November 28, 2005
Pension Funds, Hedge Funds and Branding
Posted by Victor Fleischer

The NYT had a story yesterday about the trend of pension funds pouring money into hedge funds.  Thanks to JJ Prescott for pointing me to the story.

Pension funds and hedge funds go together like milk and orange juice.  The hedge fund industry hasn't done a good job of managing its brand image.  Hedge funds have lost their original connotation of being a hedge against the market, and many laypersons instead equate hedge funds with gambling.  If hedge funds were called "absolute return funds," i.e., funds designed to produce steady returns in any market conditions, they would actually seem a perfect fit for pension funds. 

With the equity markets rather flat, pension funds are hungry for "alpha" -- positive risk-adjusted returns.  Hedge funds claim to be able to provide that.  The law, however, is getting in the way.  If hedge funds accept more than 25% of their assets from ERISA plans, the fund's assets become "plan assets," making the hedge fund managers subject to ERISA's fiduciary duty requirements.  The hedge fund industry is pushing to move the limit from 25% to 50%.   

In a sense, hedge funds just want to compete on equal footing with venture funds:  venture funds can avoid ERISA by becoming a VCOC (venture capital operating company) if they make so-called qualified venture investments.  Hedge funds have no similar exemption, in part because there is less of a difference between what many hedge fund managers do (manage a portfolio of investments in liquid securities) and what pension fund managers do (the same). 

I haven't yet heard a compelling argument for lifting the ERISA limit from 25% to 50%.  As long as we're going to have ERISA, it should have some bite.  (More on this another time.)  ERISA could help keep hedge fund managers in line.  The hedge fund industry is not yet a mature industry.  And as I've argued before, the typical compensation structure gives hedge fund managers an incentive to take on more risk than its investors would like.  Until reputation becomes a more effective constraint against this moral hazard risk, hedge fund managers who want pension money should be willing to take on ERISA fiduciary status.  The fact that some hedge fund managers already do this voluntarily suggests, to me, that change is unnecessary. 

But I haven't yet heard the arguments on the other side, so maybe I'm missing something.  Why do hedge fund managers want to avoid being ERISA fiduciaries?  Does ERISA force more disclosure?  If so, why is that so bad? 

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