| Photograph by Ye Rin Mok |
By Anastasia DondeMany sophisticated pension funds are now bypassing funds of funds and going straight into hedge funds, but the savvy San Bernardino County Employees’ Retirement Association is doing them one better. The $5 billion pension, which has already been investing directly in hedge funds for several years, is rethinking its entire portfolio structure when it comes to the firm’s alternative investments.
The pension first started investing in hedge funds in 2004 and now allocates more than 20% of its portfolio to hedge funds, with much of that money going directly into single-manager hedge funds. But the pension is also ahead of its peers in terms of how it approaches hedge fund investments as part of its overall portfolio. San Bernardino likes to disperse its hedge fund allocations throughout its portfolio to enhance returns in its equity or bond portfolios, rather than dumping all of its hedge fund investments, regardless of the strategy, into one portfolio. University endowments have been pursuing this investment model for years, but most pension funds still set a separate target to hedge fund investments.
“We don’t view hedge funds as a separate asset class. We view them as similar to any kind of legal structure,” says Tim Barrett, executive director and chief investment officer. “It’s just another option to put in the portfolio.”
San Bernardino has steadily increased the amount of money it allocates directly to hedge fund managers and decreased its investment in funds of funds, and the pension recently expanded its hedge fund roster even more. It added five long/short equity managers to enhance its global equity portfolio, and it also plans to hire emerging-market debt hedge fund managers next to spruce up its bond portfolio.
“The biggest drivers are greater transparency and information flow from the managers, as well as a better fee structure,” says Barrett of the pension’s decision to boost its direct investments. When it comes to hedge funds, “we are looking for alpha that we’re willing to pay for,” says investment officer James Perry, but he adds that San Bernardino tends to also negotiate fee structures that are slightly below the usual 2% and 20%. The pension fund still allocates 7% to what it calls absolute return managers—namely funds of funds or any hedge funds that don’t fit into another established allocation, Perry says.
San Bernardino’s recent long/short equity hires, for example, were chosen to enhance the global equity portfolio, which consists of long-only strategies, hedged equity strategies and volatility strategies. It selected Passport Capital, Tradewinds Investment Management, Clough Capital Partners, Castle Rock Partners and Select Equity Group to handle a $150 million long/short portfolio. These funds will fulfill the hedged equity portion of the global equity portfolio, which stands at about 22% of its $5.2 billion assets.
The pension began its search for long/short funds last year with the help of its consultant, NEPC. San Bernardino’s investment staff solicited pitches from hedge fund managers and received 55 responses, eventually trimming that list down to the five managers who were ultimately hired.
San Bernardino first selected Clough, Castle Rock and Select Equity in June and later asked the board for permission to hire more managers to better diversify the portfolio. In August the investment staff got permission from the pension’s board to invest in Tradewinds and Passport as well.
The firms were evaluated on various factors, Perry says, including relevant experience, track record and performance, fee structures, personnel and team, operations and compliance. San Bernardino’s investment staff and NEPC analyzed the managers based on those factors, and the five managers the pension picked scored highest, Perry says.
San Bernardino wanted managers with strong risk-adjusted performance. “We just felt they were the best of breed; their performance has been stellar, their risk management has been stellar and they can battle through a market cycle,” says Barrett of the funds that won the mandate.
He adds that the five were selected because they complemented each other well: “The strategies fit nicely with one another and are different. Some are more top-down; some are more bottom-up. They differ in how they approach the market, and there is more strategy diversification,” he says. “We have a pretty diversified long/short book.” All the long/short managers will handle separate accounts for San Bernardino.
The redesign of the pension’s long/short portfolio has been in the works since San Bernardino decided to revamp its global equity portfolio in 2008 by adding hedged equity and volatility strategies while also dumping active long-only managers. San Bernardino ultimately concluded that these managers weren’t earning their fees and began redeeming from them in 2008. The pension has since exited from Aronson+Johnson+Ortiz, Brandywine Global Investment Management, Independence Investments and Mazama Capital Management. Instead, San Bernardino is pursuing not just long/short equity hedge funds but also passive long-only strategies, Standard & Poor’s 500 futures and call options strategies that are meant to hold up during market volatility.
The pension is also looking to tweak its emerging-market debt portfolio by adding hedge funds. It recently raised its target allocation to emerging-market debt to 6% from 4%. San Bernardino already has an emerging-market debt allocation within its bond portfolio, but so far it only consists of long-only exposure, to emerging markets manager Ashmore Investment Management.
“We are looking to complement that exposure with a distressed debt manager and an opportunistic long/short manager,” says Barrett, noting that Ashmore manages both sovereign and local currency portfolios for San Bernardino. Perry expects to place about $60 million with emerging-market debt hedge fund managers and will start searching for managers toward the end of the year.
For the past two years, San Bernardino has limited most of its hedge fund activity to the bond sector, hiring several opportunistic, credit, distressed and relative-value hedge funds to take advantage of the market dislocation during that time. Some of the hedge funds in this portfolio include GoldenTree Asset Management, Stone Tower Capital, Alcentra, Ares Capital, Beach Point Capital Management, Cairn Capital, Declaration Management & Research, Marathon Asset Management and ZAIS Group.
“During the fourth quarter of 2008 and the first quarter of 2009, we recognized the relative value of the credit markets and added significantly to our credit exposure in both direct corporate and structured credit opportunities,” Barrett says.
San Bernardino hasn’t funded the long/short managers it selected yet, so it remains to be seen how these will help pump up returns in the equity portfolio. But the investment staff at San Bernardino hopes that hedge funds will be able to outperform in the long haul. “We were looking to establish a portfolio that we expect to beat the global equity markets over a market cycle,” says Perry.
