It didn’t sound like much, even at the time. In April 2002 the California Public Employees’ Retirement System invested a total of $50 million with five hedge fund firms. For the then-$235.7 billion CalPERS, the largest state pension plan in the U.S., writing $50 million in checks was hardly a noticeable occurrence. But as the first step in an initial $1 billion allocation, the investment was a monumental moment for the hedge fund industry. It marked one of the first significant commitments by a public pension fund to a program of investing with hedge fund managers, a group that the pension community and its advisers had previously shunned as too risky and secretive. And in ways that are only now starting to become completely clear, it would dramatically change how public pensions invest.
CalPERS had good reasons for wanting to get into hedge funds. By 2002 the U.S. stock market, which had overheated during the late 1990s as the mania for technology and telecommunications stocks generated trillions of dollars in paper wealth for individuals and institutions, was plunging in a bear market rout. Like most U.S. public pensions, CalPERS had heavily invested in such securities as part of an outsize allocation to large-cap equities that had made the plan rich during the boom years but hurt on the way down. The fund lost $12.3 billion in the fiscal year ended June 30, 2001, and $9.7 billion the next year. CalPERS had gone from having 110 percent of the assets it needed to meet its future pension liabilities in fiscal 2000 to being underfunded, with a 95.2 percent — and falling — funding ratio.
One person who saw the writing on the whiteboard was Mark Anson. A lawyer with a Ph.D. in finance, Anson had been recruited to CalPERS from OppenheimerFunds in New York in 1999 to head up its alternative investments. By the time he became CIO in December 2001, he was seriously worried.
“I could see the dot-com bubble popping and the impact it would have,” Anson tells Institutional Investor. “I was concerned that our asset growth would not be faster than what I could see on the liabilities side.”
Anson believed that hedge fund investing would help protect CalPERS during times of market stress. For Anson, hedge funds are their own asset class and a valuable tool for diversifying a portfolio beyond traditional bonds and equities. In The Handbook of Alternative Assets, which Anson wrote while at CalPERS and published in 2002, he devoted more than 150 pages to hedge funds, including sections on how to set up an investment program and handle risk management. Unfortunately, by the time CalPERS began seriously investing in hedge funds, it was too late to prevent the carnage from the 2000–’02 bear market, but Anson remained convinced that the asset class would help the retirement plan in the future.
He was not alone. In New Jersey newly elected governor Jim McGreevey in 2002 appointed hedge fund manager Orin Kramer to the board of the New Jersey State Investment Council, which oversaw management of the Garden State’s then-$62 billion retirement system. Like CalPERS, the New Jersey fund had been badly scarred by the bear market; it was also laboring under a debt burden in the form of $2.75 billion in pension obligation bonds. Kramer started pushing for the system to invest in alternatives, stressing the diversification and risk management benefits. But the politically charged environment made change difficult.
In Pennsylvania, Peter Gilbert was having more luck. As CIO of the Pennsylvania State Employees’ Retirement System, Gilbert had gotten permission from his board in 1998 to start investing in hedge funds. After a failed attempt at “going direct” by investing in four long-short equity managers, he says, the then-$23 billion in assets PennSERS in 2002 hired Blackstone Alternative Asset Management (BAAM), the hedge fund arm of New York–based private equity firm Blackstone Group. Gilbert was one of the early public fund adopters of “portable alpha,” the strategy of taking the alpha, or above-market returns, of an active manager — often a hedge fund — and transporting it to the more traditional parts of the portfolio (large-cap U.S. equities, in the case of the Pennsylvania retirement system).
Between 2002 and 2006 other large state pension funds began investing in hedge funds, with varying levels of sophistication. They included New York, Missouri, Massachusetts, Texas, Utah and finally New Jersey. By May 2006, Marina del Rey, California–based investment consulting firm Cliffwater, itself a product of the growing interest by institutional investors, found that 21 U.S. state retirement systems were using hedge funds, with a total investment commitment of $28 billion. But there were also funds that held back, like the Public Employee Retirement System of Idaho and the Washington State Investment Board. Some were legally prohibited from making investments; others were not convinced hedge funds were right for public plans. Hedge fund investing remained controversial.
The hedge fund experiment was put to the test in 2008, when, under the pressure of too much bad debt, the U.S. housing and mortgage markets collapsed. That was soon followed by the near-failure of the banking system, the credit markets and the entire global financial system. State pension plans lost, on average, 25 percent in 2008, according to Santa Monica, California–based Wilshire Associates’ Trust Universe Comparison Service. That was better than the broad U.S. stock market — the Standard & Poor’s 500 index plummeted 38.5 percent in 2008, its third-worst year ever — but it lagged the performance of the typical hedge fund, which was down 19 percent, according to Chicago-based Hedge Fund Research.
Hedge fund managers often like to tell investors they’ll be able to deliver positive absolute returns regardless of what happens to the market, but in 2008 most managers didn’t live up to those expectations. Hedge funds did, however, cushion their investors against the near-record drop in the stock market and proved their value as portfolio diversifiers. Now, a decade after the first generation of public pension plans started to invest in hedge funds, more and more are looking to do so. In fact, today some of the biggest holdouts from the past decade are beginning to embrace hedge funds, including the $153 billion California State Teachers’ Retirement System, the $152.5 billion Florida State Board of Administration and the $74.5 billion State of Wisconsin Investment Board.
If things looked bad for defined benefit pension plans in 2002, they look a whole lot worse today. The 126 public pension systems tracked by Wilshire Associates had, on average, a funding ratio for the 2009 fiscal year of 65 percent — meaning they had only 65 percent of the assets needed to pay for the current and future retirement benefits of the firefighters, police officers, schoolteachers and other public workers covered by their plans. The situation has been exacerbated in states like Connecticut and Illinois, which in the intervening decade decided to increase benefits without increasing their contributions to pay for them.
“The pension benefit promises that have been made to unions by politicians have been in many respects unrealizable,” says Alan Dorsey, head of investment strategy and risk at New York–based asset management firm Neuberger Berman.
To make up for the shortfall, public pension plans have few places to turn. In the current economic environment, it is political suicide to even broach the topic of raising taxes. And despite calls from some high-ranking officials, like New Jersey Governor Chris Christie, to reduce health care and retirement benefits for public workers, getting state legislators to approve such cuts won’t be easy. For beleaguered public pension officers, the best and perhaps only solution is to try to figure out a way to generate better investment returns.
“Hedge funds start looking attractive because of their superior liquidity relative to private equity and real estate, and superior risk-adjusted returns relative to the overall market,” says Daniel Celeghin, a partner with investment management consulting firm Casey, Quirk & Associates, who wrote a seminal paper on the future of hedge fund investing in the aftermath of the 2008 crisis.
That is, of course, assuming that hedge funds continue to put up superior risk-adjusted returns. Capturing alpha — skill-based, non-market-driven investment returns — is, at the end of the day, the whole point of putting money in hedge funds. Although hedge funds as a group didn’t produce the same amount of alpha in the past few years as they did early last decade, it appears that they added some.
The ability to generate alpha enables hedge funds to justify their high fees. Managers typically charge “2 and 20”: a management fee of 2 percent of assets and a performance fee of 20 percent of profits. It’s been harder for funds of hedge funds to make the case for their management and performance fees — typically 1 and 10 — which investors must pay on top of the fees of the underlying managers. As a result, many fee-conscious pension plans that initially invested through funds of funds are now electing to go direct. That approach, however, can make hedge fund investing much more challenging, especially for pension plans with small investment staffs.
Hedge funds are not like traditional money managers, says former PennSERS investment chief Gilbert, now CIO of Lehigh University, responsible for managing the Pennsylvania school’s $1 billion endowment. Hedge fund managers require more due diligence and constant monitoring because in their search for alpha they operate with few if any constraints. “You really have to know what to expect from each particular hedge fund manager and how you are going to use them,” Gilbert says. Most investment consultants, the group that public plans typically rely on to help with manager selection — which can step in to take over the role of a fund of funds at a lower cost — are still grappling with advising on hedge funds.
Public pension plans, for their part, with their billions of dollars and stringent investment requirements, are changing the parameters of the hedge fund experiment. In a January 2011 report, consulting firm Cliffwater found that 52 of the 96 state pension plans it surveyed had a total of $63 billion invested in hedge funds as of the end of fiscal 2010, more than double the amount from four years earlier. “Public pension funds are the investment group that is going to shape the hedge fund industry,” says Scott Carter, head of global prime finance sales and capital introduction in the U.S. for Deutsche Bank, as well as co-head of hedge fund consulting.
Christopher Kojima, global head of the alternative investments and manager selection group at Goldman Sachs Asset Management in New York, would agree with Carter’s assessment. “The debate we are seeing at public plans today is much less about whether hedge funds are a sensible contributor to their objectives,” Kojima says. “The question we encounter much more is how to invest with hedge funds.” Pension funds are looking at how to identify and monitor top managers, think about risk management and connect hedge funds to their broader portfolios. “Are hedge funds even a separate asset class?” Kojima asks. More and more, the answer is no.
PUBLIC PENSION PLANS WERE NOT THE FIRST institutional investors to experiment with hedge funds. During the late 1980s and early ’90s, a group of influential endowment and foundation investors steeped in Modern Portfolio Theory started exploring the notion that these managers, freed from the constraints of more-traditional funds, could enhance their returns. The hedge-fund-investing hothouses of those early years were located on the campuses of a handful of universities, including Duke, Harvard, North Carolina, Notre Dame, Virginia and Yale. As head of the Yale University Investments Office in New Haven, Connecticut, David Swensen pioneered an approach to endowment investing that put a heavy emphasis on alternatives, including hedge funds. Swensen’s acolytes at Yale would go on to run a network of school endowments, taking his ideas with them. Duke, North Carolina and Virginia were close to Julian Robertson Jr., founder of New York–based Tiger Management Corp. and one of the top hedge fund managers of that era. They embraced the Tiger investment ethos — fundamentally focused long-short strategies, sometimes with a tilt toward macro — as a source of returns.
For those early adopters, hedge funds proved their worth. In 1993 the HFRI fund-weighted composite index was up 30.88 percent, more than three times the total return of the S&P 500 composite index, which was up 10.1 percent. As the bull market started to roar, hedge fund results, on a relative basis, didn’t look so impressive. In 1997 the HFRI index rose 16.79 percent, roughly half the total return of the S&P 500, which was up 33.34 percent.
The first public plan to start looking seriously at hedge funds was the Virginia Retirement System. In the early 1990s the fund had made a controversial investment in a railroad company, leading to a legislative review, published in December 1993, that found the system had too many active managers and was paying too much in fees while not seeing much in the way of results. The review recommended that state law be amended to allow the retirement system broad discretion in the types of investments it could make. The change was enacted the following year, opening the door to hedge fund investing. By 1998, Virginia had invested $1.8 billion of its then-$23 billion in assets in market-neutral, long-short managers while at the same time indexing a significant portion of its equity portfolio.
In 2001, Virginia started talking to D.E. Shaw & Co. about having the New York–based hedge fund firm run a benchmarked long-only strategy for the retirement system. D.E. Shaw, a quant shop founded in 1988 by computer scientist David Shaw, was the classic hedge fund firm: supersecretive, using leverage, charging high fees and focused on finding returns. The firm didn’t have any close relationships with public pension plans before Virginia, but it quickly realized their potential value. “For years and years we had an absolute-return focus,” says Trey Beck, head of product development and investor relations at D.E. Shaw in New York. “This gave us an opportunity to go into the benchmarked business.” The decision to build an institutional business meant that D.E. Shaw would need to produce funds that could perform on a relative basis. It would also need to become more transparent, which the firm had already started to do (in 1999 it had registered with the Securities and Exchange Commission as an investment adviser). D.E. Shaw began to expand its investor relations and reporting. “We had to get up the curve very quickly,” Beck says. “Because ten years ago the demands placed on managers by hedge fund investors were very different from the demands placed on investors in more-traditional products.”
The CalPERS hedge fund story begins with Bob Boldt, who was brought in from money manager Scudder, Stevens & Clark as senior investment officer for public markets in December 1996. Boldt was a big advocate for hedge funds, and by September 1999 it looked like he had gotten his way. CalPERS hired its first hedge fund manager, investing $300 million with San Francisco–based, technology-focused Pivotal Asset Management, and Boldt’s plan for CalPERS to invest $11.25 billion in hedge funds surfaced in the press. Then, Boldt left in April 2000. Seven months later he landed at Pivotal.
Paying talent has always been an issue for public pension plans. But the added challenge of running the more-sophisticated portfolios that typically accompany hedge fund investments makes it an even bigger issue, especially given the wide gulf in compensation scales between the hedge fund industry and the public pension world. Boldt was not alone in making the switch, though his stint at Pivotal would be short. (The firm folded after the dot-com bubble burst.)
In the absence of Boldt, CalPERS continued to take steps toward building a hedge fund program. In November 2000 the board approved a plan to invest $1 billion in hedge funds. (By that time, Anson had been promoted to senior investment officer for public markets.) The following May, CalPERS hired fund-of-funds firm BAAM as a strategic adviser to its hedge fund portfolio, to help identify and interview potential managers, perform due diligence and provide risk management and reporting. This was a major change in the way an institution worked with a fund-of-funds firm. CalPERS paid less in fees than it would have if BAAM had been managing the money, and it had more control over the portfolio and transparency into the underlying managers. It also got to educate itself about hedge fund investing and grow its in-house expertise.
“We had not yet built up the staff within CalPERS, and we did not have feet on the ground,” says Anson, who became CIO in December 2001. “There were only so many due diligence trips I could take myself as CIO. We needed to really outsource some human capital.”
For all its pioneering work, CalPERS was actually slow to invest its first $1 billion in hedge funds. By December 2002, PennSERS had overtaken it as the largest public pension investor in hedge funds, with $2.5 billion allocated to four absolute-return fund-of-funds managers: BAAM, Mesirow Advanced Strategies, Morgan Stanley Alternative Investment Partners and Pacific Alternative Asset Management Co. (Public pension funds like PennSERS preferred the moniker “absolute-return funds” over “hedge funds” because it was more politically palatable when discussing their investments.) But rather than carve out a separate allocation, PennSERS housed its hedge fund investments in its equity portfolio as part of its portable-alpha strategy. That made it much easier for then-CIO Gilbert to build a hedge fund portfolio that rivaled many endowments’ in size and scope. By June 2006, PennSERS had invested $9 billion of its $30 billion in assets in hedge funds.
New Jersey’s Kramer is also a big believer in the benefits of investing in hedge funds. But when he became chairman of the board of the New Jersey State Investment Council in September 2002, he couldn’t act on that belief because the state’s antiquated pension system was prohibited from using any outside managers — alternative or traditional. By November 2004, Kramer had gotten the Investment Council to agree to allocate 13 percent of its assets to alternatives (private equity, real estate and hedge funds), overcoming the objections of state unions, which accused Kramer and his fellow board members of wanting to give fees to their Wall Street fat-cat friends. New Jersey made its first hedge fund investments in the summer of 2006.
“There is no avoiding politics at public plans, in the same way that you would have it at a school district or at an investment board,” says Neuberger Berman’s Dorsey. “What winds up happening is that you end up handcuffing the investment performance.”
With their high fees, wealthy founders and reputation for risk-taking, hedge funds became an attractive political target. Hedge fund managers, for their part, were not used to dealing with the scrutiny that invariably comes with running public money. Some decided it wasn’t worth the hassle. For those managers that did take public money and suffered major losses, the headlines were especially unforgiving. Just ask Nicholas Maounis, the founder of Amaranth Advisors, a Greenwich, Connecticut–based multistrategy manager that at one time was among the 30 largest hedge fund firms in the world. In the summer of 2006, the press skewered Amaranth after the firm’s supposedly diversified flagship fund lost more than $6 billion betting on natural-gas futures and had little choice but to shut down.
Amaranth’s investors included some of the U.S.’s biggest public funds, including the New Jersey system, PennSERS and Massachusetts’ Pension Reserves Investment Management Board, though most of their exposure was through funds of hedge funds. New Jersey’s CIO at the time, William Clark, pointed out in a January 2007 memo to the Investment Council on Amaranth and the lessons learned that the fund had taken greater hits from individual stock positions that same month. (New Jersey’s total exposure to Amaranth was $21.8 million, or 3 basis points of its total investment portfolio.)
Before Amaranth, the largest hedge fund disaster had been another Greenwich-based firm, Long-Term Capital Management, which famously lost 44 percent of its capital in August 1998, after Russia defaulted on its debt, and had to be bailed out by a consortium of 14 banks assembled by the Federal Reserve Bank of New York. The group put up $3.6 billion for 90 percent of the fund. But LTCM had little or no institutional money.
Public pension plans did not get off so easy during the recent financial crisis, which began with problems in the subprime mortgage market in 2007 and spiraled out of control in September 2008 when Lehman Brothers Holdings filed for bankruptcy. That month the HFRI index dropped 6.13 percent. In October 2008 the index lost a further 6.84 percent, and hedge funds started putting up gates to prevent investor redemptions. Firms liquidated struggling funds or moved troubled illiquid assets into so-called side pockets, trapping the invested capital until the walled-off assets were unwound. A record 1,470 hedge funds liquidated in 2008, according to HFR. It was an exceedingly tough time to be a hedge fund investor.
BETWEEN 2002 AND THE START OF 2008, THE HEDGE fund industry tripled in size, skyrocketing from $625.5 billion in assets to nearly $1.9 trillion, according to HFR. The bulk of the new money — approximately $610 billion — came from institutions, including public funds. These large investors wrote bigger checks than most managers were used to receiving; direct commitments of $50 million to $150 million were not unusual. In much the same way that scientists can change the results of an experiment simply by observing it, the influx of institutional investors, though they were more than mere observers, was bound to impact the return profiles of hedge funds.
As the last decade progressed, some experts began to suspect that much of hedge funds’ returns was not in fact alpha but market-driven returns, or beta, that had been leveraged using borrowed money to produce seemingly superior results. The events of 2008, when the markets collapsed and suddenly it became very expensive to borrow, bore this out. Neuberger Berman’s Dorsey and former CalPERS CIO Anson are among the money managers looking into beta creep, the notion that over time hedge fund performance has become increasingly market-driven. “Or, as I like to call it, ‘creepy beta,’ ” quips Anson, who is now a managing partner with Oak Hill Investment Management in Menlo Park, California. It’s not that beta itself is bad, just that investors do not want to pay hedge funds 2-and-20 for market returns.
After Anson left CalPERS in 2005, the hedge fund program picked up speed under the guidance of senior portfolio manager for global equities Kurt Silberstein. Two years earlier, CalPERS had replaced BAAM with Paamco and UBS and embarked on a program of direct hedge fund investments as well as fund-of-funds commitments. Silberstein is proud of what the U.S.’s biggest public pension plan has achieved. “We run a very conservative portfolio, and for each unit of risk we take, we have been rewarded with a unit of return,” he says.
Going into 2008, however, CalPERS had too much beta in its hedge fund portfolio, which fell 19 percent that year. Silberstein freely admits that 2008 was “a really black eye” and that the pension system would probably not still be investing in hedge funds “if 2008 had happened two years into us building out the program.” Since the crisis, Silberstein has almost completely redone the direct hedge fund portfolio, terminating relationships with many of the long-short equity and multistrategy managers that underperformed in 2008. Today he prefers to invest with smaller managers he believes are more likely to add alpha.
CalPERS has also taken much closer control of its hedge fund investments. It now demands what it perceives as a better alignment of fees from its hedge funds, enabling the California plan to reclaim some of the 20 percent performance fee it pays during a good year if a manager loses money the next. CalPERS invests whenever possible using separate or managed accounts instead of commingled funds; this means it, not the manager, holds the underlying securities.
“You can mitigate business risk by having control of your assets,” says Silberstein. “Once you have control you don’t have to be so adamant on the terms of the contract, because if I don’t like what a manager is doing, I can just take my money and walk.”
CalPERS is not alone in making such demands. Its crosstown Sacramento counterpart, CalSTRS, is making its first move into hedge funds with a global macro program that will be handled exclusively using managed accounts. At the $19.8 billion Utah Retirement Systems, deputy chief investment officer Lawrence Powell also has been playing hardball with hedge fund managers over fees.
Fees continue to be a big issue for funds of hedge funds, as more and more public funds opt to use less expensive investment consultants to help them construct and monitor hedge fund portfolios. Still, Neuberger Berman’s Dorsey, who worked at Darien, Connecticut–based consulting firm RogersCasey from 2002 through 2006, thinks funds of funds can play an important informational role for public plans. “Most funds of hedge funds have a large staff, and these people are engaging in continuous contact, monthly conversations and conference calls with hedge fund managers,” he says.
Although some public pension officials were disappointed with the 2008 performance of hedge funds, they are increasingly starting to look at hedge funds not as a distinct asset class but as a way of managing money. The Virginia Retirement System, for example, doesn’t separate hedge fund managers into their own group but categorizes them according to the types of securities in which they invest. Scott Pittman, CIO of the New York–based Mount Sinai Medical Center Foundation, which has more than 70 percent of its $1 billion endowment invested in hedge funds across different asset classes, thinks this approach makes a lot more sense.
“When you take hedge funds that have lots of different securities and strategies and group them together and call it an asset class, you are ignoring the consequences of those exposures on the overall portfolio, both unintended and intended,” Pittman says. “Hedge funds are just a vehicle by which we invest.”
One of the effects of 2008 was to increase discussions about risk management. Institutional investors realized they had not been doing a good enough job of paying attention to risk. The result is that some institutional investors — including Alaska Permanent Fund Corp., CalSTRS and the Wisconsin Investment Board — have been working with hedge funds or money managers that offer hedge-fund-like strategies to put together portfolios that, through tactical asset allocation and hedging, can offer overall risk protection.
“We are trying to develop a system that does not seek to time the market but does try to identify those extreme left-tail events,” CalSTRS CIO Christopher Ailman recently told Institutional Investor, referring to statistically rare events, like those experienced in 2008, that can have a seismic impact on markets and returns. Funds designed to hedge against tail risk often rely on derivatives-trading strategies and as a result have their own built-in leverage. Such funds can act as a drag on a portfolio when markets are rising, but they are expected to provide a valuable hedge in times of significant market stress and volatility.
The real key to pension fund investing has always been asset allocation — long the purview of investment consultants. As hedge funds, which roam all over the capital structure looking for returns, become a more integrated part of what pension plans do, investment officers and their boards are leaning on their managers to answer more of their general asset allocation and investment concerns. Hedge funds have had to learn to become more receptive to such inquiries from their largest clients. “The industry mind-set has changed,” says D.E. Shaw’s Beck. Hedge fund managers realize that public funds want to be able to call up investment professionals at their firms for insights into what is happening in the markets and for their views on macroeconomic events.
The Washington State Investment Board is looking forward to just such a relationship with D.E. Shaw. In April the board voted to approve the firm for a global non-U.S. active equity mandate. “Part of the reason we chose the manager was not just for the product but because of the depth of resources and talent at the investment manager that we will have access to,” says CIO Gary Bruebaker. “I call it noninvestment alpha.”
Bruebaker was a member of the President’s Working Group on Financial Markets’ investors’ committee when it released its report on hedge fund investing in April 2008. Although he appreciates the merits of D.E. Shaw, he has no plans to invest in the firm’s hedge fund strategies or, indeed, with any hedge funds at all.
“I take my responsibilities very personally; I manage the financial future of over 400,000 public employees, many of whom work a lot harder than I do,” says Bruebaker, whose mother was a public employee. “If there was a way I could make more money on a risk-adjusted basis, I would find a way to do it.” But he just does not believe the $82.2 billion Investment Board has any competitive edge when it comes to investing in hedge funds.
Public funds, he says, should be cautious investing in hedge funds: “Many of them don’t have the flexible budgets or the dollar amounts to hire the kind of skill sets they need to help them do the due diligence that would be necessary to do it correctly.”
New Jersey lost a highly skilled investor when Kramer resigned from the Investment Council in February. In his last year on the board, he successfully pushed to raise the limits on how much New Jersey could invest in alternatives. But even Kramer was finally exhausted by the years of battling to move the $74.7 billion retirement system into the modern investment era. Though public scrutiny serves an important role as a guard against corruption, the political nature of the public pension system can alienate the very best investment talent. And yet it is the resource-constrained, funding-challenged public funds that need the most help, especially as their investment portfolios become more and more complex.
