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| John Tuck and Craig Husting: We’re not resistant to terminating managers and moving on |
Many large public pensions are just starting to make their first investments in hedge funds, but the managers of Missouri’s pension for public school employees have been at it for six years—and they’ve been ramping up their exposure even more in the past year. The $30 billion Public School and Education Employee Retirement Systems of Missouri hired six new hedge fund managers in 2010, and the pension has now invested some $4.3 billion, or 14% of its assets, in hedge funds.
It has another $1.6 billion invested in a portable alpha strategy, which also uses hedge funds. The pension is now close to meeting the 15% limit that its board has set on hedge fund investments, but the plan’s investment officers are continuing to look for lucrative strategies to better diversify a hedge fund portfolio that they say has already performed well.
“We’ve worked very hard to develop a diversified program that has a lot of the aspects that we want, and we’ll continue to grow the program with additional exposure to Asia,” says John Tuck, the pension’s director of absolute return and private equity investments. Missouri’s hedge fund portfolio runs the gamut of strategies, including equity long/short, relative value, global macro, distressed credit, event driven and convertible arbitrage, among others. The portfolio returned 7.85% for the three years ending July 31, while the Standard & Poor’s 500 gained only 2.92% in the same time period.
Now that the pension’s hedge fund portfolio is fairly well diversified across strategies, the investment staff is interested in pursuing investments in the emerging markets and Asia.
“Going forward, what Asia and the emerging markets have to offer will be more attractive than the U.S. and Europe,” says Tuck.
Tuck doesn’t expect returns in these areas to always be good, but he thinks the sector will help to diversify the portfolio even more. “It will provide different timing for investment opportunities. We like it as another good form of diversification,” he says.
One reason the pension is interested in Asia right now is because it lost some of its exposure when Highbridge Capital Management decided to liquidate its Asia Opportunities Fund after its portfolio manager, Carl Huttenlocher, left the firm in March. The Missouri plan had about 4.5% of its overall hedge fund portfolio invested in Highbridge’s fund.
The investment staff spent last year scouring the globe for new opportunities and allocating to several new managers. The pension last year invested in Carlson Capital’s Double Black Diamond fund, Bridgewater Associates’ Pure Alpha Major Markets fund, Och-Ziff Capital Management’s Asia fund, the Pershing Square International fund, Owl Creek Asset Management, and AQR Capital Management’s Real Asset Fund, which is a customized strategy AQR is running for Missouri.
When selecting managers, the pension’s investment officers say they look for the likelihood of repeatable success first and foremost. “We like to focus on managers that have a long history of being successful, and we look for the quality and stability of the organization to signify that success can be repeated,” says Tuck. Low personnel turnover is a plus, he adds. “It’s a people business,” Tuck says.
Alhough the pension’s investment staff has only a couple of people dedicated to hedge fund manager research, Tuck says the investment officers like to do the bulk of the due diligence work on their own.
“We like to do the deep dive ourselves and meet with the managers two to three times in their offices,” he explains. Tuck says that even though extensive due diligence slows down the implementation process at times, he wants to get completely comfortable with a manager before committing to an investment.
This will often entail meeting with key decision makers several times, going over marketing materials and long-term performance history, spending a lot of time at the manager’s offices and involving the pension’s consultant, Albourne Partners, in operational and back-office due diligence.
Albourne also helps the Missouri plan with initial manager research and whittling down potential candidates. Tuck says the staff at Missouri is too small to ever get to know all the institutional-quality hedge funds out there, so the plan uses Albourne’s research to find the most suitable managers for the pension’s needs.
So far, the pension’s meticulous due diligence process has paid off. Missouri Public Schools has avoided all the recent hedge fund frauds and blowups and didn’t have exposure to any of the FBI-raided managers or those investigated for insider trading. Tuck says the pension also hasn’t had to replace any managers, except for the Highbridge fund that closed.
“We’re not resistant to terminating managers and moving on,” Tuck says, but so far nothing particularly troubling, such as the departures of key decision makers or chronic underperformance, has happened at any of the system’s hedge funds. Tuck says that “short-term disappointments in performance where the reasons are well communicated by the manager” wouldn’t be a reason for termination.
Craig Husting, the plan’s chief investment officer, says the pension takes a longer-term view of performance. “We have been happy with the way the portfolio has looked in its entirety,” he says.
Although individual manager performance might disappoint at times, diversification across strategies helps the portfolio outperform in the long run, Husting says. For the one-year period ending July 31, the hedge fund portfolio is slightly underperforming the S&P 500, having returned 17.49% versus 19.65% for the S&P 500. But for the three-year period, the hedge funds are beating the index by nearly five percentage points.
Even though the Missouri plan hasn’t had any exposure to individual fund blowups, “We do tell the board that at some point we will have a blowup,” Husting says. “It’s just inevitable, given what we do. But we try to do everything we can to avoid it.”
The Missouri plan has avoided getting burned on portable alpha, another well-known investment pothole that tripped up many pensions in 2008. Although the pension has been investing in a portable alpha strategy for several years, Missouri set up its portfolio in such a way that it didn’t lose that much money in 2008, and the portfolio is still delivering impressive performance in the long run.
The portable alpha portfolio uses swaps and futures on the S&P 500 for market exposure and uses hedge funds to generate excess returns. The Japan strategy of AQR, Carlson, Och-Ziff and Analytic Investors, among others, comprises the hedge fund component. The portfolio has about 20% set aside in cash at any given time so it can pay margin calls on the derivatives if the equity index takes a dive. During the 2008–2009 market crisis, the investment staff also significantly scaled back its derivatives exposure.
“After the negative market return in June 2008, the investment staff elected to decrease the equity derivatives level of the portfolio from 90% to approximately 70% as suspicion of a larger problem loomed,” Husting says. Staff kept decreasing this exposure to a low of 58% through December 2008. “The decisions proved astute as the decline of the financial markets in the fall of 2008 sent shock waves through the market,” Husting says.
While many other pension plans were forced to exit overlay strategies during the crisis, Missouri managed through the turbulence more skillfully and was later able to participate in the recovery by raising its derivatives exposure back to normal levels in March 2009, thereby beating the S&P 500 for both that year and the next. In 2008, the portable alpha program underperformed the S&P 500 by only 220 basis points.
“I think that’s really the difference between the programs that survived and the programs that didn’t,” Husting says. AR
