Institutions taking divergent paths in revamping hedge fund portfolios

Hedge fund portfolio revamps are front and center on CIOs' desks as institutions, especially public pension plans, refine their investment approaches.

The South Carolina Retirement System Investment Commission and the Teachers' Retirement System of the State of Illinois are among the most recent to begin gut rehabs.

Each is splitting a single hedge fund allocation and regrouping hedge fund strategies by whether their returns are more or less correlated to public equity and fixed-income markets.

They are emulating the leading-edge practices of other asset owners, including the $116 billion Teacher Retirement System of Texas, the $8.1 billion Missouri State Employees' Retirement System, the $28.7 billion Public School Retirement System of Missouri and the $3.1 billion Missouri Public Education Employees Retirement System (Pensions & Investments, April 1).

Other institutional investors are following less drastic evolutionary paths in managing their hedge fund portfolios:

• The $24.7 billion Employees Retirement System of Texas is moving some hedge funds in its year-old portfolio into traditional asset class allocations alongside related long-only strategies;
• The $46.1 billion Alaska Permanent Fund Corp. is edging closer to internal hedge fund management by gradually passing to staff the decision-making authority for co-investments with hedge fund managers;
• The $264.9 billion California Public Employees' Retirement System is considering moving its $5.2 billion hedge fund portfolio to a managed account platform, a structure United Parcel Service Inc. chose for an opportunistic hedge fund of funds built and managed internally for its $27 billion U.S. defined benefit plans.

South Carolina and Illinois Teachers' are undertaking much more radical portfolio reconstructions by separating their hedge fund allocations into directional and non-directional portfolios, a move that will enable chief investment officers to tactically shift weightings in response to market conditions.

Directional hedge fund strategies invest long or short, based on the manager's prediction of market trends. They have more beta exposure to stock and bond markets and therefore thrive - or weaken - in response to market conditions.

Non-directional hedge fund strategies don't make market bets and returns generally are not correlated to those of global public markets.

This approach to hedge fund investment allows the institution to capture market beta during good markets and to collect alpha generated by the non-directional portfolio during down markets, said Stephen L. Nesbitt, CEO of Cliffwater LLC, Marina del Rey, Calif.

Over the next nine months, the South Carolina investment commission will dive into the process of bifurcating the $5.5 billion hedge fund portfolio it oversees for the $27.3 billion South Carolina Retirement Systems, Columbia.

Under a new asset allocation effective July 1, the target for hedge funds will be reduced to 15% of total assets from 20%, said Hershel Harper Jr., CIO of the commission, also based in Columbia.

The allocation to a dedicated hedge fund component was increased to 8% from 5%. The dedicated hedge fund portfolio will only contain hedge fund strategies that exhibit low correlation and low beta compared with traditional stocks and bonds. Strategies will include global macro, market-neutral and managed futures strategies.

The new, less correlated hedge fund allocation will feature “a lower volatility and lower expected return than hedge fund programs that are heavily reliant on equity beta,” according to a report from Hewitt EnnisKnupp, Chicago, the commission's investment consultant.

Some of the hedge fund investments from the fund's $3.9 billion portable-alpha portfolio, such as Bridgewater's Pure Alpha Fund and a D.E. Shaw Composite fund, might be moved to the low-correlation hedge fund segment because of their return characteristics, Mr. Harper said.

The portable-alpha portfolio, which accounted for 15% of plan assets, is in the process of being eliminated. The new hedge fund policy also allows up to 7% of plan assets to be invested in hedge funds with higher beta, closer to that of traditional equity and fixed income, and moves those hedge funds into the asset classes to which they are most similar.

The reconstruction process for the $2 billion hedge fund portfolio of the $39.6 billion Illinois Teachers' Retirement System, Springfield, on the other hand, will group its 22 existing hedge fund investments into three broad portfolios and move out of hedge funds of funds.

The new portfolios are convergent or differentiated strategies that have correlated performance during times of market stress; convex, or trading strategies that provide positive performance during market downturns; and opportunistic, or strategies that don't fit into either of the other two categories.

Like the South Carolina system, the Austin-based Texas Employees fund is moving hedge funds into equity and fixed-income portfolios where appropriate. This is part of a quick evolution: the system began investing in hedge funds in early 2012.

But rather than create a portfolio of non-correlated hedge fund strategies, Texas ERS instead will maintain a broader dedicated hedge fund allocation for relative-value, event-driven and other hedge funds that don't fit well into stock and bond portfolios, confirmed Mary Jane Wardlow, an ERS spokeswoman, in an e-mailed response to questions.

The question of where to group hedge funds is immediately relevant as Texas ERS builds its hedge fund portfolio with investment of up to $600 million in eight to 12 new hedge funds before the end of its fiscal year on Aug. 31.

Alaska Permanent Fund, Juneau, hopes to create not only an internally managed hedge fund co-investment program but also a similar program for private and public equity (P&I, May 23).

Internal hedge fund staff will at first rely on external co-investment fiduciaries to decide in which opportunities offered by hedge fund managers to invest.

Over time, as investment teams gain expertise, they will assume co-investment decision-making, Laura Achee, an APFC spokeswoman, said in an e-mailed response to questions.

Alaska Permanent needs additional staff to manage the new portfolios, which requires a legislative appropriation, Ms. Achee said.