Public plan hedge fund returns still falling

Hedge fund returns of large U.S. state pension funds continued the downward slide they began in 2015 with the performance of half of the portfolios lagging their benchmark returns for the year ended Sept. 30.

Just one of the 16 hedge fund portfolios of 13 state pension funds analyzed by Pensions & Investments produced a return higher than the leading hedge fund index, although the performance of eight portfolios was above that of the top hedge fund-of-funds index.

The lower-return trajectory of these $1 billion-plus state plan hedge fund portfolios is evidenced by median returns of P&I's universe, which have fallen 903 basis points in two years — to 0.07% as of Sept. 30, 2016, from 1.5% a year earlier and 9.1% for the 12 months ended Sept. 30, 2014.

The $1.3 billion hedge fund portfolio of the $25.6 billion Employees Retirement System of Texas, Austin, had the highest one-year return in P&I's universe — 6.2% — well above the 4.9% return of the HFRI Fund Weighted Composite index and the 0.5% return of the HFRI Fund of Funds Composite index for the same period.

Texas Employees' one-year hedge fund return was 150 basis points higher than the second-place, 4.7% return of the $2.4 billion credit-oriented hedge fund portfolio of the $70.7 billion New Jersey Retirement System, which is managed by the state Division of Investment, Trenton.

The $5.2 billion hedged equity portfolio of the $38.7 billion Public School and Education Employee Retirement Systems of Missouri, Jefferson City, took third place in P&I's ranking with a 4.5% return for the year ended Sept. 30.

The Sept. 30 one-year returns of hedge fund portfolios P&I analyzed ranged widely between Texas Employees' 6.2% return to the -0.99% return of the $2.2 billion equity-oriented hedge fund portfolio of the New Jersey state system.

But a closer look at P&I's performance ranking showed that returns of state pension hedge fund portfolios were tightly clustered and roughly are “in line with the HFRI Fund of Funds Composite (index return) for the same time period,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif., in an e-mail.

Returns of 10 of the 16 hedge fund portfolios P&I examined were closely clustered around the 0.5% return of Hedge Fund Research Inc.'s hedge fund-of-funds index, ranging between 1.5% and -0.99%.

Mr. Nesbitt noted that hedge fund performance in the short term has been uninspiring.

He observed that during a period when the trailing 12-month return of the MSCI All County World index as of Sept. 30 was 12.5%, for state pension chief investment officers, “earning virtually nothing on hedge funds overall was a disappointment when return expectations might have been around 6% to 7% net of fees,” Mr. Nesbitt noted.

The Standard & Poor's 500 index (total return) and the Barclays Aggregate U.S. bond index for the year ended Sept. 30 also were tough targets for state pension fund hedge fund portfolios, returning 15.4% and 5.2%, respectively.

Careful strategy weighting within Texas Employees' hedge fund portfolio helped overcome performance obstacles not only for the year ended Sept. 30, but also since its August 2012 inception, said Anthony Curtiss, interim director of hedge funds, in e-mailed comments.

For example, the portfolio's largest strategy exposures are a 40% allocation to relative value and 33% to event-driven funds, Mr. Tuck said. Underweighting equity-oriented strategies with an 11% allocation provides diversification benefits to ERS' overall portfolio as well as helping to maintain a beta of 0.4 or lower, he said.

The remainder of the portfolio's policy allocation is 9% to global macro funds and 7% to opportunistic strategies.

About 66% of the portfolio's return in the year ended Sept. 30 is attributable to relative value and event-driven strategies, Mr. Curtiss said.

Performance of the relative value portfolio was driven by equity arbitrage, market-neutral, multistrategy and credit-oriented hedge fund managers, while the event-driven category benefited from overweighting risk arbitrage and to a lesser degree, high-yield and distressed credit, said Mr. Curtiss.

All five hedge fund strategies produced positive returns during the year with global macro contributing the least to the performance of the overall portfolio, Mr. Curtiss said, noting strategic underweighting of the subasset class for several years “has been additive given that many global macro hedge fund strategies have struggled to perform until recently.”

Despite negative focus on the degree to which hedge funds in general and state pension hedge fund portfolios returns are trailing major market indexes, most public plan investment officers and their boards of trustees gauge the success of their hedge fund lineups much differently.

The investment policy of the Public School and Education Employee Retirement Systems of Missouri, for example, requires that returns of the hedge fund portfolio be compared to two benchmarks: one, a custom benchmark made up of 50% the Barclays Intermediate Credit index, 25% Russell 3000 index and 25% ACWI Ex-U.S.; and the other, 50% of the HFRI Fund Weighted Composite and 50% of the HFRI Fund of Funds Composite indexes.

For the 12-months ended Sept. 30, the custom benchmark was up 8.8% while the HFRI blended index returned 2.7%, against the portfolio's 4.5%. The annualized returns for the five-year period were 7.7% and 3.8%, respectively.

The longer-term focus is important, said John Tuck, director of private equity and alternatives, noting the five-year return of the system's hedge fund portfolio is 6.9%, which trailed the combined equity and fixed-income benchmark return, but was 310 basis point above that of the blended hedge fund benchmark.

Since inception on Jan. 1, 2008, the pension funds' hedged equity's 5.4% return outperformed the 4.5% return of the custom equity-fixed-income benchmark and the 1.4% return of the blended HFRI benchmark.

This year is the fifth anniversary of a move by investment officials at the $63.2 billion Massachusetts Pension Reserves Investment Management Board, Boston, to direct investments from funds of funds in the $5.6 billion hedge fund portfolio.

The hedge fund portfolio returned an annualized 5.4% for the five years ended Sept. 30, topping the 3.3% return of its benchmark, the HFRI Fund of Funds Composite. The hedge fund portfolio also met MassPRIM's expectations by exhibiting very low volatility over the five-year period, said Eric R. Nierenberg, senior investment officer and director of hedge funds and low-volatility strategies, in an interview.

The hedge fund portfolio's one-year return of 2%, compared to 0.5% for the benchmark, reflects the success of moving about $2 billion of the portfolio to hedge fund managed accounts, Mr. Nierenberg said.

“By moving to the managed account format, we've been able to focus on investments in smaller hedge funds whose portfolio managers focus on more volatile, more differentiated and higher-returning strategies. These smaller hedge funds perform much better than large, legacy commingled fund managers,” Mr. Nierenberg said.

As part of his search for even better hedge funds returns through investing in “hedge fund firms with substantially smaller assets than the megamanagers,” Mr. Nierenberg convinced MassPRIM trustees to authorize a search next year for a managed account service provider to help develop an emerging hedge fund manager program. To be considered, managers must manage less than $2 billion or have minority or women ownership.

Mr. Nierenberg said his objective in setting up the emerging manager program in part is to be able to “go further down the size spectrum to find very interesting, even more differentiated managers. We want to get even nichier.”

MassPRIM's typical hedge fund investment starts around $150 million, but “some of these niche strategies can't manage more than $200 million tops,” Mr. Nierenberg said, adding “the emerging manager program will enable us to make smaller investments closer to $75 million or so.” n