US institutions more worried about falling returns than imploding funds

US institutions ask where the alpha will come from, whether a pyrrhic victory will result if their 1.5% in hedge funds is the portfolio’s sole performer, what will shake their colleagues out of hedge funds, and are hedge funds truly “monsters with five heads”?

US institutional investors at the Hedge Funds World Global Opportunities 2005 conference in New York have placed blow-up risk surprisingly low on their list of greatest concerns.

Higher up on their list was diminishing returns with greater inflows, high fees, and some consultants’ unwillingness to recommend smaller and emerging managers.

Institutions’ own tardiness coming to the hedge fund party, in some cases, has also raised investment boards’ eyebrows.

Brian Glanz from the Philadelphia Board of Pension and Retirement (PBPR), said the fund’s US consultants CRA Rogers Casey had done an “excellent job” in helping PBPR decide on which hedge funds to use to make its first foray into the assets class.

“With the help of our consultants CRA Rogers Casey, we are looking at an allocation of 6% to hedge funds and we will go into funds of hedge funds initially. The first three investments will be funds of hedge funds and as we become more familiar with the asset class we will go the direct route over time.”

The PBPR expects to make its first fund of hedge funds investment by summer’s end.

THE BIGGER THE BETTER?

But Glanz said some consultants were unwilling to suggest smaller or emerging managers for institutional investment.

“A consultant will not get fired for recommending a huge hedge fund, but I do not want our board to miss out if the better managers are the smaller ones,” he said. “We need to get consultants to open up and look at the smaller groups but I do not know how much time they have to do that because there are 6000 funds out there.”

PBPR’s fund has around 60% of its $4bn in equities, 25% in fixed income and the rest in alternatives, mostly (10%) in private equity.

Ultimately its allocation to hedge funds will come to about $250m, of which a little less than $200m will be via funds of hedge funds, Glanz said.

Glanz has dedicated one of the three rounds going into funds of hedge funds for a smaller emerging group, by which he means less than $1bn under management.

While Glanz said he could stomach an allocation of up to 10% or 15% in hedge funds he added politically this could be hard to get past a pension fund board.

(His was not the only voice at the New York conference suggesting weightier allocations to alternatve investments. Michael Hennessee, managing director of foundation and endowment advisory firm Morgan Creek Capital Management, said the existence of “so many different strategies” of hedge funds and “so much talent” in alternatives meant one could “assemble a portfolio that is…55%-60% in alternatives and it will give you a much better risk return profile.”)

“We rely heavily on our consultant,” said Glanz. “I can’t really go out and do a lot of due diligence. With our smaller staff I do wonder how we will get our emerging managers in and you have to really rely on your consultants.”

NOT LOSING SLEEP

Lawrence Powell, former hedge fund manager and now portfolio manager, strategically traded securities at the Texas Teachers Retirement System (TTRS) with one million beneficiaries and $90bn under management, said many pensions’ board members “spend too much time worrying about what the risks are.

“They’re not allocating time to whether the positive aspects of everything are, whether the stock market or bond markets or hedge funds themselves.”

“I do not spend time thinking about the risks of hedge funds, I could spend 90% of my time worrying about what the next hedge fund blow-up will be, or the next problem but is there any way I could protect against that? Not really.”

Hennessee said his main worry was shortfall risk. “There will be some event but you should have some insurance against that in your portfolio and hopefully that insurance should not cost too much.”

SHORT TRACK RECORDS

Elizabeth Flisser from Capital Z noted that the incubator and anchor investor for many hedge funds, founded in 1998, had heard many of Glanz’s concerns.

“Many allocators out there are not looking to managers with shorter track records, and we understand there is concern about headline risk with business issues,” she said.

But she added there was research showing younger managers often found in emerging manager programs did perform better – “were hungrier” – in their early years.

WHEREFORE ART THOU, OH ALPHA?

Powell said his main concern was the increasing difficulty in conducting the search for alpha.

TTRS has about 60% in equities, 30% in bonds and 10% to alternatives, of which about 4% is in private equity (targeted to rise to 6%) and 3% in real estate.

He said the 26 managers running their hedge fund money had represented 1.5%, or $1.3bn, of the portfolio since the inception of the program in December 2000, and were spread across strategies bar global macro, CTAs and short only.

Powell said: “The respect I have for capital markets is huge. Resources have been marshaled in time. But the talent, energy and dollars spent searching for this alpha has diminished returns in a lot of areas and when you add fees on top it does reduce things.”

Hennessee said alpha was, of course, “the name of the game.”

“Depending on your size you can have 55% to 60% in alternatives, and as far as exposure to the traditional world, long only managers charge up to 100bps and you can get beta cheaply and easily in a liquid format.

“But alpha is the name of the game. I would love to see markets correct to the point when long only becomes a fat pitch but I do not think we will see that.”

Hennessee said there was “almost nothing” investors could do about blow-up risk, “if a manager wants to defraud you they will, but one way to do that is by manager size.”

TIME IS MONEY

Powell noted a further, straightforward problem inhibiting greater understanding of, or allocation to, hedge funds – time scarcity.

“There is not so much time in pension board meetings and I have talked about bringing in hedge fund managers. You have a situation where you're allocating a very small amount of money from your portfolio and we already spend 80% of our time talking about 10% of our portfolio.”

However Powell gave words of comfort to the hedge fund managers at the Hedge Funds World Global Opportunities 2005 conference in New York: “I do not think you will get answers to these kinds of questions in traditional assets either.”

PYRRHIC VICTORY

Qui Vuong, chairman of America’s National Association of Investment Fiduciaries, and himself a pension trustee, noted aptly it could prove a “pyrrhic victory” for pension managers if “it is only the 1.5% of then portfolio in hedge funds that performs.”

Powell was mindful of hedge funds melting down, as well: “Hedge funds will blow up again and bad things will happen. I hope it will make some people exit from the industry because there is too much money flowing into some strategies.

“Last year was not terrible but it was not that great either and the question has to be asked about all the money flowing in,” he said

“We have been investing in funds for a while, so we are not necessarily the Johnny-come-lately in the hedge fund world so we are the ones putting the money into the market and shoring up the opportunities and eliminating some of the opportunities coming in,” he said.

“These are the problems out board is having with hedge funds and it is something that’s a big issue for us, and the reason we are still at 1.5% allocation to hedge funds.”

“The other problem is as a large institutional investor it is difficult to invest in managers with shorter term track records and we have a lot of complaints about short term track records performance.”

Powell said the other issue was waiting for the “next hedge fund crisis,” which he said would hit institutional investors “even more because of the large allocations we have made.”

But Powell added it may not be the long/short allocations that get hit – if the crisis also hits equities or other markets more generally, Powell said, “the traditional investments that are unhedged will be the ones that will be impacted.”

Glanz said his main concern was “getting to the game too little but too late and how do we justify the fees, which are quite high.

“If you get the kind of returns generated last year how do you justify them?” he asked.

The final concern he noted – which his co-panellists shared – was the “Enquirer crisis,” or that a blow-up and pension investors’ names will appear in the National Enquirer.

Some hedge funds may have been ruled out of consideration, as the PBPR requires extensive transparency, not necessarily for its own purposes, as Glanz explained. “Transparency is an issue for us because we have the right to know laws, and a lot of hedge funds do not want to provide transparency and for any request coming in we have to provide information for them.”

But Glanz said another concern over simple transparency came from many managers being “pretty vague about what they do.

“One of the issues from the sell side is managers being more open about their process. I want them to tell me exactly what they do. Why do you think you’re better than everyone else? And why do you think you’re worth 2% and 20%? I am looking to be an investor but I do not want to be an investor in someone I do not understand. There are so many esoteric strategies out there I would like them to be a little more open.”

He added greater access to the actual manager would be helpful. “If I had greater access to the decision makers I could help speed the decisions up. At the moment it is difficult not to be vague to the board because the managers are being vague and that engenders trepidation when you’re thinking about investing.”

Powell said TTRS did argue the debate “if we don’t commit at least 3% why do it all,” but the mutual fund timing scandal somewhat overshadowed the discussions on this.

“Traditional pension funds are still looking at the traditional alternative assets, private equity and real estate, as areas they feel more comfortable with, and hedge funds they see as monsters with five heads. That’s how they look at them,” he said.

Michael Hennessee, managing director of Morgan Creek Capital Management, said the position of endowments and foundations was often different to that of his pension fund counterparts. Morgan Creek Capital Management runs around $850m.

Hennessee was previously head of the University of North Carolina investment committee, overseeing all asset classes from long only through private equity to hedge funds, conducting long term tactical asset allocation and manager selection.

SUPERIOR PERFORMANCE

“Most of the money is in hedge funds in all types of strategies because we think that is a superior way of running money because of the huge amount of intelligence to be gained in the asset class.

“In foundations and endowments lots of times you will have hedge fund managers and other chief investment officers on the board, whereas our board is half made up of teachers, and the other half appointed by the governor.”

He said, despite the board members’ insight, there were still concerns about hedge fund risk.

“Ten years ago 80% of the money was in macro, today it’s 80%-90% in non-macro strategies and there is the old perception still present one person has analysed an algorithm making decisions about whether to go long the pound or short the Nikkei, but that’s not what hedge funds are about,” Hennessee added.

“In 2001,” noted Hennessee not without some ironic reflection, “it was perfectly okay to have 90% of your money in US growth stocks.” Added Powell: “Or $300m in Enron.”

To avoid blow ups, he said, the fund must needs gravitate towards larger hedge funds with a COO, CFO, risk manager and many analysts. “I am not saying that is the only type of manager we can allocate to, and we have recently allocated to two different groups in Europe and one has four people and about $500m, and indeed we are gravitating away from larger managers as our portfolio matures.

“I think I could put as much as 60% into hedge funds but not for our fund,” Powell said, “I’m not sure there is enough capacity out there. We continue to educate our board about hedge funds”

GLOBAL SEARCH

Hennessee counseled allocators not to confine their search for talent to the US. “It does make things harder looking further afield but the wards of not constraining your group’s focus are great, but it does put a toll on the travel.”

Flisser said Capital Z’s private equity manager stable exemplified the firm’s global purview, with not a single US manager in it for its first three to four years. Now, she added, it has a heavier weighting to Asia, Korea and China.

“On the hedge fund side we have seen some emerging funds come up in Singapore and Europe that are quite attractive,” she noted.

Powell concurred with Flisser that a lot of the private equity managers the plan had been drawn to were outside the US, and about 30% of the TTRS fund was European, including managers in Sweden and London. The plan’s first non-US hedge fund manager received money only in January 2005.

“But we do have hedge fund managers with offices outside the US and exposures outside the US,” Powell said.

“We are seeing and exploring opportunities outside the US,” he added, “and I am a huge fan of geographical diversification not only throughout the world but also throughout the US. There is a lot of hedge fund managers in Chicago and California and Texas and Boston and Minneapolis, you have too many guys in New York talking to each other and all of a sudden they’re running the same kind of portfolio. But if you have managers in San Francisco or Minneapolis they can’t do that.”

Some of the managers noted problems in their not being allowed to accept offers of trips from investees, or potential investees, due to public sector law. Vuong noted” “We have an industry of hedge funds that is very dislocated with institutional investors who want to invest in hedge funds but they are being handicapped by the way they go about investing.”

RETRIEVING TRUSTEES FROM THE CLOSET

Vuong noted the hedge fund industry was not doing enough to reach the ultimate decision makers “the ones who need to be the most educated.”

“They’re so afraid of appearing unknowledgeable and head in the closet and someone has to go into that closet and educate them.”