By Anastasia Donde
At a time when many investors have been spooked by a high-profile Ponzi scheme, poor performance and the shakeout among hedge funds, the Philadelphia Public Employees Retirement System hasn't retreated from hedge funds. Instead, it has been trying to gain more control over its investments by increasing its exposure to single-manager hedge funds instead of going the fund-of-funds route.
Philadelphia's $3.5 billion pension fund is now close to investing half of its 6% hedge fund allocation directly into hedge funds. And the managers that have been funded so far are already delivering strong returns and outpacing Philadelphia's funds of funds. The fund is up 11.87% year-to-date as of August 31.
Philadelphia decided to move into direct investing two years ago, chief investment officer Chris McDonough (right) says, to save on fees, have more control over its exposures and get access to better funds.
"Some [hedge funds] aren't interested in doing business with funds of funds that are likely to pull money quickly," he says, explaining that an institutional investor is expected to be more stable. Top managers also want to have direct access to their investors.
So far, Philadelphia has committed about $90 million to six funds. Regiment Capital Advisors, an event-driven strategy, was funded on October 1 with $10 million. Philadelphia also has recently selected Caspian Capital Management, an event-driven fund, to run another $10 million and expects to fund the commitment toward year-end. These moves will put the system, which has about $130 million invested with funds of funds, near its 50/50 goal. McDonough expects to take a step back at that point and assess what other tweaks could be made or whether to take more money away from funds of funds and put it in hedge funds.
To move into direct investing, the fund hired pension consultant Aksia two years ago and says it couldn't have made the transition without its help. Aksia assisted with portfolio construction, manager selection and due diligence. Aksia then started digging down into Philadelphia's funds of funds' exposures to find areas in which the plan might be underexposed. The fund is now targeting 30% to equity long/short strategies, 40% to event-driven funds, 15% to relative value and 15% to tactical trading.
In addition to Regiment and Caspian, the system has doled out $17 million to Paulson & Co., $13 million to Taconic Advisors, $18 million to DiamondBack Capital, $10 million to Karsh Capital Management and another $10 million to Advent Capital Management.
Paulson and Taconic oversee event-driven funds, while DiamondBack and Karsh handle long/short equity, and Advent is a convertible arbitrage fund. This year, through August 31, DiamondBack, Paulson and Taconic had already returnedan average of 15.84%, with DiamondBack's fund delivering the strongest returns at 19.72%. Philadelphia's funds of funds, Arden Asset Management, Attalus Capital Management and Mesirow Advanced Strategies, posted an average 10.33% gain year to date.
The Philadelphia system has no plans to abandon funds of funds, McDonough notes. He thinks they are still appropriate for getting quick diversified exposure to many funds in opportunistic areas, such as distressed debt and credit, or for tapping into niche strategies, such as commodities or energy.
In fact, Philadelphia hired funds of funds K2 Advisors and Lighthouse Partners in June for mandates of $20 million each. McDonough is open to looking at more specialized funds of funds strategies going forward and is willing to adjust the weighting to accommodate them.
While McDonough has been doing most of the manager research and due diligence himself, he has also relied on help from Aksia, which was founded three years ago by Credit Suisse fund-of-funds vet Jim Vos.
Bill Rubin, a trustee at the Philadelphia Board of Pension & Retirement, which oversees the city plan, said that Aksia's Jake Walthour and Corissa Mastropieri, who oversee advisory services, were instrumental through the education process and in helping the fund navigate difficult market conditions.
Aksia issued a statement to clients in August 2008 to halt investments due to snags in leverage, short selling and redemptions. Walthour then walked Philadelphia through this period and helped the fund reinvest during the fall of 2008.
Rubin says that the consultant addressed such issues as positioning the portfolio, the extra layer of fees with some funds of funds and how to get access to managers that may not have openings. McDonough adds that Aksia has focused on due diligence on both the investment side and the operational side, "where most of the blowups take place."
When selecting managers, McDonough often takes recommendations from his consultants as well. "They say, 'we know you're looking at event-driven, here are six managers we think are worth talking to.'" The process also works both ways. McDonough and trustees often get cold calls from managers or meet them at capital introduction events hosted by Wall Street's prime brokers. "Generally, we try to take as many meetings as we can. It's good market intelligence," says McDonough.
Rubin, who attends many industry conferences, also gets approached by hedge fund managers. "I look at it as an opportunity to become educated," he says. Rubin asks managers to make presentations about their strategies, but he warns them that such a meeting will not guarantee an investment.
"I tell them, point-blank, there will be a time when we will be investing. We want to sit down with you and talk about your strategy. When we will hire managers, it may be you, it may not be you. But I want to learn."
Rubin acknowledges that avoiding pitfalls is difficult, but he hopes that Philadelphia will come through unscathed. "The Madoff situation showed that if you do your homework and you look for the telltale signs, you can get away with it," says Rubin, who likes to take the time to get to know the managers on a personal level.
"That's why I like to sit down with these guys, find out what they're like, find out what their family life is like, what they do when they are not working," he says. "If you walk into the office and see pictures of family and wives and kids, that tells you one thing. If you go in a year later and see pictures of boats and cars, you realize their priorities might have changed."
McDonough says he's particularly concerned if managers are reluctant to be fully transparent. He says he doesn't ask to see a manager's portfolio every week or month. But if, at a meeting, the manager is unwilling to talk about specific names or positions or walk trustees through a trade, "that's a non-starter for us," he says. "Some funds are really not interested in talking about their positions. That's not the right relationship for us."
Yet many larger U.S, public funds don't invest in hedge funds at all or do so only through funds of funds. Pension officials and consultants who criticize direct hedge fund investing often cite lack of sufficient investment staff and resources to source managers and avoid scams.