge VIF is 1.30 nd the mximun is 1.78 which suggests tht regressors re independnt. The model is rstly estimted with the rndom-e ects mximum likelihood estimtor (MLE) 17. This estimtor ssumes tht rndom-e ects re independent of regressors. This ssumption is relxed with the Mundlk (1978) correction which supposes tht unobserved heterogeneity is function of the mens of 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 therefore to tckle the correltion between unobserved e ects nd regressors in the Tobit frmework. 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 being uncensored. Considering the mrginl e ects of regressors on the observed vrible (HF i;t ) llows quntittive interprettion of the results. 3.2 Results Tble (4) displys the results obtined for the whole smple nd the US subsmple. Speci- ction (1:) corresponds to the estimte of eqution (2) with the rndom-e ects MLE. In speci ction (1:b), the Mundlk (1978) correction is included. Considiering the two di erent smples or including the Mundlck correction does not modify the conclusions. Firstly, lloctions to privte equity nd rel ssest do not similrly ect the lloction in hedge funds. Results show positive nd signi cnt reltionship between privte equity (P RIV i;t 1 ) nd hedge funds lloctions, while rel ssets (REAL i;t 1 ) do not hve signi - cnt e ect. More precisely, estimted mrginl e ects in tble 4 for speci ction (1:b) show tht 1% increse in the privle equity lloction leds to 0.056% increse in the hedge funds lloction in the whole smple. This mrginl e ect is estimted t 0.030% in the 17 In short pnels, the xed e ects MLE is inconsistent (see Cmeron nd Trivedi (2005)). 15

16 US subsmple. This result highlights tht privte equity nd hedge funds hve similrities. More nd more hedge funds turn to speci c investment style: event driven; which is strtegy very close to privte equity. Indeed, event driven strtegies involve investments, long or short, in the securities of corportions undergoing signi cnt chnge (e.g., spin-o s, mergers, liquidtions, bnkruptcies). Such chnge often provides mngers with tngible ctlyst by which the mnger my be ble to relize 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, event driven ws the strtegy the more used by hedge funds mngers (HFR, 2010). The di erence between hedge funds nd privte equity is stedily blurred. Consequently, hedge funds nd privte equity hve prticulr plce into lterntives clss. They re considered s more risky strtegies thn rel ssets. Pension funds who invest in rel ssets look for less superior return thn protection ginst in tion becuse pension bene ts re in rel terms (Alestlo nd Puttonen, 2005). They tend to be prt of trditionl sset clsses. Among the de nition of CEM Benchmrking, rel ssets re included rel estte nd infrstructure. These ssets incorporte bonds nd stocks chrcteristics becuse of rent nd right of use respectively nd by the vrition of sset vlue. Secondly, concerning sophistiction indictors, we nd positive nd signi cnt reltionship t the 1% or 5% level between vrible F OR i;t (relted to the home biis) nd the hedge funds lloction while the use of ttrctive numbers in policy weight (vrible RND i;t ) does not hve signi cnt e ect. As result, sophisticted pension funds chrcterized by lower home biis invest more in hedge funds. More precisely, estimted mrginl e ects for speci ction (1:b) show tht 1% increse in the proportion of foreign equities in the equity portfolio leds to 0.012% increse in the hedge funds lloction in the whole smple nd to 0.014% increse in US subsmple. Besides, contrry to wht one might expect from descriptive sttistics, unsophisticted pension funds which round their policy weight re not signi cntly less involved in hedge funds. De Dreu nd Bikker (2007), which investigte the strtegic bond lloction (i.e. in non sophisticted ssets) for Dutch pension funds, found tht this indictors ws relevnt to explin pension funds behvior. 16

17 Thirdly, severl vribles relted to the portfolio mngement ect signi cntly the lloction to hegde funds. Pension funds 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, 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 the hedge funds lloction in the whole smple. This mrginl e ect is estimted t 0.014% in the US subsmple. The positive e ect of vrible EA i;t 1 might result from the doption of core stellite mngement by pension funds from 2000 nd bove ll their prticulr interest for hedge funds for the component stellites. Furthermore, we nd size e ect. Vrible SIZE i;t 1 hs positive nd signi cnt e ect t the 1% or 5% level. Estimted mrginl e ects for speci ction (1:b) show tht the hedge funds lloction increses by 0.104% when the log of totl ssets increses by 1% in the whole smple. This mrginl e ect is estimted t 0.162% in the US subsmple. This result con rms the ide tht the mngement of lterntive ssets is delegted nd then implies long nd costly selection process of 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 the ownership, the coe cient of vrible T Y P i;t is signi cnt nd negtive only in speci ction (1:b) t the 10% level in the whole smple nd t the 5% level in the US subsmple. Public pension funds invest therefore less in hedge funds nd the estimted mrginl e ect is respectively in the whole smple nd in the US subsmple. Di erences in the regultory frmework of public nd privte pension funds cn explin our result. However, the exible prudent mn rule is more nd more pplied by public pension funds even if some restrictive quntittive rules remin. This trend could explin tht we do not nd strong evidence in fvor of the e ect of vrible T Y P i;t. Lstly, descriptive sttistics showed tht delegtion costs for lterntive ssets under externl nd ctive mngement (DCi;t AEA ) re prticulrly high on verge. We nd this vrible hs negtive nd signi cnt coe cient in the whole smple nd in the US subsmple. This result suggests tht costs mtter for the lloction in hedge funds. Estimted mrginl e ects in speci ction (1:b) show tht 1% increse in vrible DC AEA i;t leds to 0.106% decrese in the hedge fund lloction in the whole smple nd to 0.175% decrese 17

18 in the US subsmple. 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. Indeed, focusing on hedge funds, the contrct between hedge funds 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 prevlence of contrctul freedom, contrctul terms re therefore minly de ned by co-contrctors. Consequently, the degree of trnsprency, liquidity nd performnce fees terms re the result of the blnce of power between hedge funds mngers nd pension funds dministrtors. In this contrctul frmework, some pension funds cn require more relevnt nd detiled informtion nd negotite contrctul terms relted to fees. For exmple, lrge-size pension funds nturlly hve higher brgining power (Rigot nd Tdjeddine, 2010). However, the subprime crisis hs reveled tht this blnce of power ws rther in fvor of hedge funds. Indeed, until the crisis, pension funds tended to trust their hedge funds mngers, e.g. they didn t negotite contrctul terms nd they didn t require informtion disclosures, s long s hedge fund performnce were high nd decorrelted. This pssive behvior prevents pension funds to mke good risk evlution nd my be prejudicil becuse pension funds re institutionl investors who collect svings from for employees ( nl investors) in order to degge long term retirement bene ts. The lrge losses registered by pension funds in their hedge fund lloction in 2008 hve induced mistrust nd hve incited pension funds to negotite lower fees, shorter lock up periods, more informtionl disclosures s well s the use of independent services providers in order to monitor returns (Shbd, 2009). Figure 3 illustrtes the reltive importnce of the di erence chrcteristics which mtter for the lloction to hedge funds. More precisely, we report the e ects on HF i;t of decrese in ech signi cnt explntory vrible in speci ction (1:b) 18. Firstly we consider tht ech vrible decreses by 50% of its verge vlue. Secondly we consider tht ech vrible decreses by one stndrd error. These shocks llow therefore to tke into ccount the rnge of explntory vribles. The results hve to be considered reltively to the verge vlue of 18 Vrible T Y P i;t is not considered on gure 3 since this is dummy vrible nd tble (4) directly shows tht public pensions llocte percentge point less to hedge funds. 18

19 HF i;t ; which is 4.57% in the initite subsmple. Figure 3 shows tht the mount of ssests under n externl nd ctive mngement (EA i;t 1 ) is the most importnt fctor. Pension funds chrcterised by few ssets under n externl nd ctive mngement, i.e. 50% or one stndrd error under the verge, llocte respectively 0.57 nd 0.47 percentge point less to hedge funds. The smller e ect is obtined for the delegtion costs for lterntive ssets under externl nd ctive mngement (DCi;t AEA ). Pension funds which cn negocite low delegtion costs in these ssets clsses, i.e. 50% or one stndrd error under the verge, llocte respectively 0.10 nd 0.13 percentge point more to hedge funds. The e ects obtined for the other crcteristics re round percentge point 19. In conclusion, the typicl pension fund which invests in hedge funds is lrge privte sophisticted pension fund which diversi es its portfolio in numerous clsses, in prticulr in privte equity, uses core stellites orgniztion nd hve ccess to low delegtion costs for lterntive ssets. Now tht we hve identi ed chrcteristics of pension funds llocting to hedge funds, we cn consider potentil bene ts of their lloction. 4 Returns nd lloction to hedge funds We investigte the reltionship between the globl return obtined by pension funds nd their lloction to hedge funds. Firstly, we could expect direct e ect. Investments in hedge funds re mde to generte positive "lph returns" nd for sset diversi ction which could led to positive e ect on globl return. However, high costs supported by pension funds to invest in hedge funds nd the reltive low lloction to hedge funds might weken this reltionship. Indeed, hedge funds hve speci c governnce i.e. contrctul terms with their investors. Moreover, they pretend to generte lph vi complex strtegies nd the use of nncil instruments which re not llowed for mutul funds like leverge nd short selling. Consequently these investments re more risky nd more expensive. Secondly, we could lso expect n indirect e ect. As stted in the descriptive sttistics nd in the previous section, 19 Concerning vrible SIZE i;t 1 ; the stonger e ect obtined for the rst shock (50% under the verge) comprtively to the second shock (one stndrd error) indictes reltively high concentrtion in the size of pension funds in the initite subsmple nd then the one stndrd error shock is more pproprite to pprecite the e ect of this vrible. 19

20 pension funds investing in hedge funds re more diversi ed, more sophisticted nd bigger. All the bene cil spects of these chrcteristics on the globl return could be cptured through the 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 20, j;t is country-ndtime xed e ect, i is time-invrint individul e ect, u i;t N(0; 2 u) is time-vrying idiosyncrtic rndom-error. 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 to test if the lloction to hedge funds hs signi cnt e ect on the globl return fter controlling for the ownership (T Y P i;t ), country-nd-time ( j;t ) nd individul ( i ) e ects. Alterntively, eqution (4) is estimted with vrible hf i;t dummy vrible which tkes the vlue 1 if the pension fund invests in hedge funds nd 0 otherwise insted of HF i;t : Bene cil spects on the globl return could be relted to the decision to invest in hedge funds rther thn the vlue of the lloction to hedge funds. Considering hf i;t insted of HF i;t llows therefore to identify if the e ect of hedge funds on the globl return 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 return obtined from the sub-portfolio excluding the lloction 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 we could expect. A positive reltionship between HF i;t (or hf i;t ) nd Ri;t 0 could 20 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 funds portfolios. Csh nd TAA portfolios re not considered to compute R i;t due to missing dt nd the weknesses of lloctions to these two ctegories. 20

21 only be explined by n indirect e ect. 4.2 Results Tble (5) displys the results obtined with the rndom e ect estimtor. The Husmn test indictes tht this estimtor is consistent. The estimtes re performed for the whole smple nd the US subsmple. However, the size of these smples is slightly weker thn in the previous section due to missing dt to compute vribles R i;t nd Ri;t: 0 Furthermore, controlling for ownership, country-nd-time nd individul e ects explins the reltively high vlue of the R 2 : Speci ction (2:) in tble (5) shows tht the lloction to hedge funds (HF i;t ) hs positive nd signi cnt e ect on the globl return (R i;t ). This e ect is more importnt in the US subsmple thn in the whole smple with n estimted coe cient respectively t nd In speci ction (2:b) vrible hf i;t is used insted of HF i;t to identify if the e ect is rther direct or indirect: We lso obtin positive nd signi cnt coe cient. The globl return is, on verge, higher for pension funds investing in hedge funds. More precisely, the globl return increses by % in the whole smple nd % in the US subsmple. Bene cil spects of hedge funds seem therefore relted to the decision to invest in hedge funds nd not especilly to the vlue of the lloction. In speci ctions (2:c) nd (2:d), vrible Ri;t 0 is used insted of R i;t s endogenous vrible in order to con rm the importnce of the indirect e ect. This modi ction does not chnge the results. In speci ction (2:c), the e ect of HF i;t is positive nd signi cnt with coe cient respectively t in the whole smple nd in the US subsmple. In speci ction (2:d), the e ect of hf i;t remins lso positive nd signi cnt. The return in the sub-portfolio (Ri;t) 0 is % higher for pension funds investing in hedge funds in the whole smple nd % higher in the US subsmple. Consequently, our results re minly driven by n indirect e ect. Pension funds investing in hedge funds merge severl chrcteristics which improve their returns. This lst result shows positive spect of corestellites orgniztion. However, the bene t could be higher if pension funds dopt stronger governnce concerning hedge funds delegtion. For exmple, lrge pension funds should use their brgining power to require more disclosures to better evlute hedge funds risks nd 21

22 to lower performnce fees. This is lredy the cse of the biggest US DB public pension fund Clpers which hs nnounced in 2009 to sign prtnership with hedge funds only under these renegotited conditions. 5 Conclusion Institutionl investors hve n incresing interest for hedge funds since the beginning of the 2000 s due to their high nd decorrelted returns promises. However, few studies focus on this institutionliztion phenomenon. This pper ims t bridging over this gp thnks to the use of originl nd representtive dtbse relted to investment strtegies of US nd Cndin De ned Bene ts pension funds, over the period We prticulrly focus on chrcteristics of pension llocting in hedge funds nd then, we question the potentil bene ts of these speci c lterntive investments. We nd evidence tht the typicl pension fund which invests in hedge funds is lrge sophisticted pension fund which diversi es its portfolio in numerous clsses, in prticulr in privte equity, uses core stellites orgniztion nd hve ccess to low delegtion costs for lterntive ssets. In ddition, pension funds with privte ownership llocte more to hedge funds. We lso nd evidence of bene cil spect of investments in hedge funds in terms of return. However, this positive e ect is more due to the decision to invest in hedge funds rther thn especilly to the vlue of the lloction or the return of the hedge funds investment. Consequently, this bene cil spect is minly driven by n indirect e ect. Pension funds investing in hedge funds merge severl chrcteristics which positively ect their returns, like better diversi ction for exmple. This lst result shows positive spect of core-stellites orgniztion. However, we observe tht in times of nncil turbulences, hedge funds re not unsinkble. Losses in hedge funds lloction were higher thn those on privte equity nd rel ssets lloctions 21. We cn explin this lower performnce by speci c gency problem in hedge funds delegtion nd certin pssivity of pension funds behvior. Bene ts could be higher if pension funds dopt stronger monitoring concerning hedge funds delegtion reltionship. Even pension 21 In 2008, returns in privte equity nd rel ssets lloctions were between -5% nd 10%. 22

23 funds my hve some di culties to select hedge funds mngers/styles or to monitor hedge funds risks, given the lck of trnsprency of these funds. In the cse of pension funds, privte mislloctions induced by such s excerbted informtionl symmetries my hve detrimentl consequences, becuse retirement bene ts of millions of employees re t stke (increse of contributions or/nd decrese of bene ts). These tensions relted to lck of trnsprency in the hedge fund industry were so highlighted in the crisis tht supervisory uthorities decided to chnge hedge funds regultion. They recognized tht hedge funds opcity my led to dmges which cn be estimted t micro level by mislloction nd t mcro level by incresing nncil instbility nd systemic risk. For the rst time since the beginning of the hedge fund industry in the 1950 s, hedge fund drft lws were promulgted in the Europen Union (EU) nd the US. The rst one is speci c to hedge funds, while the second one is in line with the comprehensive US nncil reform 22. We observe divergence on the con gurtion of hedge fund regultion between the US nd the EU. The EU regultion form seems to be mix of contrctul nd regultory greement modlities in order to enhnce mcro s well s micro lloction. The EU Commission considered tht intervention (with more regultory requirements) ws necessry to support investors nd to contin systemic risk. The US dministrtion seems to support regultion form whose nl im is to optimize mcro lloction, minly vi regultory greement modlities. The US considers tht there is no need for speci c lw for hedge funds. The issue of informtion symmetry is contrctul concern which must be solved between min stkeholders (clients/hedge funds nd prime brokers/hedge funds) without externl intervention. The reliztion by investors to chnge their behvior vis-à-vis hedge funds mngers is ll the more crucil tht investors continue to llocte to hedge funds, despite this crisis. The Europen directive AIFM should support with trend for Europen investors. But US investors could only count on their own to reblnce delegtion reltionship with hedge 22 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) 23