UPS gets best of both worlds with fund-of-funds platform

United Parcel Service Inc. combined investment insourcing with operational outsourcing in building its fledgling opportunistic hedge fund of funds for its U.S. defined benefit plans.

Built to pump up returns for the four U.S. plans, which total $27 billion, the new fund matches the expertise of Leo R. Svoboda, portfolio manager-absolute return at UPS, and HedgeMark International LLC, which provided the operational infrastructure, hedge fund risk monitoring and performance, and managed account know-how.

The 1907 Partners Fund is named for the year of UPS' founding as a bike and foot messenger service. But its investment premise is thoroughly rooted in the 21st century.

“We kept coming across investment opportunities that didn't meet the criteria of traditional asset classes,” Mr. Svoboda said in a telephone interview from the company's Atlanta headquarters.

“We passed up intriguing investment opportunities not because we didn't understand them, but because we didn't have a place to put them.”

About a year ago, UPS' investment staff decided that to meet the pension plans' steep 8.75% assumed rate of return, overall portfolio returns could be boosted by investing even more outside of traditional asset classes and vehicles, Brook Scardina, director of compliance and operations for the UPS pension department, said in a telephone interview.

The high assumed return rate is needed because UPS' 2012 blended discount rate across all of its pension plans is 4.42%, said Brian H. Pellegrino, chief investment officer of the UPS Group Trust, in an e-mailed response to questions.

UPS' current investment structure provides flexibility to change the plans' asset allocation when their funded status improves or when discount rates rise back to 2010 or 2011 levels, which were 5.98% and 5.64%, respectively, for UPS, Mr. Pellegrino said in the e-mail. “100 basis points is a big deal,” when it comes to discount rate changes, he added.

The UPS defined benefit plans were 78.3% funded as of Dec. 31, according to Pensions & Investments' analysis of the company's most recent annual report.

But as Mr. Pellegrino explained during a presentation at the Milken Institute Global Conference in Beverly Hills, Calif., in April, “the length of time” pension executives have to “meet liabilities makes a huge difference” in the way they can manage the fund.

UPS has a young employee population and with long-term liabilities not due for 20 to 30 years; “it means you can take more risk and tolerate more volatility,” Mr. Pellegrino said during his speech.

The UPS pension staff took that institutional tolerance for risk and began moving to a less-traditional investment approach in 2007, well before taking on the 1907 Fund project. At the end of 2012, the defined benefit plans' asset allocation was 38.8% equities, 32.5% fixed income, 11.1% hedge funds, 5.6% private equity, 4.9% real estate, 0.9% cash, 0.8% structured products and 5.4% other (including global tactical asset allocation).

Beginning this year, UPS eliminated its target asset allocations and moved to investment ranges to “provide increased trading flexibilities in support of plan objectives,” Mr. Pellegrino said in a telephone interview.

The broad asset ranges are 25% to 55% global equity, 15% to 40% fixed income, 8% to 20% liquid alternatives, 3% to 10% real assets, 3% to 10% private equity and 1% to 10% cash.

That flexible approach extends to the 1907 Fund, which is designed to allow the investment team to take advantage of fast-moving market opportunities created by market dislocations globally.

While the investment team possessed the investment skills necessary to make decisions about the opportunistic credit and fixed-income relative value deals coming UPS' way, it became apparent UPS needed to outsource the investment platform and infrastructure, Mr. Scardina said.

Because there wasn't an off-the-shelf operational infrastructure product available, Mr. Scardina said New York-based HedgeMark International was hired to build a customized investment platform that provides separate accounts managed exclusively for UPS.

It was important to Messrs. Svoboda, Pellegrino and Scardina that UPS design and control the fund's structure, rather than relying on a single hedge fund partner's design. The HedgeMark platform puts UPS — not the underlying money manager — in control of the assets, but allows the manager to invest according to the guidelines of the investment management agreement. It also provides position-level transparency and independent pricing and validation.

“The platform has really allowed us to expand the investment opportunity set without having to rely on the ... infrastructure of a particular manager, which may be less than desirable from ... an operational and compliance perspective,” Mr. Scardina said.

Mr. Svoboda's assessment from an investment perspective was more enthusiastic: “The value of the platform is that we can go anywhere and do anything.”

UPS has earmarked the trust's $1.5 billion risk-parity portfolio as the source of assets for the 1907 Fund, Mr. Svoboda said. Profits from the opportunistic fund will be reinvested or returned to the risk-parity portfolio.

The platform was launched last September. To date, $400 million has been committed to three managers. Mr. Svoboda wouldn't name the managers.

Of the three, one hedge fund manager is investing in dislocations in the global financial system, while a fundamental global macro manager and a fixed-income relative-value hedge fund manager each is managing alpha-oriented strategies as well as those that hedge exposures elsewhere in the portfolio, Mr. Svoboda said.

When asked about the 1907 Fund's performance, Mr. Svoboda would say only that it has “significantly exceeded return expectations.”

Like most investors, UPS was “typical in being underweighted” to Japanese long-only equities, around 15%. But through a separate account investment made on the HedgeMark platform for the 1907 Fund, UPS was able to get exposure to the yen through macro-traded themes and options on the currency that “the manager could not have done in a commingled fund,” Mr. Svoboda said.

“We got significantly more leverage for significantly less risk,” he added.

Mr. Svoboda said he is not seeking new deals with managers not already managing assets for UPS, preferring to “examine opportunities with companies we already have a relationship with.”