Friday, January 7, 2011

Altneratives & Public Pension Funds: A Questionable Mix

by Jeff Briskin
President, Briskin Consulting

An FBI raid on hedge fund managers Level Global and Diamondback Capital Management in December of 2010 and the revelation that the state of Massachusetts pension fund had invested $66 million with these managers once again raised questions about the prudency of including hedge funds in state pension fund portfolios.

Massachusetts officials quickly noted that the pension fund hadn’t actually lost money from Level Global and Diamondback and these investments comprised only 2% of total assets, according to a December 28 Boston Globe article. However, the raid reminded pundits of the $30 million the pension fund lost in 2007 when Sowood Capital Management failed, and the $50 million loss the state took in 2006 when Amaranth Advisors went under.

Granted that some of the pension fund’s other hedge fund managers performed extremely well during this period, the question is not necessarily whether pension funds should be investing in hedge funds at all, but how does a pension committee evaluate what makes them prudent choices?

Do hedge funds meet ERISA’s fiduciary standards?

ERISA requires all pension fund managers to make sure that costs are reasonable, that investments are prudently managed, and that all portfolio management decisions are made solely in the best interests of the fund and its participants. This in itself would not preclude investments in hedge funds, because they can play an important role in reducing the overall volatility of a portfolio by generating returns that are uncorrelated with current market conditions.

Do they live up to their reputation?

When hedge funds can help temper the overall volatility of a pension fund portfolio they are doing their job. The best hedge funds aren't necessarily those that dramatically outperform the broader market in bull markets. Rather, the true value of hedge funds comes when the market is gyrating in reaction to economic and political events. Successful hedging strategies can anticipate rapid declines in the market, resulting in greater protection against losses.

However, this performance comes with significant risks. Most hedge funds are established as privately held limited liability companies and are not registered with the SEC. Thus, they are not subject to the same level of industry scrutiny and disclosure requirements as mutual funds and other registered investment companies. Also, the cost of investing in hedge funds is generally much higher than investments in stocks, bonds and mutual funds.

How much higher?

Many hedge fund charge a flat 2% investment management fee plus between 10%-25% in so-called ‘performance fees’ that are taken directly out of gross returns. These costs can take a considerable bite out of an investor’s total returns.

A costly illustration

The HiAlpha Fund charges a 2% annual management fee and a performance fee of 20% of investment returns applied to both gross asset values and gross performance. In 2010, the Fund earns 13% in a year net of all fees.The gross returns add back the 2% management fee and adjust for the 20% of gross returns paid to HiAlpha’s manager. This means the gross returns are equal to 18.75% ( [13%+2%] / [100%-20%]). Total fees paid to HiAlpha are 5.75% (18.75%-13%). Thus, the investor’s net return is 13%. In this scenario, HiAlpha’s manager walks away with nearly a third of the gross returns.

Not to mention fund-of-funds costs

Most pension funds don’t invest in individual pension funds. Instead, they use so-called ‘funds of funds’ offered by banks and institutional investment advisors.
Typically, pension fund managers pay higher fees to fund-of-funds managers to cover both the management fees of underlying hedge funds and the fund-of-funds manager’s own advisory fee. For these added costs, the fund-of-fund's manager is supposed to take on the due diligence and fiduciary oversight over the underlying individual hedge funds on behalf of the pension fund manager.

While this may sound good on paper, it’s doesn’t always work in practice. Indeed, both Level Global and Diamondback Capital Management are fund-of-funds managers whose questionable and potentially illegal business practices drew the FBI’s attention.

So, should pension funds include hedge funds?

Unless the U.S. government fully requires all hedge funds to register with the SEC and comply with its disclosure requirements (something unlikely to happen with Republicans controlling the House of Representatives), pension fund managers will have to either continue to use funds-of-funds or conduct their own due diligence on individual hedge funds.

This is not an easy task. Most hedge funds managers are notoriously resistant to disclosing their so-called ‘business secrets’ to potential investors. Yet, no pension fund should rely on stock RFP responses, sales presentations and performance figures alone. Every aspect of the company, from the backgrounds of its senior managers to the vendors it uses for trading, banking and reporting, should be vigorously examined and evaluated.

Fund-of-funds managers should be treated with the same level of scrutiny. Just because these funds are offered by a bank or a institutional investment advisor doesn’t mean that their due diligence processes are comprehensive or fail safe. Of particular concern to pension fund manager should be any potential conflicts of interest in the way these funds evaluate and approve individual hedge funds. Even if certain managers pass the fiduciary muster, pension fund manager still need to weigh the costs and risks of investing in these funds, especially if there may be other, less expensive and less risky ways for a pension fund to add hedging strategies to their portfolios.

Such as?

It is possible to emulate hedge fund performance by allocating a portion of a the portfolio to mutual funds with market-short and market-neutral strategies. While their managers might not deliver the same potential level of alpha and volatility-reducing benefits of the best hedge funds, they offer greater liquidity and, as investment companies registered with the SEC, provide a higher degree of protection for investors. And the cost for this performance may be significantly lower.

Remember who you are investing for

It’s important for pension fund managers to remember that the purpose of their fund is not to deliver Warren Buffet-like results. A pension fund is designed to fund current and future retirement benefits for retired employees. While nearly all investments carry some level of risk, losses due to fraudulent or improper business practices—and fiduciary negligence on the part of pension fund managers who are supposed to identify these risks—aren’t acceptable at all. Particularly to the taxpayers who will have to pay to make up for any underfunding of pension liabilities resulting from these losses.

©2011 Jeffrey Briskin & Briskin Consulting. All rights reserved. Content in this article is current as of its publication date and does not constitute legal or investment advice. Please consult with your legal or compliance department before implementing any recommendations discussed in this article.

1 comment:

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