| Larry Schloss: The purpose of having hedge funds is to mitigate the volatility of the fund |
When John Liu was elected comptroller of New York City in November 2009, he kicked off a plan to overhaul the city’s public pension system, bringing in a whole new investment staff and some new trustees. That makeover also included retooling how the city’s pension funds planned to invest in hedge funds. After more than a year of discussion—and a little bit of controversy along the way—the new plans are finally starting to come to fruition. Three of the five New York City pension funds have hired Permal Asset Management to run a customized fund of funds, and they are also working on a new asset allocation study, which will include new targets to hedge funds and other asset classes. Larry Schloss, deputy comptroller for pensions and chief investment officer since January last year, is working with the consultants and boards of all five pensions for the study, and he expects to have the results in August.
“The purpose of having hedge funds is to mitigate the volatility of the fund,” says Schloss. The pensions had 70% of their assets in equities in 2008. Heavy losses in those holdings sent assets plummeting to $77 billion from $115 billion. “We were 100% long only, and we want to counterbalance that,” Schloss says. The five pensions are now back to managing $118 billion in assets.
The previous plan, engineered by former comptroller Bill Thompson and his investment staff, never got off the ground. The administration got side-tracked by the financial crisis, the so-called pay-to-play scandal and the election of a new comptroller. Although the New York City systems weren’t directly involved in the scandal (in which former New York state comptroller Alan Hevesi and another pension official pleaded guilty to ordering investment firms to pay kickbacks to a placement agent in exchange for an investment from the state pension), the New York City pensions still had to take a hard look at their arrangements with third party marketers. And with Thompson losing the New York City mayoral election, his staff—and the plans they were working on—were also out.
The pension funds for New York City employees, police and firefighters originally planned to invest 3% to 5% of their assets in hedge funds and had conducted research using their existing consultants, but no managers were ever hired. Schloss has since scrapped those targets. He is not sure yet how much the pensions will invest in hedge funds, but now that they’ve hired the only fund of funds they plan to use, he intends to go directly into single-manager hedge funds from now on.
The selection of Permal as the sole fund-of-funds manager wasn’t a completely smooth process, however. Blackstone Alternative Asset Management was also slated to receive a portion of the pensions’ assets for a hedge fund investment, but the staff reportedly squashed this plan after Byron Wien, the vice chairman of Blackstone Advisory Partners, said that public employee benefits were “too generous.” Following the flap, the comptroller’s office reportedly canceled meetings with other Blackstone’s asset management divisions.
Having originally planned to hire two funds of funds, the New York City staff later interviewed four other hopefuls after Blackstone was scrapped from the short list: EnTrust Capital, GAM, Grosvenor Capital Management and Mesirow Advanced Strategies. But the pensions ultimately decided to give all the money to Permal. (Schloss declined to comment on the selection process.)
Schloss and the investment staff at New York City wanted to start out by hiring a fund of funds to get quick diversified exposure to several strategies. Permal will run a customized portfolio for the New York City funds. “We’re working with Permal on which managers should go into the portfolio and constructing it to meet the goals of New York City,” says Seema Hingorani, director of public equities and hedge funds, who is overseeing the bulk of hedge fund manager research and selection.
Schloss and Hingorani say Permal was best suited for New York City’s investment objectives. The Employees, Police and Fire funds are investing a total of $450 million with Permal and will look to build their single-manager hedge fund portfolios around that. (The five New York City funds are governed by different boards, but the same investment staff oversees them. The pensions often pursue investment strategies in tandem and hire the same managers, pending separate board approval.)
Permal’s portfolios for the pensions will zero in on some of the strategies and managers that the New York City funds want to start with. Hingorani says that as the pensions get comfortable with hedge funds, they might decide to unwind the fund-of-funds portfolio to some extent. “As we move forward we would maybe even go direct into some of the underlying managers in the Permal portfolio, as we get to understand their strategy better,” she explains.
Permal will be handling $250 million for the $39.6 billion New York City Employees’ Retirement System, $150 million for the $23.1 billion New York City Police Pension Fund and $50 million for the $7.6 billion New York City Fire Department Pension Fund. The other two pension funds—the Teachers’ Retirement System of the City of New York and the New York City Board of Education Retirement System—had never established allocations to hedge funds to begin with, so Schloss is waiting for the results of the asset study to determine whether and how much these two systems should invest in hedge funds. The investment staff of the New York City pensions has already been meeting with hedge fund managers, and Hingorani says she is particularly interested in global macro, relative value, long/short equity and credit strategies right now.
“We’re talking to some large established managers in the U.S. and looking at European and Asian funds as well,” she says. As with the vetting process with traditional managers, the investment staff will focus on a hedge fund’s research process, long-term track record, stability and longevity of the organization, and the risk-return profile over time. “We’d also want to know how they are set up structurally in terms of analysts and portfolio managers and where they’re located,” Hingorani says.
Although the New York City pensions haven’t established targets for the hedge fund allocations yet, they are already fully staffed and ready to select managers when the time comes. The pensions tapped consulting firm Aksia in December to assist with hedge fund selection. They also recently hired Neil Messing as a senior investment officer to work specifically on manager research. He previously worked as manager of research at Unigestion (U.S.) Ltd., the American subsidiary of Geneva’s asset management company Unigestion.
Messing reports to Hingorani, who has worked in stock research at equity manager Pyramis Global Advisors and was a portfolio manager at the previous incarnation of technology hedge fund Andor Capital Management. She also co-founded a long/short equity fund, Mirador Capital Management, in 2004. Schloss, who came on board last year from private equity firm Diamond Castle Holdings, where he was co-founder and chief executive, will also be working on hedge fund research.
When looking at managers, Hingorani says that the most important thing is that their risk/return profiles match what the pensions are trying to accomplish via their hedge fund programs. “One of the goals of our program is to reduce the volatility and reduce correlation [to traditional asset classes], so we’ve been talking to managers that fit that profile,” she says.
In addition to hedge funds, the New York City pensions invest in private equity and real estate strategies to better diversify the portfolio. The five systems target about 6% to private equity, on average, and have about the same amount already invested. In real estate, “We have about $3 billion in the ground and $2 billion that we have yet to commit,” Schloss says. The target to real estate is set at 5%.
Schloss is not yet sure how the targets to different strategies might change after the asset study, but he says the pensions are already looking at ways to spruce up their traditional bond portfolios.
“We’re looking at some interesting fixed-income strategies,” Schloss says, explaining that in addition to investment-grade bonds, the pensions invest only in a high-yield strategy so far. “We’re looking for ways that we can be more opportunistic and flexible and take advantage of the market dislocation.” AR
