By Anastasia Donde
When pension funds started making their first investments in hedge funds a few years ago, many opted to hire funds-of-funds managers, thinking that these experienced middlemen could do a better job of picking out good hedge fund managers and were better equipped to investigate them.
Fed up with the high fees, low returns and sloppy due diligence offered by some funds of funds, many pension funds recently have dispensed with the middleman altogether and are going straight into hedge funds. But one California pension is thinking about going the old-school route—at least in part.
The City of San Jose Retirement Services Department, which oversees investments for two city pensions that manage a combined $4.1 billion, has decided to invest in hedge funds for the first time after losing north of 20% on its traditional investments in 2008.
San Jose is looking into funds of funds for its first hedge fund investments, says investment officer Ryan Jusko, because the best ones can still provide novice hedge fund investors valuable services—including industry knowledge, thorough due diligence and access to managers.
That said, Jusko is keenly aware of the complaints surrounding funds of funds, many of which posted big losses in 2008 and which usually charge an extra layer of fees—typically a 1% management fee and a 10% performance fee—on top of the 2% and 20% fees charged by the underlying hedge funds in their portfolios.
"The fact that they can simplify your life is not enough," Jusko says, adding that the funds-of-funds managers the two pensions hire will need to earn their extra fees.
"If we go with the fund-of-funds approach, we are looking for managers that are providing an additional layer of diversification. We'd like to see them bring something else to the table."
For Jusko, that something else is not just tracking the markets. The pensions get plenty of that from their traditional investments, and Jusko says he is looking for managers for the pensions' alternatives portfolios that can provide returns that surpass those of the funds' traditional equity and bond investments.
The two pension plans the City of San Jose Retirement Services Department manages are the $1.7 billion San Jose Federated City Employees' Retirement System and the $2.4 billion San Jose Police and Fire Department Retirement Plan, each of which voted in recent months to allocate 5% of its total assets to hedge funds. Trustees for the pensions have yet to approve a specific investment strategy, but Jusko says they are considering both funds of funds and direct hedge funds for their initial investments in hedge funds.
Jusko envisions what some are calling the core-and-satellite approach to hedge fund investing, in which part of the hedge fund portfolio would be invested in a diversified fund of funds and the rest would go to niche single-manager hedge funds. The investment officers have already been meeting with funds of funds, multistrategy hedge funds and niche single-manager funds, but the pensions probably won't start investing until August.
In the past few months, the investment staff has met with more than 30 funds. So far, Jusko likes Fuller & Thaler Asset Management, which runs a market-neutral fund based on behavioral finance, because he thinks it has a low correlation with quant market-neutral funds. The fund also stayed positive in 2008. San Francisco's Parallax Fund is another fund the San Jose staff thinks is interesting. Jusko and the staff are also impressed with BlueMountain Capital Management.
How much of the planned $400 million allocation to hedge funds will be given to funds of funds will depend on the investment staff's ability to find managers that can make savvy allocation decisions, offer exceptional risk management and due diligence and outperform in any market condition. It's a promise many funds of funds failed to live up to during the extraordinary market conditions that prevailed in 2008. "If it's a well-run fund of funds, we're not expecting it to be down 20%," Jusko says, referring to how many funds of funds performed that year.
Jusko admits that the investment staff at San Jose may not yet be sufficiently equipped to do extensive research on single-manager hedge funds, though he adds that San Jose is looking to hire more investment analysts to focus specifically on hedge funds and private equity.
The Federated City Employees' fund works with institutional consulting firm Meketa Investment Group, and the Police and Fire Department plan is advised by NEPC, which advises pensions on their asset allocation and investment strategies. The pensions are planning to work with both consultants on their hedge fund investment strategies, but they are also weighing the option of hiring a specialist hedge fund adviser.
The San Jose investment department has been making several new hires for its own team in the past few years after the addition of Russell Crosby, who came on board in 2007 as director of retirement services after working as the chief executive of the $5 billion United Food and Commercial Workers Unions and Employers Benefit Plans.
Since Crosby joined, Carmen Racy-Choy has also come on board as chief investment officer in 2008, and Jusko joined in January this year. He reports to Racy-Choy. Both used to work in the investment consulting division of consulting firm Mercer. Ali Amiry also joined the team as an investment officer two years ago from another consulting firm, Alan Biller and Associates, which advises Taft-Hartley benefit plans. Amiry previously ran a hedge fund, Quant Investment Strategies, which closed in 2001.
The staff at San Jose is also keeping a close eye on its pensions' liabilities, as many pensions, particularly corporate plans, are in danger of not having enough money in the future to fund their obligations. While public funds are less likely to run out of money than corporate plans, they still have to be cognizant of liabilities and the risk of underfunding, Jusko says. To that end, San Jose is trying to protect its portfolios with significant allocations to Treasury Inflation-Protected Securities and real assets. Many public pension funds have been looking at real assets such as timber and commodities as a hedge against inflation.
Both San Jose pension funds recently revamped their overall asset allocations, including the new targets for hedge funds, in an effort to reduce volatility, improve returns and protect the funds against losses. "We're trying to earn a higher Sharpe ratio on the overall plan," Jusko says.
Following steep declines in 2008, both plans fired many of their active equity managers in favor of passive management strategies to save on fees. They also reduced their overall exposure to equities and raised their exposure to alternative strategies, including hedge funds, private equity and real estate, to 31%. Both the Police and Fire Department and Federated City Employees' plans created new allocations to inflation-linked assets at 10%, absolute return at 5% and opportunistic strategies also at 5%, while reducing equities by almost 20 percentage points. The San Jose plans have also created 5% allocations each for esoteric strategies.
"We're trying to find uncorrelated returns and focus more on diversification. The plan to invest in hedge funds and other alternatives is ultimately meant to provide returns in any market environment. We're looking for distinct ways of deviating from the benchmark."