| Johns Hopkins University CIO Kathryn Crecelius |
Hedge fund managers, listen up: Kathryn Crecelius is just not that into you — at least, not as much as she used to be.
Crecelius, chief investment officer at Johns Hopkins University and a 15-year veteran of hedge fund investing, has watched the industry evolve from a small, clubby business boasting frothy returns and catering to ultrawealthy individuals into a more staid, conservative one that courts institutional investors by touting its ability to deliver steady returns and reduce the gut-wrenching volatility that comes from being fully exposed to markets. With that transformation, she says, the industry has lost some of the excitement that made it so appealing in the first place.
“Hedge funds are no longer the be-all and end-all,” proclaims Crecelius, who manages the university’s $3.5 billion endowment portfolio. “Even though we continue to have them, much of what made them interesting has disappeared.”
Many of the top-performing hedge fund strategies of the 1990s are not delivering the kind of high-octane returns that they once did, Crecelius observes. That’s partly down to the industry’s growth: Now that it manages some $2 trillion, there are many more managers chasing a finite number of opportunities. Meanwhile, risk-free rates have plummeted, so managers would have to use untenably high amounts of borrowed funds to deliver the breathtaking returns of the past.
Crecelius worries that in their quest for higher returns too many investors are looking to hedge funds as a panacea. Hedge funds can still serve a purpose for investors, she explains — they can either deliver outsize returns or reduce volatility in a portfolio. The problem is that they cannot do both, although that’s precisely what many investors want. The sooner investors get realistic about what hedge funds can do, the happier they’ll be, says the CIO.
“Now more than ever, if you’re clear on what hedge funds deliver and why, you’re less likely to be disappointed and redeem,” she says.
Crecelius was managing director of marketable alternatives — which include hedge funds and illiquid investments that are not private equity — at the Massachusetts Institute of Technology when Johns Hopkins University hired her in 2005 as its first chief investment officer. Based a few blocks from the school’s Baltimore campus, Crecelius also invests Johns Hopkins’s $400 million defined benefit pension plan, a $230 million retiree medical benefits trust and the university’s $1 billion of operating cash.
When Crecelius arrived at Johns Hopkins, she took on a $2.2 billion portfolio with a 15 percent allocation to funds of hedge funds. By 2007 she had liquidated them all and replaced them with direct hedge fund investments. Today 18 percent of the school’s $630 million total hedge fund portfolio is invested in 43 separate funds managed by 24 different firms. The hedge fund portfolio includes credit strategies, long-short equity, merger arbitrage and distressed debt. In addition, she oversees a 17 percent allocation to private equity, which includes buyout funds, venture capital funds and growth equity.
Crecelius, who in May won Institutional Investor’s 2013 U.S. Investment Management Award for large endowments, became a full-time hedge fund investor when longtime endowment investor and MIT CIO Allan Bufferd hired her in 1998 to start up a hedge fund portfolio at the Cambridge-based school. “It was an intellectual mandate as well as an actual mandate to go out and find people who were neither long-only equity nor private equity as defined by buyouts and venture,” Crecelius says. “It was up to me to define what we were going to do in the context of MIT’s portfolio.”
The CIO did not set out to pursue a career in endowment investing. A summa cum laude graduate of Bryn Mawr College — where she now sits on the investment committee for its $700 million endowment — Crecelius went on to earn a Ph.D. in French from Yale University and worked at MIT as a French professor. When it became clear that academia was not a route to job security, she joined the management training program at Bank of Boston. Crecelius, who is also fluent in German and did a stint in Frankfurt, covered overseas subsidiaries of U.S. multinationals, particularly those in Latin America. “Many of the countries and regions we are investing in today are places I traveled to 20 years ago as a banker,” she says. “The fact that lots of people wrote off Europe five, six years ago and were eagerly stuffing money into China and India created a big opportunity for us.” She made the leap into endowment investing at consulting firm Cambridge Associates before landing at MIT for a second tour, this time in the school’s endowment office.
Senior Writer Frances Denmark recently spoke with Crecelius to discuss how the hedge fund industry has changed during her endowment investing career and why investors need to consider whether hedge funds have any place in their portfolios.
ALPHA: You have said that investors may be expecting too much from hedge funds. Why?
Crecelius: I worry that people think of hedge funds as a magic solution to this issue of low returns. Nobody wants to own bonds because returns are low and rates seem to be moving up, and that’s fair. People worry about equities and equity volatility, and they see hedge funds as a lifeboat that’s going to give them return at lower risk. And I’m just not clear on how they’re going to do that.
I think in general it’s very hard to make money. It always has been, over the long term. And while hedge funds have the opportunity to do more in terms of having more freedom around the [market] cap size they invest in or around strategies, that also gives them an opportunity to lose more money. I think it’s going to be very hard to outperform going forward. The whole question of how we even define outperformance is one that we spend a lot of time asking ourselves and talking to our committee about.
Where do you think hedge funds are falling short?
As a caveat, there are many different kinds of hedge fund strategies. Aside from pure long-short, many hedge funds grew up in the event-driven space: merger arbitrage, convertible arbitrage, capital structure arbitrage. They were not well-known strategies, and they made good money for hedge funds and investors through the 1990s. Convert arb is now almost exclusively the playground of hedge funds. The major buyers of convertible bonds are convert arb funds, and you always want to stay away from a market where there are few natural participants.
Merger arb remains a viable strategy, but it’s much tougher because so many people are doing it and it’s highly dependent on equity market strength. The bottom line is, you’re not going to make the kind of return in merger arb that you did in the ’90s. Many of those strategies that were the cornerstone of a hedge fund portfolio are not viable, or the returns aren’t there, or returns without leverage aren’t there.
They have also fallen victim to low interest rates. In the past many merger arb managers wouldn’t risk their capital if they weren’t going to earn more than 5 percent, which is what you could get in short-term bonds or even money market funds at one point. Today, when money market funds are earning zero percent, you need to add a lot of leverage to come up with returns that are interesting.
What about long-short equity?
On the long-short side, everyone acknowledges that shorting is hard. That doesn’t mean that there aren’t going to be opportunities going forward. But we’ve realized over the past five to ten years that it’s much harder to earn money shorting than it was in the ’90s. It may well be an episodic strategy. There may be times when a long-short manager wants more long exposure. Other times they will bring the short exposure up dramatically. Other funds like to keep their short exposure within a tight band. But if you keep your net exposure low, ultimately your short book will detract from returns.
How has hedge fund investing changed since your days at MIT?
While the hedge fund world has changed, I haven’t. Or, my view of how I like to use hedge funds in the portfolio has not changed as much. It’s certainly evolved, but it has not changed as much as the hedge fund landscape has changed.
It has gotten much harder for managers to outperform. The bar has gotten quite high for a long-short equity manager because institutions like Johns Hopkins and others have very fine long-only equity managers who over time have outperformed their benchmarks. When returns are the objective, hedge fund managers are increasingly competing with long-only managers.
Given that so many classic hedge fund strategies are no longer as attractive as they used to be, why are hedge funds still such a significant part of your portfolio?
We continue to think the different funds and strategies we have are viable. They have made money for us versus benchmarks appropriate for their strategy: event-driven, long-short equity, distressed. We continue to look for and hire hedge funds, but at a much slower pace. We added two in the past fiscal year.
There are some very good hedge funds that are closed. If you are not already there, it can be difficult to get in or to allocate in a meaningful size for your program. Then the question is, how does this fit when you are trying to avoid manager proliferation [having too many managers in the portfolio]?
We also continue to rotate money out of equity hedge funds because, other things being equal, we would prefer to have money in long-only managers; as a long-term investor, we can take volatility. We would still invest in a top-tier hedge fund or group we thought had genuine skill in long-short. But we think there are more inefficiencies and more opportunities to outperform in private equity or real estate and real assets than in the hedge fund space.
What role do hedge funds play in the Johns Hopkins portfolio?
Early on in my investigation of hedge funds, somebody said to me, “Are you in the grow-capital mode or the preserve-capital mode?” I think there have always been those two strains in the hedge fund world. The arbitrage strategies were much more focused on preserving capital, whereas the equity hedge funds were more focused on growing capital. People invested in Michael Steinhardt and Julian Robertson to make money, to be up 50 percent. Hedge funds have changed from being perceived as a source of return to now being a dampener of volatility and/or a diversifier.
Today people are investing in hedge funds to make less than public equity markets at lower volatility. We use them as a source of return. But we could also call them a diversifier to the extent that managers are investing in asset classes we don’t have access to elsewhere.
I think that after the crisis the focus shifted to capital preservation, which is of course a good thing. Our mission as endowments is to preserve and grow capital. Balancing those two things is the art of endowment management or, indeed, any money management.
What sets the managers you invest in apart from the hedge funds you don’t invest in?
Broadly, we look for the same things in hedge funds we look for across the portfolio: people who know what they do and what they don’t do and who are not trying to be all things to all people. Managers who can clearly articulate their strategy and process and who have self-awareness, both personally and professionally. People who are truly thoughtful about their firm’s investment process, who have appropriate assets under management, ideally in one product or a small number of products. We like people who know their areas really well and do exhaustive research.
What strategies stand out in your hedge fund allocation?
One strategy that falls into marketable alternatives and has always played a big role in what I’ve done is distressed debt. We use the phrase “marketable alternatives” rather than “hedge funds” to divide alternative investments into both hedge funds and the private equity format. The private equity format includes venture capital, growth equity and buyouts. Distressed debt doesn’t fall into any of these. We think of distressed debt as being a marketable alternative in part because it’s cyclical. As money comes back, your allocation will decline. We try to keep a steady allocation, as a percentage of our assets, to private equity. But distressed debt waxes and wanes.
We continue to like distressed debt, although that’s cyclical. Right now our managers are returning capital or returning profits, so that part of the portfolio is shrinking. But we would expect that at the start of the next cycle, the portfolio will begin to increase again. It is mostly a long strategy, although there are distressed-debt managers who are long-short or do some shorting. But in general, the distressed-debt managers that I’ve always invested with have been very, very long-biased. It’s something that I prefer to do in a lockup fund rather than in a hedge fund format.
We don’t do macro or commodity trading advisers for two reasons. CTAs are model-driven; they don’t share the models, and if they did, most of us are not equipped to evaluate them. We like fundamental managers rather than quantitatively driven managers. Second, CTAs and macro work well until they don’t. Then the question is why. You can spend a lot of time figuring that out. And you would need a lot of CTAs because there are so many different strategies.
Do you ever invest money with new hedge fund managers?
We do invest in new funds, but philosophically, I would not invest an institution’s money, and frankly I wouldn’t invest my own money if I had it, with somebody who did not have some kind of track record. So, yes, if you’ve been the No. 2 at a major fund, that’s something we can underwrite. If you spent three years at a fund and now you think you’re going to start your own hedge fund, I see absolutely no reason why Johns Hopkins should teach you how to run a hedge fund.
I think part of the whole hedge fund mystique is finding that great “A” player. And that’s a little bit of a ’90s story rather than a 2013 story. We’re looking for people across the portfolio who are going to be able to make money for Johns Hopkins in a way that is understandable and repeatable. So while I’m not saying never — maybe if it were somebody that we knew and had a previous personal history with, we might seed them — this notion that somebody we’ve never met, with a couple of years’ experience, is going to walk in our office and get our money just doesn’t make a lot of sense to me.
What is the next stage for hedge funds?
I think we’re going to see a lot more hedge fund manager retirements. A lot of people made a lot of money. It’s not going to be easy to make money in any asset class in the next ten years. A lot of people are going to retire and simply manage their own money or manage money on a noninstitutional basis, as in the early days of hedge funds. It’s back to the future: Send me your money; I don’t want to meet you or send you a quarterly report. Some might try to build an enduring franchise. I have questions about whether that will happen.
The insider trading scandal at SAC Capital Advisors has raised questions about how difficult it is for hedge funds, particularly long-short funds, to find an edge. What is your view?
One of the many things that irritate me about hedge funds, aside from the word “alpha,” is the word “edge.” Alpha is fine; I just think there’s a lot less alpha out there than people think there is. And I think it has become a buzzword, where everybody says they have alpha, or everybody is looking for alpha, but nobody really knows what it means.
I don’t think many endowments are invested with SAC. SAC has always been a very opaque hedge fund, and I think most endowments have just said, “We’re not going to touch it.” I could be wrong. The only thing I will say is, they have put up phenomenal numbers, and from the outside it is hard to tell how any one firm would put up numbers like that, particularly net of huge fees and carry. So either they genuinely did have an edge and were just supremely better at what they did than anybody else, or something else was going on.
Do all the insider trading reports make you nervous about hedge funds in general?
As far as the broader hedge fund world, do I think that there’s rampant insider trading? No. Do I think that there is always a fine line between what is better research than somebody else’s and doing your research with people who are perhaps too close legally to the company? I don’t know. I’m an idealist, so I would like to believe that the people I’m invested with are on the right side of the line. But I don’t know; I don’t think anybody knows.
This gets back to the transparency issue. When you invest in public equity and private equity, you know what’s in the portfolio, and you can talk to the managers all day long about why they bought this company and where they’re going with it. With hedge funds, even though transparency has improved, it’s rare that you can sit down with the entire portfolio and truly go through every position and the whys and wherefores. So does that create an atmosphere in which people can cross the line? Potentially.
