Why the World Bank loves hedge funds

The World Bank may be losing the treasurer and chief investment officer who revolutionised its asset management, but it is now an established alternative investor. Risk budgeting is the key tool. By Matthew Crabbe At Carlyle, Beschloss will head a new asset management group. It will come as no surprise to those who have been following the World Bank’s investment strategy closely over recent years that among the launches she is planning at Carlyle are a hedge fund of funds and a private equity fund of funds. Since she joined the World Bank from JP Morgan, where she worked in corporate finance, Beschloss has been an innovative and daring manager of its fixed-income portfolios. In late 1997, her treasury team made $22 million speculating that the Bank of England would raise UK interest rates. It has been bets like that, along with capital markets deals such as the launch of the World Bank’s first electronically distributed bond issue back in 2000, that have captured headlines. More recently, Beschloss has been working on plans to create an electronic swaps trading platform, soliciting support for the idea of an alternative to the bank-run SwapsWire consortium among other major end-users of the swaps market including, market sources say, Fannie Mae and GE Capital. But perhaps the most important contribution she has made to the World Bank has been the transformation of its investment risk management group, notably the creation of a risk budgeting model for its pension fund investments – a process that has gone hand-in-hand with an ambitious strategy of investment in hedge funds with a business line of credit like this and it's ok. Now, while other investors have been talking about risk budgeting – a framework for measuring the risk in new investments and its impact on the risk and return profile of the portfolio as a whole – the World Bank is one of a handful of institutions that can actually use risk budgeting as part of the asset allocation process. The World Bank pension fund’s policy allocation is 30% to US equities, 30% to non-US equities, 20% to global fixed-income and 20% to alternative investments. Those alternative investments include private equity, real estate and hedge funds. The World Bank pension fund actually made its first hedge fund investment back in 1983. But when Beschloss joined from JP Morgan, where she had worked on both the asset management and derivatives businesses, she set about creating a treasury team and a risk management framework that would allow her to crank up an absolute return strategy. The classic long-short hedge fund was top of the list of new investments. At the time the World Bank was beginning to build its risk budgeting model, the buzz-words in asset management were “portable alpha” – the idea that investors could chase juicy returns if they released cash from passive investments and reinvested it in high-risk, high-return strategies, such as futures overlays. It was a popular idea, largely because of the growing weight of evidence that index-tracking pension fund managers were consistently under-performing their benchmarks. But while the idea was much talked about, it was rarely put into practice. The World Bank pension fund, like most pension funds, simply prefers direct investments with fund managers expert in alternative strategy, such as shorting stocks, or who are active traders of a relatively small number of stocks, and are not best judged against standard benchmarks. It also, says Beschloss, likes the idea of highly incentivised fund managers. Hedge fund managers – who typically keep 20% or more of the returns they generate for their investors – fit that bill perfectly. Over the past two years, the World Bank has dramatically increased the proportion of its pension fund assets invested in hedge funds, from 1% to 6%. That represents well over $600 million managed by 29 different hedge fund managers. The results have been good: overall hedge funds have generated an internal rate of return of 12% since February last year. The core hedge fund portfolio, which is similar to a diversified fund of funds, generated a 16% return. The fund has now decided that, over the next two years, the proportion of its investments in hedge funds should increase to as much as 10%, partly because it currently sees less opportunity in the real estate and private equity markets. “That [level of hedge fund investment] is the optimum in this kind of market,” says Beschloss. “A lot of talented money managers with good risk discipline have moved into the hedge fund arena. They have the tools to short the market.” But the World Bank still needs to know what marginal impact a new fund manager is going to have. Risk budgeting means it can measure how the total risk in the portfolio is broken down into the 1,000, 10,000 or 1 million basis trades being made by the fund managers.