Insider Probe Impact Felt by Pension Funds?

Steve Eder of the WSJ reports, Insider Probe Impact Felt by Pension Funds:

The federal insider-trading probe is being felt beyond the world of hedge funds and "expert network" firms in New York and Silicon Valley. Investors in some of the hedge funds involved are struggling to get information and decide whether to sell their positions.

The scandal hit close to home for the $10 billion School Employees Retirement System of Ohio: The pension fund is invested in two hedge funds raided as part of the investigation. Soon after the news of those raids broke in November, executives of the pension fund flew to New York to question the two firms, Level Global Investors LP and Diamondback Capital Management LLC.

A contact at Diamondback told them the fund's managers would be limited in what they could say about the investigation but offered to provide an update on the fund's portfolio. The pension executives balked. "We have to do our job. I don't want a portfolio update," one of the pension fund's investment executives, Phil Roblee, wrote to another employee in an email on Dec 6.

Level Global and Diamondback, which haven't been accused of wrongdoing, have told investors they aren't targets in the probe. Spokesmen for Diamondback and Level Global declined to comment for this article.

Details of the exchanges between Diamondback and the Ohio pension fund offer a look inside the relationship between a hedge fund and a big client during a period of turmoil. The information was obtained by The Wall Street Journal as part of a public-records request made to the Ohio pension system.

As part of the three-year investigation, U.S. officials are investigating whether consultants and employees for so-called expert-network firms, among others, illegally funneled nonpublic information to hedge funds and other firms. In exchange for a fee, expert-network firms connect investors looking for an information edge with employees at public companies.

In early December, Mr. Roblee, head of alternative investments at the Ohio pension system, and Jason Naber, investment officer for hedge funds there, went to New York and Connecticut and met with principals of Level Global and Diamondback in their offices.

A day before the meeting with Diamondback, its head of marketing and client services, Vickram David, told Mr. Naber during a phone call that the hedge fund principals' "won't be willing to answer a lot of detailed questions about compliance in the meeting tomorrow as they are still cooperating with the government and would not want to 'front run that process,' " Mr. Naber wrote in an email to Mr. Roblee summarizing the call, adding that Mr. David had suggested they could do a portfolio update.

In the Dec. 6 email, Mr. Roblee told Mr. Naber that a portfolio update wouldn't be good enough.

Mr. Roblee, in an interview, told the Journal that he found both meetings to be useful and that the managers were "up front" in terms of their response to the investigation.

So far, the Ohio fund hasn't sought to withdraw assets from Level Global or Diamondback, Mr. Roblee said. Nor have several other public pension funds, including New York State Common Retirement Fund, invested with both Diamondback and Level Global, and the New Jersey Division of Investment, invested with Level Global, spokesmen said.

Representatives at several funds say they have been talking to consultants, watching the news, and communicating with their boards as the investigation wears on.

Should a hedge fund or its executives be charged by civil or criminal authorities in the matter, that would likely prompt pension funds to seek to withdraw assets, according to people within the industry.

In Philadelphia, the Public Employees Retirement System is holding onto its investment in Diamondback, which has been a top performer with a 15.3% cumulative return since the system invested $20 million with the manager about two years ago, said Francis X. Bielli, the system's executive director.

"We invested for the return, and quite frankly, our return with Diamondback has been very good," Mr. Bielli said.

Some pension funds said they are getting accustomed to bad news, since the financial crisis and more recent insider-trading cases. "You have to be prepared for stuff like this. Sometimes the knives are falling and we get stabbed," said Joelle Mevi, the chief investment officer of New Mexico's Public Employees Retirement Association, in an interview shortly after the November raids.

The association has $44 million invested in Diamondback and no plans to redeem, a spokesman said.

Newer investors in the hedge funds may not be able to withdraw money quickly, due to requirements that they invest for a minimum period of time. Nor may they want to, especially if the manager is delivering strong performance.

Some investors are looking to leave. Diamondback recently told clients that investors had so far asked to pull $400 million ahead of a mid-February deadline to request quarter-end redemptions, and that it is unclear how much more might be withdrawn, people familiar with the matter said.

Level Global has more than $4 billion under management and Diamondback has more than $5 billion, according to people familiar with them.

Diamondback this month has offered investors a management-fee cut—offering to reduce the annual flat fee to 1.75% of assets invested from its current 2%—as an enticement to keep clients' money in place, the people said.

Diamondback told clients that the firm will hold back 1% of whatever they withdraw in order to fund a reserve account, one person said. The account would be used if Diamondback funds eventually have to disgorge profits it has made as a result of the probe, the person said.

Diamondback also told investors that the management company, not investors, has paid all expenses related to the investigation and will do so this year as well.

Pension funds have been investing aggressively in hedge funds and that leaves them exposed to operational and reputation risk on top of investment risk. Nonetheless, in regards to this particular case, there is no use jumping the gun and redeeming funds before the investigation is over. If civil or criminal charges are laid, then they can reassess what course of action to take (even then, redemptions might not be necessary depending on who is charged).

What investors need to know is that hedge funds are making a comeback after getting creamed in the 2008 crisis. According to Svea Herbst-Bayliss of Reuters, Hedge fund industry assets swell to $1.92 trillion:

Hedge fund assets grew a record $149 billion during the last three months of 2010, according to new data released on Wednesday.

According to Hedge Fund Research (HFR), which tracks industry performance and asset flows, hedge funds around the world now invest $1.917 trillion.

Investors added $13.1 billion in new money during the last quarter after having put in $19 billion in the third quarter. In total, pension funds, endowments and wealthy investors added $55.5 billion in new money in 2010, the highest annual total since 2007. The rest of the increase during the last quarter came from market gains.

The increased flows came even as the industry delivered only lackluster returns of 10 percent, lagging behind mutual funds and the industry's own more impressive 19 percent gain in 2009.

The industry is almost back to its peak size of the second quarter of 2008, when assets hit $1.93 trillion, right before the height of the financial crisis.

But the flows also suggest investors are taking a more cautious stance by sticking with established players. The data show that 80 percent of net new assets went to big fund firms that oversee more than $5 billion in assets.

"The second half of 2010 was a historic time in the hedge fund industry, characterized by powerful and pervasive trends shaping the institutional landscape of the hedge fund industry", Kenneth Heinz, President of HFR, said in a statement.

"As the industry is positioned to surpass its previous asset peak, global investors are focused on the dynamics of inflation protection, strategic specialization, enhanced liquidity, improved structure and transparency for accessing hedge fund performance in coming years," he said.

Macro and relative value funds were the most popular with investors, as clients hoped those types of funds could best navigate volatile currency and interest rate markets.

Event-driven funds which focus on mergers and acquisitions were also popular, pulling in $14 billion during 2010.

But the industry's biggest category, equity hedge funds that can take long and short bets, failed to excite investors and added only $2.6 billion in new money during the year.

What do all these hedge fund assets mean? It means markets are getting primed for the next ramp-up. It's going to be volatile, but liquidity flows are pushing risk assets higher. I suspect a lot of cautious fund managers are going to get caught flat-footed in 2011 as the big hedge funds and banks ramp up. The first weeks of trading mean nothing but pay attention, I think we're getting a taste of what lies ahead.