Friday, May 27, 2011

Pensions Leap Back to Hedge Funds?

Steve Eder, Gregory Zuckerman and Michael Corkery of the WSJ report, Pensions Leap Back to Hedge Funds:

Public pension plans are lifting hedge-fund investment, seeking to boost long-term returns despite losses suffered in some funds in the financial crisis.

Also, pension officials are using the historically strong returns of hedge funds to justify a rosier future outlook for their investment returns. By generating more gains from their investments, pension funds can avoid the politically unpalatable position of having to raise more money via higher taxes or bigger contributions from employees or reducing benefits for the current or future retirees.

The Fire & Police Pension Association of Colorado, which manages roughly $3.5 billion, now has 11% of its portfolio allocated to hedge funds after having no cash invested in these funds at the start of the year.

"There has been some deserved criticism of hedge funds, but many hedge funds during the market downturn in 2008 did better than the S&P 500," said Dan Slack, the chief executive of the system.

While pensions have been investing in private equity and what are called alternative investments for many years, hedge funds have represented a smaller part of their portfolio. The average hedge-fund allocation among public pensions has increased to 6.8% this year, from 6.5% for 2010 and 3.6% in 2007, according to data-tracker Preqin.

The number of public pension plans investing in hedge funds has leapt 50% since 2007 to about 300, according to Preqin. State pension systems had $63 billion invested in hedge funds as of their fiscal 2010 and are expected to invest another $20 billion in hedge funds in the next two years, according to a recent report by consultant Cliffwater.

Hedge funds typically bet on and against stocks, bonds or other securities, often using borrowed money. Investors have been giving more cash to hedge funds in recent months, as they regain comfort with markets after two years of solid returns.

On average, hedge funds as a class have delivered for large pension funds that have dabbled in them over time, data show. Large pension funds scored median annualized returns of 6.8% investing in hedge funds in the past decade, compared with 5.7% from stocks and 6.1% from bonds, according to Wilshire Associates, an investment consultant in Santa Monica, Calif. Private equity delivered 6.7%.

While hedge funds outperformed stocks in the financial crisis as an industry, some individual funds suffered significant losses or closed.

When looking at average hedge-fund performance, "there is nothing magical being created," said Steven Foresti, head of the investment research group at Wilshire. "They are not a panacea."

David St. Hilaire, who oversees the $230 million City of Danbury Retirement Plan, created hedge-fund investments for his fund's comparatively smooth recovery from the financial crisis and calls them helpful from an actuarial standpoint because of the returns they project. He said the fund has 27% of its assets in alternatives and that this percentage is likely to get bigger.

In March, the New York City Police Pension Fund voted to invest in a firm that puts money into a variety of hedge funds, the first such move by the city's pension funds, which manage $117 billion. In the past few months, two more New York City pensions made the same decision. Together the three funds invested $450 million with hedge-fund firm Permal Group.

It is a "first step into hedge funds," said Larry Schloss, the New York City chief investment officer. He says he hopes the investment will help the city's pension system avoid the "wild ride" it has taken in recent years. The system had $115 billion before market tumble in 2008, when it fell to $77 billion.

New Jersey's State Investment Council, which sets investment policy for the state's pension fund, voted last week to raise the target allocation for hedge funds to 10% from 6.7%, which would make hedge funds the $73 billion fund's largest alternative investment asset.

The bullishness comes despite a moment in the financial crisis when the fund found itself adding cash to hedge funds it was invested in that were wobbling.

"Whatever problems we've had, hedge funds have been our best performer among our alternatives," said Andrew Pratt, a spokesman for the New Jersey Treasury, which oversees the pension fund's investment operations.

By contrast, the Pennsylvania State Employees' Retirement System has been paring its hedge-fund allocation to about 15% at the end of 2010 from about 26% at the start of 2008.

The $25 billion pension system was disappointed after suffering a 16% loss on its hedge-fund investments in the financial crisis despite pursuing a so-called absolute return strategy that has a goal of no losses, a pension fund spokesman said.

"We see hedge funds as having a smaller, though still significant and important role in the asset mix," spokesman Robert Gentzel said.

I have already written a comment asking whether hedge funds have grown too large. Let me explain why the current mania pension funds have with hedge funds is a double-edge sword. On the one hand, underfunded pensions are looking for absolute returns and following the 2008 crisis, they are managing their liquidity risk more closely. For example, the Ontario Teachers' Pension Plan manages liquidity risk very carefully, and invests in hedge funds almost exclusively via a managed account platform, allowing them to have full control over the liquidity of the underlying funds.

Private equity and real estate have been strong alternative asset classes over the years but they're liquidity profile may not be optimal for mature, underfunded pensions managing liquidity risk very carefully. If they need to raise cash fast, they can't just sell a building or their stake in some private equity fund quickly (if they do, it will be at a deep discount). Even in the hedge fund space, the bulk of the assets are going to TAA and global macro managers, Long/Short Equity and commodity trading advisors (CTAs). Why? Because they're scalable strategies and large pension funds prefer writing $50, $100 or $200 million tickets to a few well known established "brand" names than writing small tickets to many less liquid absolute return strategies (more on this below).

On the other hand, the mania with hedge funds is sowing the seeds of the next financial crisis. It won't happen anytime soon, but when billions are being poured into hedge funds, regulators better pay attention to macro systemic risk. The role that large hedge funds and large bank prop desks played during the last credit crisis is still poorly understood. Economists still can't figure out the linkage between hedge fund asset growth, liquidity, credit conditions, financial leverage, asset bubbles, financial crisis and their effect on the real economy.

Over the last two and half years, I've been getting blasted on Zero Hedge for telling investors to keep buying the dips. My view remains that the financial oligarchs will do whatever it takes to reflate risk assets and introduce some inflation in the system. By allocating more and more assets into hedge funds, public pension funds are able to bypass the leverage constraints they have in their traditional assets and they are also introducing a boom in liquidity into the global financial system, thus helping the financial oligarchs achieve their goal of relating risk assets and introducing inflation in the economic system. Absolutely nothing has changed, which is one reason why I expect a lot less volatility going forward (less, not more because everyone will be bidding up risk assets).

Eventually the music will stop, most likely when the Fed signals the start of a rate hike campaign, but there is so much liquidity and leverage in the financial system that it will take several rate hikes before we see speculative activity tapering off in any meaningful way. In the meantime, global pensions and sovereign wealth funds will keep pouring billions into hedge funds and other alternative asset classes.

Let me make a few suggestions to pension funds looking to invest in hedge funds. If you don't know what you're doing in hedge funds, and don't have the in-house expertise to select your own managers, you're better off paying that extra layer of fees and partnering up with a top fund of funds (or even a smaller, less well known one) that will help you invest in hedge funds. You are better off selecting one or two fund of funds, writing them a big ticket and using this relationship to develop in-house expertise to then go the direct route.

Last Friday, I chatted with Rick Dahl, CIO at the Missouri State Employees' Retirement System (MOSERS), on many pension related issues. I am going to write a full comment on MOSERS because they're the best US public pension plan. There are a lot of reasons why and chief among them is they got the governance right. I credit Rick and Gary Findlay, MOSERS' Executive Director for their work on getting the governance right. I also think highly of Rick on a professional and personal level. When it comes to managing a pension fund, you can't ask for a better CIO.

Rick was telling me when MOSERS first got into hedge funds, they wrote two big tickets to Blackstone and PAAMCO which they still use as advisors. However, Rick was smart about the way he allocated to these fund of funds. At the time he invested significant amounts which represented a sizable chunk of their assets and he signed an investment manager agreement which stipulated knowledge transfer where his staff could visit these fund of funds managers on their premises and learn from them for two or three days a quarter. Importantly, you don't just want to give money to a fund of funds, you want to learn from them and squeeze everything you can from the relationship without abusing them.

I mention this because far too many public pension funds are clueless about investing in hedge funds and typically follow the advice of pension consultants. Some consultants are good but most of them are terrible and haven't the faintest idea of what's in the best interest of their pension clients. Worse still, many consultants and prime brokers with cap intro groups are fraught with conflicts of interest and will recommend hedge funds or fund of funds that they invest in or trade with. Again, there are excellent independent consultants and third party marketeers but they're a dying breed.

Let me wrap things up by getting back to a previous comment on Quebec's absolute return fund. I've been hearing that HR Strategies, the fund of funds mandated by the Caisse de dépôt et placement du Québec, Fondaction CSN and Fond de solidarité FTQ to run the $175 million SARA Fund, has already started disbursing funds. The problem is that the lion's share is going to already well established funds run by managers that are already multi-millionaires.

I have no issues with these successful, established managers and want them to continue on this path of success, but I sincerely hope HR Strategies will also seed some new funds run by younger managers with tremendous potential. Let me repeat what I stated before: there are exceptional, young absolute return managers in Quebec that are not getting the support they rightly deserve by Quebec's largest financial institutions (Caisse, PSP Investments, Desjardins, Fondaction, FTQ, National Bank and Hydro Quebec).

This is a tragedy for Quebec's finance community. I was at the gym the other day after meeting a couple of these new talented managers and my trainer and I started chatting about hedge funds. He's Canadian of Lebanese origin and it turns out his friend is Tim Barakett's father. In case you don't know, Tim Barakett is the founder of hedge-fund firm Atticus Capital, which handed $3 billion back to his investors two years ago and closed down his flagship fund to spend time with his family. Along with his brothers, they are arguably the most successful investment managers from Quebec (apart from, of course, the Desmarais family, one of the richest and most powerful families in Canada).

I mention this because apparently Tim Barakett once said to become successful, you need to get out of Quebec. It's sad but true. Most of the ultra successful Quebecers in finance that I know got out of Quebec. This needs to change. HR Strategies and Quebec's large institutions should place more emphasis on seeding Quebec absolute return managers, just like Ontario Teachers' did in Ontario.

Going primarily with established managers is good for HR Strategies when it markets its fund of funds to investors, but it doesn't create new jobs and it doesn't raise the profile of Quebec's financial industry (HR Strategies should publicly disclose which funds got what amounts and based on what criteria and deal terms). These large and powerful institutions need to step up to the plate and start seeding new managers with tremendous potential. God knows we have plenty of them right in our backyard that are being ignored for purely political reasons.

This really pisses me off. I feel like starting my own seed fund. It will be run on a managed account platform, fully transparent, zero operational risk, and invest in diverse strategies run by Quebec's young but talented absolute return managers. If pension funds were smart and not engaging in cover-your-ass politics, they would be actively seeding young, talented absolute return fund managers.

If you've seen what I have seen in Montreal in terms of quality managers with years of experience at large shops struggling to raise more assets for their fund, you would be utterly dismayed. These managers deserve more assets and they need more financial support. If you're a large global asset manager or even large family office, please contact me (LKolivakis@gmail.com) and come visit our beautiful city. Let me show you why I am beating the drum hard on Quebec's talented absolute return managers. They can compete with the best hedge fund managers in the world. I should know, I used to invest in them.

***Public Disclosure***

Public disclosure: I am not in the cap intro business, at least not yet. I have no signed legal agreements with any of the funds that I am discussing on my blog and have not met all of them. I am very impressed with the ones I have met and have absolutely no qualms recommending them to public pension plans and sovereign wealth funds. Importantly, I would never recommend any fund that I wouldn't invest in myself.

Below, Aleks Weiler, senior portfolio manager at CPPIB, says it like it is. Don't trust the track record, understand why people are making money, and focus on the character of the fund managers. Are they trustworthy?

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