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  2. SPECIAL REPORT: HEDGE FUNDS
September 16, 2019 12:00 AM

Customization key in investor search for better returns

Managers responding to asset owners' requests

Christine Williamson
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    Michelle Noyes
    Michelle Noyes called customization ‘the new normal’ for investors.

    Institutional investors increasingly are asking for — and receiving — customized versions of flagship hedge fund strategies that better meet their investment needs at a significant discount.

    Because custom hedge fund and hedge funds-of-funds strategies generally are offered as separately managed accounts, the investor has complete control and transparency within its account, including access to managers' real-time portfolio holdings, industry sources said.

    Hedge fund managers are creating a wide range of customized strategies at the request of asset owners.

    Variations include tweaking standard flagship strategies, isolating and investing in a particular strategy from within a multistrategy portfolio approach and building a specific solution to a portfolio issue, interviews with large asset owners showed.

    "Customization is the new normal for institutional hedge fund investors," said Michelle Noyes, the New York-based managing director and head of Americas for the Alternative Investment Management Association Inc., an international industry group.

    "The hedge fund industry has become more institutionally oriented, and asset owners are becoming more demanding. With customization, asset owners can get more of what they want in hedge fund strategies," Ms. Noyes said.

    An AIMA survey of 118 hedge fund managers conducted in the first quarter this year found that 53% of respondents agreed that offering customized solutions to asset owners is important to aligning their interests with the investor, compared with just 14% in 2016.

    For now, only large asset owners are able to command customized portfolios, having the heft to meet minimum mandate sizes of at least $100 million. That's enough to convince a hedge fund manager to custom craft a strategy, set up a separately managed account and deal with compliance and operational issues, said Steven B, Nadel, a partner in the asset management practice of Seward & Kissel LLP, a New York law firm.

    "From the perspective of a large hedge fund manager, offering customized strategies is driven by supply and demand. Is the (separately managed account) worth the hassle? It depends on the size," said Mr. Nadel, whose practice includes working closely with both investors and hedge fund managers to set up customized hedge fund vehicles.

     

    Using size to their advantage

    Large, sophisticated investors such as the $152.2 billion Teacher Retirement System of Texas, Austin, are cognizant of their desirability as a client and use that status to persuade hedge fund managers that TRS' desired customized strategy is worth the hassle.

    "We believe TRS is a unique investor and the 'off the rack' offering is not always ideal," said Brad Gilbert, Texas Teachers' senior director, hedge funds, in an email.

    "TRS' competitive advantages include its size, liquidity and long-term (investment) horizon. Our team is constantly looking for ways to utilize these advantages to improve a manager's investment strategy," Mr. Gilbert added.

    Because the pension fund's average allocation to customized hedge fund strategies is $300 million and can meet most hedge fund managers' minimum for customization, Mr. Gilbert said the plan's hedge fund team has found it fairly easy to create unique hedge fund portfolios across a range of strategies.

    About 25% of the strategies in TRS' $12.4 billion hedge fund portfolios are customized, Mr. Gilbert said.

    Similarly, the investment team of the $74.8 billion Massachusetts Pension Reserves Investment Management Board, Boston, has had "smashing success" in convincing hedge fund managers to create customized portfolios, noting that "all of our customized funds have performed really well," said Eric. R. Nierenberg, chief strategy officer, in an interview.

    "With customized hedge fund managed accounts, you become the CIO of your multimanager hedge fund portfolio," Mr. Nierenberg said, stressing that the "value proposition of separately managed accounts (includes) direct control over your hedge fund portfolios, full transparency, the ability to modify your hedge fund portfolios as needed and fee reductions."

    PRIM began using customized hedge funds in 2014 and about 35% of the fund's $6 billion hedge fund portfolio now is managed in customized strategies, primarily in managed futures approaches.

    Mr. Nierenberg said confidentiality agreements prohibit him from identifying the hedge fund managers running custom strategies for PRIM, but said one of the fund's successes included "carving out" an esoteric credit strategy from a big commingled hedge fund PRIM was invested in that was producing "mediocre returns." The separately managed account set up for the firm's credit team produced stronger returns than the flagship fund, Mr. Nierenberg said.

    "I saw customization as a critical part of going into managed futures strategies" and often "as critical to getting lower fees," Mr. Nierenberg said.

    "If the ticket size for a customized strategy is large enough, managers usually provide a fee reduction," he said, noting that the fee reduction for some strategies PRIM invested in was 40%. The weighted-average fees for PRIM's customized hedge fund managed accounts are a management fee of 1% and performance fees of between 12% to 13%.

    Fees decline

    Regarding fees, the enhanced efficiency of hedge fund managed account investment platforms offered by subsidiaries of large banks, including State Street Corp., The Bank of New York Mellon Corp. and Societe Generale Group, has resulted in a drastic decline in fees, said Robert Vanderpool, head of global business development for State Street Managed Account Services Ltd., Boston, in an interview. He also is president of InfraHedge North America, part of State Street's managed account business.

    Fees for dedicated managed accounts have decreased between 50% to 70% over the last three years and now range between 3.5 to 7 basis points of hedge fund assets compared to between 15 and 25 basis points three years ago, Mr. Vanderpool said.

    Investment officers of six large hedge fund investors interviewed for this story stressed that achieving lower fees for hedge fund management was an important goal of moving to customized strategies, but for some, alpha generation is paramount.

    "Our view is that hedge funds are primarily in the portfolio to produce alpha to complement the beta returns driven primarily by our long-only portfolio," said Michael O. Weinberg, managing director and head of hedge funds, for APG Asset Management U.S. Inc., in an interview. Mr. Weinberg is based in the New York office of APG Asset Management NV, which managed €505 billion ($566 billion) as of April 1 for Stichting Pensioensfonds ABP, Heerlen, Netherlands, and other Dutch pension funds.

    Mr. Weinberg said APG has been using customized strategies for more than a decade, noting "we were trailblazers because we were quite early to adopt customized approaches. Managers love working with us because we're a long-term partner, a sizable investor and invest early in new hedge funds. We tend to get pretty good fees."

    APG uses customized approaches to optimize the overall portfolio by eliminating overlap between hedge fund portfolios as well as to scale up some hedge fund managers' best investment ideas via co-investment funds.

    Every investment made by APG must adhere to its internal environmental, social and governance and sustainability principles, and hedge funds of one or separately managed accounts give Mr. Weinberg and his staff the opportunity to collaborate with and influence managers to make appropriate investment choices and to adhere to an exclusion list.

    APG does not disclose the size of its hedge fund portfolio or the percentage invested in customized strategies.

    The $31.9 billion Texas County & District Retirement System, Austin, turned to customized strategies for both hedge fund and long-only alternative credit managers "to make sure the underlying funds/strategies have the proper investment mandate, liquidity and fees we are looking for," said Casey Wolf, chief investment officer, in an email. The pension fund looks at if there are "specific portfolio issues that a customized hedge fund strategy could solve better than the manager's standard strategy?"

    Mr. Wolf said investment staff want to make sure that its hedge fund managers have appropriate discretion to maximize returns, noting that if a manager "really isn't seeing opportunities on the short side (because of market conditions), we don't want them to be forced to short because that's the fund mandate."

    In February, TCDRS invested $200 million in its first customized credit hedge fund through a separate account managed by Chatham Asset Management LLC from the plan's $5 billion hedge fund portfolio. The pension fund has committed or invested a total of $1.7 billion in five long-only customized credit funds.

    A way to diversify

    Two other large pension funds turned to customized hedge funds primarily to complement or diversify other asset class investments within the overall portfolio.

    The Florida State Board of Administration, Tallahassee, which manages a total of $206.4 billion, including the $163.1 billion Florida Retirement System, for example, sought to diversify equity exposure of more than 60% in the defined benefit plan asset allocation with two customized hedge funds of funds.

    "We like to add strategies that are diversifying" in the $4.5 billion hedge fund allocation including managed futures, global macro, relative value and quantitatively managed strategies, said Trent T. Webster, senior investment officer, strategic investments.

    BlackRock Inc. and J.P. Morgan Asset Management each manage roughly $500 million in customized hedge fund-of-funds strategies for the Florida board, which are focused on quantitatively managed strategies and trend-following managed futures approaches. J.P. Morgan's fund specializes in investing with quantitative and managed futures managers using artificial intelligence to fuel their investment decisions.

    Both customized hedge fund strategies within the $1.5 billion hedge fund portfolio of the Employees Retirement System of Texas, Austin, are explicitly designed to complement other investments in the fund's $28.7 billion portfolio, said Nicholas Maffeo, hedge fund portfolio manager.

    Both Algert Japan Extension Fund, managed by Algert Global LLC, and Marshall Wace TOPS World Equities Fund, managed by Marshall Wace LLP, are customized 130/30 or 150/50 strategies, Mr. Maffeo said. The two funds manage a total of $510 million.

    The Algert fund is managed quantitatively, which Mr. Maffeo said is a good offset to the pension fund's internally managed active Japanese equity portfolio and increases the overall exposure within the ERS portfolio to Japan.

    The Marshall Wace customized global equity hedge fund strategy also is systematically managed in contrast to active global equity strategies managed internally. Mr. Maffeo said the ERS team works very collaboratively with the managers of its customized hedge fund strategies, noting that both firms, like others the fund officials are talking to about possible new custom funds, are "willing to hear us out because of our size. Both sides have to figure out whether the proposed strategy is feasible and affordable."

    Regarding affordability, Mr. Maffeo said ERS routinely "negotiates hard on fees, but not so hard that it doesn't let the manager make money."

    As for the willingness of hedge fund managers to listen to investors turning the tables and pitching new custom strategies, technological advancements in automated trading over the past 10 years have made it much easier for hedge fund managers to allocate trades across multiple accounts, said State Street's Mr. Vanderpool.

    The ease of trading and greater operational ease has convinced more firms to give investors exactly the hedge strategy they want, he added.

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