With the media spotlight fixed unremittingly on the embattled hedge fund industry over the last 18 months, revealing tales of investment losses redemptions, liquidations, gates, extravagant fees and the occasional mind-blowing fraud, it is significant to note that some of the world’s largest institutional investors resisted the hype and happily stayed on the sidelines.
The pensions reserve funds of France and Ireland, for instance, still harbour misgivings that hinder their involvement in the hedge fund industry. It will take more than a few months of positive investment performance to sway these sceptical investors.
Up until this year, the £26.8bn (€29.7bn) Universities Superannuation Scheme (USS) was in the same camp, but driven partly by the belief that the hedge fund industry has moved to address a number of controversial issues, the UK’s second largest private sector pension fund is making a progressive commitment to the asset class.
Mike Powell, USS’s  head of alternative investments, says one of the main reasons he delayed the roll-out of a hedge fund programme until early 2009 was concern over the asset-liability mismatching within the industry, where hedge funds were becoming increasingly exposed to illiquid assets, while funds of hedge funds in a bid to attract investors were offering more liquid redemption terms.
He comments: “From my perspective,  funds-of-funds have not changed, but hedge fund managers are now aligning their redemption terms with the underlying liquidity of their investments.”
So USS has eschewed funds-of-hedge funds in favour of single strategies. To date, £150m (€166m) has been invested in a hedge fund replication strategy run by State Street Global Advisors “to provide a core low risk, cheap exposure to the systematic part of hedge fund returns”, while another £200m has been divided between two global macro funds and an equity long/short fund. Further allocations are in preparation.
The plan is to invest in a diverse portfolio of 25 single strategy funds over the next two years until the hedge fund portfolio is worth about £1.5bn and accounts for one-third of an alternative asset portfolio, which is targeted to reach 20 per cent of the total fund by 2012.
The benchmark for USS’s hedge fund exposure is Libor plus 5 per cent.
“My main concern is that we have control over our own due diligence process,” says Mr Powell, who has recruited a team of five people to assemble and monitor the hedge fund portfolio. “We have full responsibility for the managers that go in our portfolio, whereas with a funds-of-funds manager, you still have responsibility for that investment but you have not conducted the due diligence yourself. The other reason we avoided funds-of-funds was the additional fee drag, but some are trying to come up with more innovative fee structures to attract institutional investors. We get approached by funds-of-funds, some of whom are willing to offer managed accounts on reduced fees.”
Hedge funds must  provide a minimum level of transparency before USS will even consider investing, says Mr Powell. Every hedge fund manager has to agree to provide position level data via their administrator to the risk information aggregator, RiskMetrics, which will provide position-based risk analysis to USS. This, he adds, will enable the scheme to build a more accurate picture of the actual risks within each single strategy and the overall hedge fund portfolio.
Mr Powell observes: “Most of the managers we have targeted have agreed to provide that position level data to RiskMetrics. There are some notable exceptions, but I think the industry is moving towards such service providers as a positive compromise in terms of providing useful transparency, without some of the confidentiality issues that concern people about giving out full portfolio holdings to all of their investors.”
Private equity and infrastructure make up two-thirds of an alternative assets portfolio, which currently accounts for 9 per cent of the overall fund.
Unlike the alternative asset programme, which involves hiring a growing number of external managers, USS’s traditional investment portfolios are run predominantly by in-house fund managers. Notable exceptions include a £2.6bn global equity brief handled by Capital International and a socially responsible investment mandate managed by Climate Change Capital.
In its statement of  investment beliefs, USS contends that “the short-term commercial pressure experienced by most third-party providers makes it hard (if not impossible) for them to adopt the long-term approaches that USS requires.”
Roger Gray, chief investment officer, reveals the remuneration structure for in-house asset managers is based on five-year rolling performance periods. This, he says, “strongly aligns” the interest of the fund manager with the scheme’s investment objectives.
“Our internal reward structure is on a longer-term basis than the typical compensation structure of external fund managers. In addition, a portion of managers’ performance bonuses are deferred for a further three years,” he says.
USS states that its long-term investment horizon, coupled with its scale and not-for-profit basis, justifies the use of active management.
Mr Gray maintains that, being a large scheme, it is possible for USS to defray the cost of an in-house active team against a large pool of assets to keep the cost level within reasonable bounds.
He says: “The question is, can our manager skill and evidence of that skill and prospects for it justify active management costs, which are not high by industry standards?”
He says that USS’s active in-house managers have a strong record in both US equities and UK equities and have significantly outperformed their benchmark indices over both three and five-year periods to end-September.
“Our experience has been that our securities managers, both bonds and public equities, have outperformed internally. We have not had as good an experience with external managers in relation to [traditional] securities mandates. I don’t want to give the impression that any external manager is liable to underperform. We just may not have been as successful in managing the external manager programme as we would

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