‘Alpha engine’ portfolio revving up controversy

SAN DIEGO — A hedge fund by any other name would smell as sweet. Or perhaps sweeter.

Following news that the San Diego County Employees' Retirement Association had lost close to 50% of its $175 million investment with Amaranth Advisors LLC, officials at the $7.7 billion pension fund decided to set the record straight. Amaranth is the Greenwich, Conn.-basedmultistrategy hedge fund that lost $6 billion within two weeks on a bad bet on natural gas prices.

At an Oct. 19 educational workshop on hedge fund investments, San Diego fund officials proclaimed that, contrary to popular perception, the fund did not have one-fifth of its assets invested in hedge funds.

"It's been bruited about that SDCERA has 20% of its assets in hedge funds. And that's not the case," Chief Investment Officer David Deutsch told the board.

Rather, Mr. Deutsch drew a line between high-risk hedge funds and low-risk absolute return strategies.

But observers said the line Mr. Deutsch was drawing is imaginary.

"It's two sides of the same coin. It's just that people are trying to get T-bill-plus returns with capital preservation in many strategies. But the reality is that every strategy has risk," said Jim McKee, director of hedge fund research at Callan Associates Inc., San Francisco.

Mr. Deutsch said both hedge funds and absolute return strategies are employed in the pension fund's $1.5 billion "alpha engine," which replaces conventional U.S. large-cap exposure with a variety of alpha-generating strategies transported onto Standard & Poor's 500 derivatives contracts.

Hedge funds, Mr. Deutsch elaborated, tend to be higher volatility strategies that often employ leverage, short selling and lockup periods, and may or may not be registered with the U.S. Securities and Exchange Commission.

In contrast, absolute return strategies tend to have lower volatility and are designed to produce consistent risk-controlled returns, he said. Such strategies include market neutral, fixed-income arbitrage and enhanced cash portfolios.

Mr. Deutsch said the San Diego fund uses a "barbelled" structure for its alpha engine, combining higher-risk hedge funds and lower-risk absolute return strategies.

He added the SEC uses a different definition of hedge funds, based not on funds' hedging techniques, but on their status as private and unregistered investment pools.

Using Mr. Deutsch's definition, the fund had only 8.44% of assets invested in hedge funds as of June 30, before Amaranth's late September implosion. (The firm is in the process of closing.)

As of Oct. 13, the San Diego fund was left with 6.07% of its assets in hedge funds. Another 4.91% were in market-neutral, 1.95% in global macro and 5.34% in fixed-income and cash strategies.

Outside experts did not buy San Diego's distinction between hedge funds and absolute return strategies.

"‘Hedge fund' is a term that is meaningless," said Michael Litt, partner and portfolio strategies for FrontPoint Partners LLC, a Stamford, Conn.-based multistrategy manager. "It can be a manager who is long-only distressed debt locked up for three years, or a manager with 1,000 stocks long and 1,000 stocks short and little market risk."

David Hsieh, a professor at Duke University's Fuqua School of Business and well-known expert on hedge funds, wrote in an e-mail to Pensions & Investments: "I do not think it is relevant to distinguish between low-risk or high-risk fund(s)." The risk in a fund can always be leveraged up or down, he explained.

The only way to guarantee a positive return is to own a Treasury bill, Mr. Hsieh added. Any other approach involves taking on some risk.

Added one consultant, who asked not to be named: "Most people use absolute return as a substitute to characterize the entire hedge fund asset class, just like they started using high yield instead of junk bonds" to avoid negative connotations.

Will Goetzmann, a Yale University finance professor who spoke at the San Diego workshop, said hedge funds cover a very broad range of investments, including arbitrage, global macro, and market-neutral strategies — all of which Mr. Deutsch categorized as examples of absolute return strategies.

Definitional issues aside, San Diego officials gave no sign that they plan to pull back the fund's investments with absolute return and hedge fund managers, despite pressure from outside groups.

Lani Lutar, president and chief executive officer of the San Diego County Taxpayers Association, said the group is not comfortable with a 20% allocation to hedge funds. "Zero to 1% is a level we would be comfortable with," she said in response to a question from board member Dianne Jacobs.

Mr. Deutsch also said staff will take on greater responsibility for running the program, relying less on outside parties to conduct due diligence on managers. Rocaton Investment Advisors LLC, Norwalk, Conn., San Diego's general consultant, resigned the account Oct. 17. Neither Rocaton nor San Diego executives would comment on reasons for the resignation.

San Diego officials plan to seek a new general consultant and a special consultant for its portable alpha strategy in the next few days, said Brian White, the fund's chief executive officer. Mr. White said fund officials expect to complete the searches within the next 90 days.

In the interim, sources said fund officials intend to hire Cliffwater LLC, Marina del Rey, Calif., as general consultant. Cliffwater already consults to the fund on specialized asset classes. Mr. White declined to confirm the Cliffwater choice, but said fund officials are close to signing an agreement with an unnamed firm.

Mr. Deutsch also said officials will continue to diversify the fund's alpha exposure and will seek better ways to manage event risk. One way endowment funds do this is by cultivating relationships with managers for years, he noted.

In addition, fund officials will assume that multistrategy managers and other hedge funds are not sufficiently diversified all the time, Mr. Deutsch said. San Diego will now assume that one hedge fund manager will blow up in any given year, he said.

Mr. White said fund officials do not expect one hedge fund manager to implode annually, but officials will test the program to take the possibility into account.