Rhode Island’s Big Bet on Hedge Funds?
A few weeks ago, New York billionaire hedge fund trader Daniel Loeb, who has $66 million in Rhode Island state pension funds, made nearly 10 times that when he sold 40 million shares of Yahoo stock, two years after buying a stake in the Internet giant and orchestrating Marissa Mayer’s hiring as CEO.This is an excellent article discussing the pros and cons of hedge funds and the issues that surround them. I recently covered some of my general thoughts on hedge funds in the hedge fund myth, but let me go over some key points discussed above:
In the spring, another billionaire hedge fund manager, Paul Singer, who has $70 million in Rhode Island pension money, made headlines for buying up Hess Corp. stock and forcing a board shakeup to prod the oil company to pursue fracking for natural gas. The jury’s still out on that deal.
And last year, Ken Garschina, who has $64 million in Rhode Island pension assets, stumbled in his nearly $2-billion bet on a Canadian telecommunications giant, contributing to his Mason Capital’s 7-percent decline for 2012.
So it goes in the world of hedge funds, where sophisticated money managers have invested large pools of money for wealthy investors, private foundations, universities and, increasingly in recent years, public pension funds.
Around the globe, 18 hedge funds are putting $1 billion of Rhode Island pension money to work — in Asian futures, Midwestern commodities, global currencies, distressed securities, startup companies and residential mortgage-backed securities. They employ such investment strategies as short-selling, leverage, risk arbitrage, spread trading and structured credit.
One of the state's hedge-fund managers, D.E. Shaw, is the chief financial backer of Deepwater Wind, the Providence-based energy firm that last week won a federal auction to develop wind farms off the coast of Rhode Island and Massachusetts.
In the view of Rhode Island Treasurer Gina M. Raimondo and the State Investment Commission, as well as many outside investment experts, putting 14 percent of the state’s $7.5-billion pension fund into hedge funds is a prudent move to lower risk and volatility. This is especially vital after the 2008 stock market crash wiped out 25 percent of the state pension fund, and with Rhode Island needing to write a huge check every month — totaling more than $924 million last year — for retiree benefits.
With interest rates so low on bonds — the traditional “hedge” against stock-market losses — many investment professionals argue that hedge funds offer better protection from another stock-market tumble. The logic is that by investing in things that are not correlated to the stock market, hedge funds will smooth out the roller-coaster ride. They won’t soar as high, but won’t dip so low, preserving capital when stocks go down.
But a growing number of critics attack hedge funds as over-hyped, risky and costly investments that have lagged behind strong stock-market gains. The only people getting rich from hedge funds, the skeptics say, are the Wall Street tycoons who run them, raking in high fees while retirees and working men and women see their retirement benefits slashed.
For the 2012-’13 fiscal year ending June 30, Rhode Island’s hedge fund portfolio earned 11.22 percent, trailing the Russell 3000 stock index of 21.46 percent. The state’s overall $7.5-billion pension fund gained 11.07 percent in 2012-’13. Had the hedge fund money been invested in stocks, the pension fund could have earned $100 million more based on the Russell index. During the same period, the state paid out $200 million less by suspending cost-of-living allowances to retirees.
On top of that are the high fees — an average management fee of 1.7 percent of assets, plus an average performance fee of 20 percent on any profits.
Those fees totaled an estimated $45 million on hedge fund gains of about $140 million for 2012-’13, according to a Providence Journal analysis of hedge fund data provided by the treasurer’s office and confirmed by the state’s private hedge fund consultant.
Public employee unions nationally and in Rhode Island, as well as a growing chorus of others in the investment community, have questioned hedge funds. A July 11 Bloomberg Businessweek cover story was headlined, “The Hedge Fund Myth.”
Raimondo’s strategy
Raimondo, a Democrat and former venture capitalist who is contemplating a run for governor in 2014, has been criticized for pushing a strategy that results in paying millions more in management fees while lower-income retirees go without cost-of-living increases. In the fall of 2011, as the Investment Commission she chairs was voting to hire hedge funds, Raimondo spearheaded an overhaul of the state pension system that reduced the unfunded liability by $3 billion, in part by partially moving state workers from defined benefit to a 401(k)-style defined contribution plan.
A key component was a suspension of cost-of-living allowances. With lower hedge fund returns a drag on the pension fund’s growth, retirees will have to wait longer for the retirement system to recover from past underfunding so they can regain their COLAs.
“They’re turning the pension fund into a fee machine for Wall Street,” said Daniel Pedrotty, of the American Federation of Teachers (AFT) in Washington. “In the years since 2008, the stock market has roared back. Hedge funds have not. It’s a disturbing story.”
Raimondo won national acclaim as a pension reformer, including a 2012 “urban innovator” award from a conservative New York think tank, the Manhattan Institute, which advocates for defined-benefit plans. Three of the hedge fund managers Rhode Island hired — Loeb, Singer and Garschina — are trustees of the Manhattan Institute; last spring, their funds were placed on an AFT watch list for being hostile to union workers.
The treasurer says she doesn’t like the high fees, but has a fiduciary obligation to look at the bigger picture — the welfare of the pension fund. She says she doesn’t recall meeting Loeb, Singer or Garschina, and that the selection of their hedge funds was vetted by the Treasury’s staff and outside consultant, and approved unanimously by the Investment Commission. Of Loeb’s Third Point Partners, the state’s highest-performing hedge fund with a 29.46-percent return in 2012-’13, she said, “I’m proud of his accomplishments.”
During a discussion of hedge fund fees and transparency at an Investment Commission meeting this spring, Raimondo said: “I’m troubled by the fees. It’s too much money. But my job is to maximize returns. We’ve reduced risk substantially. … A year and a half ago we sat around this table talking about how we’ve got to protect people’s pensions. We put in place a risk strategy. We monitor these guys. It’s working. So I say, let’s stay the course.”
Risky business
Critics call hedge funds risky business. But proponents warn that big investors ignore them at their own risk.
The average public pension plan has 1.2 percent of its money in hedge funds and 11 percent in alternative investments, according to the 2013 Wilshire Trust Universe Comparison of plans with more than $1 billion. But that average includes plans that don’t invest in hedge funds. Of those public plans that do invest in them, many are in the 5-percent to 10-percent range, says a Wilshire analyst.
Rhode Island, whose 14-percent hedge fund portfolio is part of its 26-percent stake in alternative investments, including venture capital and real estate, is not alone. In 2013, overall hedge fund assets are expected to increase by 11 percent, to a record $2.5 trillion, according to a Deutsche Bank survey.
Public pension plans are the largest single investors in hedge funds, according to a recent report by Preqin, a New York financial data firm.
Alfred Winslow Jones is credited with launching the first hedge fund in 1949. He used leverage — borrowing — to buy more stock. And he used short-selling — borrowing shares in anticipation they would decline in value — to avoid market risk when stocks dropped. Given his “hedged” position, his fate was not determined by whether the market rose or fell, but by his choice of stocks.
Over the years, hedge funds became more complex. Today, there are more than 9,000 funds, chasing more than two-dozen investment strategies. Some hedge fund managers have made headlines for their excesses, yachts and mansions, and for insider trading and the mortgage derivatives that helped fuel the 2008 financial collapse. Two weeks ago, federal prosecutors in Manhattan announced the indictment of SAC Capital, one of the country’s most successful hedge funds (but not one of Rhode Island’s funds), on insider-trading charges.
Still, investment advisers say hedge funds have a place in a prudent investor’s portfolio. Some point to universities, including Brown University, which have higher allocations than public pensions. Brown reports having 24 percent of its $2.6-billion long-term pool, which includes endowed and university funds, in hedged strategies and another 24 percent in private equity.
The key is to focus not solely on returns, but the risk associated with achieving them.
“Risk is very important,” says Eileen Neill, a managing director at Wilshire Associates who works with large pension funds, including state plans in Iowa and Wisconsin.
To average investors, she says, risk is the danger of losing their principal. But to institutional investors, risk is the level of volatility associated with making money. And since the 2008 crash, risk to pension funds is the danger of “missing your objective so much that you risk insolvency, and have to put in external capital,” says Neill. That’s why more public plans have added hedge funds.
Raimondo echoes that. Hedge funds are not about outperforming the stock market in good times, she said in an interview, but providing a safety net in bad. During a 2011 Investment Commission meeting to consider adding hedge funds, she urged the board to start thinking about risk the way investors traditionally think about returns.
Without hedge funds, the state pension fund lost 25 percent of its value — $2 billion — in the 2008 financial collapse; with hedge funds, the losses would have been $500 million less, according to the state’s hedge fund consultant, Cliffwater. According to the treasurer’s office, 5 of Rhode Island’s 18 hedge funds suffered double-digit losses in 2008 — 3 in the teens — while the S&P 500 stock index dropped 37 percent.
With the state still digging out of that hole and paying more than $70 million a month to retirees, Raimondo says, “it’s essential to preserve capital and minimize risk. How do you do that? Hedge funds.”
“Managing money is a lot harder than it’s ever been,” she says. “The thinking was, ‘Let’s pick hedge funds that provide us with the tools we don’t have now, so we don’t have another 2008.’ … This hedge fund portfolio is designed for a different market, one that will capture most of the upside but not all of the downside.”
Her chief investment officer, Anne-Marie Fink, notes that the recent stock market dip provides an example. Faced with fears of rising interest rates and a slowdown in China, stocks were down 2.7 percent in June, compared with 0.7 percent for the state’s global equities hedge funds; bonds were down 1.6 percent, compared with 1.1 percent for the state’s “absolute returns hedge funds” group, which invests in currencies and commodities.
Risk is plotted as a mathematical formula in which the returns of different types of investments are arranged on a graph, to show how far they deviate from the average return. The higher the standard deviation, the riskier it is, like a roller coaster that lurches up and down, leaving investors with a lot of butterflies in their stomachs.
A safer investment rises more gradually, with fewer dramatic dips, so that when it does go down it doesn’t have as far to travel to reach the top again.
Stephen L. Nesbitt, CEO of Cliffwater, the state’s hedge fund consultant, produced a report for the Investment Commission this spring, charting Rhode Island’s first 18 months in hedge funds, through April 30, 2013. The standard deviation for the hedge fund portfolio was just over 2 percent, compared with just under 6 percent for the entire Rhode Island pension fund and about 7 percent for a traditional mix of 60 percent stocks, 40 percent bonds.
Nesbitt’s message: “Your hedge funds are behaving the way they were intended to.”
Not everyone agrees
In April, prominent investment manager Robert Arnott told CNN that most hedge funds have been “a disappointment” and rejected the argument that they generate better risk-adjusted returns. To prove it, Arnott’s colleagues at Research Affiliates took a portfolio with a basic mix of 60 percent stocks, 40 percent bonds and studied what would happen if it was gradually shifted, 10 percent at a time, into hedge funds. The result: returns went down, and risk went up.
The study concluded that a pension fund would have performed better with a passively, less expensively managed blend of commodities, real estate and other assets.
Simon Lack, a former Morgan Stanley hedge fund trader and author of “The Hedge Fund Mirage,” has become a leading guru of hedge fund skeptics. Lack writes that “if all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would be twice as good.”
But investment expert Brian Portnoy, author of “The Investor’s Paradox,” says Lack misread the data and that hedge funds actually beat Treasury bills over time.
Gordon H. Dash, a University of Rhode Island finance professor who teaches a class in hedge funds, says Raimondo’s strategy is correct, and that it can’t be fairly judged in the short term and during a bull market.
“These strategies, properly executed, do work,” said Dash. “Indexing [investing in funds that track the stock-market index] is always offered as an alternative, but the problem is that when the market tanks, the index tanks. And then your funding to pay pension obligations is in jeopardy. You have to have a hedge in place.”
Still, critics such as Ted Siedle, a pension investigator and Forbes contributor who is critical of Raimondo, and who is investigating the Rhode Island fund for a state public-employees union, warn that that doesn’t mean hedge fund investors can get their money out quickly.
A “lock-up” prevents investors from withdrawing money before a specified period, usually one or two years. In a “soft lock-up,” money can be withdrawn, but with a penalty. A “gate” prevents investors from withdrawing too much money at once. For instance, Paul Singer’s Elliott Associates, which has $69 million in Rhode Island pension money, limits withdrawals to 25 percent twice a year, with a 1.75-percent fee, plus 60 days’ notice.
Last winter, Rhode Island got out of two underperforming hedge funds, serving notice in December and January and getting $89 million of $91 million back by the end of June. (The remaining money will be returned in 2014, after an audit confirms the numbers.)
Fee fights
There are two ways to view hedge fund fees: a necessary evil or an unnecessary gouging.
Either way, they add up to a significant chunk of change, which helps explain why 7 of Rhode Island’s 18 hedge fund managers are billionaires who made Forbes’ list of the richest 40 hedge fund managers last year.
In Rhode Island’s first 20 months in hedge funds, from November 2011 through June 2013, the state paid $61 million in fees — $16 million for 2011-’12 plus the estimated $45 million last year. In addition, the state paid $2.5 million last year in fund expenses.
Raimondo notes that a sizable chunk of Rhode Island’s pension fund — 47 percent — is in low-cost, indexed stocks and another 14 percent is in low-cost bonds. Excluding hedge fund fees, the state reported $17 million in fees in 2012-’13. Adding the hedge fund fees for last year, the total would climb to an estimated $62 million.
Hedge fund advocates say it’s important to view the bigger picture — the positive risk-adjusted returns that hedge funds deliver, even after those fees are deducted. They invoke Oscar Wilde’s definition of a cynic: “A man who knows the price of everything and the value of nothing.”
But financial advisers who say the cardinal rule of investing is to lower your fees cite Benjamin Franklin: “A penny saved is a penny earned.”
Advocates argue that investors pay for the hedge fund traders’ skills and acumen, and in some cases sophisticated mathematical algorithms and computer programs.
A Cliffwater report on one of Rhode Island’s global equity funds, Davidson Kempner Institutional Partners, which has $62 million in state pension money, cites an example of the firm’s research-driven approach to investing in distressed companies. In evaluating a business, the report says, the fund’s research analysts develop “a strong understanding of the restructuring and legal process.”
“For example, the analyst focused on transportation has created a model to evaluate structured securities secured by planes,” the Cliffwater report says. “For each security, he has analyzed the types, ages and manufacturer of each plane to understand how valuable the collateral [the planes] is to the market.”
Fink, Rhode Island’s chief investment officer, cites another example involving the Indus Asia Pacific Fund, which invests $43 million of Rhode Island pension money in Asian countries. In China, where government statistics on growth and inflation aren’t always reliable, the fund hires people to go into supermarkets and other stores to price commodities, such as chicken, rice and gasoline, and create an independent database to measure inflation.
“That’s expensive,” says Fink. “When we pay high fees we want to ensure that we’re generating a good return. If somebody’s charging 2 and 20 [percent] and it’s two guys with a Bloomberg [terminal], that’s not worth it. We want to make sure we’re getting value for our money.”
Consequently, Fink says, she visits the offices of the hedge funds Rhode Island invests in, and pays attention to the size and experience of the staff, as well as its investment strategies. She cited one of the state’s most expensive hedge firms, D.E. Shaw & Co., which charges a 25-percent performance fee and a 2.5-percent management fee, and manages $64 million for Rhode Island.
“They employ 1,000 people. They have 55 Ph.D.s running all these crazy statistical models,” said Fink.
The D.E. Shaw Composite International Fund gained 18.9 percent over the past year and has averaged 10.9 percent over the past three years, according to Cliffwater, which monitors the hedge funds. So far this year, it’s up 9.58 percent.
Hedge fund critics, however, say investors could put their money to work more cheaply and effectively elsewhere.
“Why are you paying performance fees for someone who’s underperforming the market?” asks Barry Ritholtz, managing partner of Fusion Analytics Investment Partners in New York and a financial author and commentator.
The explosive growth of hedge funds and pools of money to invest makes it harder for everyone to be the smartest guy in the room, says Jay Youngdahl, a visiting fellow at the Initiative for Responsible Investment at the Hauser Center for Nonprofit Organizations at Harvard University.
“Paying 2 and 20 percent, you’d need to earn a ridiculously high return,” he says. “While lightning strikes from time to time, it seldom strikes in the same place, and most of us never get hit.”
A recent study by a pair of Maryland think tanks found that the 10 state pension systems paying the highest fees often had some of the worst investment returns. In contrast, the Maryland Public Policy Institute and the Maryland Tax Education Foundation found that the 10 states with the lowest fees generated the best returns.
The study, which didn’t focus exclusively on hedge funds, examined fees in 46 state pension funds; Rhode Island was not included because the authors say they didn’t have access to data for the 2012 fiscal year.
While money managers claim they have a “secret sauce” to consistently beat the market, many “buy and sell publicly traded securities (i.e., ‘hedge funds’), so this idea is simply ‘old wine in a new bottle,’ ” the study said. By indexing a larger portion of pension portfolios — 80 to 90 percent — to stocks and bonds, the study contends, states could collectively save billions of dollars, while reducing their unfunded liabilities by tens of billions.
Raimondo says Rhode Islanders should focus less on fees and more on results — the protection for public employees and retirees from another catastrophic stock market collapse. After fees are deducted, Rhode Island’s hedge funds are still earning double-digit returns.
“We’ve reduced risk by 10 percent, and part of that is moving into these alternative investments,” said Raimondo. “They’re the best in the business, whether or not they have some colorful, overly paid hedge fund managers. They’ve delivered strong returns over time.”
- Top funds: Rhode Island is invested with top hedge fund managers. Their external consultant, Cliffwater, is one of the best at providing advice on hedge funds to institutional investors. Third Point, Elliott Management, Mason Capital and D.E. Shaw are all hedge funds with long, exceptional track records. Still, top brand name funds don't always deliver exceptional results and they need to be closely monitored just like any other hedge fund.
- High fees vs good results: Raimondo says Rhode Island should focus more on results and less on fees. She has a point, after all what counts are returns net of all fees. But when a $7.5 billion public pension fund pays $61 million in fees to hedge funds, it's a lot of money and critics will claim this is another example of the secret pension money grab. In Canada, public pension funds are increasingly bringing assets internally, lowering costs, and controlling for liquidity and operational risks. $61 million can pay a lot of good salaries but U.S. pension funds don't have the governance structure of their Canadian counterparts (compensation is too low), thus relying almost exclusively on external managers.
- Downside risk protection: Raimondo also points out that hedge funds protect against catastrophic stock market collapses like the one we experienced in 2008. Take this with a grain of salt. Most hedge funds charge alpha fees for leveraged beta. When the stock market collapsed in 2008, a lot of them, including top funds, got clobbered and experienced significant losses. The very best of them recovered nicely but most are still struggling. And while it isn't fair (and downright stupid) to compare hedge funds' performance with that of stock market indexes, once you factor all the risks of investing with hedge funds -- including liquidity, operational, and other risks -- you have to also take into consideration the opportunity cost of investing in these strategies. Cliffwater claims Rhode Island would have lost much less had they been as heavily invested in hedge funds in 2008. This may be true but their analysis doesn't factor all the liquidity issues that arose back then when funds closed the gates of hedge hell or the high fees that it would have cost them to invest in all these hedge funds.
- Benefits of hedge funds: While I'm skeptical of the industry as a whole and worry that many public pension funds are getting raked on fees, I'm a firm believer that there are huge benefits in investing with excellent hedge funds. The same goes for top private equity and real estate funds. Pension funds can cultivate long-term relationships with these external managers and reduce the "beta" risk of their portfolio. They can do so by leveraging off the expertise of these external managers to improve their asset allocation decisions. How much should public pension funds allocate to hedge funds and other alternatives? The average allocation to alternatives is 26%, with most of the money going to private equity and real estate. I think pensions should always be thinking about their liquidity risk and figure out where they're comfortable. Also, they need to recognize that these investments are complex and require a specialized skill set. If they don't have it internally, they need to seek this expertise from external consultants or top funds of funds and make sure that there is solid alignment of interests.
As I stated in the hedge fund myth, institutional investors should temper their expectations and realize there is no Hedge Fund Tooth Fairy that will provide consistently high risk-adjusted results in all market cycles. As institutions allocate increasingly more into hedge funds and other alternatives, they are diluting future returns of these investments and exposing themselves to liquidity risk.
Below, Charlie Rose takes a look the case against Steve Cohen and his hedge fund, SAC Capital, with Sheelah Kolhatkar, a features editor and national correspondent at Bloomberg Businessweek, and Tom Keene, editor-at-large at Bloomberg News and host of Bloomberg Surveillance.
With the increase in regulatory scrutiny, more and more hedge funds are following George Soros, returning money to external investors and restructuring as family offices. The few who can afford it will take this route, sidestepping the increase in regulations. The majority of funds, however, will have to adapt to the new regulatory environment.