Tuesday, June 14, 2016

Cambridge Associates: De-risk the deficit with hedge funds

Pension funds are underfunded and need some investment magic to solve their problem. The problem is very simple. Pension funds could go out and buy more risky assets to generate higher returns but that will only come at the expense of higher risks. If they are wrong, the underfunding problem only get worse. 

Cambridge Associates in their latest research note "Hedge Fund-ing the Pension Deficit" believes there is a better alternative. Add hedge funds as a low risk alternative that can generate non-beta returns. In a perfect world, hedge funds will have lower correlation with the stock market and the ability to generate uncorrelated return through alpha. 

There is nothing new with their analysis but it highlights one of the key roles that hedge funds can play in a portfolio. For a pension fund, the story is very straight-forward. For either the Tech Bubble or the Financial Crisis, the funding gap was reduced through holding 20% in hedge funds. From their numbers, there is a 3.5% protection of funded status per 10% allocation in hedge funds during these two crises.

If there is a market correction, a hedge fund allocation will always provide some drawdown protection. This should be be expected from diversification, but what may be a surprise is how well it does versus a traditional portfolio. A 20% allocation, which is not too large, will reduce drawdowns on average by 1-2% relative to a traditional portfolio.

The funding problem will not be solved with hedge funds. It is not a magic bullet slaying pension problems, but it can help and offer some well-needed protection.

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