25/03/2010 Author: Kapila Gohel

State intentions

US institutional investors' long-running relationship with hedge funds looks set to gain momentum in 2010, as last year's strong performance and growing investor confidence augurs significant commitments from state pension funds. HFMWeek looks at where the big allocations will come from this year.

With the number of hedge fund investors on the rise, ‘alternatives’ long ago began breaking into the mainstream. This trend will further crystallise in 2010, as traditional wafer-thin allocations to hedge funds broaden into
increased investment.

Market dislocation and portfolio evolution are propelling investors into radical directions; with hedge funds standing to benefit. Many investors are seeking ‘diversified growth’, as they begin to break free of the narrow constructs of equity, bond and alternative buckets. More are replacing these old-fashioned and zonal constructs with strategies based around risk, as they ape the success of large US endowment and pension funds, like Calpers.        
Change is already translating into cash. According to Deutsche Bank research, the industry is readying itself for $222bn in inflows this year (see insight, p4). Much of this will stem from US institutional investors, including some of the largest, whose major allocations have been exclusively unveiled in the pages of HFMWeek since the start of the year.

Many of these investors are making their first step, such as the state pensions in Wisconsin, Connecticut and Vermont, others are developing and evolving their portfolios. Jaeson Dubrovay, Partner at Aksia, has noticed a lot of activity this year. “New investors to hedge funds are mainly going with funds of hedge funds (FoHF) as a first step; some are making their first move into direct investing while maintaining their core FoHFs, while others are tearing down FoHF portfolios completely in favour of going direct,” he says. The South Carolina System Investment Commission is one plan that announced its move to a direct approach at the end of 2009, and will be ploughing around $3bn into single manager hedge funds.

While it’s unusual for public pension plans to make their first move into hedge funds a direct one, two of the US’s largest retirement pots recently announced they would do exactly that. The $132.6bn California State Teachers’ Retirement System told HFMWeek last month that it would hire up to five single manger funds, meanwhile the $71bn State of Wisconsin Retirement System is set to hire up to five times as many as California.  

An interesting trend Dubrovay has seen is that some experienced hedge fund investors are looking to replace their long-only equity books with long/short strategies. “Once an investor understands the nature of hedge fund investments, they can evolve their equity portfolios with long/short equity strategies that potentially allow you to benefit from both long and short positions while maintaining a hedged exposure,” he says.

It is a strategy that is being adopted by investors that have the experience to navigate the hedge fund sector directly, as with the Texas Treasury Safekeeping Trust Company, which recently hired Shumway Capital, Kingdon Capital and Healthcor Partners as part of a hedged equity allocation, among other single managers.

Two years ago, investors were in a strong position relative to managers, but now the balance of power has shifted back, due to improved market conditions and steady hedge fund performance. “As capacity gets tighter, managers become much more selective about who they accept,” explains Dubrovay. Managers favour investors with strong track records and experience with hedge funds; those that won’t flinch at the first sign of market dislocation. Indeed, these times are particularly favourable for managers with stable capital.

While precious capacity will go to investors that take a long-term view and understand the issues with hedge fund investments, in some cases, managers are close to not accepting any new capital at all due to space constraints on their strategy.  

“The trouble is, if you’ve never had any exposure to hedge funds before, there is a chance that you could redeem from a fund prematurely. Your reputation as an investor counts and those that have more experience have more of an understanding of what they are investing in. What they [hedge funds] don’t want is FoHFs going in and out.”

From the other side, investors are more adamant about standards, with transparency topping the list of demands. Due to their inbuilt opaqueness, so-called ‘black box’ hedge funds will find it hard to attract institutional money.

Liquidity is also an issue. However, Dubrovay says, for increasing numbers of investors it is no longer a deal breaker. “Some investors are still fighting last year’s war for liquidity, however, to the extent investors have the ability to lock up capital, they are going to benefit  – we [Aksia] call this the ‘illiquidity premium’.” He adds that Aksia is advocating that those clients that can, should invest in opportunities that are dislocated and have private equity-like structures.

 Lock-ups and liquidity aside, the main point is diversification. Meaning that, in 2010, US investors new and old are opening up to hedge funds and transforming portfolios.

CALIFORNIA

SAN BERNARDINO COUNTY EMPLOYEES’ RETIREMENT ASSOCIATION
AuM: $5bn
Absolute Return Allocation: 10%

The San Bernardino County Employees' Retirement Association (SBCERA), which manages a portfolio of $5bn, will be hiring from four to six long/short equity hedge funds over the next 18 months. The pension fund has plans to invest a total of $150m, awarding 30m to each fund, James Perry, investment officer at SBCERA told HFMWeek. The pension is looking for high alpha managers rather than ‘typical 30/50 long-beta managers’.  It has a 10% allocation to absolute return, however this search is part of the 20% equities allocation. SBCERA’s hedge funds include GoldenTree Asset Management, Oaktree Capital, York Capital Management, Tricadia Capital Management and Ares Enhanced Credit Opportunities. The retirement system will be working with its consultant, NEPC, on its current search. In May 2008, SBCERA increased its alternatives allocation to 35% of the total portfolio.

CALIFORNIA STATE TEACHERS' RETIREMENT SYSTEM
AuM: $132.6bn
Absolute Return Allocation: 5% (long-term target)

The $132.6bn California State Teachers’ Retirement System (CalSTRS) has yet to make any investments in hedge funds, however, the fund is poised to hire a specialist investment consultant to advise it on its maiden investment in the space, HFMWeek exclusively reported in February. CalSTRS has yet to decide on an actual absolute return allocation, although the asset class is recognised within its investment portfolio as it looks at hedge funds as a diversifier. The pension, the second largest public system in the US, will be investing in direct hedge funds and may invest in three to five managers. A specialist hedge fund consultant is expected to be hired by mid-summer to early fall this year. At the end of 2009, CalSTRS established new long-term target asset allocations which are weighted 47% global stock, 20% fixed income, 15% real estate, 12% private equity, 1% cash and 5% absolute return.

TEXAS

TEXAS TREASURY SAFEKEEPING TRUST COMPANY
AuM: $3bn
Absolute Return Allocation: 20%
Hedged Equity Allocation: 10%

In a move to transition its investment portfolio from funds of hedge funds (FoHFs) to direct strategies, the Texas Treasury Safekeeping Trust Company, which manages $3bn in endowment assets, announced plans to hire around 25 managers in the space of a year in December. The new managers, which will be awarded with allocations of up to $20m apiece, will be across all strategies, as part of the trust's 20% absolute return allocation as well as the 10% hedged equity allocation. So far, the Trust Company has hired 12 hedge funds, including Oaktree Capital, Regiment Capital Advisors, Brigade Capital, Level Global Investors, Diamondback Capital Management, Mason Capital, Davidson Kempner Capital Management, Aristeia Capital and Bridgewater Pure Alpha, since the end of 2009. At the same time, it is gradually liquidating its current FoHF portfolio, which includes Rock Creek, Austin Capital, Lazard, K2 Advisors and Mariner Select International.

FLORIDA

FLORIDA STATE BOARD OF ADMINISTRATION
AuM: $138.6bn
Absolute return allocation: 2.3%
Long/short equity allocation: 3.9%

The $138.6bn Florida State Board of Administration (SBA) is currently working with its investment advisor, Cambridge Associates, to develop a forward plan for new hedge fund manager hires. SBA has yet to make any investments as part of its absolute return allocation, but recently hired four activist hedge funds as part of a corporate governance activist mandate – Cevian Capital, Knight Vinke, P2 Capital and Ramius Capital. The Board, which manages the $113bn Florida Retirement System among others, is set to start hiring more traditional hedge fund managers in June. Executive director and CIO, Ash Williams, stated during the Investment Advisory Council meeting in March that SBA is likely to steer clear of highly levered hedge funds, particularly global macro and quant funds. SBA has a 10% allocation to alternatives. Absolute return hedge funds have a 2.3% allocation and long/short equity hedge funds have a 3.9% allocation according to the fund's universal asset allocation plan, compiled by Ennis Knupp.

WISCONSIN

STATE OF WISCONSIN INVESTMENT BOARD
AuM: $71bn
Absolute return allocation: 2%-5%

The State of Wisconsin Investment Board (SWIB), which manages $78bn, announced plans within its 2010 asset allocation to make its first move into hedge funds with a bang. The $71bn retirement system of the portfolio will be making investments in around 25 managers over the next 36 months. The absolute return multiple manager hedge fund portfolio will be diversified by style, strategy, geography and manager, according to an SWIB memo. Consultant Cliffwater will guide SWIB through the move which will start with an initial allocation of 2% this year across 15 hedge funds. Following that, the allocation is set to be increased to 4% then 5% to reach a total of 25 managers for a fully diversified portfolio. But first, Cliffwater is helping SWIB construct a set of policies and an implementation plan. The advisor is yet to bring recommendations to the board, a spokesperson confirmed.

NEW HAMPSHIRE

NEW HAMPSHIRE RETIREMENT SYSTEM
AuM: $5bn
Absolute return allocation: 4%

The $5bn New Hampshire Retirement System (NHRS) is rekindling plans to allocate $125m across 12 hedge fund strategies, which it had delayed last year. NHRS’s investment committee approved a 4% allocation to absolute return funds in 2008 and devised an Absolute Return Implementation Plan which included investments of $40m to four equity-linked funds; $33m to two multi-strategy funds; $29m to two credit-linked funds; $15m to three trading funds; and $8m to one event-driven fund over the course of 2009, depending on the market. The plan was put on hold due to liquidity issues, but NHRS is now back on track. The portfolio will include strategies and investments in the US, Europe, and Asia to increase diversification, Richard Shafer former director of investments, told HFMWeek in 2008. NHRS is also set to carve out a real return asset allocation as part of its opportunities bucket in 2010 which will include some absolute return-type strategies.