Infovest21 White Papers

 

Institutional inflows into hedge funds/funds of funds have been strong over the past year as some institutions have come into the space for the first time while others
increased their existing hedge fund allocations. Others have issued Requests
for Proposals for managers, funds of funds or specialized hedge fund
consultants.

Some institutional investors are looking to diversify their portfolios while others
are taking advantage of perceived attractive beta and alpha opportunities as
downside protection. Others are trying to boost their returns due to funding
shortfalls.

 

Lois Peltz, president of Infovest21, observes: “In the past year, several institutions made their first foray into hedge funds, such as Connecticut Retirement Plan & Trust
Fund, El Paso County Retirement Plan, Kansas City Police Employees’ Retirement
System, Los Angeles County Employees’ Retirement Association, Massachusetts
Water Resources Authority Retirement System, New York City Police, New York
City Employees’ Retirement, New York City Fire, San Jose Federated City
Employees’ Retirement System, Vermont State Retirement System and West Palm
Beach Firefighters’ Pension.”

Other institutions have increased their allocations such as Alaska Retirement
Management Board, City of Danbury, Metro Nashville, North Carolina Retirement
System, Ohio State Employees’ Retirement System, Orange County Retirement
System, Sacramento County Employees’ Retirement System, San Mateo County
Employees’ Retirement Association.

A number of the largest pension allocators to hedge funds have increased their target allocation to hedge funds. For example, Texas City and District increased the cap from 15% to 20% while New Jersey State Investment Council increased it from 10% to 15%. Texas Teachers Retirement System upped the target from 5% to 10%. Illinois
Teachers’ Retirement System increased the cap from 5% to 8%.

Many pensions have rebalanced their portfolios – firing some hedge funds/funds of funds while replacing them with others.

RFPs and searches are out (or expected soon) for Ohio School Employees’ Retirement
System, Orange County Employees’ Retirement System, Seattle City Employees’
Retirement System, State-Boston Retirement System and State of Wisconsin.

Meanwhile, a few pensions have been redeeming allocations to hedge funds e.g. PennSERS, Delaware Public Employees Retirement System, or avoiding them altogether after a bad experience e.g.Ohio Bureau of Workers Compensation.

Some interesting trends in the past fiscal year include:

 Strong overall portfolio returns in FY2011…Pension underfunding remains a factor motivating pensions to allocate to hedge funds

A strong stock market helped pension plans’ returns in FY2011. Returns in the 20%-23% range have been recorded by a number of systems including Alaska Permanent
Fund, CalPERS, CalSTRS, Florida Retirement System, MassPRIM and New York City
Pension Funds. In many cases, these are the strongest gains in 20+ years.
However, 10-year returns are still below the required level. For example,
CalPERS’ 10-year return is 5.36% while CalSTRS is 5.7%.¹

 Wilshire Associates says the annual return in the next 15 years will be 6.5%.²

Using government accounting standards, the aggregated underfunding for US state and local governments is about $1 trillion. But if using corporate accounting standards, the shortfall is about $2.5 trillion. A third approach, often used by economists who consider even the private accounting standards too lenient, yields a $3.5 trillion answer.³

The bill for retirement benefits is already straining budgets and is competing for
resources with other critical needs such as education, infrastructure and
health care.

To close the funding gap, some states have increased the retirement age and length
of service requirements while others increased employee contribution
requirements. Some systems lowered their discount rate assumptions. Some
pensions are looking to hedge funds as a means to close the funding gap.

 Momentum continues toward direct investing

Institutions are increasingly allocating directly to hedge funds rather than take the funds of funds route, especially if they have in-house capability to select hedge
funds. Relatively poor fund of funds performance in 2008 and 2009, some funds
of funds getting caught allocating to Madoff and other Ponzi schemes, the
pressure for lower fees, institutions and their consultants acquiring more
knowledge and expertise on hedge funds as well as some hedge funds becoming
more institutional in nature have encouraged some institutions to invest
directly with hedge funds.

Recent examples include Massachusetts Pension Reserves Investment Management’s pilot program to allocate assets directly with hedge funds. The pension plans to
allocate to 20 hedge funds managers in the fourth quarter. Ohio Public
Employees Retirement System, which initially used funds of funds, plans to
invest $1.2 billion directly to hedge funds.

There is no standard approach for pensions which are direct allocators to hedge
funds. Some use outsourced chief investment officers while others use
consultants or fund of funds advisors to support their direct allocating
efforts. ⁴

 First time users tend to prefer funds of funds

Some pensions, mostly first time allocators, prefer funds of funds. Recent examples
include Connecticut State Employees’ Retirement System,  El Paso County Retirement Plan, Kansas City Police Employees’ Retirement System, Los Angeles County Employees’ Retirement Association, Massachusetts Water Resources Authority Employees’ Retirement System, Metro Nashville, New York City Pension Funds, North Carolina Retirement Funds, Orange County and Vermont State Retirement System.

Smaller pensions which lack resources to select or access direct hedge fund investments may continue to have funds of funds as their core investment. Some institutions continue with the core-satellite approach where the core allocation is to a
fund of funds supplemented by a number of single strategy funds. Others seek more specialized funds of funds in place of, or in addition to, a diversified fund of funds mandate.

Hiring consultants for those pensions allocating directly to hedge funds

As more pensions consider investing directly with hedge funds, they are in need of
a specialized hedge fund consultant. For example, the Maryland State Retirement
Agency issued a Request for Information seeking a consulting firm to advise the
staff on its absolute return portfolio. MassPRIM hired Cliffwater in April 2011
as its hedge fund consultant while Texas Employees Retirement System hired
Albourne. CalSTRS hired Lyxor Asset Management as a consultant for its global
macro hedge fund portfolio.

 Fee reductions

Pensions have also been keeping a strict eye on fees – one reason that a number are taking the direct hedge fund route over funds of funds. For instance, New Jersey negotiated a $40 million fee savings in alternative investment fees. Texas County & District Retirement System and CalPERS also were among those pensions taking steps to limit fees.

 Growth potential with corporate plans

Whereas public pension funds comprise a larger number investing in hedge funds, the largest growth potential is with private corporate plans. The private sector
started investing later than public pensions and endowments. Recent activity
shows select corporate pensions are starting to make large allocations to hedge
funds.

Japan corporate pension funds are now more closely examining hedge funds. Surveys indicate that typically 2-5% of the corporate pension goes to hedge funds but
that percentage could increase to 10-15% over the next two years.

 European pension interest in hedge funds is strong

European-based pensions have the greatest appetite for new commitments. One survey found that 45% are seeking new opportunities.

Smaller endowments looking closer at hedge funds/funds of funds

On the endowment front, some smaller endowments e.g. Wilfrid Laurier University, are starting to look at and invest in hedge funds. Previously, large endowments had generally been the sole users of hedge funds/funds of funds.

 Some endowments seed

Meanwhile, some of the larger endowments who have been allocating to hedge funds for a while are seeding hedge fund managers e.g. University of London seeded a Calamos fund.

Sovereign Wealth Funds’ allocations to hedge funds stay flat

Surveys indicate that SWFs’ allocations to hedge funds are about 36% of their portfolio – about the same as last year.

 

Sampling
of Largest Public Pension Fund Allocations to Hedge Funds

 

Infovest21’s annual white paper examines trends on a global basis. The white paper looks at recent (June 1, 2010 to June 30, 2011) hedge fund interest and activity by
pensions, endowments, sovereign wealth funds. Summary highlights of recent
activity as well as plans for moving ahead are provided for a sampling of
institutions.

Institutional activity is examined in North America, Europe, UK and Japan. Special emphasis is placed on the largest allocators i.e. those allocating $1 billion or more to
hedge funds.  The white paper also provides a survey of smaller institutions making allocations as well as those issuing RFPs or conducting searches. Those institutions deciding not to allocate or who have reduced their hedge fund allocation are also listed.

While we try to provide the most recent information available, in some cases, such as
sovereign wealth funds, endowments or private pensions, current information may
be difficult to get. As a result, in those cases, the latest information may be
from 2009 or early 2010. And on a geographic basis, information is more readily
available for US institutions than other locations such as Japan.