Fresh from attending the annual convocation of the California State Association of County Retirement Systems, Tom Ford, a 32-year veteran pension fund administrator, concluded in November that consultants were about to discover what he had long suspected: that the subjects of many of the supposedly educational meetings they ran for pension fund administrators were not all that well understood. And if fund officials were just then learning what they should have known much earlier, it probably didn’t speak well of their consultants.
“A lot of trustees in a lot of systems are finding out they don’t have the appetite for the amount of risk their portfolios took on, such as hedge funds,” says Ford, the interim retirement administrator of the $1.4 billion Santa Barbara County Employees’ Retirement System. “There’s a good possibility there will be some consultant changes when all this is done.”
Pension fund officials across the U.S., in fact, are reeling from double-digit hits to their investment portfolios. Public plans alone have lost $1 trillion since October 2007, reducing total assets by nearly a third, to $2.3 trillion, according to the National Association of State Retirement Administrators. The defined benefit plans of the 1,500 biggest U.S. corporations saw $340 billion in assets vaporize during the first 11 months of 2008, according to New York–based consulting firm Mercer. Add to such losses the fact that the remainder of many portfolios are packed with illiquid assets — private equity, real estate, timber and hedge funds — and it’s no wonder that many plan sponsors are struggling to make monthly payments to retirees.
Consultants, who play a huge role in the investment process of pension funds and other institutional investors, clearly deserve some of the blame. It’s an uncomfortable spot because they are faced now with having to scrutinize and reconsider the very portfolio allocations that they helped construct and that have not delivered as promised. Among the many crumbling investments recommended by consultants are hedge funds, most of which are now underwater, as well as complex strategies like portable alpha, which can pay off in up markets but can be devastating to portfolios in down ones.
The market events of the past few months — the seizing up of credit, the crash in stock values, the relentless volatility — have humbled consultants and their clients alike. And yet most of the relationships seem intact, as fund managers and consultants hunker down together to weather the storm.
“We are in daily contact now,” says Ford, referring to his investment adviser, Neil Rue of Pension Consulting Alliance in Portland, Oregon. Ford used to be satisfied with a weekly phone chat or a couple of e-mails from Rue, but that’s all changed. Because Ford is juggling the demands of a tumultuous market, a sinking pension fund and its worried members and trustees, he relies more than ever on Rue for market intelligence that he can use in letters to constituents.
“We’re looking for positive things to say,” says Ford, whose once-$1.9 billion fund dropped $100 million in October alone. “The steady hand of the consultant keeps people from making moves they’ll regret later. A lot of us look for consultants to bless what we do.”
Faced with sinking assets amid forecasts of a prolonged recession, institutional investors are leaning more than ever on investment consultants, historically hired to pick and choose asset managers, measure fund performance and help craft asset allocation and investment policy. They also depend on consultants for portfolio reviews, database research and trustee education sessions. And ever since the bottom fell out of the market in September, consultants have worked unusually long hours advising and even consoling clients who have seen assets tumble, taking with them many of the hopes and dreams of retirees, college administrators and foundation beneficiaries.
“We’re earning our money right now,” says Michael Rosen, chief investment officer of Angeles Investment Advisors in Santa Monica, California. Rosen adds that many of his clients call every day now, asking, “How much time do I have before the world ends?”
If the reputation of consultants has taken a hit amid the turmoil, so has that of hedge funds. Some consultants, like Rosen and Lee Giovannetti, founder and head of Memphis-based Consulting Services Group, see an end to the hype of hedge funds as a portfolio panacea.
“The sense that they’re universal money machines has been damaged,” agrees Terry Dennison, the Washington, D.C.–based U.S. director of consulting for Mercer.
There are dissenters, to be sure. Kevin Lynch, head of hedge fund research at Rogerscasey in Darien, Connecticut, and Jim Vos, CEO and head of research of Aksia, a hedge fund specialty consultant in New York, are more optimistic. They argue that the double-digit losses of most hedge funds still look a lot better than the 40 percent-plus losses in equity portfolios. “There will be enormous opportunities at the end of this,” says Lynch, who was director of absolute-return strategies for the $40 billion Verizon Investment Managing Corp. pension plan before he left to join Rogerscasey in 2006.
Investment officers are shaken by what has happened. Alan Van Noord, CIO of the $62 billion Pennsylvania Public School Employees’ Retirement System in Harrisburg, is charged with seeing that $300 million in benefit payments goes smoothly out the door every month to retired teachers and their beneficiaries. The fund has an expected annual return of 8.5 percent, a tad higher than the average of 7 to 8 percent at many pension funds, and is down 11 percent for the nine months through September and almost 17 percent over 12 months. “At times like this there’s definitely a lot of hand-holding,” says Van Noord. “You commiserate with your consultant over what’s going on.”
Two blocks from Van Noord’s office, the $27 billion Pennsylvania State Employees’ Retirement System is down 14 percent through September, with more damage expected by year-end. Both Pennsylvania funds have taken big hits in their pursuit of portable alpha, a derivatives-based strategy that typically seeks to marry hedge fund returns to those of a market index, and PennSERS has begun incrementally unwinding theirs (see sidebar story, An Alpha Bet Gone Bad). The median performance was down 13.79 percent for all master trusts for the 12 months ended September 30, 2008, according to the Wilshire Trust Universe Comparison Service. Corporate pension plans were down 15.44 percent for the same time period; public funds fell 14.43 percent. Foundations and endowments had an equally dismal 14.88 percent loss. As bleak as these numbers are, returns for October and November — still being tallied — will probably be even uglier.
Hedge funds have done poorly too. The HFRI fund-weighted composite index was down 17.7 percent through November, according to Chicago-based Hedge Fund Research; industry assets dropped to $1.56 trillion from a record $2 trillion in 2007. Some of the biggest hedge funds have done even worse. Chicago-based Citadel Investment Group plunged 47 percent for the calender year through November, and Maverick Capital in New York was off 27 percent. Although some institutions continue to hang tough, leaving their hedge fund assets in place, skittish high-net-worth investors are pulling the plug on their hedge fund and fund-of-funds investments, accounting for much of the recent outflows, consultants say. Some report that many institutional clients are bailing out of hedge funds, however, not so much for performance disappointment but to access precious liquidity. “Even funds with good returns are being used like ATMs,” Lynch says.
Yet even as they advise clients to stick it out, consultants are examining hedge funds more closely than before, in part to suss out which firms are likely to stay in business and work their way back to high-water marks. Almost every consultant agrees that things are going to get tougher for fund managers. “There will be thousands that go away because thousands were created in very easy conditions,” says Rosen, recalling the halcyon days of only a couple of years ago, when credit and prime brokerage relationships were easily had. “That’s gone and doesn’t come back.”
What also may be gone is the job security that investment consultants may have taken for granted, though institutional investors have rarely replaced their consultants, in part because the process of hiring them is so painstaking. In 2006 the San Diego County Employees Retirement Association terminated Norwalk, Connecticut–based Rocaton Investment Advisors after one of the hedge funds Rocaton had recommended, Amaranth Advisors, lost $6 bil-
lion in an ill-conceived energy trade. (Known for promoting investments in hedge funds, Rocaton still counts International Paper Co., based in Memphis, Tennessee, and PennSERS among its disciples.) The San Diego fund is now advised by London-based Albourne Partners and Ennis Knupp & Associates in Chicago.
One of the biggest issues that investors and their consultants must tackle now is illiquidity. At the Pennsylvania school retirement fund, for instance, which has about 40 percent of its assets in illiquid holdings — either portable alpha funds (9 percent), private equity (19 percent) or real estate (13 percent) — “Liquidity is job No. 1,” CIO Van Noord says. With $4.7 billion a year needed to pay retiree benefits, the fund will likely have to raise cash by liquidating active equity and fixed-income portfolios. “You really don’t know how much liquidity you need until you don’t have access to it,” Van Noord notes.
Gregory Curtis, chairman of Greycourt & Co., a Pittsburgh-based consulting firm, says that some consultants advised clients to beef up in extremely illiquid areas — private equity, timber and real estate holdings — to mimic the endowment portfolios run by Harvard and Yale universities. Curtis, who sits on the investment committees of four endowments, including those of Carnegie Mellon University in Pittsburgh and St. John’s College in New Mexico, says many university endowments “are tremendously underallocated in liquid-asset classes.” In the second quarter of 2007, Curtis began shifting his own endowment clients into even more liquid assets. But although most colleges and universities can withstand a major market downturn by cutting back on spending for facility improvements or academic programs, retired teachers and auto workers have no such buffer.
To free up cash, some fund officials are even trying to sell private equity and hedge fund stakes on the secondary market, where investors can sell their shares. Steve Nesbitt, head of hedge fund consulting firm Cliffwater in Santa Monica, California, says these investments spell potential bargains for hedge-fund-hungry investors previously shut out of closed funds run by top-tier managers like Greenlight Capital and Lone Pine Capital. Along with the secondary-market discount comes a big potential savings for buyers who can avoid paying performance fees until after the fund hits its original high-water mark.
But Giovannetti, the Memphis consultant, says he will steer clear. “I wouldn’t buy a position in Citadel or Maverick in the secondary markets just because it appears you are buying it at a discount,” he says. “At the end of the day, what is that fund going to do to manage their business? Managing your business and managing your clients’ capital can’t always be complementary to each other.”
The endowment at Malibu, California’s Pepperdine University, a client of Boston-based Cambridge Associates, relies on Cambridge to help manage its alternative-investment mandate for hedge funds and private equity. But Pepperdine CIO Jeff Pippin says he brings investment ideas to the Pepperdine investment committee himself. “We’re trying to stay close to our managers,” says Pippin. The endowment’s $700 million portfolio has a 17 percent allotment to five hedge funds of funds. Pippin, who declines identifying which funds Pepperdine holds, says that although the endowment was down 20 percent for the year through October, its hedge fund allocation was off only about 11 percent. For the ten-year period through the end of October, the Pepperdine portfolio earned a compounded 6.50 percent a year, about 2.25 percent better than its goal — proof to Pippin that over the long term, Pepperdine’s strategy is working.
Consultants in general are adopting a better-informed view and keeping a much more skeptical eye on hedge funds. Rogerscasey’s Lynch is regularly visiting these funds now to determine managers’ motivation and whether they plan to remain in business. He reports wide use of gates to halt redemptions and has just lowered his firm’s ratings on several multistrategy managers who have lost more than half their assets and staff.
Angeles CIO Rosen is highly critical of hedge fund managers who close shop in a bad market. “Investors never have a chance to make back their money,” he says, and as part of his due diligence he tries to measure certain intangibles: “We try to understand the character of the people we are investing with.”
David Gold, a hedge fund research consultant in Watson Wyatt Worldwide’s New York office, is studying how hedge fund managers compensate themselves, given that many hedge funds will now have to make do without performance fees for at least the next year.
Across the board, consultants insist that the pressure on the hedge fund industry will ultimately result in better terms for their clients. Gold is talking to managers about renegotiating fees and conditions, for instance. Some managers, like Camulos Capital, have already done so. The credit-strategy firm in Stamford, Connecticut, cut its management fee to 1.25 percent from 2 percent and its performance fee in half, to 10 percent, in exchange for locking up investors’ money through September 2009.
Although institutional investors for the most part are sticking with their managers for now, little new money is being allocated to hedge funds. But Peter Keliuotis, a consultant with Strategic Investment Solutions in San Francisco who points out that investors who got into distressed funds 18 months ago now regret it, says that investing steadily in hedge funds rather than diving in all at once may be the ticket. Had distressed-funds investors waited and averaged in over time, they would be better able to take advantage of today’s opportunities.
A basic belief in the utility of hedge funds seems still very much alive at many pensions, endowments and foundations — and among consultants. “Some of our clients should be building up exposure to macro and commodity trading advisers. They always do well in a crisis,” explains Aksia CEO Vos, who says he also favors long-short equity for its simplicity.
Ford, the Santa Barbara retirement fund manager, reports that, as of September 30, the total fund was down 17.4 percent on the year, but the return on its hedge fund portfolio was up 3.9 percent, hardly an indication to bail. And at Pepperdine, Pippin stands unequivocally by hedge funds. “Our hedge funds have done what we’ve asked them to do.”
Consultants say stories like these prove that their services have value, and some argue that it has only grown as hedge funds have faltered. “When any idiot could throw money at hedge funds and be up 15 percent,” Rosen says, “my services weren’t needed.”
Today, he argues, they are.
