When Nestle's pension fund manager first brought up the idea of investing in hedge funds in the late 1990s, the company's top brass balked. After all, hedge funds had long been seen as the province of the financial world's high rollers. But after arguing persuasively that equity markets had peaked, the manager won permission to put a small portion of the food company's retirement plan for some 11,000 Swiss employees in a fund of hedge funds. That proved to be a smart move. While major global stock markets tanked in 2000, the hedge fund investment remained in the black. It was a "textbook" case, says Jean Pierre Steiner, Nestlé's (NSRGY ) corporate pension fund manager, of a hedge fund's returns moving counter to the markets' direction.
The experience has been so positive that Nestlé has upped its Swiss plan's exposure to hedge funds from 3% of its investments in 1997 to 18% of the current $5.5 billion. The company's other pension plans, including those in the U.S. and Britain, now have 5% to 15% of their $21 billion in assets invested in hedge funds. No wonder: Steiner says annual returns have averaged more than 10% over the past eight years.
Nestle, a pioneer investor in hedge funds, is no longer alone. Many European pension funds, charities, and universities are turning to them as a way to diversify their portfolios, which have traditionally relied on equities and low-yield, low-risk bonds. But experts say future return expectations for conventional stocks and bonds aren't high. "In an environment like this, the search for yield is more important than ever," says Justin Dew, a senior hedge fund specialist at Standard & Poor's in New York.
Last year, 32% of European institutional investors put money in hedge funds, up from 23% in 2003, according to consultants Greenwich Associates in Greenwich, Conn. Worldwide, $450 billion flowed into funds of hedge funds, more than five times the $80 billion seen in 2000, according to Morgan Stanley (MWD ). Hedge funds seek to maximize returns by investing in futures, options, distressed debt, and derivatives such as currency and interest-rate swaps that carry higher risk than plain-vanilla stock and bond funds. "It's perceived to be a risky asset class, but if you get into a multi-strategy fund, you reduce that risk," says Peter Ball, head of British institutional business at J.P. Morgan Fleming Asset Management in London.
Besides Nestlé's pension plan, other blue-chip institutional investors in Europe with a sweet tooth for hedge funds include BT Group PLC (BT ), the Dutch retirement scheme PGGM, some of the endowments at Oxford and Cambridge Universities, as well as Railpen, the pension program for Britain's rail industry. Brendan Reville, Railpen's investment director, says he plans to invest up to 5% of the fund's $29 billion in hedge funds. "There are clear concerns about an unregulated area," Reville says. "But these assets can provide stable, real returns."
As good as the returns can be, no major institutions are going for broke. They usually risk only a small slice of their portfolios -- about 2% to 3% at first. And most prefer to invest in funds of hedge funds to spread the risk. Even then, institutions take few chances. Nestlé, for instance, has an intense due diligence program in which its own staff investigates the strategy, operations, and even personal backgrounds of hedge-fund managers. "These people are intrinsically fearful and are quite different from the traditional hedge fund investors," says Catherine Doherty, principal of Investit Intelligence, a London consultancy. "They are attracted by the idea of a free lunch, but they know there is no such thing."
That's the rub. Just because some hedge funds have performed well doesn't mean they'll be able to repeat that magic. In fact, as interest rates in the U.S. rise, the markets may become more volatile and could trigger a meltdown at hedge funds caught on the wrong side of a trade. So far this year the S&P Hedge Fund Index, a measure of returns, is down 1.0%. Last year the index rose just 3.9%.
So institutions are treading cautiously -- even as they up the ante by courting hedge funds more assiduously. Take BT's approach. Before its initial investment late last year, the telecom giant's pension manager spent two years researching the idea, coming up with an internal plan, and building up a specialized team. By this summer, BT's manager, Hermes Pensions Management Ltd., hopes to commit some $1 billion to a fund of hedge funds. That's about 2% of BT's $57 billion retirement program, which covers more than 350,000 people. "We're not looking to shoot the lights out," says James Walsh, head of strategy at Hermes. "We're trying to build a diversified portfolio." Just make sure the portfolio doesn't have a nasty accident in the process.
By Laura Cohn in London