In defense of hedge funds: why NYCERS should reconsider

In defense of hedge funds: why NYCERS should reconsider

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Last month, we heard that the New York City civil employees scheme, NYCERS, will pull its entire $1.5bn hedge fund portfolio. Pension funds should always be managed in the best interest of the plan’s beneficiaries. I believe this blanket decision to eliminate a full set of investment opportunities contradicts this rule.

It should cause concern that a consultant to the fund states they can reach their targeted investment returns with less risky funds. One of the main benefits hedge funds provide to institutional investors is to reduce the risk in their portfolios. Hedge fund indices historically have had significantly less volatility than the equity markets. In addition, many hedge fund strategies have very low correlation to long only benchmarks, which helps reduce the overall volatility of a portfolio through diversification.

Most pension funds have an actuarial rate of return assumption of 7% to 8%. This is a very difficult return target to achieve using only traditional fixed income and equity investments. On the fixed income side, the US 10-year treasury is yielding less than 2% and fixed income securities will lose value if interest rates rise. On the equity side, stock valuations are above their historical averages with a back drop of tepid global economic growth, and little dry powder left for monetary stimulus by central banks. Many pension funds currently have 60% to 70% of their asset in equities. Is it prudent to increase that allocation?

It is true that the hedge fund indices have performed poorly over the past few years, but that does not mean that all hedge funds are bad. Remember, the vast majority of long only mutual funds underperform their market benchmarks. With 15,000 funds, the industry is crowded with significant numbers of poor performers, damaging overall performance.

Hedge funds are not an asset class, but a fund structure incorporating many different strategies. Each of these strategies should be viewed independently and evaluated on its merits. It is important that a pension fund’s investment staff be highly qualified to identify strategies and managers that can add value to their portfolio. Many large institutions have built hedge fund portfolios comprising of the largest and most well-known managers, which is probably not the best strategy to maximize risk adjusted returns.

Asset allocation and manager selection decisions should always be made in pursuit of enhancing the risk-adjusted return of the total portfolio, with politics and personal prejudices excluded. It’s a surprise to hear sources associated with NYCERS demand, “let them sell their summer homes and jets, and return those fees to their investors”: not only because most hedge fund managers have neither. The publicly-minded pension fund should also remember that New York City benefits significantly from the hedge fund industry, which is a huge contributor to its tax base. Additionally, hedge fund managers are major donors to a broad array of non-profit organizations that support the city.

The Hamptons, Long Island: No hedge fund managers here
The Hamptons, Long Island: No hedge fund managers here (Credit: Ralph CC)

Some of the media are using this story as evidence that institutional investors are giving up on hedge funds. They often mention CALPERS that exited hedge funds around a year and a half ago. What they don’t mention are the many investors who have been increasing their allocation to hedge funds. Just this month Financial News reported that US insurers plan to expand investments in hedge funds, the Financial Times reported Finland’s State Pension is increasing their hedge fund investments by $500 million, and Pension and Investments reported that Illinois SURS is investing $495 million in hedge funds.

In summary, NYCERS should terminate all managers they believe will not generate strong risk adjusted returns after fees, but this should be done on a manager-by-manager basis and not simply by how they are categorized in their portfolio. The hedge fund industry is made up of a broad array of strategies and many of these can enhance the risk adjusted return of a pension fund’s portfolio after fees. In this challenging investment environment, on behalf of the NYCERS beneficiaries they serve, the board should be using every opportunity to create the best possible investment portfolio.

At GAIM 2016, we give you the alternatives rundown by asset class on Tuesday 21st June at 8:10 – 9:00 am. It’s not too late to join us in Amsterdam. Can’t make it? Join us here on GAIM Live or on Twitter.

Don A. Steinbrugge
Don is the Founder and Managing Partner of Agecroft Partners, a global hedge fund consulting and marketing firm. Agecroft Partners has won 23 industry awards and is in contact with over two thousand hedge fund investors on a monthly basis and devotes a significant amount of time performing due diligence on hedge fund managers. He has 29 years of experience in the investment management industry. Don was a founding principal of Andor Capital Management, which was formed when he and a number of his associates spun out of Pequot Capital Management. Previous to Pequot, Don was a Managing Director and Head of Institutional Sales for Merrill Lynch Investment Managers (now part of BlackRock).

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