Types of Hedge Fund Investors

individually directed plans are discussed earlier in this chapter along with
other types of individual investments in hedge funds. This section dis-
cusses traditional company-sponsored pension plans.
A defined contribution plan is a pension plan where the employer or
employee makes contributions to the pension accounts of eligible work-
ers. Workers may have some input as to how the pension balance is in-
vested. More importantly, the worker bears all of the investment risk,
enjoying a growing account balance when returns are good and suffering
losses when performance is bad. Importantly, the employer makes no
commitment to that worker that the pension benefit will be of any partic-
ular amount.
Like the IRA and Keogh plan, it makes sense for highly taxed workers
who can qualify based on their incomes, net worth, and investment knowl-
edge to invest their defined contribution balances in hedge funds. These in-
vestments would benefit from the tax deferral on the investment returns of
the hedge funds. However, individuals can elect to invest in hedge funds
only if the plan sponsor (usually the employer) offers that as an option. Yet
most group defined contribution plans have been replaced by individually
directed 401(k) plans, so company defined contribution plans are not a
source of funding for hedge funds.
In a defined benefit plan, an employer makes a commitment to fund a
retirement benefit at a particular level. It is typical to guarantee some per-
cent of salary upon retirement (often with several strings attached). The
company funds the plan but also bears the risk of shortfall if the contribu-
tions and investment returns fall short of providing for the promised bene-
fits. Similarly, if the pension returns are high, the company can reduce its
own contributions to the plan. Because the corporation bears all the invest-
ment risk, it is not important that many of the plan beneficiaries would not
qualify to invest in hedge funds.
Pension funds have been slow to invest in hedge funds. Lately, their
allocation to hedge funds has accelerated. Pension assets allocated to
hedge funds have more than doubled in two years, from $30 billion in
2001 to $70 billion in 2003.
9
With trillions of dollars under manage-
ment, pension funds have the potential to be sizable hedge fund in-
vestors. As discussed in Chapter 8, hedge funds are not prepared to
accept large increases in funds from pensions for fear of falling under
the regulations of ERISA.
Pension funds have traditionally been cost-conscious investors. The
size of fees often determines the relative performance of traditional fund
managers. That is, the managers that charge the lowest fees often generate
the highest net return. Not surprisingly, pension funds, which have been
able to negotiate low management fees for traditional portfolio manage-
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