| Steven Grossman: Our approach in virtually every other asset class is to meet managers one-on-one |
Senior executives at the Massachusetts state pension for public workers have a message for hedge fund managers: They want to meet you face-to-face. The $48.3 billion Pension Reserves Investment Management board has invested in hedge fund managers through funds of funds for years, but the people who run the pension say that accessing these managers through intermediaries is no longer close enough for comfort.
“Our approach in virtually every other asset class is to meet the managers one-on-one,” says Massachusetts’ state treasurer, Steven Grossman, who is also chairman of the pension’s board. “In our private equity bucket, we have 93 managers, and we have a team that knows each one of those managers.” In contrast, Grossman says the pension’s investment staffers have never met most of the 200 hedge funds that are ultimately managing the pension’s money, because its entire 8% allocation to hedge funds is invested via funds of funds.
That’s about to change. MassPRIM is kicking off a $500 million pilot program for direct investment into hedge funds and is in the process of selecting a consultant to help it choose managers for the program.
The pension’s desire to meet managers face-to-face took on new significance in November, when MassPRIM’s managers found the pension mentioned in news stories about Diamondback Capital Management and Level Global Investors, two of the hedge funds that were raided by the Federal Bureau of Investigation as part of a broad government probe into insider trading activities. MassPRIM had a $12 million investment in Diamondback via its funds-of-funds investments. (The pension also had $48 million invested in Level Global through various funds-of-funds investments.) Although the Diamondback investment was tiny by MassPRIM standards and Diamondback was never charged with any wrongdoing, the headlines were still unsettling to the pension’s staff and reinforced the message that it was time to get to know the people who were managing their money.
“What are we doing with a $12 million position in a hedge fund that got raided and we’ve never met them?” asks Michael Trotsky, MassPRIM’s executive director. Trotsky notes that such small positions probably wouldn’t be significant enough to move the needle in terms of performance, but they could present a big risk if the hedge funds turn out to be tainted in any way. For example, MassPRIM had a $12 million position in Bernie Madoff’s Ponzi scheme via a fund of funds investment that the pension has since terminated.
The press coverage also reinforced Grossman’s view that funds of funds are not foolproof when it comes to protecting clients from headline risk. But that risk is not the only reason MassPRIM is looking to go direct, according to Grossman and Trotsky. Disappointing performance, complex fee structures and due diligence problems have also caused them to take a harder look at funds of funds.
For a start, the pension staff’s internal evaluation of direct hedge fund investment revealed that MassPRIM could save $30 million on fees if it went direct. Performance was another issue: Several of the funds of funds in which MassPRIM is invested have failed to beat the pension’s custom benchmark for that portfolio (the benchmark consists of a weighted average of the underlying strategies in MassPRIM’s hedge fund portfolio). The five funds of funds that comprise MassPRIM’s hedge fund portfolio returned just 6.3% last year on average, compared with 13.6% for MassPRIM’s overall return and 9.15% for the AR Composite Index. For the past three years, the funds-of-funds portfolio lost 1.1%, net of fees, compared with the custom benchmark, which returned 4.9%.
MassPRIM also wants access to top-tier hedge fund managers, and some do not work with funds of funds. Trotsky is also worried that with exposure to some 200 managers across the various funds of funds it’s invested in, the plan might have too much overlap in terms of strategies and too much diversification in its hedge fund portfolio. Still, Grossman and Trotsky say they are not planning to dump their funds-of-funds managers altogether. For now, they’ll be redeeming from them as needed to free up cash for new hedge fund investments.
This isn’t the first time MassPRIM has set out to restructure its hedge fund allocation. Two years ago, the pension axed its portable alpha program because of poor performance. The strategy lost 18.62% on an annualized basis since inception in August 2006 through June 30, 2009.
In the summer of 2009, the pension started unwinding the derivatives overlay portion of the program and decided to retain some of the funds of funds in the portfolio as stand-alone investments. MassPRIM terminated several funds of funds at the time. The remaining funds-of-funds managers in the pension’s portfolio are Pacific Alternative Asset Management, Grosvenor Capital Management, K2 Advisors, the Rock Creek Group and Arden Asset Management.
Most of these managers were invested in Diamondback and Level Global before the FBI raids in November. Arden is redeeming its position in Diamondback, while K2, Grosvenor and Rock Creek are also getting their money back from Level Global, which announced in February that it would shut down. (Level Global was never charged with any wrongdoing, but founder David Ganek told investors in the $4 billion firm that mounting redemption requests meant he would no longer be able to operate the firm in the way he saw fit.)
“We’re not going in this direction as a direct result of those events,” says Grossman. And he acknowledges that the plan won’t necessarily avoid headline risk on its own. “I’m not suggesting that because we’d be in a direct program, we could somehow exercise superior due diligence and be able to avoid all of the headline risk all of the time. I don’t think that’s realistic.”
But the pension wants to try its hand anyway, though it is initially taking baby steps. MassPRIM plans to select a hedge fund consultant by April and will then work on devising an investment strategy for the pilot program with the adviser. Grossman expects to start hiring hedge funds by the fourth quarter, and the consultant will assist with choosing managers and conducting due diligence.
Trotsky, who joined the pension’s board in August, expects to have a heavy hand in manager selection and due diligence, given his previous experience managing money at two Boston hedge funds. He spent five years as a portfolio manager at PAR Capital Management, a $1.5 billion long/short fund, and also spent five years as a senior technology analyst at Greenberg-Summit Partners, another long/short fund with more than $1 billion. At MassPRIM, he replaced Michael Travaglini, who went to work for one of the pension’s funds of funds managers—Grosvenor—as a managing director in its client service group.
Trotsky is also concerned about investing in managers the staff has never met and is keen to do on-site visits himself. “My personal feeling is that I don’t want to invest my money unless I meet and greet and kick the tires on the manager, and I feel the same way about the pension’s money,” he says.
For now, the staff at MassPRIM plans to evaluate the success of its initial foray into direct investing before moving any further into direct investments. “I’m not suggesting that funds of funds don’t provide a valuable service,” says Grossman. “But when the performance has been somewhat disappointing and some of those other factors are taken into account, moving further in that direction as time goes on seems to make sense to us.”
