Texas County & District herds hedge fund alpha with a 25% target allocation

May 12, 2014  

The plan is to beef up exposure with more than $400m set aside for hedge fund ‘brands’

By Susan Barreto

A couple of years ago, direct hedge fund investments were the domain of large corporate pension plans, university endowments and sizeable state pension plans. This trend has evolved, as evidenced by pension funds such as the Texas County & District Retirement System in Austin that are accessing the hedge fund 'brands’ that were once reserved for elite investors.

Since the beginning of 2014, more than $400 million in fresh capital has been put to work in both equity and credit hedge funds. More than $1 billion was allocated to hedge funds in 2013 as trustees approved an increased allocation to hedge funds that are also used in the equity and credit portfolio segments.

Already one-quarter of the county and district pension fund assets are dedicated to hedge funds – which is on a par with what is dubbed the endowment model, where alternative assets are the crown jewel in a fully diversified investment portfolio. For a mid-size public pension fund with $23 billion in assets, the Texas County & District Retirement System is flying high in the ranks of large-scale hedge fund investors such as California Public Employees’ Retirement System, Harvard Management Company and the neighbouring Texas Teachers’ Retirement System.

Officials through an external public relations firm declined to comment on Texas County & District’s hedge fund aims and whether or not the hedge fund allocation could grow further. What is clear, though, is that hedge fund investing is clearly an absolute aim rather than a relative gain in light of rising equity markets.

Unlike some of the largest US institutional investors previously mentioned, Texas County & District was created only 47 years ago and today serves more than 655 participating employers. Unlike other state-wide pension plans, the system does not receive funding from the state, but rather each underlying plan is funded independently by the county or district.

The fund’s investment objective is an optimistic 8% annually and investment returns fund 77 cents of every dollar the system pays in benefits. The remaining funding comes from employee deposits (10 cents) and employer contributions (13 cents). This translates into a funding ratio of 88%. Texas County & District’s investment philosophy is all about keeping investment risk at acceptable levels. In 2013, the overall investment portfolio returned 16% net of fees. Seeking long-term success, officials continually balance the risk of short-term volatility against the risk of not achieving its long-term target return.

Paul Williams is the investment officer at Texas County & District. He joined the system in 1999 and within this role he allocates new funds across asset classes, directs external investment managers and recommends investment strategies to the board of trustees. Prior to joining the pension fund, Williams served in various positions in Texas state government, including deputy treasurer of the state of Texas and chief of staff for Governor Ann Richards. He also served as a member of the State Board of Insurance.

Under his leadership, the retirement system has moved into hedge fund investments boldly and in 2013 a new investment policy gained trustee approval. Leaning heavily on alternative investments, the retirement system’s asset mix was set at 38% equities, 25% hedge funds, 13% high-yield investments, 12% private equity and 9% real assets. Hedge funds are investment strategies with the goal of achieving positive returns with a degree of independence from movements in financial markets and independent of traditional performance benchmarks, according to Texas County & District’s investment policy statement.

While the target allocation to hedge funds is 25%, the maximum allocation gives the portfolio leeway to grow to 30% of the overall investment portfolio. The expected rate of return for hedge funds is 7% net of fees.

Recent allocations to hedge funds are housed both in the dedicated portfolio and in the credit programme. In April, the pension fund committed $150 million to Highline Capital Partners, a $2 billion New York-based, US long/short equity hedge fund. The York Global Credit Income Fund received a $100 million mandate in early March as part of the growing credit and direct lending investment portfolio that since the beginning of 2013 has grown by more than $600 million. The hedge fund programme over the same time frame has swelled by nearly $1 billion, with another recent allocation being $30 million to ESG Cross Border Equity Fund.

In January and February, the pension fund committed $20 million to AG Super Fund, $30 million to Brevan Howard Credit Catalysts Fund, $30 million to MKP Credit, $20 million to OZ Domestic Partners II, $30 million to York Capital Management and $10 million to Lakewood Capital Partners.

In addition to credit, the equity portfolio also houses some hedge fund holdings with allocations to the long-only products of Marathon and Viking. Making the case for hedge funds in equities has been difficult lately. In a year such as 2013 when the S&P was up 29.6%, making the case for hedge funds that returned a median 9.21% – according to HedgeFund Intelligence Global Indices – is a tough call for the sceptical ones, but those that understand that hedge funds are there for the sudden downturns, are continuing to plow more money in.

In Texas, however, hedge funds have had an unlikely fan base. The University of Texas Investment Management Company has placed millions with Tiger cubs, while the Teachers’ Retirement System of Texas has consistently maintained an allocation to hedge funds for more than a decade.

Texas County & District was a trailblazer among its peer group in 2011 and never allocated to FoHFs, as was the tradition when an investor started out in hedge funds. With nearly $6 billion in hedge funds, the system has a hedge fund portfolio size that was once the domain of elite university endowments and the largest pension funds in the world, but Texas County & District is in a league of its own as diversification across hedge fund strategies continues to grow.

The retirement system hiked its absolute target allocation in 2010 to 20% of the overall portfolio and as far back as 2009 had allocations to credit, distressed, equity long/short and multi-strategy funds. Last year, that target allocation was boosted to 25%, or roughly $5.75 billion, and the pension fund now has commitments to more than 30 hedge funds, with a total of 14 allocations – equivalent to more than $1 billion – that have been made since the beginning of 2013.

In 2013, the board decided to make several changes to its asset allocation in an effort to reduce the volatility of the portfolio’s return and protect against an adverse economic event, according to meeting minutes. The hedge fund allocation was bumped up from 20% as the high-yield strategies allocation was grown to 16%. The aim is to use hedge funds to achieve positive returns that are independent from movement in equity and fixed-income markets and independent of traditional performance benchmarks. The risk level is also set to be lower than stocks and bonds.

Hedge fund investment styles are varied, with strategies such as event-driven accounting for a target weighting of 40% of the portfolio (see chart on page 16). Equity long/short and global macro strategies account for 25% to 20% of the portfolio respectively. The goal is to ensure both diversity of managers and strategies, with a set rule of no more than 15% of the hedge fund programme’s assets going to any single multi-strategy manager and no more than 10% of the portfolio being invested in any single strategy.

Texas County & District staff and hedge fund portfolio consultant Cliffwater consider a number of factors when hiring hedge funds, including the quality and stability of the investment team; the previous investment track record; alignment of interests; and the legal and economic terms governing the hedge fund.

Along with Cliffwater, investment staff aggregate manager data and perform analysis on the overall hedge fund portfolio with a focus on individual hedge fund allocations and strategy/sector concentrations to maintain highly diversified holdings across the hedge fund programme. Due diligence duties, including onsite reviews, confirm the appropriate infrastructure is in place to support the investment process.

Cliffwater, a specialist alternative investment consultant, advises a number of US public pension fund clients including the Rhode Island State Investment Commission (which recently terminated Third Point); Ohio Public Employees Retirement System (which also has holdings in Highline); New Mexico PERA (which started adding more single-manager hedge funds in late 2012); and Massachusetts Pension Reserve Investment Management Board (which is now searching for a managed account platform provider).

Besides consulting, Cliffwater has teamed up with Virtus Investment Partners, which operates a multi-manager asset management business, to establish Cliffwater Investments, an investment adviser that will sub-advise a series of multi-strategy, multi-manager alternative mutual funds for retail investors, providing further evidence of the flow of consulting firms into asset management. Cliffwater has approximately $70 billion of assets under advice, including roughly $52 billion in alternative strategies.

The past three years or so have been busy for Texas County & District beginning with its sizeable shopping spree in late 2011. This saw commitments to 14 hedge fund managers totalling more than $815 million. The largest allocations were made to the Brigade Leveraged Capital Structures Fund and Taconic Opportunity Fund totalling $180 million each, while $100 million was committed to Viking Global Equities.

In 2011, smaller tickets were filled with the remaining 10 funds. These funds are:Archipelago Partners ($50 million); Caxton Global ($50 million); Claren Road Credit Partners ($40 million); Glenview Institutional Partners ($30 million); Meditor European Master Fund ($30 million); Canyon Value Realization Fund ($25 million); Davidson Kempner Institutional Partners ($25 million); Wexford Spectrum Fund ($20 million); Indus Asia Pacific Fund ($20 million); and Pershing Square ($20 million).

A number of these allocations were add-on investments from previous allocations made in early 2011. Those add-on allocations were made to Caxton, Claren Road, Davidson Kempner, Glenview, Indus Asia Pacific, Meditor, Viking Global and Wexford Spectrum.

In 2012, the hedge fund allocation continued to grow as Texas allocated a total of $367 million to the credit space and credit-oriented funds such as Canyon-TCDRS, AG Diversified Credit Strategies Fund, OZ Structured Products Domestic Partners II and AG TCDRS Diversified Income. Other allocations were to Graham Global Investment Fund ($175 million) and Asian Century Quest ($130 million), while staffers chose to award an add-on allocation of $100 million to York Capital Management for its York Global Credit Income Fund.

Then in 2013, the retirement system added two additional top hedge fund brands to its stable: Brevan Howard and BlueCrest. Brevan Howard received a $50 million commitment late in 2012, while the Brevan Howard Credit Catalysts Fund was awarded a $200 million allocation in early 2013. Also in January, BlueCrest Capital was awarded $200 million.

At the beginning of 2014, another $130 million was placed in hedge funds with $30 million mandates going to MKP Credit, Brevan Howard Credit Catalysts Fund and York Capital Management. Smaller $20 million mandates went to AG Super Fund and OZ Domestic Partners.

Some of the same hedge fund names are also prevalent in the $1.8 billion opportunistic credit portfolio that includes allocations to Och Ziff, Angelo Gordon, Canyon Capital and York Capital Management, which is part of the alternative investment allocation and is broadly defined as investments in debt instruments that provide return opportunities resulting from dislocations in the capital markets.

Manager-selection criteria are similar to what one would see at other public pension plans with officials reviewing managers’ returns and strategies regularly. Few drastic changes to the portfolio have been necessary.

Since 2011, the only managers/funds not still on the Texas County & District allocation list released by pension officials are Meditor European Master Fund, Wexford Spectrum Fund and Asian Century Quest.

As of 31 December 2013, the hedge fund portfolio returned 13.6% for the year and 10.5% annualised over five years net of fees. The benchmark for the programme is the HFR Fund of Fund Composite index. To incentivise general partners to maintain performance over the life of a partnership, periods of negative performance may result in previously accrued carried interest being reduced or "clawed back", according to a recent annual report of the system.

In 2012, roughly $80 million was paid in management fees and $79 million in carried interest was paid to the hedge fund programme. Hedge funds were the most expensive alternative investment asset class in the portfolio.

Hedge funds represent a distinctive investment style from traditional, long-only funds, according to the investment policy of the retirement system. That fundamental difference is that hedge funds emphasise absolute rather than relative returns and they may apply a wider range of investment techniques. In general, Texas County & District is looking for the hedge fund portfolio to have a low correlation to other asset classes and specifically to achieve positive returns with "a degree of independence from movements in equity and fixed-income markets".

Depending on liquidity of certain offerings exposures may temporarily exceed limits, but it is the investment staff’s intention that liquidity risk is managed by monitoring and maintaining a schedule of the liquidity of each individual fund that is then aggregated to the programme level, according to the board’s investment policy.

Managers are also monitored on a regular basis. Texas County & District and Cliffwater say they monitor funds formally and consistently whether it is a monthly, quarterly, semi-annual or annual process with the intention to determine whether the initial reasons for selecting the strategy and manager remain valid. Site visits are also performed when necessary to determine that a firm has the appropriate infrastructure in place.

Going forward, the retirement system is likely to continue to monitor hedge fund returns in general. In a time of rising liabilities, diversified absolute returns have never been so important. No matter what the size of pension system, it seems the hedge fund programme, like many other things in Texas, prides itself on being above average in size and scope.

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