Title: Pension funds' allocations to hedge funds: an empirical analysis of US and Canadian defined benefit plans
Abstract: Abstract This article investigates the characteristics of US and Canadian pension funds that allocate assets to hedge funds. The typical pension fund that invests in hedge funds is a large sophisticated pension fund that diversifies its portfolio across numerous classes of investments, private equity in particular, uses a core-satellite organization and has access to low delegation costs for alternative assets. Moreover, we find that pension funds investing in hedge funds significantly obtained higher global returns. Keywords: pension fundshedge fundsasset allocationdiversificationJEL Classification:: G23 Acknowledgements We would like to thank Michel Aglietta, Gunther Capelle-Blancard and an anonymous referee for helpful remarks and suggestions. The usual disclaimer applies. Notes 1 Alternative assets are made up of private equity, real assets and hedge fund investments. 2 Funds of funds are collective investment vehicles that allocate assets to several hedge funds to benefit through a diversification of benefits. As a general rule, they are managed by private banks, mutual funds or institutional asset managers. 3 Alternative investments allow a portfolio diversification because their return drivers differ from the equity and bond markets drivers (Schneeweis and Martin, Citation2001). 4 Investors are charged three types of fees: management fees (1%–2%), performance fees (15%–20%) and early termination fees (1%–2%) in the event of an early liquidation. 5 Total assets are disaggregated into seven classes: equity, fixed income, real assets, private equity, hedge funds, cash and Tactical Asset Allocation (TAA). In addition, for assets under management, equities and fixed income assets are also disaggregated into subclasses. 6 More precisely, total assets managed by US pension funds amounted to $9500 billion in 2007 and approximately half of those assets were managed by DB pension funds. 7 There is no distinction in the database between allocations to hedge funds or to funds of hedge funds. 8 For example, French (Citation2008) compare the fees, expenses and trading costs that society pays to invest in the US stock market along with an estimate of what would be paid if everyone invested passively. Bauer et al. (Citation2010) document the performance and costs of the domestic equity investments of a large sample of US pension funds (small–large size) in comparison with mutual funds. 9 This is not exactly 50% because the dataset is not balanced. 10 Total assets are divided into seven categories (equity, fixed income, real assets, private equity, hedge funds, cash and TAA) and each category can be subsequently disaggregated into three dimensions at most: (i) a subcategory (only for equity and fixed income); (ii) internal/external delegation; (iii) active/passive delegation. Subcategories refer to a geographical criterion (US, Canada, EAFE, Emerging, etc.) or an asset specificity (high yield bonds, mortgage bonds, etc.). 11 The subscript i indexes pension funds, t indexes years and j indexes countries (Canada or the US). For simplicity, the subscript j is used only for the country-and-time fixed effect. 12 The Tobit model is based on a latent (i.e. unobservable)-dependant variable () generated by a classical linear regression model. The latent variable is only observed if > 0. The observable dependent variable HF i,t is defined to be equal to the latent variable whenever the latent variable is above zero and zero otherwise. 13 In short panels, the fixed effects MLE is inconsistent (Cameron and Trivedi, Citation2005). 14 Bikker and De Dreu (Citation2009) find that economies of scale exist for largest pension funds with regard to investment costs. 15 More precisely, R i,t represents the average return minus the average cost obtained from the equity, fixed income, real assets, private equity and hedge fund portfolios. 16 In 2008, the returns on private equity and real asset allocations were between −5% and 10%. 17 Directive of the European Parliament and Council on Alternative Investment Fund Managers; (AIFM) Second Proposal with amendments – November 2009 (Gauzes report); Directive of the European Parliament and Council on Alternative Investment Fund Managers (AIFM) Final Proposal – May 2010; US Treasury financial regulation reform, Geithner Plan (June, 2009); Financial reform, a framework for financial stability, Volcker plan (January 2010); US Financial reform bill (July 2010).