After an exhaustive and time-consuming due diligence process, the trustees for the pension plan of Sheet Metal Workers Union Local 46 added hedge fund exposure several years ago to its asset allocation strategy.
In the past, our board never considered hedge fund exposure to be an option; however, our thoughts changed when the fund’s investment consultant alerted us that our plan — similar to many of the nation’s other union funds — could fall far short of the target needed to meet our long-term liabilities for a number of key reasons.
First, the original actuarial assumptions from the 1980s significantly underestimated our members’ life expectancies. Second, the investment environment at the time, in the early 2000s, was highly unfavorable. Finally, we knew that the prospect of economic growth in upstate New York, where Local 46 is located, was less than robust.
Our plan’s investment consultant, Marc Fischer of Citigroup Institutional Consulting, explained that in order to meet the fund’s obligations, we needed an asset class with bond-like risk and volatility but with higher, more predictable, equity-like returns.
Mr. Fischer discussed a change in investment strategy with our three labor and three management trustees at the June 2003 board meeting. One obvious solution was to significantly increase the plan’s 65% allocation to equities (vs. 35% fixed income). However, no one on the board wished to endorse a potential increase in total portfolio volatility for our $63.9 million fund. A second obvious alternative was to make substantially larger dollar contributions to the plan each year, but the trustees were acutely aware that increased contributions were not a realistic alternative, given the outlook for the upstate New York economy at the time.
The consultant suggested that we consider allocating a small — but statistically significant — portion of the plan to alternative investments, which might help to improve returns over time and mitigate volatility. He quickly received initial enthusiasm from one of the trustees, Richard Hogan, who had read about the virtues of alternative investments and their increasing use by large institutional investors. Mr. Hogan was most interested in how these institutions employed hedge funds as a means to help enhance returns, reduce risk and restabilize portfolios that had lost momentum.
Some of the trustees greeted the suggestion with unease and skepticism. They were aware of hedge funds but believed, with some justification, that the term was subject to ambiguity. The majority equated hedge funds with the very public implosion of Long Term Capital Management. Even those trustees who were most knowledgeable about hedge funds had serious concerns about the board’s skill to accurately judge the impact of hedge fund exposure on the plan’s total portfolio or to assess appropriate hedge fund alternatives.
After a preliminary presentation that addressed both the merits and disadvantages of hedge funds, the board became convinced of the merits of an allocation of this nature. We therefore formed a subcommittee to conduct additional research into alternative investments.
A committee Mr. Hogan headed — representing both the trustees and the plan’s legal counsel — reviewed a broad array of research on hedge funds and agreed that three key messages were essential in order to convince the board that an allocation to hedge funds would be prudent.
The first message: hedge funds were simply one of the newest manifestations of a decades-long evolutionary process, in which pension plans have become familiar with and accepted “unconventional” investment exposures.
The second message: Trustees were unlikely to be called upon to explain a “blow-up” within the hedge fund allocation, as long as the plan invested in a properly diversified fund of funds that could mitigate the risk associated with a single hedge fund manager.
The third message: Acknowledgement that hedge fund strategies were more complex and difficult to understand than most traditional disciplines. Consequently, it was imperative to retain a capable fund-of-funds manager, which in turn necessitated that the plan had a rigorous process in place to select this manager.
At the ensuing October meeting, Mr. Hogan and the consultant made a formal presentation to the undecided board members that lasted more than two hours. The board members asked a host of questions, many of which focused on risks, worst-case scenarios, return projections and how the addition of hedge fund exposure might impact the plan’s ability to help meet future liabilities. Many of the questions also centered on how the trustees could explain and defend a hedge fund allocation decision to membership. Trustees who were undecided were provided with additional case studies, and one-on-one talks were held to address specific objections.
After prolonged discussion at the following December meeting, a formal recommendation was made to adopt a $5 million allocation through the addition of a fund of funds manager, funding the new investment by reducing fixed income to a 30% allocation. The next year, at the March meeting, a motion was unanimously adopted to amend the investment policy statement to add hedge funds and to hire a manager, Ivy Enhanced Income. One trustee suggested that this board had devoted more time, effort and discussion to reach this decision than any other in his memory.
To assist the board, Citigroup Institutional Consulting and Smith Barney’s Consulting Group primarily monitor the hedge fund allocation, while the plan’s certified public accountant visits the hedge fund of funds’ managers and custodian annually.
Since adding the fund-of-funds allocation, the Sheet Metal Workers’ alternative investment allocation has improved the overall fund’s risk and return metrics. Mr. Hogan and other board members have observed that the membership rarely asks questions anymore about the performance of the alternative investments portfolios. As Mr. Hogan noted, “Hedge fund is no longer a knee-jerk term around here.”
Michael J. Morgan is a trustee of the Sheet Metal Workers Union Local 46 fund in Rochester, N.Y., and its recently retired business manager.
