The role of hedge funds in pension fund portfolios: Buying protection in bear markets

Abstract

This paper will outline the benefits of including hedge funds, and funds of hedge funds, in pension fund portfolios. Due in part to their non-correlation to traditional stock markets, hedge funds are powerful tools for portfolio diversification, and help to enhance returns, reduce volatility and increase risk-adjusted returns, especially during bear markets. An allocation of 10–20 per cent of portfolio assets into alternative investments such as hedge funds and funds of hedge funds is considered sufficient. Hedge funds typically charge a management fee of 1–2 per cent and a performance fee of 20 per cent, but also include high water marks and hurdle rates. Hedge funds are loosely regulated and their non-transparency makes it difficult to evaluate their positions. Selecting hedge funds and funds of hedge funds can be challenging, and a number of different factors, including the size of the fund, the number of managers, and the nature of its trading strategies, must be examined for this to be done appropriately.