Hedge Fund Investing Chapter 2 Part 2: Pensions, Sovereign Wealth, and Funds of Funds

In Part 1 we covered the research behind hedge fund investing and how rich people, family offices, and endowments got into the game. Now let’s talk about the really big money: pension plans, sovereign wealth funds, and funds of funds. Plus, if hedge funds are so great, why doesn’t everyone just put 100% of their money there?

Public Pension Plans

Pension plans are long-term pools of capital managed for retirees. Government workers, company employees. The money sits there for decades. That long time horizon makes pensions a natural fit for illiquid investments like hedge funds.

But here is the thing. Only the biggest pension funds invest directly in hedge funds. Why? Because due diligence on hedge funds is complicated and time-consuming. Smaller plans don’t have the staff for it. They use funds of hedge funds (FoFs) instead, which adds another layer of fees but handles the research and access for them.

The numbers are wild when you think about scale. CalPERS (California Public Employees’ Retirement System) manages around $200 billion. A 10% allocation means $20 billion going into hedge funds. Every 1% change is a $2 billion swing.

Globally, pension plans control over $25 trillion. If all of them moved just 1% into hedge funds, that would be $250 billion. At 5%, it is $1.25 trillion. At 10%, it is $2.5 trillion. And hedge fund industry total assets were only about $2 trillion at the time.

So if pensions shifted 10% into hedge funds, the industry’s assets would more than double. That sounds great until you realize what that actually means: too much money chasing too few good managers. Weaker managers entering the business. Returns getting diluted. A fast flood of capital would probably hurt the industry more than help it.

Many underfunded pension plans were looking to hedge funds for 10-25% of their allocation to hit their target returns of 5-8%. Traditional stocks and bonds alone were not getting the job done.

Sovereign Wealth Funds

Sovereign wealth funds are government-owned investment pools. Countries set them up to invest national wealth, often from natural resources or trade surpluses. Think Korea, Middle Eastern nations, Norway.

These funds are similar to pensions in many ways. Long-term outlook. Increasing sophistication. Growing interest in alternatives. The Korean National Pension Fund, for example, was actively planning to increase its allocation to alternative investments.

These are patient investors. They don’t panic when markets drop for a quarter. They think in decades. That makes them attractive partners for hedge funds that need stable capital.

Funds of Hedge Funds (FoFs)

This is where it gets interesting.

A fund of hedge funds collects money from smaller investors and spreads it across multiple hedge fund managers. Think of it as a hedge fund buffet. Instead of picking one manager, you get a diversified plate.

FoFs have been around since the early 1970s. Grosvenor Capital Management launched one of the first ones. For years, the main value proposition was simple: access and diversification. Individual hedge funds had high minimums and limits on how many investors they could accept. FoFs pooled smaller investors together and got them through the door.

The FoF industry grew fast. By 2007, FoFs managed about $800 billion and represented over 50% of all hedge fund assets. Big institutions like CalPERS used FoFs for their first hedge fund allocations because they did not have internal teams to handle it.

But the industry got greedy. FoFs started offering products with up to 4x leverage on top of the leverage the underlying hedge funds already used. European FoFs offered monthly redemptions to attract investors, even when the underlying funds were much less liquid.

Then 2008 happened.

The average FoF dropped more than 20%. The Madoff fraud was exposed, and several FoFs had invested with him. Everyone tried to redeem at the same time. Underlying hedge funds had to put up gates or suspend redemptions entirely.

After 2008, the FoF industry contracted for four consecutive years. The old model of “pay us extra fees for access” lost its appeal. FoFs dropped from 50% of industry assets to about 35%. More institutions started investing directly with managers, cutting out the middleman.

Why Not Allocate 100% to Hedge Funds?

If hedge funds improve returns and reduce risk, why not go all-in? Mirabile gives several solid reasons.

The industry is still young. Half of all managers have been in business less than five years. Only 35% have been around more than seven years. The regulations, practices, and infrastructure are still evolving. After the blowups of 2008, investor confidence is still recovering.

Liquidity problems. Most funds require minimum investments over $500,000. Redemptions are typically monthly or quarterly with 15+ days notice. Once your money is in, getting it out takes time. That is a real problem if you need cash.

Limited transparency. Unlike mutual funds, hedge funds rarely share daily or weekly position data. Risk reporting comes with delays. Models and methods are rarely disclosed. This makes it hard to integrate hedge fund positions with the rest of your portfolio.

Reputational risk. Nobody wants to be the pension fund manager who put money with the next Madoff. High-profile frauds and scandals make institutions cautious. Even if the math says allocate 40%, the board might say 10% because they don’t want to be on the front page of the newspaper.

Concentration risk. Half the 10,000 managers in the industry are small shops with $100 million or less in assets. But over 70% of industry assets sit with the very largest funds (over $5 billion). That concentration creates systemic risk.

Business risk. Many funds were still below their high-water marks after 2008 losses, running on management fees alone. Funds that cannot cover costs close, and a closure can mean fire sales and investor losses.

Investor Survey Highlights

Industry surveys around 2011-2012 showed that investors remained committed to hedge funds despite the rough years.

From the Barclays Capital “Money Trail” report: 56% of investors planned to increase allocations, only 8% planned to decrease. Pensions, endowments, and private banks were the most active allocators. Family offices and endowments had about 25% in hedge funds. No positive flows were expected for FoFs.

From the SEI survey: 38% planned to increase allocations. Average hedge fund allocation was 16.7% of portfolios, up from 12% during the crisis. Direct investing was rising fast, with 56% of large investors ($5B+) using single-manager funds only.

One interesting shift: performance overtook transparency as the top concern. In 2009-2010, investors worried most about transparency. By 2011, they just wanted results.

The hedge fund industry was not looking for a capital flood. What it wanted was steady, sustainable growth. A boom-and-bust allocation cycle would do more harm than good.

Previous: Chapter 2 Part 1: Who Invests in Hedge Funds | Next: Chapter 3: Industry Trends and History

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.