Public pensions stick with hedge funds despite frustrations

By Lawrence Delevingne and Svea Herbst-Bayliss

NEW YORK (Reuters) - At quick glance, public pensions should be running from hedge funds.

The secretive investment firms famous for their market-beating returns — and high fees to match — have recently produced losses or meager profits far below expectations. And thanks to a steady stream of bad publicity, public perception of the industry may be at an all-time low. At least one recent estimate found that clients are pulling money at a rate not seen since the financial crisis, according to research firm HFR's tally of industry flows.

Recent moves by a few large institutional investors were seen as the beginning of a mass exodus. In 2014, the $300 billion California Public Employees' Retirement System said it was getting out of most hedge funds. Then, this February, the $15 billion Illinois State Board of Investment said it would reduce its target allocation from 10 percent to just 3 percent. In April, the $51 billion New York City Employees Retirement System (NYCERS) decided to exit hedge funds entirely.

Henry Garrido, a worker union leader and NYCERS trustee, cited the industry's high fees and poor performance in scoring a near-unanimous vote in favor of his proposal to axe about $1.4 billion from hedge funds including Brevan Howard and D.E. Shaw Group, about 3 percent of its portfolio.

"I think it's insane," Garrido said in a pension trustee meeting this year, "that we keep pouring money into hedge funds."

Data, however, suggest that U.S. public pensions are staying put. The number of public pensions that use hedge funds has steadily increased to 282 in 2016 from 234 in 2010, data from research firm Preqin show. The average percentage of pension portfolios in hedge funds has also rose to nearly 10 percent.

Steve Yoakum, executive director of the Public School & Education Employee Retirement Systems of Missouri, said his pensions are sticking with hedge funds despite concerns about high fees and low returns.

"We are parking our money there because we don't like the alternatives," Yoakum told Reuters, adding "They are doing what they were hired to do."

Approximately 12 percent of the systems' $38 billion is invested with hedge funds, including those managed by AQR Capital Management, Renaissance Technologies, Pershing Square Capital Management, Och-Ziff Capital Management and Bridgewater Associates.

Indeed, most institutional investors do not look to hedge funds primarily for outsize returns. A 2014 Preqin survey found the most important factor were returns uncorrelated to stock markets, followed by gains regardless of market direction, and lowering portfolio volatility, among others. Just 7 percent said high returns were an objective, according to Preqin.

Teachers in Missouri are not the only ones sticking with hedge funds. Recent surveys by Deutsche Bank, Preqin and BlackRock show that the majority of pensions and other institutional investors were keeping or increasing their hedge fund allocations.

Large public pensions planning or considering an increase to their hedge fund allocation are the California State Teachers Retirement System, and the general state pensions of Massachusetts and North Carolina. At least six pensions are considering an investment in hedge funds for the first time, according to Preqin, including the Chicago Firemen's Annuity & Benefit Fund, Louisiana School Employees' Retirement System, Iowa Public Employees' Retirement System and the San Francisco Employees' Retirement System. None of the them responded to questions seeking comment.

FRUSTRATION AND HARD BARGAINS

Pensions may be standing by hedge funds, but they must reckon with increased frustration.

Public perception may be at a low point. Hedge fund managers seem to be pilloried daily by politicians and plutocrats, including Democratic presidential candidate Hillary Clinton and billionaire Warren Buffett. Organized labor has also been highly critical of hedge funds; a coalition of New York state unions are the major backers of the "Hedge Clippers," a protest group launched in early 2015. A popular U.S. television series, Showtime's "Billions", also plays on the industry’s negative stereotypes, including risky investing, insider trading and conspicuous consumption.

Joanne Fonseca, a retired public school teacher in Rhode Island whose pension invested in Luxor Capital Group and Och-Ziff, tapped into a growing sense of anger.

"I am struggling to pay my electric bill while these hedge fund managers waste fuel riding around in private planes," she said.

Eric Nierenberg, senior investment officer in charge of picking hedge funds at Massachusetts' $60 billion state pension, said the fund has been aggressive in pushing for lower fees.

It exited funds of hedge funds, which come with an additional layer of costs; the move translated into an annual savings of $38.2 million. And its negotiations on fees and getting funds to agree to custom accounts saves the pension fund $26.5 million a year.

"The fundraising environment has changed and the kind of conversations you can have with managers are different," Nierenberg said.

Incentive fees — the amount of investment gains that a hedge fund manager can take of client gains — fell by an average of 5.3 percent between the end of 2011 and year-end 2015, according to industry data tracker HFR.

Others are looking elsewhere. Jonathan Grabel, chief investment officer of the $14 billion Public Employees Retirement Association of New Mexico, said the fund was exiting a fund managed by Pershing Square, among other stock-focused managers, in favor of increasing allocation to credit and real assets.

Sona Menon, head of North American pensions at investment consultant Cambridge Associates, said that some retirement systems dissatisfied with hedge funds had not devoted enough of their assets to them for a long enough period of time, and then had unfairly compared them to stock market gains in the recent bull market — just as markets may be cooling.

"The timing here couldn’t be poorer," Menon said.

Mark McCombe, global head of BlackRock's institutional client business, said pensions will continue to look to hedge funds to help them achieve their financial goals.

"These are very individual decisions," McCombe said of the CalPERS and NYCERS pull outs. "This is not a systemic move away from hedge funds."

(Editing by Bernard Orr)

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