Public pension plan hedge fund returns OK, but lag 2010

Hedge fund returns of large U.S. public pension plans were strongly positive in the year ended June 30, but, on average, were lower than a year earlier.

Plus, fewer outperformed industry benchmarks.

The average return for the 12 months ended June 30 was 10.3% for the 13 hedge fund portfolios analyzed in Pensions & Investments' second annual review of large public plan hedge fund investors. By comparison, the average hedge fund return as of June 30, 2010, was 11% for the eight large public plan investors analyzed in P&I's first review (Sept. 20, 2010).

This year, four of the 13 hedge fund portfolios analyzed had better performance than the 11.5% return of the HFRI Fund Weighted index. That index tracks single and multistrategy hedge funds.

Last year, six of the eight funds reviewed outperformed the 9.1% one-year return of the HFRI Fund Weighted Composite index.

This year, 11 of the 13 hedge fund portfolios analyzed trounced the one-year 6.7% return of the HFRI Fund of Funds Composite index, which tracks hedge funds of funds. In the year ended June 30, 2010, all of the hedge fund portfolios reviewed outperformed the 4.7% return of the HFRI Fund of Funds composite index.

In both years, all of the public pension hedge fund portfolios easily surpassed their internal hedge fund benchmarks.

Hedge fund returns of the 13 plans for the year ended June 30, 2011, ranged from 5.9% to 18.8%. Policy benchmark returns ranged from 2.3% to 18.3%, averaging 6.1% for the group.

Last year, the average internal hedge fund benchmark return was 4.3% for the eight pension plans, whose policy benchmark returns ranged from 0.56% to 8% for the year. Actual hedge fund returns for the period ranged from 7.1% to 15.6%.

An examination of this year's larger universe of showed a high degree of outperformance over a plan's internal hedge fund benchmark, with average outperformance topping out at 420 basis points. Eleven of the 13 hedge fund portfolios outperformed their policy benchmarks by at least 250 basis points.

One exception was the $30.8 billion Missouri Public School and Education Employee Retirement Systems, Jefferson City, which had the best-performing hedge fund portfolio in the universe with an 18.8% return, but only outperformed its internal benchmark by 52 basis points for the year ended June 30. Still, the fund's $4.2 billion hedge fund portfolio outperformed the next-best performing fund by 560 basis points.

The hedge fund portfolios of the 13 pension funds reviewed for this story ranged in size from $5.6 billion to $851 million. Ten of the 13 funds increased their hedge fund allocations in the year ended June 30.

None of the returns of the hedge fund portfolios reviewed by P&I came close to those of major equity market indexes. The Standard & Poor's 500 index returned 30.7% and the Morgan Stanley Capital International World index, 31.2%. The BarclaysCapital Aggregate Bond index returned 3.9% for the period.

Because equity market returns were so good, total fund returns for the pension plans in P&I's universe ranged from 18% to 24% for the year ended June 30 and, in every case, were significantly higher than those of their hedge fund portfolios.

A year earlier, total fund returns for the pension plans analyzed ranged from 12.9% to 14.5% and in all but one case, were higher than those of the hedge fund portfolios. The exception last year was the Pennsylvania Public School Employees' Retirement System, Harrisburg, which bested the total fund return by 101 basis points.

Some hedge fund investors in P&I's universe obviously caught more of the equity market beta rise in their portfolios than others, said Darren W. Spencer, director of alternative investment consulting for the Americas for Russell Investments. Mr. Spencer is based in New York.

Mr. Spencer said he was struck by “the significant dispersion of returns” among the 13 pension funds, which “obviously show individual investor objectives. Some investors obviously are seeking zero beta exposure, while others included targeted, controlled equity beta exposure,” to catch some of the rising markets during this period.

“The hedge fund value proposition was validated during this period,” said Mr. Spencer. “If you look into the individual portfolios of hedge fund managers and of institutional investors, it's clear that hedge funds did what they are supposed to doby generating returns to help pension funds, especially public plans, meet their funding objectives with significantly less volatility than equity markets.”

Volatility control was one of the primary reasons the Missouri Public School fund started ramping up its nascent hedge fund portfolio back in 2006. The fund wasn't included in last year's review.

John Tuck, director of private equity and alternatives, said trustees decided five years ago that the plan was too reliant on traditional long-only equity, so the board directed investment staff to move slowly and methodically into direct investment in hedge funds with the goal of reducing the plan's volatility.

The hedge fund portfolio now is very close to its target weighting of 15%. The portfolio is made up of 29 hedge fund investments managed by 20 externalmanagers, and is broadly diversified into eight strategy categories with the following allocations as of June 30: equity long/short, 34%; event-driven, 16.5%; diversified beta portfolio, 11.5%; diversified multistrategy, 9%; credit opportunities, 8.5%; relative value, 7.5%; inflation hedge portfolio, 7%; and global macro, 6%.

Mr. Tuck said the hedge fund portfolio has done a good job of dampening volatility, sheltering the fund from about 60% of market volatility over both the one- and three-year periods ended June 30.

The hedge fund also turned in “much better performance” than the fund's traditional equity managers in the difficult markets in 2007 and 2008, said Craig H. Husting, chief investment officer.

“The one thing we've learned over the past five or six years of hedge fund investing is that you really have to be proactive in managing the portfolio,” Mr. Husting said. “We look at hedge fund strategies and allocations quarterly and at the margins, take the risk of the portfolio up or down” by reallocating assets between managers and strategies in response to market conditions.

Second in P&I's hedge fund performance ranking was the $5.3 billion portfolio of the $51.4 billion Pennsylvania Public Schools fund, whose 13.2% composite return came from its 14 hedge fund managers. The fund's internal hedge fund benchmark returned 8% for the same period.

In P&I's prior review, the Pennsylvania Public Schools fund had the highest hedge fund return for the year, at 15.6%.

Both Missouri School Employees and PennPSERS make only direct investments in individual hedge fund managers, but the third best performer, the $37.5 billion Illinois Teachers Retirement System, Springfield, had 68% of its $1.5 billion portfolio invested through hedge funds of funds.

The 12.4% return of Illinois Teachers' combined direct investment and fund-of-funds portfolio for the year outperformed the 4.2% return of the internal hedge fund benchmark by a staggering 821 basis points. The Illinois fund increased its hedge fund allocation by 23% during the period.

Illinois Teachers had the fourth best-performing portfolio as of June 30, 2010, with an 11.1% return for the one-year period.

The $5.6 billion hedge fund portfolio of the $26.3 billion South Carolina Retirement Systems Investment Commission, Columbia, made its first appearance in P&I's hedge fund review and was the largest in the universe. It also had the fourth-best performance, at 11.6% for the year ended June 30, besting its internal benchmark return of 4.2% by 740 basis points.