The Benefits of Hedge Funds in Asset-Liability Management

Recent diffi culties have drawn attention to the risk management practices of institutional investors in general and defi ned benefi t pension plans in particular. A perfect storm of adverse market conditions over the years 2000-2003 has devastated many corporate defi ned benefi t pension plans. Negative equity market returns have eroded plan assets at the same time as declining interest rates have increased the marked-to-market value of benefi t obligations and contributions. In extreme cases, corporate pension plans have been left with funding gaps as large as or larger than the market capitalisation of the plan sponsor. For example, in 2003, the companies included in the S&P 500 and FTSE 100 indices faced a cumulative defi cit of $225 billion and £55 billion respectively (Credit Suisse First Boston 2003 and Standard Life Investments 2003), while the worldwide defi cit reached an estimated $1,500 to $2,000 billion (Watson Wyatt 2003). Similar diffi culties have been encountered by insurance companies, as declines in bond returns have encouraged them to seek performance potential in the equity asset class, at a time when the perceived risk was increasing signifi cantly. That institutional investors have been so dramatically affected by market downturns has led to major changes in institutional money management, including an increased focus on asset-liability management (ALM). In this context, institutional investors are desperately seeking new asset classes or investment styles that could be cast in a surplus optimisation context and would offer access to equity-like premiums without the associated downside risks.