Rocky market giving hedge funds a leg up for investors

Many institutional investors were satisfied with the defensive role their hedge fund portfolios played during the ferocious market conditions sparked by the COVID-19 pandemic, even if the performance of some of their hedge fund managers was down in the first quarter.

In fact, some asset owners are actively seeking to invest more in hedge funds that can take advantage of extreme market mispricing, consultants said.

Aggregate returns of Hedge Fund Research Inc.'s broad hedge fund indexes were negative in the first quarter — the HFRI Fund Weighted Composite slumped 9.4% and the HFRI Asset Weighted Composite was down 10% — but both bested the 20% decline of the S&P 500 index as did all but one of HFR's major strategy indexes.

The returns of hedge funds compared with long-only market indexes demonstrate the diversification and alpha production benefits they provide to institutional portfolios, sources said.

"Our clients are generally pleased with what's in their hedge fund portfolios in terms of both top-down strategy and individual managers," said James A. Neumann, New York-based CIO of hedge fund consultant Sussex Partners U.K. Ltd., in an interview.

"The environment in the first quarter was a good test of the power of diversification hedge funds offer institutional portfolios," he said.

For example, the $1.2 billion hedge fund portfolio of the Employees' Retirement System of Texas, Austin, proved its worth as an important diversifier for the $26.5 billion defined benefit plan in the quarter ended March 31, said CIO Charles Thomas "Tom" Tull, in an interview.

Even as total fund assets fell 9.9% in the quarter and the preliminary return of the fund was -9.9%, the 12 hedge funds in the pension fund's portfolio produced an aggregate return of 2.3% in the quarter. Returns for illiquid alternative strategies such as private equity and real estate lag by at least one quarter.

"The hedge fund portfolio continues to do well," Mr. Tull said, noting that about a year ago, the hedge fund team trimmed the then 5%-plus allocation down to 3.5%.

But given market conditions "it's a good time to add hedge funds. We're taking the hedge fund portfolio back up to 5%," Mr. Tull said.

That process began in January when ERS invested $60 million in Laurion Capital, a quantitatively managed global relative-value hedge fund run by a new manager for the fund, Laurion Capital Management LP, New York.

The investment in the Laurion hedge fund was prescient. The hedge fund returned 4.8% in volatile markets in the month of February and was the best performer among the 12 hedge funds in the portfolio, according to the pension fund's February 2020 market summary report. The Laurion Capital fund returned 8.6% in March and 15.5% in the quarter ended March 31.

Other asset owners also are taking advantage of "huge dislocations and are actively looking at this environment as a great buying opportunity," said Toby Goodworth, managing director and head of risk and diversifying strategies at bfinance International Ltd., London.

"Hedge funds flourish in markets that are unsettled and this period of market change and volatility will prove to be a more useful period for hedge funds. The expectation is that there will be massive dispersion between hedge fund strategies and between managers. We already are seeing manager rotation by investors using March returns as the acid test as they evaluate their managers and expect to see more," Mr. Goodworth said.

Among institutional investors that invested in hedge funds in February and March after the coronavirus pandemic roiled global markets was the $25.1 billion San Francisco City & County Employees' Retirement System.

In investment reports to the fund's board of trustees in March and April, CIO William J. Coaker Jr. said the investment team had earmarked a total of $1 billion to three new long/short equity hedge funds.

Marshall Wace LLP was allocated $500 million for investment in Marshall Wace TOPS World Equities (U.S.) Fund, with an initial allocation of $250 million in April. Whale Rock Capital Management LLC's Long Opportunities Fund received a $300 million allocation, with initial funding of $200 million in March. Staff earmarked a total of $200 million for investment in Altimeter Partners Fund, managed by Altimeter Capital Management LP, with $150 million invested in March.

The $53.6 billion Los Angeles County Employees Retirement Association, Pasadena, Calif., also made a substantial investment of $400 million in mid-April to a hedge fund managed by Polar Asset Management Partners Inc.

LACERA CIO Jonathan Grabel declined to identify the Polar Asset Management fund, in an email.

Other plan sponsors were swift in cutting hedge fund managers from their portfolios in the quarter ended March 31.

The $1.1 billion Kansas City (Mo.) Employees' Retirement System terminated AQR Capital Management LLC for management of $19 million in the AQR Delta XN Offshore Fund in February, confirmed Barbara Davis, executive director, in an email.

"The board's decision to terminate AQR was the result of the cumulative effect of organizational changes within AQR, underperformance of the AQR Delta Fund, AQR's firmwide asset outflows and the limited transparency regarding changes within the AQR organization."

The system's return from its AQR investment was not available.

The $9.3 billion Sacramento County (Calif). Employees' Retirement Association also terminated AQR for management of $40 million in AQR Delta Fund II at an April 15 board meeting. The system previously redeemed $12.5 million from the AQR hedge fund in September 2019 for performance reasons.

As of Dec. 31, the most recent date available, the AQR fund returned a net -2.4% in the quarter compared with 1.7% for the benchmark. For the year, it had net performance of -9.2% vs. 6.3% return for the benchmark, a performance report showed.

Steve Davis, SCERS' CIO, did not reply to a request for more information about the termination.

AQR spokesmen declined to comment on the terminations by the Kansas City and Sacramento County pension funds.

SCERS' staff also was investing in hedge funds during the first quarter, giving an additional allocation of $12.5 million to Davidson Kempner Capital Management LP in April, bringing the total invested in Davidson Kempner Institutional Partners to $44 million. In March, the board approved a $45 million investment in BlackRock Event Driven Equity Fund, with funding coming from a partial redemption from a hedge fund of funds managed by Grosvenor Capital Management LP, reducing its allocation to $109 million.

James Comtois, Arleen Jacobius and Rob Kozlowski contributed to this story.