The great adventure: US public retirement funds continue to explore hedge funds

October 10, 2013  

Twenty-three pension plans account for $75 billion in committed capital as strategies such event-driven, global macro and credit remain in demand in 2013

Investing in hedge funds is no longer a pastime for intrepid daredevil explorers, but it is also still not quite a walk in the park. And yet the number of hedge fund mandates from US public pension funds shows no signs of slowing down, proving that this investor community is still up for an investment adventure.

With a total of 23 state, county and municipal pensions awarding 70 mandates to a mix of single-manager hedge funds and funds of hedge funds (FoHFs) during the calendar year to September 2013, according to InvestHedge, public plans have truly been a gold mine for hedge fund marketers.

The shift to direct hedge fund portfolios has ramped up in pace with increasing interest in keeping FoHFs employed as advisers, rather than fiduciaries, behind the scenes.

As institutional interest in hedge funds is expected to continue to rise by as much as $1 trillion by 2017, US public pensions’ adventures (and misadventures) in hedge funds are likely to be watched like reality television by investors large and small.

The size of the absolute return mandates has varied widely from plan to plan, but in total more than $6 billion has been put to work in recent months with the average target allocation to hedge funds remaining steady at 10% of total assets. Whether the committed assets are $10 million or $100 million, the focus on manager selection and strategies is at an all-time high.

Managers winning mandates in 2013 include: Carlson Capital, Claren Road, Third Point, Scopia, Canyon Value, York, Hoplite, DE Shaw, Davidson Kempner and Och Ziff. Fund of hedge fund activity, while slower, does continue as well, with SSARIS Advisors, Arden Asset Management, EnTrust Capital, Blackstone Alternative Asset Management and Rock Creek Group all collecting fresh capital.

In the first nine months of the year, the active allocators to hedge funds oversee a total of $1.2 trillion in assets, of which $75 billion has been set aside for hedge funds. While a number of plans have allowed their allocations to go beyond their stated targets, others are revisiting their asset mix this autumn with asset liability studies, such as the North Carolina Retirement System that recently expanded its alternative investment portfolio via new legislation.

New York City Employees Retirement Systems and Ohio Public Employees Retirement System have been the most active allocators so far this year – each putting to work more than $1 billion. Ohio’s consultant, Cliffwater, was the busiest among the consultants, putting roughly $2.4 billion to work in hedge funds in a variety of strategies. Aksia, which consults to plans such as New York City and Orange County Employees, did a brisk $2 billion in fresh allocations among US public plans over the same time frame.

In a report of state pension funds released in July, Cliffwater noted that hedge fund allocations are the most rapidly growing alternative sector, representing 4% of total state pension assets and 15% of alternative allocations. For the year ending 31 December 2012, the firm had a total of $20 billion of client capital in hedge funds and ranked sixth in our survey of investment consultants.

  Steven Nesbitt
The main source of fresh capital for alternatives continues to be equities, according to Cliffwater. Equity allocations have dropped two percentage points in the most recent year. Steven Nesbitt, founder of the firm says, "We suspect that future funding for alternatives might instead come from fixed income given their current low yields and increasing trustee comfort with lower risk hedge funds as an alternative to fixed income."

Earlier this year, Cliffwater was selected as the alternatives consultant to the $24 billion Connecticut Retirement Plan and Trust Funds, which only has allocated $400 million to hedge funds. As an initial foray, Connecticut prefers to remain allocated to funds of hedge funds.

The most active allocator for 2013 so far has been Cliffwater’s client, the $83 billion Ohio Public Employees Retirement System in Columbus. The pension fund has built-out roughly one-quarter of its hedge fund allocation in recent months with a variety of single hedge fund managers and FoHFs, totalling 21 managers, receiving $1.1 billion. Event-driven, macro and credit have been of particular interest; a shift that is being reflected in strategy allocations such as SkyBridge Capital’s move from pre-paid mortgage-backed securities to event-driven.

The new mandates in Ohio bring the hedge fund programme total in the Buckeye State to $4.4 billion. The 2013 year-to-date return for hedge funds through 31 May was 5.4% versus the benchmark return of 2.8%.

One of the most high-profile additions in Ohio this year has been to the JANA Nirvana Fund, which is a value-oriented, event-driven fund focusing on companies considering or implementing strategic change. While not adding the same JANA fund, New Jersey Division of Investment also tapped a co-investment fund offered by the firm.

Ohio Public Employees has targeted a 6% exposure to hedge funds, a target it expects it will hit this year. The programme now surpasses 20 single-manager holdings and additional hedge funds have been undergoing legal review following investment due diligence and onsite meetings conducted by Cliffwater. Unlike many other pension funds on this list of active public pension fund allocators, Ohio still maintains FoHF holdings. Prisma Capital Partners and K2 Advisors maintain allocations.

New York City, on the other hand, has a far larger pension fund than that of the state of Ohio with $139 billion in combined pension assets of five city plans. The three largest city plans, with a combined $70 billion in pension assets, have maintained an allocation to Permal Group and employ local hedge fund consulting firm Aksia.

The city’s target allocation to hedge funds in dollar terms is slightly smaller than that of Ohio at $3.5 billion. New York allocated just more than $1 billion to hedge funds this year with mandates going to Carlson Capital, Perry Capital, Pharo Macro, Cantab Capital Partners and FirTree Partners. The strategies that were considered this year were event-driven, commodity trading advisers, global macro and relative value.

The long-term plan in New York is very similar to what is to be found at other public pension plans – to invest in between 15 and 20 managers over the next few years. The aim is to earn between 8% and 10% annual return with up to 5% to 7% volatility.

On the West Coast, the Orange County Employees Retirement System in California is getting close to filling its target allocation of $1.3 billion by moving $910 million to hedge funds in recent months. Recent hires with the help of Aksia saw DE Shaw appointed to manage up to $74 million in its DE Shaw Mult-Asset International Fund, while $63 million apiece was set aside for the Hoplite Offshore Fund and the PFM Healthcare Fund.

The Orange County allocation to hedge funds will max out at around 15 managers and plans are to ultimately phase out its allocation to FoHFs. Much of the renewed hedge fund activity at Orange County took place at the end of 2012 with the addition of CQS, Tricadia Capital Management and Brigade Capital.

Among the most active state pension allocators this year, New Jersey Division of Investment has also set aside the largest target allocation to hedge funds with a whopping 15% target or roughly $10 billion plus in hedge funds. The $74 billion pension programme has made slow and steady moves into the space.

In recent months, officials have focused on niche strategies with JANA and GSO gaining approval for $100 million and $150 million commitments respectively. New Jersey investment officials view the JANA activist strategy as a complement to the fund’s internal equity portfolio. GSO, meanwhile, is a fund offering up the 'best’ ideas across the long and short credit space.

Generally, the trend among public pensions has been to allocate to hedge funds within the alternatives investment programme and/or within the equity portfolio. Risk parity too has been a growing opportunity for hedge fund managers such as Bridgewater and AQR to straddle the hedge fund/long-only divide, although some in the industry question whether or not this investment trend is coming to an end.

In its survey of 97 state pension fund systems, Cliffwater found hedge fund allocations totalling $95 billion or roughly accounting for 4% of overall assets and 17% of alternative assets. Alternative investment allocations vary widely among state pensions, from 0% to 65%, while there was very little agreement among state pensions as to what diversification should look like.

Some of the differences may be chalked up to whether or not state investment statutes have needed to be changed to include hedge funds in the asset mix. While prudent investor rules generally give leeway to allocate to alternatives, each state differs on whether legislatures need to lift investment restrictions and support extensive rewrites of investment policies.

Politics has also come to bear as many states have battled the public’s negative views of Wall Street. Some state treasurers have met with resistance when it comes to including hedge funds in the mix. One example can be found in Rhode Island (InvestHedge, February 2013). Treasurer Gina Raimondo has taken on critics of her pension reform measures that included an increased commitment to hedge funds with a 15% allocation.

Cliffwater, which is also a consultant to the $7.4 billion Rhode Island State Investment Commission, says that state pensions added 3% to alternatives in 2012, mostly from equities. This brought their total weighted allocation to 24% of assets, which is still less than half of the 55% allocation for endowments.

Public pensions have been beginning to shift toward what is referred to as the 'endowment model’, which includes a significant allocation to alternatives. Hedge funds in particular represent a much larger 34% fraction of the endowment alternative asset pie, as compared to 17% for state pensions, according to Cliffwater.

Hedge funds have been viewed as a way to dampen equity volatility and have also been considered a way to boost returns as the majority of state pension funds battle lower funding ratios. For instance, of the public pensions that were active hedge fund allocators in recent months, the funded levels range from 67% to 96%. But the plan that is only 67% funded (California State Teachers’ Retirement System) has implemented a policy of less than 1% of assets in hedge funds, while the better-funded plan (Colorado Fire and Police) has an 11% allocation to hedge funds.

Undoubtedly prospective investors have been keeping a sharp eye on performance after poor returns in 2011 for hedge funds and mixed gains in 2012. As for the portfolios of public pensions, returns are positive for the year. Active hedge fund allocators in 2013 saw annualised returns for the year ending 30 June 2013 ranging from 6.4% to over 12%.

According to consulting firm Cambridge Associates, the path selected by hedge fund managers to achieve those returns is important. "Good hedge fund managers are good business partners, and tend to have long-term relationships with their investors," wrote Cambridge Associates in a white paper called Hedge Funds: Value Proposition, Fees, and Future. "Investors should look to allocate capital to managers they believe will treat all investors equally and honorably both in good times and through any rough patches."

There has been debate as to whether or not recent returns albeit net of fees are really enough to pique long-term investor interest. In fact some investors are sceptical as to whether managers are taking more than their fair share of the returns via incentive fees. Consultants such as Cambridge are realising that fees are indeed coming down mostly with management fee discounts being applied as assets grow or based on the lock-ups agreed to by the investor.

Many variables are at play in effectively analysing fees. High water-marks, claw-back provisions or other modified fee arrangements based on performance are all under consideration by pensions. Hedge funds have effectively said goodbye to the "good old days" of a simple two and 20 fee structure. This is while public pension consultants and advisers are getting better at reading the fine print of fund expenses and are willing to create various fund structures for the benefit of the institutional investor with long-term interest in absolute return strategies.

At the very least public pension executives are realising that their size and long-term commitment are attributes that can play in their favour when negotiating. Some recent examples of this can be found at pension funds such as New Jersey Division of Investment, the California Public Employees’ Retirement System (CalPERS), and the Illinois State Board of Investment.

At New Jersey, investment officials negotiated a blended management fee of 0.6% on invested capital with ValueAct Capital Partners. Also part of the deal was a 10% performance fee that would only be paid after the return of the pension fund’s initial capital and an annualised 8% preferred return. Omega Advisors is another better than average fee example with a negotiated 1% management fee and 15% incentive fee arrangement.

Staff overseeing hedge funds at the $240 billion CalPERS fund budgeted resources of $1.5 million as they are growing the number of staffers, but the expectation is that those additional bodies will be paid for by the reduction of fees paid to both advisers and FoHF managers. A proponent of 'fund of one’ structures, CalPERS has been structuring deals with a better 'alignment of interests’ since 2009 with more than 10 'funds of one’ in its portfolio.

At the $11 billion Illinois State Board of Investment in Chicago, lower FoHF fees were struck, with Rock Creek Group, EnTrust and Mesirow Advanced Strategies agreeing to flat management fees of 70 basis points. In the case of Rock Creek and EnTrust, there was an increase in capital after another FoHF was terminated. In general, many have questioned the traditional fee model of FoHFs and that has been a significant reason why so many institutions have looked to allocate directly and maintain their FoHF relationships as advisory relationships.

The Oklahoma Police Pension and Retirement System terminated one of its FoHFs last year with an eye toward creating a direct hedge fund portfolio. But instead of terminating Grosvenor, the pension fund decided to rely on the firm to do due diligence for its new direct programme (InvestHedge, May 2013). The Fire and Police Pension Association of Colorado is also winding down its FoHF relationships, but is keeping both K2 and GAM on board to help fine-tune and sharpen its growing single-manager portfolio.

Little is known about how much – if anything – FoHFs are paid for these new advisory relationships, but it does not seem that the blurring of the lines between advisers and consultants will be going away any time soon. For hedge fund consultants such as Towers Watson, the perception of being a FoHF does not hold a negative connotation – as the firm entered the InvestHedge Billion Dollar Club this year (InvestHedge, September 2013).

Whether consultants or FoHFs acting as advisers will win the majority US public plan business going forward has yet to be determined. Many consultants charge flat fees based on the size of portfolios, while strategically using their combined assets of their clients as leverage in negotiations. This is a role that can also easily be replicated by FoHFs.

InvestHedge surveyed nine consulting firms in early 2013 to find that they oversaw a combined $464 billion in assets. The FoHF industry (now including Towers Watson) has grown to $623 billion. Unlike consultants, FoHFs are also looking increasingly to retail investors and family offices for new capital that moved directly into hedge funds in recent years.

Who will hold the sway in sourcing the best-performing managers is what public pension trustees are taking bets on, as the stakes remain high to ensure their investment funds’ long-term survival. As long as investors keep a healthy sense of adventure, there is some potential for upside in returns in light of the overall uncertainty in global markets. 

Active US public pensions in 2013

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