THE P&I 1,000: Pension funds continue torrid hedge fund pace

The pace of investment in hedge funds and funds of funds by the top 200 U.S. pension funds remained nothing short of blistering.

Investment in hedge fund vehicles reported by the largest U.S. funds increased 46.5%, to $21.1 billion as of Sept. 30, from $14.4 billion a year earlier. That figure would rise by least $3 billion if assets were added from pension funds known to be invested in the asset class but that did not disclose that data on Pensions & Investments' questionnaire.

The 46% growth rate, however, actually represents a decline from the 69.4% rise for the 12-month period ended Sept. 30, 2003. Despite the dip in the overall pace, however, 13 of the 31 funds reporting hedge fund investments were doing so for the first time and six plans reported increases of more than $200 million.

Defined benefit plans reporting hedge fund investments to P&I for the first time are:

• Verizon Communications Inc., with $1.3 billion;

• the Massachusetts Pension Reserves Investment Management Board, with $1.3 billion;

• the Virginia Retirement System, with $1.1 billion;

• Boeing Co., with $823 million;

• ITT Industries Inc., with $387 million;

• the State of Michigan Retirement Systems, with $359 million; and

• the Alaska State Pension Investment Board, with $300 million.

Top 200 defined benefit plans that significantly increased their hedge fund investments included: the Pennsylvania State Employees' Retirement System, up $1.8 billion, to $4.8 billion; Teacher Retirement System of Texas, up $155 million, to $1.15 billion; Missouri State Employees' Retirement System, up $269 million, to $866 million; and the World Bank fund, up $208 million to $802 million.

New investment flows aren't likely to stop soon. Nearly $2.9 billion is close to being put to work in new or additional hedge fund investments by several funds among the top 200, including:

• the California Public Employees' Retirement System, which will increase its total hedge fund investments by about $1.2 billion to $2 billion;

• the defined benefit plan of International Paper Co., which will double its 5% or approximately $316 million investment;

• the Illinois State Board of Investment, which is searching for its first hedge fund managers for a 5% or $500 million allocation;

• the Ohio Police & Fire Pension Fund, which is searching for hedge fund-of-funds managers for a $300 million mandate;

• the Ohio Public Employees Retirement System, which will make an initial hedge fund-of-funds investment of between $20 million and $50 million; and

• the Wyoming Retirement System, which is searching for an absolute return manager for a $50 million to $100 million assignment.

Additionally, several defined benefit plans announced intentions to make unspecified hedge fund investments, including: the California State Teachers' Retirement System; the Maryland Supplemental Retirement Agency; the New Jersey State Investment Council; and the New York City Retirement Systems.

Stephen L. Nesbitt, chief executive officer of alternatives consultant Cliffwater LLC, Santa Monica, Calif., predicted more flows to hedge funds at a much more rapid pace than in the past, as plan sponsors seek diversification and move assets from core equity to non-correlated alternatives.

"Trustees are motivated by the need to match liabilities and find returns. Hedge fund returns this year have held up pretty well. I think the learning curve has shortened considerably and the time from understanding hedge funds to deciding to search to hiring is shrinking considerably," Mr. Nesbitt said.

By way of additional support for a continued appetite for hedge funds by institutional investors, a survey by Casey Quirk & Associates LLC, Darien, Conn., conducted for the Bank of New York, predicted institutional investors will have $300 billion in hedge funds within five years, up from an estimated $60 billion in mid-2004. CQA's institutional universe included endowments and foundations that are not covered by P&I's survey. By 2008, CQA estimates, institutional investors will account for more than half of hedge fund investments, up from less than 10% in 2001.

Hedge funds of funds remain the most popular vehicle for pension fund investment in the asset class. The top 200 pension funds reported $13.6 billion of investment in funds of funds as of Sept. 30 or 64% of the overall hedge fund allocation. Direct hedge fund investments totaled $7.5 billion.

Growth of assets in hedge funds of funds in 2004 also far surpassed that of direct hedge fund investments at 65%, up from $8.3 billion as of Sept. 30, 2003; the growth in the year-earlier period for funds of funds was 69%.

The growth rate for direct hedge fund investment slowed significantly for the year ended Sept. 30, 2004 to 23%, vs. the 70% growth in the year-earlier period.

The rapid growth of hedge fund investment has changed the makeup of the overall alternative investment portfolio of the top 200 defined benefit plans in each of the past three years.

As of Sept. 30, 2004, the allocation to hedge funds as a percentage of the overall alternatives allocation of $149.3 billion was 14.1%. As of Sept. 30, 2003, hedge fund investments were 10.7% of the $134.9 billion alternatives total. As of Sept. 30, 2002, they were 6.9% of the $122 billion total alternative allocation.

By contrast, venture capital accounted for 13% of alternative investments as of Sept. 30, 2004, compared with 12.1% in 2003 and 15.7% in 2002.

Private equity as a percentage of alternatives is suffering as a result of increases in hedge fund and venture capital investment, dropping to 56.6% of alternatives investments as of Sept. 30, 2004, from 61.1% in 2003 and 59.8% in 2002.

Despite the popularity of hedge funds, there are still some deliberate holdouts. The Teachers' Retirement System of Illinois, the Indiana Public Employees' Retirement Fund and the Indiana State Teachers' Retirement Fund all decided to abandon searches for hedge fund and funds of funds managers in 2004.