Big public pension funds trump hedge fund benchmarks

Big public pension funds reaped strong returns from their hedge fund portfolios in 2012, with most of them handily surpassing their own benchmarks and well-used industry indexes.

The hedge fund portfolios, for the most part, achieved close to what chief investment officers wanted, despite a 1,500-basis-point difference between the best and worst performers, according to Pensions & Investments' analysis of the returns of 19 hedge fund portfolios from 17 U.S. public retirement plans with aggregate hedge fund assets of $60.7 billion.

Unlike P&I's typical performance ranking, being at the bottom was not necessarily a bad thing if the CIO's intent was not to capture equity market beta in 2012, when the MSCI All Country World index returned 16.9% and the Standard & Poor's 500 index came in at 16%.

All but four of the public fund hedge fund portfolios in P&I's universe topped the one-year return of the HFRI Fund of Funds index, the benchmark most commonly used by institutional investors. Seven of 19 portfolios trailed their internal benchmarks.

The top return for the year ended Dec. 31 was a high of 17.3% for the $300 million directional hedge fund portfolio of the $8.1 billion defined benefit plan of the Missouri State Employees' Retirement System, Jefferson City.

The lowest was 2.3% for the $4.1 billion non-directional portfolio of the $112 billion Teacher Retirement System of Texas, Austin.

But being smack dab in the middle of the pack is where a number of CIOs said they were glad to be.

“We are relatively happy with our hedge fund portfolio returns. 2012 was a good year,” said Paul J. Williams, investment officer of the $19.7 billion Texas County & District Retirement System, Austin. The plan's $5.3 billion hedge fund portfolio returned 8.6% in 2012, roughly in the center of P&I's return ranking.

That return was by intent. Mr. Williams said 5.5 percentage points of represented alpha — outperformance over the equity market return — with low beta exposure (0.2) to the MSCI ACWI.

As to be expected in an ebullient equity market, Mr. Williams said returns from investments in strategies uncorrelated to equity markets, such as global macro and managed futures, did not contribute much to overall hedge fund portfolio performance.

“Basically, we really got very little return from our risk-free investments in 2012,” he said.

The 8.2% return of the $2 billion hedge fund portfolio of the $38.2 billion Teachers' Retirement System of the State of Illinois, Springfield, also was in the middle, mostly because fund executives have been careful to make direct investments in uncorrelated hedge fund strategies, especially credit funds, said R. Stanley Rupnik, CIO.

The reason for the deliberateness is that the system made its first hedge fund investments in 2007 through hedge funds of funds, which “have quite a bit of equity beta exposure.” By design, the correlation to equity markets was reduced as the percentage invested directly in single strategy and multistrategy hedge funds rose to 55% as of Dec. 31, Mr. Rupnik said.

Equity beta was the key to top performance in P&I's ranking; portfolios with less equity beta by design ranked much lower, sources said.

Although MOSERS' directional portfolio came in at 17.3%, the system's far larger $2.2 billion non-directional hedge fund portfolio returned 6.5% for the year, placing it 15th in the return ranking. Texas Teachers' $4.5 billion directional hedge fund portfolio returned 8.2%, good for 10th place and a big jump from the 2.3% return of its non-directional portfolio.

While Texas County & District and Illinois Teachers funds run combined directional and non-directional hedge fund portfolios, MOSERS and Texas TRS followed the trend of splitting them.

Directional strategies invest long or short, based on the manager's prediction of future market trends. Non-directional strategies don't make market bets and tend to produce returns uncorrelated to equity and fixed-income markets.

“At a very high level, investors can bifurcate their hedge funds into directional and non-directional categories. Internally, we split the portfolio accordingly. The returns we're aiming for depend on the purpose of each portfolio,” said Rick Dahl, CIO of MOSERS.

“In big years for equity markets like 2012, the directional hedge fund managers tend to catch the market beta. In years when the equity markets are negative, returns of the directional and non-directional hedge fund portfolios reverse” he said.

Non-directional strategies are included within MOSERS' alpha pool; the directional hedge fund managers are included in the plan's global equity strategy.

The $28.7 billion Public School Retirement System of Missouri and the $3.1 billion Missouri Public Education Employee Retirement System, sister funds managed together in Jefferson City, also have separate directional and non-directional hedge fund portfolios, said Travis Allen, investment officer.

The public school fund's 11.6% hedge fund return edged out the public education fund's 11.4% return for the year, ranking third and fourth, respectively, in P&I's table. Mr. Allen said the hedge fund portfolio is commingled, with the minimal difference in performance due to cash flow variation.

The shared hedge fund portfolio had 0.3 beta to the MSCI World index last year, slightly higher than the beta of the Texas County & District fund's portfolio. That was the result of deliberate “beta plays that did very well,” Mr. Allen said.

Returns of the Public School/ Public Education funds' non-directional hedge fund portfolios, totaling $2 billion and $198 million, respectively, are included within the U.S. equity allocation, Mr. Allen said.

The approach that MOSERS and its fellow Show-Me State pension funds use — capturing equity beta through the directional allocation when markets are running high and generating alpha from the non-directional strategies when markets are dismal — illustrates how important hedge fund portfolio structure is to producing positive returns in a variety of market conditions, said Stephen L. Nesbitt, CEO of Cliffwater LLC, Marina del Rey, Calif., a specialist alternatives investment consultant.

The structure of an institutional hedge fund portfolio “made a huge difference to returns in 2012, whether purposefully or by accident,” Mr. Nesbitt said.

Two hedge fund portfolios that trailed the HFRI index return did so because their portfolios are virtually devoid of equity market exposure.

The State of Wisconsin Investment Board, Madison, has “basically no beta” in its $1.4 billion hedge fund portfolio, which returned 4.1% in 2012, Mr. Nesbitt said. The board manages the state's defined benefit plan, which totaled $84.6 billion as of Dec. 31. The hedge fund portfolio is part of the defined benefit plan's $78.8 billion core fund.

The $49.7 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, deliberately scrubbed equity beta out of its $5.9 billion hedge fund portfolio, which returned 3.4% in 2012, spokeswoman Evelyn Tatkovski said in an e-mail.

“The absolute-return asset allocation is used to increase diversification in the fund, focusing on strategies that are not systematically long (or short) equity, credit or interest rate exposures ... The performance of our program should not be correlated to the equity markets, providing more idiosyncratic returns,” Ms. Tatkovski said.