US public pension funds double down on hedge fund allocations

Worryingly low return expectations for stocks and bonds have left US public pension plans with little option but to raise allocations to hedge funds.

Faced with multi-billion dollar funding gaps, strained state finances and volatile markets, US public pension plans are turning to hedge funds to help improve the quality of their investment returns.

According to a study by Barclays Capital, pension plans in North America have increased allocations to hedge funds by around $250 billion since 2009, more than any other class of investors. These funds now have a total of $550 billion invested in hedge funds, up 80% from 2009. A further $40 billion in pension money is set to flow into hedge funds in 2012, according to BarCap.

Among the public pension plans leading the charge are the Florida State Board of Administration (FSBA), Teacher Retirement System of Texas and the North Carolina Retirement System (NCRS). Collectively they plan to allocate over $12 billion to hedge funds this year.

The $154 billion FSBA plan made its first hedge fund investments only last year as part of a $6 billion allocation to alternatives. The plan currently has $1 billion in hedge funds.

This could change dramatically. The Florida state legislature recently approved a bill to increase the FSBA's cap on alternative investments from 10% to 20%, putting the pot available at $30 billion. If approved by Florida governor Rick Scott, the law would allow the FSBA to press ahead with plans to put 11% or $16.5 billion of its total portfolio into hedge funds.

The $108 billion Teachers Retirement System of Texas has already won approval from its state legislature to raise its allocation to hedge funds from 5% to 10%, enabling it to invest a further $5.5 billion into hedge funds.

More controversially, Texas Teachers has also purchased an ownership stake in Bridgewater Associates. The pension system, a long-term investor in Bridgewater’s funds, paid $250 million for a non-voting equity stake in the company and a share of its future profits. Bridgewater manages approximately $120 billion in its hedge funds.

Texas Teachers is a fairly aggressive investor in alternatives, but the promise of consistent hedge fund returns that are less correlated to markets holds appeal even for pension plans that are generally risk averse.

The $72 billion NCRS is one of the most conservatively managed public pension plans in the US. It has a target allocation of 36% to fixed income and only 40% in equities. A funding ratio of 95% also means it is one of the healthiest public pension systems in the country.

Yet North Carolina is about to become a major investor in hedge funds. It has plans to allocate around $4 billion to long/short equity managers. The investments are part of the plan’s allocation to public equities and will represent around 6.5% of its total assets.

Janet Cowell, the state treasurer of North Carolina (pictured), says the main rationale for the investment in long/short strategies is to reduce volatility and not necessarily to boost returns. “We are looking to long/short equity managers to temper the volatility of the public equity allocation. A long/short manager should be able to reduce systematic market risk and deliver equity-like returns with lower volatility over market cycles,” she says.

NCRS also has exposure to hedge funds within its allocations to credit and inflation strategies. In these sectors “hedge funds are able to capture opportunities that we could not access with traditional managers,” says Cowell. North Carolina’s pension system has a total allocation of 11% to hedge funds split across equity, inflation and credit strategies and a legacy investment in a fund of hedge funds (FoHF).

The flow of pension money into hedge funds looks set to continue despite a recent slip in performance. The average hedge fund lost 5% in 2011 while equity long/short funds fared even worse, losing 8.3% on average in a flat year for the S&P 500, according to data from Hedge Fund Research.

While hedge funds are expected to do better, the losses in 2011 have not seriously undermined the case for investing in them, says Jane Buchan, CEO of FoHF manager Pacific Alternative Asset Management Company (Paamco). “The primary reason pension funds invest in hedge funds is to control volatility and preserve capital, not to beat the markets,” she says.

The notion that hedge funds preserve capital in down markets was put to the test in 2008 when the financial crisis sent markets into a tailspin. Hedge funds lost 19% on average that year but they still managed to shield investors from the full extent of the collapse in equity prices, which fell 38.5%.

Michael Flaherman, a managing director at FoHF manager Lyrical Partners, says the diversification argument for investing in hedge funds still holds. “If the rationale for investing in hedge funds was to protect capital and reduce volatility at the portfolio level, then hedge funds have delivered,” he says.

Flaherman was chairman of the investment committee at the California Public Employees Retirement System (Calpers) from 2000 to 2003 when it embarked on a landmark $1 billion hedge fund programme. Since inception in April 2002 to June 2011, Calpers’ hedge fund investments returned 5.66% compared with 6.02% for equities but with around a third of the volatility.

According to data from Hedge Funds Research, the average hedge fund has returned 5.9% since 2002 with standard deviation of 6.5%. This compares to a net return of 2.9% and volatility of 15.9% for US equities.

Far from sparking an exodus of capital from hedge funds, the re-pricing of equity risk in the aftermath of the financial crisis has been a catalyst for rising interest in the industry.

A survey by pension consultant Cliffwater found that by the end of fiscal year 2010, hedge funds managed a total of $63 billion on behalf of 52 of the 96 state pension systems in the US, more than double the amount from four years earlier when it last conducted the survey.

First steps
Now, some of the big US pension systems that previously shunned hedge funds are also starting to invest in them.

The California State Teachers Retirement Systems (Calstrs), the second-largest public pension in the US with nearly $140 billion in assets, will this year make its first allocation to hedge funds. The $200 million investment in global macro strategies is part of a wider effort to diversify the risk factors the plan has exposure to in its portfolio.

“The premise of investing in global macro funds is to protect capital by allocating to diversifying strategies that have low correlations and a different risk profile to our existing investments,” says Steven Tong, director of innovation and risk at Calstrs.

For Calstrs the interest in hedge funds stemmed from the need to find investments that could offset losses in market downturns. “As we analysed the merits of individual hedge fund strategies, discretionary global macro bubbled to the surface as a low correlation strategy that could help improve the performance of the overall portfolio in volatile periods when correlations go to one,” says Carrie Lo, a portfolio manager in the innovation and risk group at Calstrs.

“Global macro has an asymmetric risk/return profile so it adds something different to the existing mix of investments in the portfolio,” she says.

The Calstrs board approved a trial investment in global macro funds in March 2009. The plan started hiring managers after selecting Lyxor Asset Management as an adviser in December 2011 to help implement the programme. Tong’s group has the authority to manage the programme for up to three years, at which point it has to prepare a report for the investment committee on the performance of the funds and their contribution to the plan’s returns. The committee will then decide whether to continue with the investment, terminate the programme or increase the allocation.

Lo says Calstrs is looking for “consistent performance with controlled drawdowns, strong capital protection and different return drivers” to the rest of the portfolio. “If we get all that, then we can conclude there is value in global macro funds,” she says.

The case for investing in hedge funds is stronger today than it was before 2008 given the funding shortfalls of many public pension plans and the worryingly low return expectations for traditional investments.

According to a study by Bradley Jones, a macro investment strategist at Deutsche Bank, stocks and bonds are set to return 2.1% and negative 0.3% respectively over the next decade. Under that scenario a 60/40 portfolio will deliver annual returns of only 1.1% over the next 10 years, well short of the 7% to 8% return targets of most pension plans.

“A portfolio of stocks and bonds is not going to get you anywhere near your actuarial rate of return,” says Peter Carey, a managing director at SkyBridge Capital and the former head of absolute return strategies at the New York State Common Retirement Fund. “In this environment pension funds need to find ways to reduce volatility and add positive convexity to their portfolios. Hedge funds are one of the best ways to do that because they have the ability to capture most of the upside in markets and limit the downside.”

Pension plans are increasingly finding a place for hedge funds in their equity and fixed income portfolios, rather than treating them as a separate asset class. As this trend develops Carey sees hedge fund allocations rising from their current levels of 5% to 10% to at least 15% or 20%, where they can have a meaningful impact on a plan’s overall performance.

But for some, there is a hint of desperation in the recent surge in allocations to hedge funds. “The initial wave of interest in hedge funds turned into a flood once people realised equities and bonds were not going to generate the returns necessary to meet pension liabilities in the next decade,” says Flaherman. “There is a sense that hedge funds and alternative assets broadly are the only hope. Pension funds see themselves as having no other choice.”

That assumes hedge funds will continue to deliver superior risk-adjusted returns across a broad range of strategies. Flaherman questions whether this is realistic.

“A lot of the assumptions about hedge funds are based on historic data from a period in time when equities were rising, interest rates were in long-term secular decline and there was a lot less capital chasing returns,” he says. “It is not clear the same strategies will continue do well in the future.”

The concentration of hedge fund assets in a handful of established strategies and managers will inevitably erode returns and may even be dangerous, he worries. “Pension funds need to venture off the beaten path and invest in smaller hedge funds that are not in the same trades as everyone else but that’s not easy to do when you have billions of dollars to allocate,” says Flaherman.

Hedge fund programmes will have to be managed more actively and dynamically to generate meaningful returns in the future, notes Carey. A static portfolio with exposure to the main hedge fund strategies will decay over time and underperform in the long term, he argues.

“Certain strategies like long/short equity are already over saturated and as more money comes in, it will only make it harder for them to generate returns,” he says. However, other hedge fund strategies, such as those investing in mortgage-backed securities, have ample capacity and the potential to generate strong returns.

“The investment landscape is constantly changing, which makes it all the more important to actively manage allocations to different hedge fund strategies. If you try and build an ‘allweather’ hedge fund portfolio, it is not going to work,” he says.

One of the effects of 2008 was to focus greater attention on the sources of hedge fund returns. There has been a backlash against strategies that rely on the illiquidity premium as a primary source of returns and funds that make directional bets with leverage.

Liquidity issues
During the financial crisis, some highly leveraged hedge funds had to liquidate assets at fire sale prices to meet redemption requests and margin calls. Others were holding illiquid and hard-to-value assets and were forced to suspend redemptions. The crisis also revealed a liquidity mismatch in many FoHFs that promised investors better liquidity than their underlying hedge funds could provide.

“Liquidity is really important for pension funds,” says Paamco’s Buchan. “To the extent that hedge funds are seen as a substitute for long-only equity and fixed income investments, they need to be liquid. Pension funds need liquidity to pay benefits.”

Pension funds are using their considerable muscle to press for improvements in these areas. Calpers completely restructured its $5 billion hedge fund programme after 2009. The plan fired 15 managers and moved most of its hedge fund investments into separate accounts, which give it complete transparency and control over assets. Calpers has also taken a tougher stance on fees, insisting that managers agree to ‘claw-back’ terms that allow it to recoup performance fees paid in profitable years if they subsequently underperform.

The desire to reduce fees and gain greater transparency and control over underlying assets has also fuelled a move away from FoHFs in favour of direct investments. A survey by SEI found that 40% of institutional investors now invest directly in hedge funds compared with only 24% in 2010.

When Carey joined New York Common as its director of absolute return strategies in March 2007, its $4 billion hedge fund programme was invested largely in seven FoHFs, which had exposure to 184 underlying managers.

“We had massive redundancy in the programme and a cost structure that did not make sense for New York Common,” Carey says, “So we came up with a plan to eliminate redundancies, lower costs, improve transparency, basically gain control over our investments and ultimately achieve a better risk/return profile in the hedge fund programme.”

Over the next three years, New York Common replaced its FoHFs with direct investments in 28 hedge funds. The plan was able to realise “huge savings in fees” by negotiating directly with managers. The restructured portfolio has outperformed the FoHF indexes with lower correlation to markets during Carey’s time at the plan.

While the direct investing approach worked for New York Common, it may not be for everyone. It requires the pension plan to build a dedicated hedge fund investment team and equip them with the systems and tools they need to analyse and monitor complex strategies.

New York Common had a team of five overseeing its hedge fund programme and licensed software from Measurisk and PerTrac for risk management and portfolio analytics. It also hired BNY Mellon as an independent administrator to verify and price the underlying assets.

However, Carey says FoHFs still have a role in the public pensions sector. “Smaller pension funds that don’t have the staff and expertise to go direct have to work with a FoHF or an external advisor,” he says. “The problem at New York Common was that we had seven FoHFs when we needed one or two.”

Resource constraints are a fact of life for many public pension plans but many are making a concerted effort to secure the expertise and sophisticated risk systems necessary to run their hedge fund programmes. Indeed, the meagre expected returns of stocks and bonds over the next decade leave pension plans with little option but to explore alternatives seriously.

For all their benefits, hedge funds are not a panacea for fixing underfunded public pension plans. “Hedge funds are not a solution to the problem of underfunded liabilities. They cannot manufacture returns,” says Carey.

“What they can do is help lower the volatility of pension portfolios so that, over time, they can achieve the best risk-adjusted returns and begin to address the problem,” he adds.