Korea’s National Pension Service (NPS) has started work on building an allocation to hedge funds, and is tipped to strengthen its capabilities in this area and ultimately start investing in single-strategy funds.

Other institutions in the country are also moving to boost their exposure in the asset class, despite growing concerns that hedge funds charge too much for mediocre performance.

The $435 billion retirement fund said last week it had shortlisted BlackRock, Blackstone, GCM Grosvenor Capital Management and UBS as candidates to run a planned global fund-of-hedge-fund portfolio.

Within a few months NPS is expected to appoint two finalists, after completing its due diligence. The two finalists will receive $500 million each and will select funds for the portfolio in the second half of this year.

NPS’s total investment in these strategies will ultimately rise to $2 billion, 0.5% of its current AUM. It will start by investing in overseas funds of hedge funds and then gradually expand into other types of hedged strategies. This comes as the state fund moves to raise its alternative asset allocation from 5% to 10% over the next five years.

Market observers expect NPS to look at making direct investments in single-strategy hedge funds two years from now and to add more professionals to its team with this aim.

Other pension funds in Korea told AsianInvestor they were upbeat on potential returns from overseas hedge funds. The asset class has fallen short of performance expectations over the past couple of years, but in the medium- to long-term hedge funds will generate favourable returns, said Yoon Seung-joon, head of global alternative investments at Korean Teachers’ Credit Union.

Moreover, many local market professionals said NPS’s move into hedge funds was overdue and would act as a catalyst for local investors to access foreign hedge funds more actively.

NPS had initially intended to start investing in overseas hedge funds in 2015, as reported, but the plan was delayed by concerns about the potential outcome. The fund had appointed a head of hedge fund investments in September last year.

Shinhan Investment Corporation has reportedly estimated that NPS's participation will help boost the size of Korea's local hedge fund industry to $6 billion by 2017. This forecast reflects the swift growth of the domestic hedge fund market in Korea, after the barriers to entry were relaxed significantly in October last year.

Meanwhile, Korea Post is building a pool of hedge fund managers from which to draw for future mandates, as reported. The institution's $65 billion savings bureau recently issued an RFP for hedge managers for fixed income arbitrage and long/short structured credit.

However, a senior official from another Korean pension fund said he was in no rush to make allocations to hedge funds. He did not feel they could guarantee the right balance of risk versus return in light of their past performance, especially during the past six months.

“As such, I would wait a bit longer until I can be assured that hedge funds provide stable returns going forward,” he said, adding that they were “rather expensive” in terms of fees.

NPS’s move certainly comes amid something of a wider backlash against the asset class by institutional investors elsewhere. For instance, the New York Employees’ Retirement System last month cashed out of its hedge fund allocation. And, according to Chicago-based Hedge Fund Research, pension funds and other big institutions now account for only 43.1% of hedge funds’ assets, down from 47% three years ago.

According to its latest five-year investment plan, NPS plans to allocate 45% of its assets to stocks, 45% to bonds and at least 10% to alternative assets by the end of 2021, by which time it expects to have $870 billion in AUM. The fund aims to achieve an annual average return of 5.0% over that period, having posted annualised performance of 4.5% between 2011 and 2015.