SAN FRANCISCO - Trustees of the San Francisco City & County Employees' Retirement System are starting to kick the tires of hedge funds, trying to figure out how these absolute-return strategies fit into their overall portfolios.
"As a board, we need to look at `why are we doing this?' " said Brenda Wright, newly elected president of the board, toward the end of a 90-minute session on the topic at the $11.6 billion fund's March 13 meeting. Trustees since have asked staff to explore higher-alpha-generating hedge-fund strategies, and to report back on May 29.
Pension funds generally have been slow coming to the hedge-fund party. What investments they have made usually have been small, on the order of 1% of assets.
In part, the 20%-plus returns earned annually from U.S. equities from 1996 through 1999 dampened incentives to explore hedge funds. Now that traditional stock portfolio strategies are suffering, projected returns in the mid-teens for hedge funds suddenly appear more attractive.
"In the past 18 months ... we have been seeing more and more interest" by pension funds in hedge funds, noted Virginia Reynolds Parker, managing member of Parker Global Strategies LLC, Stamford, Conn., which runs about $550 million in hedge fund-of-funds strategies.
Lower volatility, correlations
Hedge funds offer far lower volatility than stocks and have very low correlations with traditional asset classes. And they fill a gap left by traditional active equity managers, who face the conundrum of making their money from short-turn moves while tied to long-term objectives, according to a recent advisory letter by Keith Ambachtsheer, president of K.P.A. Advisory Services Ltd., Toronto.
There's no need to reinvent active management when hedge funds offer a ready solution, he wrote. "There is persuasive 1990s evidence that, when properly implemented, this new formula (of using hedge funds for active equity management) produced far superior reward-to-risk ratios than those produced by the old formula of simply dishing out asset class mandates with a little `tracking error' room thrown in."
Still, pension fund executives and trustees have many questions about hedge funds, which as a group have performed worse than publicly traded stocks, typically are opaque, lack long-term performance data, carry high fees and are somewhat illiquid.
Trustees at the $11.9 billion Teachers' Retirement System of Louisiana, Baton Rouge, recently turned down the idea of pursuing hedge funds. "It would be my opinion that it was just too risky, too many unknowns, not enough control," said Bonita Brown, assistant director. "I just don't think the board felt comfortable with the risk vs. return equation."
Survival issue
Similarly, the $30 billion Colorado Public Employees' Retirement Association, Denver, has rejected hedge funds. Norman Benedict, deputy executive director-investments, cited data showing most hedge funds have not survived for long. What's more, hedge funds charge high fees for moderate returns, and are not regulated, he added.
Recent hedge-fund returns give little reason to invest in the area. Hedge funds returned a compound annual 22.8% for 1995 through 1999, compared with 28.6% for the Standard & Poor's 500 stock index, according to a paper by Carl Wilberg, senior investment officer at the San Francisco fund.
And while volatility was much lower - 10.7% for the Van U.S. Hedge Fund index vs. 14.4% for the S&P - the Sharpe ratio, which measures a fund or portfolio's risk-adjusted return, was nearly identical for both indexes, he noted.
But data for a longer period paint a different picture. From Jan. 1, 1988, through Sept. 30, 2000, 10 of 14 hedge fund strategies outperformed the S&P, and all had lower standard deviations and higher risk-return ratios, offering the prospect to add value, Mr. Wilberg said.
Lindsay Van Voorhis, a consultant with Cambridge Associates LLC, Menlo Park, Calif., said he expects hedge-fund "strategies to do better in down markets," and to provide roughly equivalent long-term returns to stock-market returns. Cambridge advises the fund on alternative investments.
That didn't satisfy all San Francisco trustees. Twelve years in the life of a fund is "a blink of an eye," said Herbert Meiberger, who also is a fixed-income analyst for the fund.
Messrs. Wilberg and Van Voorhis told the board there is no real benchmark for hedge funds, given the wide array of investment styles and dispersion within a given style.
That threw Mr. Meiberger, who recently stepped down as board president, for a loop. "If you give a manager money, I want to see a benchmark," he insisted.
The real issue, Mr. Van Voorhis said, is whether one can identify top-quartile managers. Because manager skill is so important in hedge funds, it's far more important to pick the best hedge-fund manager than to pick the best traditional manager, he said.
The difference
While selecting median hedge-fund managers to run 4% or 5% of San Francisco's pension assets would slightly lower returns and dampen volatility, picking top-quartile hedge fund managers would marginally improve returns while lowering volatility, he said.
But trustee Joseph Driscoll questioned whether top-quartile managers have adequate capacity to handle pension-fund flows.
"It is getting tougher. There's more money chasing managers," said Steven A. Lonsdorf, chief executive officer, Van Hedge Fund Advisors International Inc., Nashville, Tenn., who also addressed the board.
Trustees also discussed whether hedge funds should enhance returns, reduce risk or both. Mr. Meiberger thought one of the key attractions would be to reduce risk.
But trustee William Breall questioned whether it was worth shifting 4% of assets from bonds if the net gain in returns was only 37 basis points, as estimated by Cambridge.
Mr. Driscoll said a move into hedge funds must boost total fund returns by at least 200 basis points or "I don't see where it's worth it."
Now, staff is studying how to generate added alpha while possibly reducing volatility, Mr. Wilberg said.
