Investing in Hedge Funds: Uncut hedges
Hedge funds have had a tough time recently. The largest US public employee pension fund, CalPERS, sparked controversy when it announced it was exiting its hedge fund holdings, saying results didn’t justify their cost and complexity. Coming from one of the world’s bellwether funds, it highlighted the issue of fees. Some large US public pension plans have come under public pressure about fee disclosure, typically wrapped in politically-charged allegations that hedge funds were little more than a way to funnel plan members’ assets to Wall Street billionaires.
The latest set of data from eVestment suggests that the hedge fund industry suffered a $6.9bn (€5.5bn) net outflow in September 2014. Combined with poor performance, this led to the first quarterly decline in industry assets since Q2 2012. Nonetheless, net flows for the whole of Q3 2014 were actually positive to the tune of $9.6bn; and for the year to September 2014 net inflow was $107bn, already 73% more than the whole of 2013. The discussion around the CalPERS decision is unlikely to derail the secular trends that are reshaping the place of hedge funds in pension investing, including integration of hedge funds into traditional asset buckets, refocusing hedge fund buckets to strategies aimed at generating outsized returns, and presenting trustees with a fee breakdown for different levels of hedge fund allocation as they make their investment decisions.
“I don’t expect it to have a meaningful impact on allocations to hedge funds,” says Stephen Nesbitt, CEO of Cliffwater, a California-based alternatives advisory firm for institutional investors. Although, CalPERS “came to the right conclusion, for them”, its issues with cost and complexity “vary markedly from the experience of many funds that we consult with”, he says.
Nonetheless, CalPERS’ decision has raised a question about the value hedge funds deliver to pension portfolios, says Frederick Rowe, vice chairman of the Employees Retirement System of Texas and general partner at Greenbrier Partners, a money management firm in Dallas. Hedge funds face a fundamental challenge, he says: “When you have a diversified group of managers, it’s going to be hard to beat the market after expenses and fees.”
Is ‘beating the market’ what pension funds look for from their hedge funds? With core fixed income returns in the 2.5-3.0% range, hedge funds are attractive to pension CIOs striving to meet typical actuarial targeted returns of 7% for public plan portfolios. Institutions currently target after-fee returns of 4-7% for a diversified portfolio of hedge funds, says Donald Steinbrugge, managing partner of hedge fund consultancy Agecroft Partners – who notes that the past five years have seen hedge funds offering fee breaks for large pension funds and the clients of institutional consulting firms, often discounting by as much as 25%.
Investors “don’t mind paying fees if there’s performance”, adds Cliffwater’s Nesbitt. “If you can realise net-of-fee alpha of 3-4% annually, people are willing to pay for that.”
In Pennsylvania, the $53bn Public School Employees’ Retirement System (PSERS) regards its $7bn hedge fund allocation as a way to “reduce the risk and/or enhance the returns of [the] overall investment program”, as well as setting out the goal of an annualised return of LIBOR plus 3.5% with volatility of 9% or less “over a full market cycle”.
“[The investment] provides diversification for our asset allocation and is specifically structured so it does not correlate with traditional equity markets,” adds CIO James Grossman. “We not only look at fees paid and risk levels; we look at our funding, diversification and cash flow needs which are very specific to our fund. We do not have any immediate plans to change our hedge fund asset allocation.”
The hedge fund allocation begun in 2011 at the $29.4bn State of Connecticut Retirement Plans and Trust Funds (CRPTF) that targets a return of 300bps over the 90-day T-bill rate and returned an estimated 10.3% net of all fees for the fiscal year ended 30 June, according to Connecticut State Treasurer Denise Nappier. That compares with a 7.5% gain for the HFRI Fund-of-Funds Composite index, and a 9.1% gain for the HFRI Fund Weighted Composite index, which tracks direct fund performance.
“Our hedge fund programme has been highly successful and will continue to play an important role in our investment strategy,” said Nappier, currently campaigning for re-election, in a written statement.
Connecticut implements its allocation through a fund of funds platform advised by Cliffwater. The $1.7bn investment represents 5.7% of total assets, under a mandate that encompasses absolute return strategies, real assets, opportunistic funds and a ‘new ideas’ bucket. As well as having a return objective, CRPTF targets correlation of this portfolio with standard equity benchmarks of less than 0.50 over a full market cycle.
Perhaps fittingly for a city in the heart of Silicon Valley, the City of San Jose has one of the most innovative approaches to hedge funds. It starts with governance. In 2010, the city council reformulated the boards overseeing its $3bn Police and Fire Department Retirement Plan and the $2bn Federated City Employees Retirement System, so each board would have a majority of independent outside trustees who are required to have significant investment experience. In 2011, the boards retained London-based Albourne Partners as hedge fund consultant.
In initial 2012 allocations, the Federated plan invested 25% of its assets in hedge funds, and the Police and Fire plan invested 10%, says Arn Andrews, CIO at the San Jose Department of Retirement Services.
CalPERS’ exit from hedge funds will not affect San Jose’s programme, says Andrews, but the city continually refines its asset allocation and performance reporting to make the most of its hedge fund investments. Starting in October, each plan moved hedge funds with equity- and fixed income-related characteristics into the allocations of those asset classes, says Andrews. The Federated plan reclassified a 6% allocation to long/short equity managers, and a 4% allocation to credit strategies, while the Police and Fire plan moved 2% of assets from its absolute return bucket into the allocations to equity and fixed income. The Police and Fire plan now invests 10% of its assets in a global tactical asset allocation strategy within the alternatives allocation.
The reclassified hedge fund positions are monitored by the primary consultants for each plan, NEPC for the Police and Fire fund, and Meketa for the Federated fund. Each consultant reviewed the hedge funds they inherited, and retained all of them, says Andrews. From now on, San Jose will direct each consultant to present the fees associated with each subsequent asset allocation scenario presented to trustees, adopting an approach NPEC uses for another client.
This rigour and creativity in the utilisation of hedge funds mirrors the creativity that investors claim to find in the industry itself – and many say that it is necessary to embrace both to get the best out.
“We cannot rest on our laurels, and do only what is easy and familiar,” as Staffan Sevon, director of tactical asset allocation at Finland’s Ilmarinen, who recently wrote on the firm’s blog making the case for hedge funds, puts it. “We must constantly explore new investment opportunities, and hedge funds are a key way to take advantage of new understanding of issues.”
Ted Eliopoulos, CalPERS’ interim CIO announced his fund’s decision to end its absolute return strategies programme by citing “complexity, cost, and the lack of ability to scale at CalPERS’ size”. Investors need to engage closely with these complex strategies for them to work well, and that effort only makes sense if they can make a meaningful allocation. CalPERS’ $4bn allocation was barely 2% of its overall assets – an amount difficult to justify in portfolio-management terms. Nonetheless, Eliopoulos added, “Hedge funds are certainly a viable strategy for some”.
The examples cited here demonstrate that, but, hedge fund managers must respond to the changing ways these investors are accessing and utilising their products and services. Dixon Boardman, CEO and CIO of Optima Fund Management, one of the earliest fund-of-funds innovators, says that firms that have the technology and resources to satisfy increasing demands for customised portfolios and cost transparency will thrive. Now managing more than $5bn in funds-of-funds, single-manager hedge funds and institutional multi-manager programmes, Optima’s biggest growth area, says Boardman, is ‘funds of one’, where institutions work with advisers to tailor hedge fund portfolios to their unique parameters.
Boardman admits that life would be easier if he did not have to add the staff and technology to meet these demands, but to survive in one of the most competitive sectors of the investment world, he concedes, “you do what you have to do.” His message to other hedge funds managers is clear: “Adapt or die.”