The National Pension Service (NPS) has kicked off its first investment in hedge funds by choosing two fund of funds managers to entrust a total of $1 billion earlier this month. But except for the NPS and Korea Investment Corporation (KIC), many other institutional investors in South Korea remain cautious about hedge funds.
Setting aside the recent money outflows from hedge funds and criticism about their poor performance and high fees, industry observers say there are also structural reasons that make Korean institutions shy away from hedge funds: their preference for bond-type stable cash flows, discomfort with strict mark-to-market appraisal of hedge funds performance and the trauma of the Madoff investment scandal in 2008 that had a number of Korean asset managers embroiled in legal wrangling.
“Whenever an events happens, hedge funds which claim to pursue absolute returns end up with valuation losses of 10~20%, so it is difficult to continue to invest there,” said Sang-ho Lee, the chief investment officer of the Military Mutual Aid Association, South Korea’s $8 billion savings fund. “They also fail to use market volatility as an investment opportunity. Other than the $60 million we invested in a fund of funds in 2014, we do not plan to make an additional investment (in hedge funds) for the time being.”
“Returns on alternative investments are lower than they were in the past. But real estate and infrastructure provide better opportunities, so I don’t think we need to look at hedge funds,” said Hyun-jang Shin, Financial Investment Division Head Manager of South Korea’s Police Mutual Aid Association.
The Hedge Fund Research Composite Index, a measure of hedge funds’ performance around the world, eked out a gain of 1.6% for the first six months ended June 30, 2016. By comparison, the S&P 500 Index has risen 5.76% during the same period.
(1) Preference for fixed-income type assets generating stable cash flows
Institutional investors in South Korea are trimming the proportion of bonds and instead boosting alternative investments in search for higher returns. Still, they favor fixed-income type assets such as private debt funds producing cash on a steady basis. Although contributions from members surpass cash paid to them at most of domestic retirement savings funds, they cannot help but care about cash flows.
Dong-hun Jang, the CIO of the Public Officials Benefit Association (POBA), had told the Korea Economic Daily in a recent interview that the savings fund for local public officials is strongly interested in brownfield-type infrastructure assets which produce cash flows immediately after it makes investment. “When it comes to hedge funds, their returns were below expectations, despite high volatility. This year, we have no plan to make an additional investment in hedge funds,” Jang added. POBA has put 40 billion won into offshore hedge funds through funds of funds, which makes up just a 0.48% of its total AUM of 8.2 trillion won, or 1.04% of its alternative assets of 3.8 trillion won.
The Korea Scientists and Engineers Mutual-aid Association (SEMA) cancelled a plan of committing a total of 60 billion won ($53 million) to two funds of hedge funds last April. The last-minute cancellation of the new investment plan was blamed on the disappointing returns on the SEMA’s investment in March last year of 30 billion won in each of three funds of funds, run by UBS, Grosvenor and EnTrust Permal. The retirement fund plans to maintain its offshore hedge fund exposure to around 2.3% of total assets of 3.9 trillion won for the time being.
“Although the goal of hedge funds is to lower risks of the whole portfolio through investment asset diversification, it would make inefficient use of resources if we invest in hedge funds when there is other immediate opportunity for alternative investments which can provide more stable and higher returns,” said Du Yeong Jeong, the CIO of the SEMA. “We are interested in loan-type assets with less of the J-curve effect and infrastructure assets. We are looking for investment opportunity out there.”
(2) Mark to market risk
The mark-to-market assessment of hedge fund performance, conducted on a monthly basis, is a big burden to institutional investors. They are required to report to their bosses or auditors the reasons for investment losses whenever incurred. But under the current market environment, it is not easy to explain why a certain hedge fund strategy is losing money unless they have professional knowledge.
“Except for those making large-scale investments such as the NPS and the KIC, it is virtually difficult for Korean institutions to hire staff specializing in hedge funds,” said a source of a local savings fund in charge of overseas alternative investments. “Given that, fund managers who have little knowledge (about hedge funds) have to report to bosses or auditors who have poorer knowledge about them. This process itself is a backbreaker,” he added. “Despite such hard effort, if they fail to deliver two-digit returns, even working-level officials will be reluctant to invest in hedge funds.”
By contrast, institutional investors say that private equity funds are relatively easy to invest because they are hardly marked to market. According to them, despite quarterly evaluation of portfolio companies in PEFs via an accounting firm, the assumption and discount rate on future cash flows are subjective, so it is impossible to make as strict mark-to-market assessment on PEFs as hedge funds. Further, the investment techniques for PEFs are simpler than hedge funds, and thus they are easier to explain to nonprofessionals.
That is why the NPS put a priority on “transparent communication,” along with fund performance when selecting BlackRock and Grosvenor as fund of hedge fund managers this month. “How much information and database they have on each single fund and how much they are willing to share them with the NPS was an important criterion for screening,” a source familiar with the selection process told the Korea Economic Daily.
(3) Trauma of Madoff scandal
Some blame the losses from a fund run by Bernard Madoff in 2008 on domestic institutions’ lukewarm attitude toward hedge funds.
The Teachers’ Pension, the Korean Teachers’ Credit Union, Korea Life Insurance (currently, Hanwha Life Insurance) and other South Korean institutions had invested about $100 million on aggregate in a fund of Bernard Madoff via Fairfield Sentry, then a U.S. fund of hedge fund manager. After the Madoff Ponzi scheme erupted, asset management firms which had introduced Fairfield Sentry to South Korea got embroiled in legal disputes with local financial institutions.
“South Korean institutions became comfortable with investing in PEFs after seeing foreign PEF managers make a big fortune in Korea from leveraged buyouts or the like. But about hedge funds, little trust has been built due to the early failure,” said a South Korea-based hedge fund source. According to him, South Korean institutions started investing in hedge funds around 2002 and their total commitments had ballooned to about $7 billion just before the Madoff investment scandal. Afterwards, their exposure more than halved to around $3 billion at one point and has yet to bounce back, he noted.
By comparison, global hedge fund assets in 2013 exceeded the level of 2007 just before the Madoff fraudulent scheme was revealed. According to a market research firm, Barclay Hedge, total assets under management for the hedge fund industry shrunk to $1.5 billion in 2008 when the Madoff investment scandal erupted from $2.1 billion in 2007. The balance expanded to as much as $2.7 billion in the first quarter of this year.
(4) Added value of hedge funds
Hedge fund industry experts say that it will require more learning and experience before South Korea institutional investors make any meaningful investment in hedge funds. That is, they need to have an investment philosophy for hedge funds, together with success experience.
“The added value that hedge funds bring to investors contributes to maximizing the effect of investment diversification by earning returns uncorrelated to market,” said a New York-based hedge fund manager. “Institutional investors, managers who sell products to them and sales people all have to reach a consensus in that respect and make it the most important decision-making standard.”
Another hedge fund source advised: “Hedge funds should be regarded not as an individual investment product, but as part of a long-term strategic asset allocation.”
By Chang Jae Yoo and Daehoon Kim
<Edited by Yeonhee Kim>