By Anastasia Donde
After some embarrassing missteps, including investments in the high-profile blowup of Amaranth Advisors and the allegedly fraudulent Westridge Capital, and losing money on its portable alpha program, the San Diego County Employees Retirement Association is getting its act together.
Though the $7.3 billion pension hasn't taken its losses lightly—it filed a lawsuit to recover the roughly $150 million it lost in Amaranth—it also hasn't wasted any time revamping its approach to hedge funds. (The Amaranth suit was recently thrown out of court, though the pension did recover $61 million in liquidation payments. SDCERA's chief executive, Brian White, says the pension will appeal the ruling.)
In August the firm replaced former in-house chief investment officer David Deutsch, who resigned in March 2009, with former Teacher Retirement System of Texas deputy chief investment officer Lee Partridge. The decision to hire Partridge was a novel choice for a public pension fund, since Partridge is not working directly for the pension—he's the founder and chief executive of Integrity Capital, which provides outsourced investment management services to pensions.
Partridge says his mission is to completely revamp how SDCERA allocates to hedge funds. Right now the pension has about $569 million invested with Brevan Howard Asset Management, Bridgewater Associates, the D.E. Shaw Group, UBS O'Connor, Carlson Capital, Davidson Kempner Capital Management, GoldenTree Asset Management and Silver Point Capital, among others. At issue is not the funds themselves, but rather how the investments were structured as part of SDCERA's overall portfolio. Partridge is hoping to build a portfolio for SDCERA that is similar to what TRS has.
"We tried to create a bottom-up portfolio that was much more market neutral than what we started with," he says. "You can use hedge funds for different things."
Partridge started out by rejigging the plan's existing hedge fund manager portfolio. He placed the portfolio's long-short equity managers into the fund's equity allocation and put credit and distressed funds within the fixed-income allocation. He is also drafting a new asset allocation structure. Previously, SDCERA's hedge funds were tied to its portable alpha strategy, which has since been eliminated.
The hedge funds SDCERA invested in had been allocated to a portfolio that consisted of a mix of multistrategy funds, credit-based funds and global macro. Pensions often use these types of so-called opportunistic portfolios to house strategies or assets that can't be easily defined, but SDCERA is scrapping this portfolio in favor of setting new allocation targets of 10% each to what he calls "hedge fund-like strategies," which can include traditional hedge funds but may also include strategies that are not strictly hedge funds but use similar tools, such as derivatives and leverage, or which resemble hedge funds but are not structured as such. This allocation can also include other alternative strategies. Partridge plans to devote one of these 10% allocations to top-down, asset allocation-type strategies—such as macro, global tactical asset allocation and multistrategy—that would be measured against a self-constructed benchmark comprising the Barclay CTA Index (which would make up one-third of the index) and the Hedge Fund Research macro index (which would make up the other two-thirds).
He also plans to dedicate another 10% of SDCERA's portfolio to market-neutral, relative value strategies that are targeted toward equity, credit, interest rates, volatility and commodities. This portfolio will be benchmarked against Treasury bills, plus 200 basis points. "We anticipate it being a truly market-neutral source of alpha," says Partridge. These new portfolios will account for 20% of SDCERA's total investment portfolio, and they will include some hedge funds SCDERA had already invested in.
Partridge says the pension's existing hedge fund managers will be filtered into the new portfolios as they are set up, and he is also planning to scout for more managers to fill out these new portfolios. He's particularly interested in global macro managers, as well as those who employ global tactical asset allocation strategies. Partridge also plans to look for managers who can exploit opportunities in credit, volatility, commodities and interest rate arbitrage, though he is wary of specialist credit managers right now.
"You don't want to be long credit," he says, echoing a sentiment uttered recently by several top hedge fund managers. Partridge believes that the markets, which have come a long way in a short time, could be headed for a fall. "The last thing I want is for managers to take a bunch of credit risk, dump it on us and call it alpha."
He's also generally opposed to using hedge funds to access investments that are naturally long market risk, saying it is not in investors' best interests. "There are too many instances where incentive fees can be high, but those types of funds are actually underperforming a passive investment equivalent in a particular index," he says, adding that investors are not charged for relative performance, but rather a hard hurdle. "Many hedge funds that embed a long exposure may exhibit skill, it's just that the fee structure doesn't work."
As for portable alpha, Partridge says he believes the original premise of portable alpha makes sense, and he regrets that SDCERA decided to scrap it altogether. The pension's portable alpha program consisted of a collection of multistrategy and market-neutral funds, which were meant to offer diversification. But when the market crashed, everything fell at once, and the strategies underperformed. "The commodity exposure, and the equity exposure that was laid on top of it, became highly correlated with the hedge funds themselves," he says. Partridge believes the problem was not portable alpha itself, but in how the pension executed it, however.
"The fundamental concept is solid; the problems are in the implementation," he says. "We need to be cautious not to double up risk. Overlaying market risk on top of a hedge fund that has credit, distressed or equity exposure is very dangerous. The correlations between the underlying and overlay exposure are fundamentally higher when those strategies are employed."
Reducing the pension fund's risk, particularly in the aftermath of its failed investments, is Partridge's top priority. He says he is structuring asset allocation in such a way as to take most of the equity risk off the table, seek out uncorrelated returns and develop a significant allocation to Treasuries. The pension's board recently voted to increase its allocation to what it calls "stable value" strategies, such as U.S. Treasuries and emerging fixed
income, from 21% to 35%, and to reduce its exposure to public equities from 47% to 25%.
Partridge adds that risk can't be avoided entirely, however, and investors should make sure they are taking on the right kinds of risk. "It shouldn't be a surprise if once in a while we get it wrong," he says, adding that naive investors who strive for perfection may find themselves mired in another kind of risk.
"They say, 'We're going to get it right, and we're never going to have a hedge fund that's down,' and they wind up with a bunch of Madoffs." AR