Last year was a notoriously difficult one for hedge funds. Not only did the asset class fail to stand against the fall in equity markets, but 2008 was also a year of scandals, when hedge funds’ already tarnished reputation was damaged even further. It gave investors a painful reminder that hedge funds are exposed to a large number of risk factors, such as credit risk, liquidity risk and several equity risk factors, as outlined in the conclusions of French business school Edhec’s 2008 hedge fund report.

Furthermore, few hedge fund strategies turned out to be good investments. The asset class was supposed to weigh up a fall in equity and bond markets, but for many, that has not been the case. While the losses may have been less severe than for equities, many pension funds, like Finnish Keva and Varma, still lost 17.1 per cent and 26.3 per cent respectively from their hedge funds.

Swedish pension funds have had a long love affair with the asset class and have traditionally been the Nordic region’s most enthusiastic investors. Boldest of all is Svensk Handel Försäkringar, which has a hefty 40 per cent allocated to hedge funds. That may be an exception to the rule, but 10 out of 13 occupational pension funds have exposure to hedge funds and the average allocation is 9 per cent of assets, according to recent figures from Finansinspektionen, the Swedish supervisory authority. Finnish pension funds have, however, been quick to catch up with their Swedish peers following more liberal investment regulations in 2007, and several players have boosted their allocation to around 14 per cent of assets.

As confidence in hedge funds became increasingly damaged over the course of last year, many expected an exodus from the asset class. Undeniably, assets have been withdrawn from hedge funds, but probably not to the extent that was originally feared.

“It’s been an extremely tough year for hedge funds,” says Kjetil Houg, finance director of Oslo Pensjonsforsikring (OPF). “The flow situation has been very difficult, but I think that the market will be more stable going forward and that the largest redemptions have now been made.”

Surprisingly, the troubles of 2008 do not seem to have been enough for pension funds to lose their appetite for hedge funds. In general, Nordic pension funds do not seem to be rejecting the asset class.

Länsförsäkringar, the Swedish pensions company, decided to stop investing in hedge funds in 2005 because of high fees and to concentrate on adding to its infrastructure and private equity holdings. But the firm has just made a turnaround and put money into its first hedge fund for four years: a credit opportunity fund run by Swedish Nektar Asset Management. Gustav Kärner, chief financial officer of Länsförsäkringar, would not disclose the size of investment, but says it is “a significant amount”.

“We saw an opportunity to take advantage of the arbitrage in the market. We haven’t ruled out making further hedge fund investments if the right opportunity comes up, but we no longer have a target allocation,” he explains, adding that it is a comfort that they personally know the managers behind the fund.

Even AP1, the first Swedish national buffer fund, is contemplating adding hedge funds to its portfolio – an asset class it has so far steered clear of. It is an interesting sign, although Rikard Kjörling, head of external management at AP1, says no decision has yet been made and that the fund will probably not decide until the end of the year.

Perhaps more astonishing is that even pension funds that have suffered significant losses are showing no indication of turning away from hedge funds. That also goes for funds that have lost money through fraud, for example in the Madoff scandal.

Arkitekternas pensionskassa, the Swedish architects’ pension fund, made the unfortunate move of investing in a hedge fund with an allocation to Madoff. During the course of 2008, it increased its hedge funds from 7 per cent to 11 per cent of assets, and in doing so, it took on Fairfield Sentry – a fund that was later hit by the Madoff fraud.

“Up until November, our hedge fund returns were over 9 per cent, but that damned Madoff wiped out all our profits. But my opinion of hedge funds has not changed. I still believe in hedge funds – they are a good buffer during difficult times. We have no plans to reduce our long-term hedge fund allocation because of what has happened,” says Maritha Lindberg, chief executive officer of AP.

On the contrary, the pension fund has recently invested in an additional hedge fund, which brings its exposure to the asset class up to 14 per cent.

Perhaps AP’s apparent confidence has something to do with its lengthy experience with hedge funds. The fund started investing in the asset class as early as 1998 and its first hedge fund, Nektar, has been its best long-term investment.

Ms Lindberg’s views are shared by Viveka Ekberg, chief executive officer of PP Pension, the Swedish pension fund for journalists. Together with the Volvo and Saab pension funds, PP Pension invested in Weavering Capital’s macro fixed income fund last year. In March, the company went into administration as a result of suspected fraud and, as a consequence, PP Pension lost 1 per cent of its assets. Although Ms Ekberg says that the losses are very unfortunate for its members, they have not made the pension fund lose faith in the asset class.

“One rotten apple should not ruin the whole fruit basket. Well-run hedge funds have a role to play in a portfolio and non-correlated strategies with good risk-adjusted returns will always be attractive. We have a mandate to increase our hedge funds to up to 10 per cent of assets and will continue to look for good managers,” says Ms Ekberg.

Before having to write down its investments in Weavering Capital from SKr100m (€9.18m) to zero, the fund had an exposure to hedge funds of 7 per cent.

Some are, however, comfortable with no longer having any hedge funds. AP7, the manager of the default option in the Swedish premium pension system, has simply had enough and is in the process of divesting from all of its hedge funds. The high fees were one reason, but the decision to divest primarily concerned the media risk involved. After losing money through two hedge funds that went bankrupt – Amaranth and Bear Sterns – AP7 came to the conclusion that explaining and defending its hedge funds was taking up too much time and energy, and also exposed the fund to heavy public criticism.

But instead of leaving its dealings with hedge funds behind, the pension fund shifted to hedge fund replication strategies. Richard Gröttheim, executive vice-president of AP7, explains: “We realised that there were other ways of achieving what our fund of fund investments had previously done – but with much lower costs and without the media risk. We looked into how hedge fund replication worked and concluded that the advantages were greater than the downsides.”

The strategy has so far paid off and has given AP7 reason to continue expanding the replication strategies. Its hedge fund portfolio returned a remarkable 14.2 per cent in 2008, mainly due to the flexibility that replication strategies offer.

It is, however, unlikely that all Nordic pension funds will embrace hedge funds. Those who have had limited experience of and exposure to the asset class, such as several Danish pension schemes, seem unlikely to start ploughing money into the asset class. Henrik Franck, chief investment officer of Danish PFA, previously told nrpn that, unless the fee structures and transparency changed, he believed that it would be unlikely that PFA or anyone else would invest in hedge funds in the future.

While this has yet to happen, many are expecting that a restructuring of the hedge fund industry is finally about to take place. Pressure has been building on the hedge fund industry to react and change, not least when it comes to issues such as transparency and fee structures. Regulators are also expected to get involved and more closely monitor a market that has so far been very loosely regulated.

But it is not just the hedge fund industry that is set to transform – institutional investors are also bound to change and continue reassessing their investment behaviour and strategies for hedge funds. While the appetite for the asset class remains strong, pension funds have not been unaffected by the trouble in the market and both managers and strategies are up for reconsideration.

Norwegian OPF has done just that. It has increased its allocation from 3.2 per cent to 4.6 per cent of assets, but has also shifted from single hedge fund strategies to fund of funds.

“We reduced the risk by increasing the diversification. We realised that we had too much single manager risk in our portfolio and have invested in some funds of hedge funds to spread the risk,” says OPF’s Mr Houg. The pension fund now has two funds of funds and six single manager funds.

While its total portfolio returned -9.3 per cent, the difference in performance was striking. The strongest performing hedge fund returned 51 per cent and the weakest -31 per cent.

Going forward, OPF plans to put more emphasis on liquidity since its time horizon for hedge fund investments is shorter than for other assets. Mr Houg also emphasises the importance of making thorough due diligence.

“We never invest with managers without having met the people that actually manage the fund – not just the sales side. It’s also important that the fund delivers what it has set out to do over time, and that there is stability in the management philosophy and in assets under management,” he says.

The importance of knowing the managers behind a hedge fund is a lesson that the Swedish architects’ pension fund has learnt the hard way. Until last year, its strategy had been to invest in domestic funds, but external advisers made it change its principles. For the first time, it took on two hedge funds – Jupiter Hyde Park and Fairfield Sentry – without knowing or having met the managers.

“Until we took on Fairfield and Jupiter, our strategy for hedge funds was to invest in Swedish funds with managers that we were familiar with. After the Madoff scandal, we have decided to go back to our previous strategy and make sure that we know the managers and what we actually get. There are so many operational risks with hedge funds that we just can’t control. We don’t have the capacity to conduct advanced and time consuming due diligence processes,” Ms Lindberg says.

She admits that only being able to choose managers among the domestic players gives them certain limitations, but that it is a price they will have to pay.

Pension funds are also likely to reassess the use of consultants and advisers – not least who they decide to co-operate with. Both PP Pension and AP relied on external advice to make their fatal investments in Weavering and Fairfield. PP Pension, together with other Swedish institutional investors, invested with the help of Swedish investment consultant Wassum. AP preferred not to disclose the name of the adviser that recommended Fairfield.

PP Pension’s Ms Ekberg, who only joined the fund in February this year and was not at the helm when the investment was made, says that what has happened will have consequences for the future.

“It will affect how we work, which strategies we use and which advisers we rely on. When things like this happen, you need to re-evaluate which partners you co-operate with.”

A nuanced view

It is not only Nordic institutional investors who remain committed to hedge funds, investors globally are also keeping faith in the asset class, according to a recent study by State Street. Almost half of all institutions plan to increase their allocation to hedge funds in 2009, while almost 40 per cent plan to keep their current hedge fund exposure.

But while the financial turbulence has revealed weaknesses with hedge funds, freezing or reducing exposure is not necessarily related to dissatisfaction or a lack of trust in the asset class. There are also far simpler reasons why hedge funds may not be that interesting.

Norwegian pensions company Vital Forsikring has put its plans to increase alternatives on hold, including hedge funds. But Øystein Stephansen, chief investment officer, says that this has nothing to do with disappointment in the asset class, but rather that the fund primarily intends to boost its limited listed equity portfolio of 2 per cent when it starts to take risks again.

“We’ve had good experiences with both hedge funds and private equity, but we’ve put all new investments on hold. When we do decide to start investing again, we will begin by increasing our listed equities,” he says.

Kjetil Houg, finance director of Norwegian OPF, also believes that, while hedge funds undoubtedly have a role to play in a portfolio, there are currently other more interesting opportunities out there, not least within the credit and equity markets.

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