By Anastasia Donde
Like many public pension plans, the Pennsylvania Public School Employees' Retirement System got hooked on the concept of portable alpha earlier in the decade but ultimately lived to regret it when the market crashed and the strategy produced disappointing results. Now the pension is regrouping following its decision last year to reshape that program and also carve out a separate hedge fund bucket.
PSERS has gotten religion quickly. Since making the decision to rethink its approach to portable alpha and hedge funds, the $46.7 billion pension plan has already made several direct investments in blue-chip hedge fund managers and is about to ratchet up its exposure even further. At board meetings on March 11 and 12, the finance committee approved raising the pension's allocation to absolute return strategies from 7.5% to 10%. This higher allocation to absolute return managers means the pension will need to add even more hedge fund investments. To that end, PSERS is on the hunt for a specialty hedge fund consultant as well.
"We're open to all strategies," says James Grossman, managing director of external public markets, risk and compliance for PSERS. But the fund is liquidity driven, Grossman notes. "That's going to preclude us from investing in some strategies," he adds, referring to strategies that may require long lockups.
The pension decided to scale down its portable alpha program last March, after the program—like many portable alpha portfolios—lost money in 2008. Pre-crash, portable alpha was hugely popular with pension managers who were looking for a way to produce enhanced index returns. Portable alpha is created when managers invest in market index futures, which require only a small cash margin, then use the excess money to invest in strategies they believe will boost those market returns, such as hedge funds. In most cases, this proved to be impossible after the market crash, when equity indices plummeted and hedge funds also suffered losses. PSERS then separated the equity overlays from the hedge funds and significantly reduced its overall equity exposure.
PSERS has since created a new program called absolute return. In a quest to diversify the portfolio, the pension recently hired London hedge fund firm Brevan Howard Asset Management to handle a $350 million global macro/relative value strategy and Oppenheimer Capital to manage $200 million in its Structured Alpha offering. It also hired London firms Millennium Global Asset Management and Pareto Investment Management to run currency strategies.
Brevan Howard's fund invests primarily in global fixed income and FX markets but also trades in the equity, credit and commodity markets. The firm has about $25 billion under management, making it one of the largest hedge funds in the world. Brevan Howard charges a 1.5% management fee and a 20% performance fee, according to PSERS documents, and returned 18.66% net of fees last year.
Other managers in the absolute return portfolio are AQR Capital Management, Barclays Global Investors (now part of BlackRock), Bridgewater Associates, First Quadrant, The Boston Company Asset Management, Brigade Capital Management, PIMCO, Lazard Asset Management, Acorn Derivatives Management and FX Concepts. The portfolio formerly included Goldman Sachs Asset Management, which ran a currency strategy for PSERS, but GSAM was axed last June over lagging performance and organizational changes.
A March 2009 memo to the finance committee from PSERS' chief investment officer Alan Van Noord and William Bensur, the fund's consultant at Wilshire Associates, said that the portable alpha program was originally meant to generate uncorrelated returns and that those returns should be transferred to the pension's U.S. equity allocation. Van Noord and Bensur told the finance committee that by transferring a large portion of the portable alpha program, the pension could quickly reduce its U.S. equity exposure and reduce the cash volatility created by the S&P 500 index futures overlaying the portable alpha strategies.
But PSERS isn't looking to scrap portable alpha altogether. These days, the pension's investment managers say they still believe portable alpha can be implemented on a smaller scale, with just a couple of managers. BlackRock, for example, was recently hired to handle $150 million in an emerging market macro strategy for the pension.
The mandate is being managed as a portable alpha strategy, with the internal staff at PSERS handling the equity overlays, according to Grossman.
"We think that portable alpha, if used properly, makes sense," he says. BlackRock's fund was placed within the system's equity portfolio, as opposed to the absolute return portfolio, because the investment staff felt the fund would be a better fit for that portfolio to complement its global equity exposure. For the five-year period ended June 30, 2009, PSERS' portable alpha program in U.S. equities had added nearly 2% over the S&P 500's return over the same period.
"We learned some valuable lessons from the portable alpha program we managed in U.S. large cap equities," Grossman says. "It was a very large program which had minimal immediate liquidity to meet daily margin calls for the equity index exposure we gained through listed futures. As we structure portable alpha portfolios now, we pair up the portable alpha strategies with cash to create a portfolio that, though it will have lower expected excess returns due to this excess cash, will have enough liquidity to meet margin or collateral requirements during market dislocations without stressing other portions of our asset allocation."
OpCap, which is now part of Allianz Global Investors, also offers a portable alpha-type strategy within its Structured Alpha product. In this version, OpCap supplies both the alpha and beta pieces of the portfolio, and the firm can customize each exposure based on the client's needs. The product allows customers to layer in any beta exposure they want, says Jeff Sheran, senior vice president at OpCap. PSERS has set a target return for its absolute return program of 8% annualized, and the plan targets 8% return on an annual basis for the total portfolio, with an 8% volatility target.
The overall PSERS portfolio returned 7.25% between June 30 and December 31, 2009. One-year numbers were not available as the hedge fund managers were only separated from the equity overlays used to manage portable alpha in March of 2009.
The pension is now looking to increase its absolute return allocation to achieve the kinds of impressive returns that will be needed to reach its 8% target.
Van Noord and Grossman are not yet certain which hedge fund strategies they will add next, but they are hoping to create a more diversified portfolio—and they're planning to hire a hedge fund consultant to help them figure out how to do that. PSERS issued requests for proposals for a hedge fund consultant back in February, and the proposals are due in early April.
"The program itself has become fairly large, and we have specialty consultants in private equity and real estate already, so it's prudent to have a consultant assist on the hedge fund side," Grossman says.
Once hired, the consultant will perform due diligence on hedge fund strategies and back office operations. Wilshire Associates is the fund's general consultant.