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Eric NierenbergMassachusetts Pension Reserves Investment Management BoardEric Nierenberg is a self-described hedge fund skeptic — an unusual trait for someone who manages a roughly $5.2 billion portfolio of hedge fund investments. Nierenberg , 42, is senior investment officer and director of hedge funds and low-volatility strategies at the $61 billion Massachusetts Pension Reserves Investment Management Board. Raised in Miami, Nierenberg attended Harvard University. There he earned a BA in economics and a Ph.D. in business economics before joining the asset management field as a quantitative researcher at Boston-based Independence Investments, now part of LMCG Investments, where he later worked as a portfolio manager. Nierenberg’s boss, PRIM executive director and CIO Michael Trotsky, also came from the asset management world, where he was a hedge fund manager. Their collective experience shaped their view that many hedge funds simply don’t have the goods, but it convinced them that hedge funds do serve a valuable role for institutions, provided they can diversify the portfolios and are accessible at reasonable terms. For PRIM that means investing via managed accounts. Today about 50 percent of the pension’s total hedge fund portfolio is invested in these structures, either directly or via the sole fund of funds that remains in its portfolio. That’s a dramatic change from 2004, when PRIM began investing in hedge funds. The pension went mostly direct following the financial crisis in 2008; when Nierenberg joined, toward the end of 2012, he instituted further changes, pressing hard to negotiate for better fee terms and more transparency.
You have been critical of hedge fund performance, yet you still invest in them. Why?
Nierenberg: We do believe the vast majority of the hedge funds out there probably don’t have enough alpha-generating ability to justify hedge fund–like fees. We continue to hold the philosophy that certain hedge fund strategies can be very additive to an institutional investor’s portfolio, especially a large, sophisticated pension fund. But there are a lot of frogs out there that you have to potentially kiss first to see which ones turn into princes. That’s in a nutshell what we’ve tried to do in the three-plus years I’ve been here — try to be more systematic in the way we approach hedge fund selection and structuring a hedge fund program that makes sense from the investor’s point of view.
It makes the job difficult just from a sourcing perspective because we need a system to try to separate the wheat from the chaff. About the time I came in, we decided we needed to add a more quantitative, analytic piece to the qualitative, kick-the-tires approach and then also to more fundamentally reassess what exactly we want hedge funds to do for our portfolio. I think it’s been instructive for how we have decided which managers to keep, which managers to redeploy capital away from and which managers to hire.
The board decided to radically overhaul the pension’s hedge fund portfolio in 2011. What did the pension change, and why?
By the time of the financial crisis, there were probably five or six different fund-of-funds managers in the portfolio. In total, there were roughly 250 underlying hedge funds. And what you wound up with, and I think what the board realized, was mediocre returns. You effectively had an index replication, whether you realized it or not, but you retained that added level of fees.
Even then hedge funds were a pretty significant part of the portfolio — it wasn’t that much lower than where we’re at right now. In 2011, displeased with the results, the board made a determination to try doing direct hedge fund investing. So PRIM terminated four of the five funds of funds and kept one: Pacific Alternative Asset Management Co., out in California. PAAMCO’s specific mandate from us focuses on emerging managers because there was a belief even back then that there can be advantages to having exposure to some of these more under-the-radar, smaller, more nimble managers. And the board hired a consultant, Cliffwater, one of the well-known hedge fund consultants, which built the first direct hedge fund portfolio for PRIM.
What did the portfolio look like when you arrived at the end of 2012, and what changes did you make?
It was very much a down-the-fairway, predictable kind of portfolio, with very large, very blue-chip names in it. What we realized after I came in was that there was a lot of overlap in some of these large, megacap hedge funds by design, just because when you’re that large, there’s a limit; there are not that many different kinds of trades you can put into the portfolio.
Some of those worked out very well. I’ll give you an example — the Lehman Brothers liquidation. We probably had at least half a dozen, and probably closer to a dozen, of our hedge funds out of two dozen direct hedge funds that had exposure to that. Now, it turned out to be a phenomenal trade, so I’m not complaining about it. But these portfolios started to look very similar.
And certain things have not worked out. When the AbbVie–Shire merger broke, that turned out to be in a lot of the portfolios. That was not a good result because when the deal broke and the share prices fell, we got whacked in several different places. We had already known these kinds of issues were there, but it just hit home even further that we need more diversification within the hedge fund portfolio.
One thing you have talked about accomplishing with PRIM is being able to really negotiate fees. What prompted that change?
It’s very difficult to build a complete hedge fund portfolio paying 2-and-20 fees and have that really work for you over time. Just given the way the hedge fund industry has changed — I think hedge funds do a lot more hedging than they did prior to the financial crisis — the expected returns for hedge funds are lower than they were, but so is the risk. So that’s not a bad thing in itself, but when you do have a lower overall expected return structure, you can’t have the same kind of fee composition because the math just doesn’t work anymore.
I have a very firm belief that if we’re going to be a successful hedge fund investor, we’re going to need to be very aggressive in reducing fees. And as I tell managers, especially ones we’re negotiating with, if we’re not proactive about negotiating fees, somebody will be proactive with us in ultimately deciding we shouldn’t be invested in this asset class or in these strategies.
How have you accomplished getting better fee terms?
Just in the three years that I’ve been here, there has been a dramatic change in the willingness and understanding of managers recognizing that the needs of institutional investors, particularly large investors like PRIM, really need to be addressed through managed accounts. That’s really the mechanism by which we’re able to negotiate such significant fee savings. Now, not every manager agrees with it. And there are some managers that we’ve had to either part ways with or ultimately not wind up hiring because they just weren’t where we needed to be in terms of structuring the investment and where we needed to be in fees. But a lot of managers have, and that number is increasing. Three years ago there weren’t very many larger hedge funds that were really interested in having this kind of discussion. Now there are a lot more that are willing to have this discussion, including some who, frankly, I’m surprised that it’s changed that quickly.
Are fees becoming more fair industrywide?
In terms of me negotiating, having more and more institutional investors deciding to pull out or scale back their investments gives a lot of credibility to what we’re saying, [that] we’re not making this up. We’re saying this is something we really, really need to have in order to justify these investments.
CalPERS is pretty much old news now, but even more recently, between PFZW, AIG, MetLife, New York Common, New York City, New Jersey — these are big investors in hedge funds that are scaling back considerably. And you combine that with returns for the hedge fund industry that have been muted at best and mediocre to poor at worst — that really has an effect. Managers see people leaving, and that has an impact.
And then there are others like us, and some other institutional investors, pushing more aggressively on fees and saying we do want to have hedge fund strategies in our portfolios where appropriate, because we do think they can be additive. But the economics have to work for us.
One critique of managed accounts is that the best managers won’t agree to those terms because they don’t have to. Does it lead to a self-selection problem in terms of performance?
We’ve had this managed-account program in place for about a year and a half now, but it really took off over the past year. The returns of the managed-account managers, which I should also say tend to be smaller overall than the rest of the legacy commingled funds, were significantly better for the most recent fiscal year than the rest of the portfolio — and than the industry overall. Not infrequently, people will say, “Managed accounts are not going to work, because only crappy managers are going to want to do a managed account because the very best managers aren’t going to want to do it.” And if it’s a great manager who has $30 billion and is closed to new investment, okay, yeah, maybe. They’re probably not going to have much interest in doing it. But there are a lot of great managers out there that have $500 million in assets or $700 million in assets. They’re hungry to build their business and say: “I recognize that I’m making an investment here in myself. I’m attracting a large, meaningful investor, and that will help me with my own business development purposes, especially if I do a good job.”
We’ve been careful. I would like the managed-accounts program to be even bigger than it is today, but I think the biggest bottleneck, such that it is, is sourcing. You have to be really, really careful with who you’re hiring as managers. We do have to believe we can identify good managers. We think they’re out there, but you do have to search pretty thoroughly. And fortunately, we have a good adviser to help us with that.
How about transparency? Have managers become more willing to share information in recent years?
You hear institutional investors complain all the time: “We just don’t know what’s in the portfolio. The manager won’t even tell me what stocks he’s short.” It’s just not acceptable. You can’t really manage enterprise risk effectively that way. When we have the full transparency with the managed accounts, it’s hard to overstate the difference for us as an investor between being able to really dive down into individual positioning and see how exposures are changing — not just at the individual manager level but at the overall portfolio level — versus just getting a risk report from a manager, which doesn’t really conform to anything else you’re getting from a different manager, and crossing your fingers and hoping it all works out.
Some managers clearly get it and have increased the amount of transparency they provide. Others, not so much. Some of it’s just individual manager selection and how they feel about this kind of thing. Some are just more paranoid than others, I guess. They’re more scared about their positions potentially getting out than others. But other managers have said: “It’s your money. You’re entitled to know what’s in the portfolio.”
Do you think the balance of power, which has historically — and notoriously — favored managers, is finally shifting?
Yes. I do believe it’s starting to shift. I’ve seen it firsthand in each of the years that I’ve been here. You can attribute it to a number of factors. The overall level of industry returns has accelerated that process, in my view. It’s a double-edged sword. It’s good for the investors to have more power in the process. It’s not good the returns haven’t been that good.
But overall, the balance of power has been changing. Obviously, I would like it to be changing even faster than it is, but I think the progress is very encouraging. It’s good for the industry long-term, too. The managers in the thick of it may not get that part, but some of them are forward-thinking enough to recognize that if this is not going to be a shrinking industry, they’re going to have to be more responsive to investors. That means more fair on business terms, more fair on fees, greater transparency. Fortunately, there are more managers that are really getting that message. •
