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State pensions' strategy shift causes manager fees to rise

July 28, 2012

Indiana pension officials think they can avoid paying eye-popping fees on hedge funds and other alternative assets, even while making those investments a cornerstone of their strategy.

The $25.3 billion Indiana Public Retirement System is in the midst of hiring managers to carry out a strategy where more money will be in hedge funds, private equity and real estate than stocks.

Pension officials think the new allocation will improve returns, but critics say the alternative-asset managers don’t bring results to justify their fees, which are at least four times greater than the fees charged by stock managers. Those managers also stand to make bonuses, which, critics say, could prompt them to take unnecessary risks.

“The fees on those things are just exorbitant,” said Ken Skarbeck, principal at Aldebaran Capital and an IBJ columnist on wealth management. “When you compare it to the performance you get, it’s hard to justify.”

The Indiana system applies the same investing strategy to its two main funds, the Public Employees Retirement Fund and Teachers Retirement Fund. The two funds were managed separately until a July 1, 2011, merger.

russo-steve-mug.jpg Russo

The merger allowed Indiana to cut the total number of money managers it uses, and negotiate lower fees, Executive Director Steve Russo said. He acknowledges that management fees for alternative assets are high, but he thinks that will change as more pension funds go into alternatives, and more managers get into the alternatives game.

“It’s making for a more competitive landscape,” Russo said.

pension tableIndiana paid $122 million in basic money-management fees for the fiscal year ended June 30. That figure does not include the cut of profits kept by private-equity managers, which state pension officials say is not available.

This year, the pension funds expect to pay $126.5 million to $151.8 million in fees, depending on asset levels at the end of the year. Again, the estimated fees don’t include bonuses, which will be paid to managers who hit certain performance targets.

The shift out of stocks, from 36 percent to 23 percent of assets, will contribute to that increase in fees. INPRS will pay stock managers an average 0.23 percent of the assets they oversee, while managers of hedge funds, real estate and private equity funds charge 1 percent to 2 percent, plus performance incentives.

The allocation to hedge funds and private equity will stay at 10 percent each, while real estate will slightly increase from 6 percent to 7.5 percent. The move out of stocks will fund an entirely new category of managers under something called “risk parity.”

The risk parity managers actually reallocate money across stocks, bonds and commodities in an effort to reduce volatility while still striving to hit INPRS’ annual return target of 7.52 percent. Those managers charge a flat fee, but it’s 0.31 percent.

Those fractions of a percent translate to millions of dollars. If the new allocations were applied to current assets, stock managers collectively would take home $13 million, while the hedge fund managers would make anywhere from $25.3 million to $50.6 million, plus potential bonuses.

The risk parity managers would make $7.8 million.

Indiana’s costs are nowhere close to those of the South Carolina Retirement System, which is similar in size but paid $239 million in fees in 2011, Bloomberg News reported. The system’s former director raised alternative-asset holdings to about 40 percent of the portfolio and created partnerships with multiple investment advisers, which then paid various managers additional fees.

Indiana is more aggressive than most states when it comes to investing in alternatives, ranking 32nd out of 98 public funds in a recent survey by the National Association of State Retirement Administrators.

INPRS notes that its alternative-asset classes have outperformed benchmarks, though to varying degrees.

Private equity has posted an annualized return of 7.98 percent since INPRS first invested in May 2001, compared with a 3.23-percent return over that period on the Russell 3000 index.

Hedge funds have had an annualized return of 3.08 percent since September 2005, compared with 2.02 percent for Hedge Fund Research Inc.’s Fund of Funds Composite.

Overall, though, Indiana pensions have lagged other public funds.

INPRS’ total return was 3.42 percent in the one year ended March 31, compared with 4.03 percent for similar funds tracked by the Wilshire Trust Universe Comparison Service.

Over the 10-year period, INPRS saw a 5.27-percent return, compared with 6.27 percent in the Wilshire TUCS.

Wading deeper

“Every pension fund in the country is wading into treacherous waters, assuring the public they’re not going to get sucked under,” said Edward Siedle, a former Securities and Exchange Commission attorney who investigates pension fraud.

Hedge funds are free to pursue any number of nontraditional assets, and they may use leveraging, or borrow against the fund, to magnify returns. Private equity takes stakes in privately held firms, then tries to make them more efficient and resell them at a profit.

Pension funds have no business investing in either category, said Siedle, president of Benchmark Financial Services in Florida. Those investments are not transparent, not sold on open markets, and as a result not easy to price, he said. Meanwhile, hedge fund managers have incentives to pump up their own profits, even though pension funds negotiate provisions that are supposed to protect investors.

Most investors, including Indiana, set high-water marks for bonus pay, which means a manager can’t collect a cut of the profit unless the fund’s net asset value exceeds its previous high. That’s supposed to keep managers from profiting on ups and downs.

But if a hedge fund manager uses leverage, the downside risk is equally magnified.

“What happens when the market plummets 20 percent, and because of leverage we’re down 40?” Siedle asked. “You fire me. I made a fortune. I don’t have to pay it back.”

Local private wealth adviser John Guy has similar concerns.

“Performance fees have bothered me, especially in assets where you can’t sit over cocktails and tell your friends what they’re doing,” he said. “I believe the healthiest of all fees is a stated percentage of all assets, so the real incentive for the manager is to increase assets.”

Bret Swanson, a local tech industry analyst who serves on the Indiana pension fund’s board of trustees, admits alternatives are riskier. However, he said, “I think those are important and potentially high-returning investments. It just depends on whether our investment staff and our board are rigorous in filtering and vetting the best managers.”

INPRS employs about 187 money managers, 130 of them in private equity. The consulting firm Strategic Investment Solutions Inc. of San Francisco helped set the allocation strategy, which the INPRS board approved last fall, and is assisting in vetting the individual managers that will carry it out.

Even if a hedge-fund manager has a great track record, the fact that pensions are flocking to alternatives means their returns eventually will look mainstream, Skarbeck said. In other words, it’s harder to ferret out oddball investments, such as distressed debt, and capitalize on discounts when everyone else is looking for the same thing.

“It’s the law of large numbers,” Skarbeck said. “A lot of money has flowed into those things, so their ability to outperform based on market discrepancies has gone away.”

New paradigm

Indiana’s biggest manager hire so far involved two giant hedge fund firms, but for a completely different strategy.

Bridgewater Associates of Westport, Conn., and AQR Capital Management of Greenwich, Conn., each will manage $400 million in funds dedicated to risk parity.

Most of the stock allocation that INPRS is giving up will go to risk parity, which will account for 10 percent of the portfolio. The managers seek to limit volatility by spreading money across stocks, commodities and bonds, while still providing decent returns.

Traditionally, investors that want less volatility, or risk, put more money in bonds and accept a lower return. One way the risk-parity managers boost returns, even while holding fixed-income assets, is by using leverage.

Although bonds are considered low-risk, borrowing against them could mean big losses if interest rates, which are at historic lows, start to rise. Under the risk-parity strategy, those losses would be offset by gains in commodities, Swanson said.

In general, the funds emphasize mitigating economic downturns over capitalizing on market booms, Swanson said.

It’s easy to see why INPRS officials gravitated toward managers promising good returns with less volatility.

INPRS lost nearly $8.7 billion, or 43 percent of its value, between late 2008 and February 2009. It’s recovered 70 percent since then, but its constituents—governments making annual payments on behalf of employees—are still feeling the aftereffects.

Those annual payments go up when the market goes down. The payments lag actual market performance by several years, so the increase is hitting local governments now, while they’re still dealing with a drop in tax revenue and the poor economy, Russo said.

“The taxpayer’s on the hook for the ups and downs,” he said.•

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