When Steven Grossman took over as Massachusetts Treasurer earlier this year, he knew he had to take tough action with the state’s $49.5 billion pension fund. Its very high 8.25 percent mandated return in general requires more risk than other pension funds might tolerate. This means he would need to depend more heavily on the contribution of alternative investments, which account for one-third of the overall portfolio.
Trouble is, the $3.8 billion hedge fund portfolio has not delivered satisfactorily, lagging its benchmark in four of the past five years, including 2010 when it generated a return that was less than half the bogey. “There is a strong perception our hedge fund portfolio over the past five years has been somewhat disappointing, underperforming the benchmarks,” says Grossman, who as treasurer serves as chairman of the nine-member board of the Massachusetts Pension Reserves Investment Trust.
So, in early April the 65 year-old former chairman of both the Massachusetts and national Democratic parties who was elected Treasurer in 2010 decided to shift $500 million of the hedge fund portfolio from funds of funds to single manager funds by the fourth quarter of this year. The state pension fund hired Cliffwater LLC to advise it through a pilot program, which Grossman stresses could possibly increase significantly by next year.
Grossman says this is not a radical move. He points out that Massachusetts’s pension fund is one of only two among the 10 largest public pension funds in the country to have its entire hedge fund portfolio invested with funds of funds. Five of them have 100 percent of their portfolio invested directly with funds, while on average two-thirds of this top-10 group is invested directly.
The Massachusetts pension fund is also not the only major institution looking to move more of its hedge fund assets into single manager funds. A March Deutsche Bank survey of more than 500 hedge fund investors representing $1.3 trillion in hedge fund assets found that 62 percent of institutional investors state that none of their allocations will be directed to fund of funds. In addition, 60 percent said that more than 50 percent of their historical funds of funds allocations are now going directly to single-strategy managers.
“The liquidity crisis of 2008, the Madoff fraud and increasing sophistication of the end investor base, have resulted in large outflows, particularly in Europe, and raised questions about the validity of this business model,” Deutsche Bank asserted in its report. “Accordingly, this investor group has been required to change with the times.”
Funds of funds charge fees that could range as high as 1 percent of assets under management and even 10 percent of performance on top of the underlying hedge fund portfolio. Little surprise, then, funds of funds have underperformed single manager hedge funds in four of the past five years, according to HFR.
Other critics point out that some investors who wanted to redeem in the aftermath of the 2008 global market meltdown had trouble getting their money back from funds of funds, which in turn had faced gates from the underlying hedge funds. “Clearly people are sensitive to the fees and liquidity,” acknowledges, Kenneth Heinz, President at Hedge Fund Research.
Grossman says liquidity was not an important issue for moving more toward single manager funds. But he does cite a half dozen or so other critical factors.
They include performance, of course. He also says investing directly will give him access to prominent managers who refuse to do business with funds of funds. This is consistent with the pension fund’s policy for investing in other alternatives, such as private equity funds.
Grossman points out that the 84 basis points in management fees paid on his entire funds of funds portfolio potentially translates into $32 million of savings. He also says his portfolio of funds is unwieldy, resulting in some 200 different hedge funds collectively held by all of his funds of funds, resulting in unnecessary duplication. The direct approach will provide more customization and sufficient diversification.
He disputes another widely held belief that funds of funds insulate investors from headline risk, asserting if the FBI raids a hedge fund in your fund of fund’s portfolio, your name will be dragged into the press anyway.
When Grossman and his team reallocate the $500 million, they expect to wind up with around 20 to 25 funds, which he says Cliffwater assures is sufficient enough to reduce 95 percent of the risk.
What will Grossman be looking for in a hedge fund? It’s not a surprise that a fund’s proven track record is at the top of his requirement list. He also wants to see a demonstrated coolness under fire and how the fund’s team handled the crisis in 2008 and 2009 and protected clients’ money.
Grossman also wants to see stability of leadership. This means looking at the longevity of the top managers, employee turnover, consistency of management. Acknowledging that the founders of a number of the top hedge fund firms are approaching retirement age, Grossman also wants to be confident in their succession plan — that the team has a consistent philosophy with the individual whose name rests on the door. “We will shy away from a firm where one person guided it to great success but the succession planning is not well thought out,” Grossman stresses.
Ultimately, it won’t be Grossman who will actually be picking the individual funds. That task will be left to a team led by executive director Michael Trotsky and Chief Investment Officer Stan Mavromates.
Trotsky has spent more than 20 years in the investment management business. He joined the pension board last year after serving as the Executive Director of the Massachusetts Health Care Security Trust, the state government agency charged with managing and investing payments Massachusetts receives from the tobacco litigation settlement, and managing and investing the State Retiree Benefits Trust Fund, the fund that invests assets allocated by state and local government agencies to fund the health care benefits of retired government employees.
Mavromates, whose job it is to provide the overall investment strategy and asset allocation for the fund and to evaluate, select, monitor and manage external investment managers, joined PRIM in February 2000. Prior to joining PRIM, he was an investment consultant for John Hancock Financial Services, responsible for investment oversight, due diligence, and selection of investment managers for Hancock’s variable products, 401K, and pension plans.
Some experts, however, are not about to sound the death knell for funds of funds. Deutsche Bank insists there will always be a place for funds of funds that can provide expert advice, resources for due diligence, access to quality managers and or differentiated products.
In fact, Joe Gieger, Managing Director of GAM USA, who is responsible for fund and institutional business activities of the funds of funds giant in North America, insists he has not seen outflows from the institutional market, especially in the U.S. But, he says funds of funds must move away from a product orientation that highlights returns to what he calls a partner orientation. This means educating investment boards how different underlying strategies within the portfolio correlate or don’t correlate, and about the fund’s beta, standard deviation and drawdown. “It’s not just about returns but how the returns are generated,” he explains.
Heinz points out funds of funds are now better able to provide a more integrated, analytical characterization of the multi-manager allocation. With technology they can look at the entirety of the portfolio under a single allocation. “Performance and the lowest fees are always important,” he says. “But as the fund of funds makes better use of technology, investor are able to get a better analytical understanding of their exposure.”
