Why ISBI’s Marc Levine Slashed Its Hedge Fund Exposure

In person, Marc Levine is anything but passive. Particularly when talking about pensions, one of his favorite subjects, Levine is positively animated. He raises his voice, he gesticulates, he speaks with passion, he cracks jokes. He’s not one to shy away from the debate: Levine has a powerful point of view, and he likes to share it. Those views have led Levine, chair of the $11.2 billion Illinois State Board of Investment (ISBI), to become one of the most vocal — and active — proponents of passive investing in the country today.

Levine’s perspective is this: Pension plans should index most — maybe even all — of their money. The obvious outcome of this strategy would be the eschewing of most active managers. A former asset-backed security fund manager and trader, Levine believes public plans — and, indeed, all investors — should avoid investing in hedge funds unless they can identify those very rare managers that can be proven to be adding long-term value. Whether such managers exist is an open question in Levine’s mind.

At ISBI, Levine has begun transforming his personal views into professional action. What was only recently an almost entirely actively managed pool of capital is now 64 percent passive. The total number of hedge funds in the portfolio, once at 81, today is 14. Among the few to endure are Viking Global Investors, Tiger Global Management, and Soroban Capital Partners.

One other firm to survive the changes is ISBI’s alternative-investment adviser, Rock Creek Group. Other constants include longtime executive director Bill Atwood and deputy executive director Johara Farhadieh, who was promoted to head up investments.

As a result of the changes to the hedge fund portfolio and elsewhere, ISBI has been able to reduce net fees on its portfolio by close to $40 million a year. The gross number is around $60 million.

Anyone following financial news will be familiar with recent criticism of Wall Street, hedge funds, and asset management fees. However, while Levine may agree with the progressive left on fees and indexing, he could hardly be more their political opposite when it comes to most other pension issues. Levine, who first became active in local state politics in 2010, is a strong proponent of pension reform. With a state-level funding ratio of 40.9 percent, Illinois has for many years been seeking to reduce its pension burden. Levine has advocated for changes that would move away from prepromised benefits and encourage the adoption of 401(k) retirement options. He also believes in allowing for the possibility of cutting benefits previously promised to existing workers.

This track record on pension reform was one reason Levine, 53, was greeted with suspicion by some when he was appointed to ISBI in January 2015. Levine was one of three ISBI appointments that Governor Bruce Rauner made shortly after the Republican, who made his fortune in private equity, was sworn into office. When Levine was named chair that September, it completed a GOP takeover of the pension plan. As chair, Levine has moved swiftly to stamp his vision on the fund. Close to two years after his original ISBI appointment, Institutional Investor’s Alpha’s Imogen Rose-Smith caught up with Levine to talk hedge funds, indexing, and the beauty of simplicity.

What are your views on hedge funds as a source of alpha?

ML: They just haven’t gotten the job done over the last 15 years. It is an industry that took in way too much capital they couldn’t deploy effectively. And 2 and 20 is a very big obstacle to generating adequate excess returns. Our experience was we had 81 hedge funds and we paid them $180 million over the trailing three years — and their performance before fees was worse than a balanced index fund.

But instead of going from 10 percent allocation to hedge funds to zero, we went from 10 to 3 because we want to see if there is something there, and we think maybe there is. We told Rock Creek, “We need to pick the best.” Now we’ve got a $350 million hedge fund portfolio, and you look at its trailing five-year performance and it’s really strong.

So the way you come up with a great $350 million hedge fund portfolio is to start with $1.5 billion. It’s survivorship bias in some sense. One thing we learned was that, of our 81 hedge funds, roughly 65 were open and 15 were closed. We ended up terminating 64 of the 65 open hedge funds and keeping almost all of the closed ones because their performance was just so much better.

And why do you think that is?

I could be cute and say the open funds should fire their salespeople and hire investment managers, but I don’t think that is what it’s about, actually. I think it’s just easier to invest finite amounts of funds. It speaks to the growth in the hedge fund industry to have gone from $1 trillion five years ago to $3 trillion today. They just can’t invest the money profitably.

Someone has to be at fault here . . .

The consultants. I really do think that. They are supposed to be the experts, and they bought into all these themes that in retrospect don’t make sense. Theme number one: diversification. There are ways to diversify without paying 2 percent of our assets. In a zero-rate environment — give me a break. Theme number two: lowering volatility. You lower volatility to generate returns over time. You can’t pay beneficiaries with lower volatility; lower volatility is not a goal in itself. You look at low volatility in a post–Lehman Brothers era and the returns are not great. The third piece is the benchmarking. Benchmarking, generally, was atrocious. You have investment managers who are investing in equity, and you don’t benchmark them against equities?

Why was benchmarking such a problem? It seems relatively simple compared with the other issues faced.

The consultants did not sit down and think about what the appropriate benchmarks were. Consultants need to be homogeneous — that is their business model. Serving multiple clients, all with trustees and staff, they serve a lot of people. And when you do that, you need to simplify. Hedge funds and monitoring a hedge fund portfolio don’t lend themselves to simplification and harmonization. So it really doesn’t work.

So do hedge funds make sense for anyone?

Hedge funds don’t make sense for the vast majority of personal and institutional investors because they are so hard to monitor. At ISBI we are working with a highly sophisticated strategic partner, and we have a fairly sophisticated board as well. Can you get alpha with appropriate pie sharing? I suspect it’s achievable. For ISBI, time will tell. We’ll zero it out if it isn’t working. There is nothing wrong with zeroing it out.

What do you mean by appropriate pie sharing?

First of all, you’ve got to benchmark hedge funds correctly. Number two, your hedge funds need to generate excess returns over those benchmarks, and then they need to do that after fees. Why would you spend any energy investing in something that you could do for free in an index fund? What are the gross excess returns, and what are the fees that are paid to the hedge fund manager, and what are the excess returns that are being retained by the investors? If there is a penny of excess returns and 99 cents of fees being paid, that is not aligned interest. This is where ISBI is really at the leading edge. I don’t think anyone is having the conversations we are.

The managers that you’ve retained — what are you saying to them?

What we tell Rock Creek very clearly is that we want to know whether our interests are aligned. Is the benchmark right? Calculate the excess returns: What is our piece of the pie in excess returns, and what is their piece with their 2 and 20?

And are you asking these managers to lower their fees?

We can’t do that. We know we can’t move the market compensationwise.

So there is some give on your end?

Yes. We are absolutely willing to pay 2 and 20 for material excess returns. We want to. That is why we have a 3 percent allocation to hedge funds. We want that to be great, and maybe it will be.

I view it through a lens of “Does great performance persist?” In the traditional asset management industry, S&P, Vanguard, and others have done all these studies that outperformance doesn’t persist. We want to invest in great managers, and great managers want to get paid a lot of money.

The hedge fund label and structure are a problem — for example, you can’t have your investment with your custodian. The only reason to invest with that thing called a hedge fund is so you can get access to the very best managers in the world.

Indexing. Why?

The primary reason is that it is very complicated to run these large portfolios. Complexity is an obstacle to investment excellence. So we need to simplify, and everyone needs to simplify.

The way we are going about doing that is by indexing two thirds of our portfolio. Then we don’t have to think about it. The staff doesn’t have to spend any time; the trustees don’t have to spend any time. That way we can focus on the other 30 percent. We are going to attempt to get alpha with the other third of our portfolio in five categories: hedge funds, private equity, private debt, opportunistic real estate, and liquid active managers.

Why has active management proven so hard for public pension plans — in the U.S., at least?

These are government entities; there are opportunities for political meddling and other things. Investing is hard. You throw other elements on top of that and it makes it harder. Trustees come from all walks of life: They might be appointed by unions, they might be elected, they might be appointed by a governor as I was. Often they are not investment experts. I used to think that was the significant problem, the lack of investment expertise. But I don’t believe it to be the case anymore. I’ve changed my mind on that, because this can be done very easily — if you just index everything. Why make it complicated?

So you now believe it is not the lack of finance knowledge among trustees that is the problem but that investment approaches have become overcomplicated?

Yes.

Foundation and endowment trustees tend to have more investment experience than those serving at public pensions. Do you think the same fault of overcomplicating applies to them?

Isn’t it funny? They often don’t do any better. Most active managers don’t outperform the market. That is just the data. It kind of is what it is. You have these indexes where very smart people, instead of trying to come up with the best investment, are spending their time trying to figure out what stocks best mimic the entire market. That is an interesting exercise. They then charge a tiny fee. And it works.

Should people worry about the consequences of indexing? That if everything becomes passive, markets are no longer rewarding good companies or punishing the bad ones?

The numbers I’ve seen are that 25 percent of all the assets [are indexed] but account for less than 10 percent of the trading. So 90 percent of the trades in the market are being ordered by active managers. There is a free-ride element to this, but there is nothing wrong with that. So 90 percent of the trades are being done with price discovery and intelligence. That 10 percent can go up quite a bit before what you’re talking about — insufficient intelligence in the trading — is a problem. That would be horrible. But we’re nowhere near that yet.•