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Public pension funds’ hedge funds top benchmarks, but returns not great

Numbers fall from 2014, but careful choices pay off in challenging year

Stephen Nesbitt
Stephen L. Nesbitt called 2015 a year of capital preservation and added that hedge fund performance was influenced by MSCI ACWI returns.

Hedge fund returns of big U.S. state pension funds in the year ended Sept. 30 were hundreds of basis points lower than the prior year, but more than half of those portfolios managed to squeak past their benchmark returns during a tough period for hedge fund strategies.

State pension investment officials produced higher returns than the leading hedge fund industry index through careful strategy selection and portfolio construction. Better yet, 68% of portfolios analyzed by Pensions & Investments topped the one-year return of the Standard & Poor's 500 index and all of them bettered that of the MSCI All Country World index.

Fourteen state pension plans accounting for 19 hedge fund portfolios had reported Sept. 30 performance by last week.

One-year returns as of that date ranged from 5.2% for the $2.6 billion hedge fund portfolio of the $27.7 billion South Carolina Public Benefit Authority, Columbia, to -3.1% for the $6.1 billion directional hedge fund portfolio of the $127.3 billion Teacher Retirement System of Texas, Austin.

By contrast, hedge fund portfolio returns as of Sept. 30, 2014, ranged from 12.1% to 2.5% in P&I's previous ranking (P&I, Dec. 22, 2014).

Public plans' hedge fund returns
U.S. public pension plans ranked by hedge fund portfolio return for the 12 months ended Sept. 30, 2015. Assets are in millions.
FundReturnBenchmarkOver/under-
performance vs. benchmark (pct. pts.)
Total hedge fund assetsHedge fund assets as % of total assets
South Carolina Retirement 5.2%-1.5%6.7$2,6409.5%
Texas Employees14.9%4.0%0.9$1,2795.2%
Illinois Teachers24.4%0.6%3.8$1,2883.0%
Texas Teachers34.3%0.6%3.7$5,3134.2%
Missouri State Employees4.1%14.1%-10.0$1,35716.9%
Pennsylvania Public School 3.5%3.8%-0.3$4,6009.7%
Wisconsin Investment Board43.2%1.6%1.6$3,2523.8%
Illinois Teachers52.8%0.6%2.2$2,1004.8%
Michigan Retirement System62.4%1.9%0.5$4,1379.8%
New Jersey Division of Investment71.3%3.1%-1.8$3,5634.8%
Pennsylvania State Employees 1.3%-1.1%2.4$1,7006.4%
Missouri Public School/Education -0.1%-2.1%2.0$5,15014.0%
New Jersey Division of Investment8-0.3%-1.4%1.1$2,8593.9%
New Mexico Public Employees-0.7%5.3%-6.0$7305.3%
Texas County & District -0.7%0.0%-0.7$6,18625.8%
Massachusetts PRIM-0.8%N/AN/A$4,9628.4%
Florida State Board9-1.3%-2.7%1.4$2,3951.7%
New Jersey Division of Investment10-1.3%-5.1%3.8$2,5363.5%
Texas Teachers11-3.1%-0.1%-3.0$6,0514.8%
MEAN RETURN 1.5%1.2%
MEDIAN RETURN1.3%0.6%
Notes: 1 Texas Employees absolute-return portfolio. 2 Illinois Teachers convex portfolio. 3 Texas TRS stable value/non-directional portfolio. 4 Data are for Wisconsin State Retirement System Core Fund. 5 Illinois Teachers convergent portfolio. 6 Hedge fund return is for the $42.2 billion Michigan Public School Employees Retirement System; hedge fund assets and allocation are for all four MRS funds. 7 New Jersey State Retirement System absolute-return portfolio portfolio as of Oct. 31, 2015. 8 New Jersey State Retirement System equity-oriented hedge fund portfolio as of Oct. 31, 2015. 9 Data are for Florida State Retirement System; exclude activist and managed futures funds. 10 New Jersey State Retirement System credit-oriented hedge fund portfolio as of Oct. 31, 2015. 11 Texas TRS directional portfolio.
Source: Pension plan officials and plan documents

The investment staff of the South Carolina Retirement Systems Investment Commission, which manages the state pension fund, has dedeliberately focused the hedge fund portfolio on non-directional, low-beta strategies, said Geoffrey Berg, acting chief investment officer, in an e-mail.

“We're not remotely interested in paying hedge fund managers' (management) fee and carry for giving us market beta,” Mr. Berg said, noting the hedge fund lineup hasn't undergone meaningful changes in the recent past, but he and his staff are “going to continue to explore ways to improve economics for our plan participants.”

57% top benchmarks

Analysis of returns collected by P&I showed 57% of public pension hedge fund portfolios topped their benchmark returns as of Sept. 30 compared with 81% a year earlier.

The difference of 760 basis points between the 1.5% median return of the hedge fund portfolios in P&I's universe as of Sept. 30, 2015, and the 9.1% median return the year earlier reflects the Jekyll and Hyde performance turnaround for hedge fund strategies from one year to the next, sources said.

The 1.7% decline of the HFRI Fund Weighted Composite index for most recent period, for example, was in sharp contrast to the 6.4% index return the prior year.

Ditto for major equity market indexes: The one-year return as of Sept. 30 for the S&P 500 was -0.6%, but for the year-earlier period was 19.7%; the MSCI ACWI dropped 6.1% in the year ended Sept. 30 and rose 11.9% the prior year.

Despite strong headwinds, nearly every state pension plan's hedge fund portfolio reviewed by P&I did outperform the HFRI Fund Weighted composite returns in 2015, as they did in 2014.

The return of the Texas Teachers directional portfolio lagged the index in 2015. In 2014, the 2.5% return of the $3.3 billion hedge fund portfolio of the $84.5 billion Wisconsin State Retirement System Core Fund, Madison, was behind the index return that year.

However, neither the Texas Teachers nor the Wisconsin hedge fund portfolio is designed to outperform the HFRI index. Rather, the portfolios have been constructed to provide positive returns in all market environments.

Texas Teachers, for example, divides its total $7.8 billion total allocation to hedge funds into the directional portfolio, which is designed to do well in strongly positive markets, and a non-directional portfolio, which is expected to perform well in down markets.

As of Sept. 30, Texas Teachers' non-directional portfolio held 67.7% of the pension fund's hedge fund assets and its 4.3% one-year return was the fourth best in P&I's ranking. In 2014, the hedge funds portfolios' positions reversed: the directional portfolio ranked fifth in the ranking with a 9.4% one-year return, while the non-directional portfolio ranked 12th.

Juliana Hernandez Helton, a Texas Teachers spokeswoman, did not provide comment about the pension fund's hedge fund returns by press time.

“Hedge funds largely preserved capital in 2015,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif., in an e-mail. He noted that Cliffwater researchers have calculated positive alpha production of one to three percentage points by most public pension plan hedge fund portfolios in 2015.

Producing a positive return — however small — in a hedge fund portfolio in 2015 was no easy feat.

“For many in the hedge fund industry, 2015 is shaping up as the worst year since 2011, if not since 2008,” according to researchers at industry tracker eVestment LLC, Marietta, Ga., in their third-quarter hedge fund performance review.

The reason — at least in part — for both the decline in hedge fund portfolio returns in 2015 and healthier 2014 performance was the same, sources said: an abundance of market beta in pension funds' portfolios.

“In aggregate, poor 2015 numbers compared to 2014 numbers were heavily influenced by MSCI ACWI returns. Most state hedge fund portfolios do have some beta, and (that is) partly responsible for differences in yearly results,” Cliffwater's Mr. Nesbitt said.

Jonathan Grabel, chief investment officer of the $14.4 billion Public Employees Retirement Association of New Mexico, Santa Fe, was more emphatic about the influence of market beta on hedge fund strategy performance.

“Equity beta absolutely screams through 2015 returns, especially in the third quarter,” Mr. Grabel said, adding “we don't need any equity beta exposure in the hedge fund portfolio. We have plenty of that in our public equity portfolio where we pay a lot less for it.”

New Mexico PERA has spent this year “significantly restructuring” its hedge fund portfolio to scrub out sources of market beta and downsize from a nearly 8% allocation to 4%, $730 million in current dollars, Mr. Grabel said. The portfolio returned -0.7% in the year ended Sept. 30 and 9.2% the prior year.

Alpha overlay

The State of Wisconsin Investment Board, Madison, which oversees investment of $104 billion, manages an alpha overlay internally to produce synthetic market beta using its hedge fund portfolio as the underlying asset pool, CIO David Villa said.

The hedge fund portfolio, which is not counted among SWIB's asset classes, is designed to provide low-volatility, pure alpha returns of between three and five percentage points over the London interbank offered rate in any market environment and as such is as devoid of market beta as it can possibly be, Mr. Villa said.

“We aim for zero beta in the hedge fund portfolio and definitely less than 0.1. Most hedge fund portfolios have market beta of 0.3 to 0.4. I think other pension funds are trying to get alpha, market beta and a cash return from their hedge fund portfolios, but we don't want to pay a management fee and carry on market beta and cash,” Mr. Villa said.

In answer to the perennial question of how SWIB investment officers find hedge fund managers and strategies that produce truly uncorrelated returns, Mr. Villa acknowledged “it's really hard to find managers that make it through all of our screens.”

This article originally appeared in the December 14, 2015 print issue as, "Public funds top benchmarks, but returns not great".