Pension funds are hot for long/short strategies

Institutional investors are continuing a significant shift into long/short equity and fixed-income hedge funds.

More than $2.5 billion was allocated to these strategies, according to the searches and hirings tracked by Pensions & Investments, and more than that is slated to be invested in 2012 and beyond.

Both long/short equity and credit managers have been recipients of reasonably strong inflows as institutions, especially public pension plans, build their hedge fund portfolios with big weightings to strategies that promise to control volatility and generate alpha on both the long and short side of the portfolio.

In addition, pension funds are continuing to incorporate long/ short hedge fund strategies into their overall global equity and fixed-income portfolios, rather than keeping hedge funds segregated in a separate asset class.

Institutions that invested directly in long/short hedge funds from 2011 on include the $3 billion Colorado Fire & Police Pension Association, Greenwood Village; the $126.3 billion Florida State Board of Administration, Tallahassee; the $36 billion Illinois Teachers' Retirement System, Springfield; and the $83.3 billion State of Wisconsin Investment Board, Madison.

Among pension funds planning to add a long/short equity hedge fund allocation to their global equity portfolio is the $71.8 billion North Carolina Retirement Systems, Raleigh.

The pension fund received legislative authority in 2011 to allocate a maximum of 6.5% of plan assets to equity hedge fund strategies. The system already has about $2.4 billion invested in non-equity hedge fund strategies that will remain separate from the new investments.

The system's investment staff aims to invest between 3% and 5% of plan assets or as much as $4 billion in current dollars, mostly in long/short equity strategies over the next three to five years, said Julia A. Vail, a spokeswoman for the system, in an e-mail. The equity hedge fund investments will be used to reduce risk throughout the global equity portfolio, rather than kept as a separate hedge fund allocation.

Among the long/short equity managers that brought in a lot of new institutional business in 2011 were Ascend Capital LLC, Davidson Kempner Capital Management LLC, Elliott Associates LP and Highline Capital Management LLC. On the credit side, the list would include Anchorage Advisors LLC, BlueMountain Capital Management LLC, Claren Road Asset Management LLC and King Street Capital Management LLC (P&I, Jan. 9).

The push of institutional money into long/short equity funds comes despite what David McMillan calls “disappointing” performance in 2011. Mr. McMillan, the St. Louis-based director of hedge funds for Mercer Investment Consulting, said the performance was the result of volatility spikes throughout the year and very high correlations among equity securities, especially in August and September.

In aggregate, long/short equity hedge funds were down 8.3% in the year ended Dec. 31, as gauged by the HFRI Equity Hedge Fund index. The annualized return of the index over the three-year span was much better at 8.01%, but returns over the five-year period were flat at 0.45%.

Long/short fixed-income hedge funds were better able to handle similarly high correlations among fixed-income securities in the fall of 2011, Mr. McMillan said.

Because volatility control, rather than performance, is the primary reason for investing in long/short equity hedge funds, most institutional investors are sticking with their existing or planned allocations, said consultant Roger Fenningdorf, partner and head of manager research at Rocaton Investment Advisors LLC, Norwalk, Conn.

“The premise for investing in long/short equity hedge funds is to reduce volatility and to provide downside (protection). Through good manager selection, you may also get some alpha generation, but that's not the first priority,” Mr. Fenningdorf said.

Long/short fixed-income hedge fund strategies, on the other hand, represent an opportunistic, alpha-seeking investment, rather than a portfolio volatility dampener, he said.

Adding long/short equity and credit hedge fund managers in order to protect against volatility spikes will be the final phase of a multiyear restructuring of the $6.5 billion Wyoming Retirement System's equity and global fixed-income portfolios, said John Johnson, chief investment officer of the Cheyenne-based pension fund.

The $1.6 billion credit portfolio has been mostly rebuilt with 60% of assets managed passively and 30% invested in active opportunistic credit approaches.

The remaining 10% will be invested in long/short credit hedge funds, Mr. Johnson said.

A 10% target for long/short equity hedge funds also has been set for the fund's $3.4 billion equity portfolio. A 70% allocation to passive equity managers has been completed and a search is under way for active long-only equity managers for a 20% allocation.

Mr. Johnson said the fund's investment staff probably won't begin a combined search for long/short equity and credit managers until next year, but stressed that the addition of these hedge funds to the equity and fixed-income portfolios will be crucial in providing volatility control.

“Volatility isn't a bad thing in a portfolio, if it's in the right place. We apply a fairly quantitative approach to every asset class and to assessing every manager within them. When we know where the volatility is, we can manage the risk appropriately,” Mr. Johnson said.

He added that Wyoming's investment team seeks to create a correlation benefit within all subasset classes and in the case of the system's long/short equity and fixed-income hedge funds, the correlations will tend to be negative.

The $3 billion Colorado Fire & Police Pension Association, Greenwood Village, recently reallocated 20% from its $1.5 billion global equity portfolio to invest in long/short equity, activist and event-driven strategies, confirmed Dan Slack, CEO of the $3 billion pension plan, in an interview in early February.

The first of 10 direct investments in equity hedge funds planned for 2012 was a $34.5 million investment in a long/short equity hedge strategy managed by Coatue Management LLC. Each manager will receive about $30 million, Mr. Slack said, noting the addition of hedge fund strategies within the overall equity portfolio is designed to reduce beta exposure to the S&P 500 index and to reduce the maximum drawdown in a down market.

Reporter Kevin Olsen contributed to this story.