Tastes great. Less filling.
Like the Miller Lite ads, hedge funds appear to offer the best of both worlds to institutional investors: equity-like returns with bond-like risk.
Paul Platkin, general director of absolute return strategies at General Motors Asset Management, New York, said GMAM studies show that, over the long run, hedge funds generate "relatively growth-oriented returns, while the risk profile is a lot more subdued."
What's more, hedge funds lower the risk of the total fund because of their extremely low correlations with traditional stock and bond portfolios. Hedge funds "march to their own drummer and can produce some positive returns while reducing overall portfolio risk," added Sandra Ell, treasurer and chief investment officer for the California Institute of Technology, Pasadena.
And they certainly do perform. The $10.5 billion Yale University endowment fund, New Haven, Conn., noted in its 2002 annual report that absolute-return strategies "exceeded expectations, returning 12.1% per year with essentially no correlation to domestic stock and bond markets" during the 10-year period ended June 30, 2002. Yale endowment officials recently cranked up their target hedge fund allocation to 25% from 22.5%.
But finding and monitoring good hedge fund managers takes a lot more sophistication and effort than finding traditional managers, institutional investors said.
A different game
"It's a much more intense process than with a traditional public equity manager," explained Anne Casscells, formerly chief investment officer of Stanford Management Co., manager of the university's $10 billion in endowment and trust assets, Menlo Park, Calif. She is CIO of Aetos Alternative Management LLC, the absolute-return arm of Aetos Capital LLC, a New York-based hedge fund manager.
With a traditional manager, investors can monitor how their portfolio is invested through their custodians. "The typical hedge fund is done as a partnership; the documents are quite broad in terms of permitted strategies and instruments, and you usually don't have custody of the underlying assets, nor in most cases do you have complete transparency of what you are doing," she said.
What's more, hedge funds run the risk of unlimited losses from short-selling. "Lots of people try to cross that chasm, and short-selling is more art form than science," said Mark W. Yusko, CIO of the University of North Carolina at Chapel Hill's $1 billion endowment fund. "The best you can do is make 100%; the worst you can do is lose everything."
Here's how five leading pension funds and endowment funds, from the $1 billion University of North Carolina at Chapel Hill endowment fund to the $134 billion California Public Employees' Retirement System, Sacramento, have tackled the thorny hedge fund arena.
University of North Carolina
When the University of North Carolina at Chapel Hill's endowment fund hunted for its first hedge fund manager in 1990, the board of trustees ended up looking in their own backyard.
After scrutinizing many managers, they turned to fellow board member and UNC graduate Julian Robertson, founder of Tiger Management Corp., and decided he had the best track record. So Mr. Robertson quit the board and accepted a small mandate from the endowment fund, which grew substantially over time, Mr. Yusko said. The fund added other hedge fund managers over time.
But an April 1996 Business Week cover story questioned whether Mr. Robertson had lost his touch. University trustees got skittish and reduced the endowment's hedge-fund exposure by two-thirds, from roughly 15%. The following year, Tiger doubled money for its investors.
When Mr. Yusko joined the UNC staff in January 1998, he moved the endowment heavily into alternative strategies. (Like most institutional investors, he eschews the term "hedge funds" as misleading.) The fund created 10% targets for opportunistic equity -- which includes long-short strategies -- and absolute returns, which include arbitrage strategies.
Now, the endowment fund has close to 40% of its assets invested with hedge fund managers. It also includes hedge funds in its enhanced fixed-income program, which was spun out of the fund's fixed-income program two years ago, and in its public equities portfolio, including managers that focus on specific market sectors, such as the Raptor Global Funds, run by U.S. long-short equity manager Tudor Investment Corp., Greenwich, Conn.
Other managers include AQR Capital Management LLC, New York, which has a global trading mandate; Och-Ziff Capital Management Group, New York, a multistrategy arbitrage strategy; and Citadel Investment Group, Chicago, an absolute-return manager.
All told, UNC now runs eight distinct funds of funds in strategies ranging from domestic equities to energy to fixed income. "We really are a F3 -- a fund of funds of funds," Mr. Yusko said.
The program has been a boon to the endowment fund, offsetting losses from other investments. The endowment's overall three-year rolling return is 0.4%, when many institutions have experienced negative numbers. In particular, its absolute-return strategies returned 8.9% last year, and 13.7% annualized for the three years ended Dec. 31.
California Inst. of Technology
For a university endowment, Cal Tech is a latecomer to hedge funds. Before its new asset mix was adopted in May 2002, the $1.1 billion California Institute of Technology, Pasadena, had a 3% target to hedge funds but no money invested.
That changed radically last spring when fund officials jacked up alternative strategies to 46% from 25% of the total portfolio. Absolute-return strategies -- which include hedge funds, distressed debt and high-yield bond portfolios -- were hiked to 21% of the alternatives allocation, and the remaining 25% is invested in private equities and inflation hedges, which include inflation-protected bonds, oil and gas, and real estate.
Domestic equities were slashed to 22% from 40%, while international equities were pared to 10% from 15%. Core fixed-income investments were raised to 22% from 20%.
The changes were generated by a view that equity returns are going to be weak for the next several years.
"We are going to see single-digit returns in equity markets in the next five years, and I don't think we've come out of the bear market," Ms. Ell said. "I would be surprised if we see 1% returns in the equity market this year."
But investing in hedge funds comes at a cost.
Each plan sponsor needs to conduct asset allocation modeling to see how these strategies have fared historically, she said.
And fund officials who choose to invest directly, rather than going the fund-of-funds route, need to have a nimble governance structure or they could miss opportunities.
What's more, the fund must have adequate internal resources for investing in and monitoring hedge fund investments. "If you hire, for example, (managers of) diversified arb strategies, you will see them shifting over the course of the year from one strategy to another," explained Ms. Ell, who has been beefing up her staff.
"It's not like private equity, where you put the cake in the oven and let it bake," Ms. Ell said. "You may need to have some temperature adjustments."
GE Asset Management
For John Meyers, president and chief executive officer of GE Asset Management, Stamford, Conn., personal relationships with his 10 hedge-fund managers are critical.
Mr. Meyers said he has known the managers he's picked for virtually his entire professional career. "As I like to tease the guys who run the money, I know where they live, I know the names of their children, and I hold them accountable for their results," he said.
GE made its first-hedge fund investment in 1991, unusually early for a pension fund. It invests directly with nine managers, mostly in long-short equity strategies, and with one fund of funds. Mr. Meyers declined to identify the managers, which collectively handle $1.1 billion in assets for GE, or nearly 3% of its $38 billion in pension assets.
Mr. Meyers said he looks for managers with long-term track records and a sizable chunk of their own net worth invested in their strategies. "It's a very, very important factor for us, that principals of hedge funds have some very serious skin in the game," he explained.
He noted that hedge funds don't provide the level of transparency that many institutional investors would like. "I'm looking for an intellectual dialogue where myself and key members of my team can have an understanding of the current strategy and where the bets are, and why they are where they are," he said. "I don't need security-level transparency, but if I do need it, I can get it."
GE officials favor equity strategies that are based on strong fundamental research and avoid hedge funds that rely on leverage -- particularly fixed-income strategies, which tend to use leverage to jack up their alpha.
"If you look through the history of the last 15 years, the landscape is littered with hedge funds who have used excess leverage," Mr. Meyers said. Most of the disasters have involved fixed-income strategies that rely on big directional bets, including Long-Term Capital Management's spectacular 1998 blowup, he added.
General Motors Asset Mgmt.
In contrast, General Motors Asset Management, New York, is a relative newcomer to hedge funds.
The pension fund, with $57 billion in defined benefit assets as of Sept. 30, made its first hedge fund investment in a fund of funds run by Glenwood Capital Investments, Chicago, a unit of Man Group PLC, London, in July 2001. Fund officials reportedly allocated $100 million to Glenwood.
The fund now has about $700 million in about 20 different strategies. They declined to name the other managers.
"We were skeptical" about hedge funds initially, said Edgar Sullivan, vice president, investment research. But officials started looking at impressive returns from diversified hedge funds. Returns were "not up to the level of equities during the bull market, but on a risk-adjusted basis were better," he said.
In general, GMAM officials stay away from long-biased equity strategies, instead focusing on absolute returns. They focus on "good risk-adjusted returns with low betas and correlations with traditional asset classes," explained Mr. Platkin.
In the early days, GMAM officials leaned toward "larger, more established hedge funds that had more institutional structures and business plans, more of the array of personnel" that one found in traditional managers, he added.
Over time, however, they have "gotten more comfortable with smaller, less established firms," ones that might have only $200 million in assets under management, or, for a fund-of-funds manager, just $50 million, Mr. Platkin said.
"We're basically a long-only shop," Mr. Platkin said. "There are a lot of things that are much different in absolute-return space. You're dealing with small, less established organizations. Even if we delve into larger hedge funds, they're still pretty different from the Fidelitys of the world."
GMAM officials hint they may eventually market their approach -- which essentially is a fund of funds -- to other investors. "The program is definitely scalable," Mr. Platkin said.
Critics have questioned whether CalPERS' $1 billion hedge-fund program -- probably the most closely watched in the world -- will have any affect on the $134 billion pension fund's total returns.
The program returned 2.4% before fees from its first investment on April 1, 2002, through Dec. 31, 2002. (It returned -0.9% after fees.) That compares with the -21.4% last year for CalPERS' internal domestic passive portfolio, from which the assets were taken.
"At 23 percentage points of outperformance, any amount of money allocated will have an impact" on total fund performance," said Mark Anson, CalPERS chief investment officer.
Officials for the system plan to suggest boosting its hedge-fund allocation at the investment committee's June meeting, after fund officials have fully invested the initial $1 billion allocation.
Mr. Anson said the fund has invested $700 million to date; the latest CalPERS disclosure reveals $550 million invested with 13 hedge funds, ranging from Andor Technology Fund LP to Symphony Asset Management LLC's Rhapsody Fund.
What's more, CalPERS officials plan to hire a number of strategic advisers to help locate and vet potential hedge fund managers. That should help expand the potential universe, improve due diligence and increase capacity as well as negotiate better fees, a staff memo to the investment committee noted. CalPERS' original adviser, Blackstone Alternative Asset Management, likely will be included in the pool.
Picking hedge-fund managers is a different, though not necessarily a tougher, challenge than selecting traditional managers, Mr. Anson said. "It's not more intense, it's just having to know how to ask the right questions."
For example, Mr. Anson pointed out that talking to a manager's back office is very important. "Do they have the infrastructure to support the capacity and higher volume of trading?"
What's more, Mr. Anson probes how hedge-fund managers manage their risks. Will a long-short manager put in stops on losses? Limit the size of positions? Liquidate holdings at set thresholds?
He also warns about volatility in certain strategies. Merger arbitrage is a short-volatility strategy, where the manager goes long on the target company and short on the acquirer, trying to capture the spread. "What you cannot see from the balance sheet is, is the manager short a synthetic put option?"
Mr. Anson is also concerned about the flood of money pouring into hedge funds, which have anywhere from $500 billion to $1 trillion in assets. "That's too much money to be absorbed," he said.
He thinks there will be another big hedge fund blowup. "In a strange way, that will be good for industry," he said. "Newer, less experienced entrants will leave the market," he explained, allowing things to settle down and get back to normal.