Lawmakers Eye Employer Use of Hedge Funds

Congress’ recent calls for increased scrutiny of how defined-benefit plans utilize hedge funds may give some employers pause before they invest in such vehicles.

But experts say that as long as employers diversify their hedge fund investments, they shouldn’t run into trouble.

A recent survey conducted by Greenwich Associates found that 27 percent of employers with defined-benefit plans invest in hedge funds, up from 21 percent in 2004.

These investment options are particularly popular because their performance is not tied to the equity markets. So when equity markets tank, hedge funds do well. That’s why International Paper invests $723 million of its $8.4 billion defined-benefit plan in hedge funds, says Robert Hunkeler, vice president of investments.

“Our investment in hedge funds came out of our realization that we would have a hard time reaching our performance objectives by being 50 percent invested in large-cap equities and bonds,” he says.

But Senate Finance Committee Chairman Max Baucus, D-Montana, and Sen. Chuck Grassley, R-Iowa, aren’t so sure about this line of thinking. On March 1, they wrote a letter requesting the Government Accountability Office to review how pension plans use hedge funds.

“Of particular concern to the committee is the extent to which under-funded plans sponsored by financially weak employers may be investing in hedge funds,” the letter states.

Then on March 7, Grassley proposed an amendment that would require hedge funds to register with the Securities and Exchange Commission, meaning they would be regulated by the agency.

Congress has reason to be concerned. Last September, Amaranth, a $9.5 billion hedge fund based in Greenwich, Connecticut, lost $6 billion and collapsed after a trader made a poor energy bet.

Experts, however, say that as long as defined-benefit plan sponsors diversify their hedge fund investments and perform proper due diligence on managers, they have no reason to worry.

“The lesson of Amaranth was, don’t invest directly in one hedge fund firm that represents more than 5 percent of your portfolio,” Hunkeler says.

After the Amaranth blowup, International Paper diversified its holdings to include more funds of hedge funds—which are umbrella investments of hedge funds, and thus more diversified. And the firm won’t put more than 5 percent of its hedge fund investment in one manager.

Diversification, however, doesn’t necessarily deter employers from investing a large percentage of their defined-benefit plans in hedge funds, says Keith Hocter, investment consultant at Bellwether Consulting in Montclair, New Jersey.

“It’s not unheard of for a company to invest 100 percent in hedge funds,” he says. “Hedge funds are a very broad space; some are very conservative and some are very aggressive.”

Employers need to make sure they fully understand the funds’ investment strategies and risks, Hocter says.

Experts are conflicted about whether regulation of hedge funds would be valuable in the long run.

“I’m not sure the costs of making hedge funds register is going to justify the benefit,” says Jeff Gabrione, who heads manager research for Mercer Investment Consulting. “And like everything else, those costs will get passed on to the consumers.”