Eric Nierenberg, senior investment officer, hedge funds and low volatility strategies at the Massachusetts Pension Reserves Investment Management (Mass PRIM), has overseen a major recalibration of its hedge fund program in recent years. On a recent trip to Australia for the Conexus Financial Absolute Returns Conference he talked through some of the outcomes from this portfolio realignment.
Nierenberg’s position oversees the US$60 billion fund’s 9 per cent target for hedge funds, and 4 per cent portfolio completion strategies. Although Nierenberg’s team is small – it comprises two people, including him – he outlines how determining risk diversification is a priority, and how moving from a fund of funds setup to managing direct relationship helps Mass PRIM achieve its objectives.
“The way that we see that is to try and figure out how to help diversify the risk that’s within the overall pension fund while still achieving the attractive risk-adjusted rate of return, but most importantly, having low to zero correlation with equities, since that’s the predominant risk.
“A lot of the things we’ve done over the last couple of years in terms of restricting the hedge fund portfolio, has really been designed to try and reach those objectives,” he says.
“In the past five years PRIM has moved from five fund-of-funds to 24-25 direct relationships. PRIM has been invested in hedge funds for about 12 years, and when they started in 2004 and you looked into the five fund of funds, it turned out to be approximately 250 hedge fund managers. It really was over-diversified. So the returns for that portfolio were basically index-like, but we were paying a double layer of fees.
“About five years ago, the board was not really very pleased with the results, and we had to make a decision: do we pull the plug in hedge funds investing completely, or do we find a different way of doing this?
“So the decision was made to move to a direct model of hedge fund investing. Which makes a lot of sense for investors like PRIM who are going to be allocating billions of dollars to the asset class, the average allocation really is large enough that it was prudent to try and invest with the hedge funds directly without really needing the fund of funds layer there.
“That took the number of funds down by 90 per cent, but I think very importantly by saving on the fund of funds fees, that resulted in annual savings of $40 million dollars per year,” Nierenberg says.
‘Duty’ to be prudent on fees
A focus on costs is a part of Mass PRIM’s approach and personally, something Nierenberg feels very strongly about. The $40 million savings on removing the fund of funds approach has grown into much larger savings.
“We really think it’s our duty to try and be as prudent on fees as we possibly can. Now, that doesn’t mean that there are investments that we won’t do because there are high fees; it simply means that if an investment is a high-fee investment it has a higher hurdle to clear in order to determine whether or not it’s something that we feel like would be prudent to do. That $40 million was just basically the first stage of the savings in the hedge fund program –as we restructured further, that number has more than doubled.”
When Mass PRIM started implementing change, it changed not only the number of managers but also the style of managers and types of strategies.
“In that first stage, in 2011, they took the low hanging fruit which was to cut off the fund of funds layer, but the overall profile of the hedge funds that they had really didn’t change that much. So if you looked at the 24 managers that were put into the portfolios in 2011 they were mega-cap hedge funds, $30 billion to $40 billion in size.
“When I joined in 2012 and we really started decomposing the portfolio, there was a tremendous amount of overlap in the positions that these funds had, so there was very high correlation among the funds, and even more worryingly, the fundamental correlation of these funds to equity markets was very high. Yes the beta was .3 to .4 but because they had managed volatility down, in some cases by holding huge cash balances, which is not a great sign.
“So it was at that point we realised we really needed to make some continued changes to the portfolio, and it was at that point that we decided that if we’re going to do this, we’re going to have to focus on strategies that have that lower correlation; we need to find managers who can operate on those smaller niches that maybe the larger managers aren’t able to access.”
Great change in composition
Although the number of direct relationships with hedge funds remains at the same, it’s markedly different to when the fund first established its own relationships.
“We still have about two dozen hedge fund relationships, but the composition has changed pretty dramatically. And really, the genesis of that was around two years ago we decided to make all of our new hedge fund investments in managed account format,” Nierenberg says.
“I come from a long-only equity background. When I came over to the hedge fund side I was shocked at how antiquated it was that everyone’s invested in a commingled fund. And a lot of the reasons that were given to me about why it’s necessary to be invested in a commingled fund didn’t make sense to me. So the managed account format has been crucial in achieving a lot of those different objectives.
“First of all, it’s having direct control of the assets. That’s something that the board of trustees felt very pleased to have, that you can’t be gated out of an account that you fundamentally own.”
Nierenberg says that there were limits on how much Mass PRIM could be in a commingled fund. Once the board set a limit of 20 to 25 per cent of any commingled fund, given the size of the allocations made by Mass PRIM, it pushed up the minimum entry point to funds of US$1 billion and above. This had the effect of wiping out a massive part of the potential manager pool, but once the fund moved into managed accounts, it specifically targeted those managers operating in the smaller space.
“We think that’s been really beneficial because these managers have differentiated strategies which we think have higher alpha potential; and it’s not just us, there’s a number of different academics both on the mutual fund side, where it’s very well known, but also on the hedge fund side where it’s maybe not as well known, that smaller funds do tend to outperform larger ones.
“The other piece is fee reduction. With commingled funds, a lot of managers are able to give some discounts for sizeable allocations, but frankly, they’re somewhat limited. With managed accounts, really it’s a whole different ball game, especially if you’re tweaking the mandate so it looks somewhat different to the commingled fund. We’ve been able to get fee reductions on the order of 40-50 per cent, so if have a rack rate of 2 and 20, you’re talking in the range of 1 in 10 or 1.25 in 12.That’s really meaningful cost savings. That $40 million in cost savings in the fund-of-fund layer being removed, it’s now up over $100 million a year because of the savings from management fees.”
Although Mass PRIM has had an identifiable bias to US-based managers, with a handful in the UK, Nierenberg says it is time for change.
“One of the weaknesses in our portfolio currently is not having enough managers from other part of the world. I’m here for the conference but I’m also meeting with managers here in Australia this week to try and broaden our horizons and try and find opportunities that maybe other institutional investors aren’t looking at.
“Finding good managers is without a doubt the bottleneck in this process. I wish I had deployed even more of our legacy commingled fund capital into more managed accounts with more new managers.
“It’s just that it’s a tough process. Alternative beta is a huge part of our diligence process. We’ve developed an internal framework that really can take a manager’s returns and decompose them into alternative beta loadings, and we’re looking for those managers that have true alpha exposure. We have a risk premia portfolio that sits in our portfolio completion strategies. That portfolio is about $700 million in size and will probably grow in the coming months, and I definitely think alternative beta and risk premia are an important part of the portfolio, but focusing on the active hedge fund piece, we need to find those funds that are willing to accept the fact that the fee structure of the industry is changing, and we’re not going to be willing or able to pay 2 in 20 or anywhere close to that going forward. Willing to accept the idea of a managed account, and really, have some unique skill that doesn’t just get captured by some kind of alternative beta. What they get in return is really a very patient, very knowledgeable organisation that’s willing to stand by them, especially if there are periods of performance that aren’t so great.”
One of the biggest thing Nierenberg advocates is to bring in a specialist if an investor plans to move from a fund of fund model to managed accounts.
“There’s a lot of different organisations out there that can help an institution set up a managed account program, and that’s one thing I’ll stress, if you’re thinking about doing it yourself – don’t. Make sure that you utilise someone else. This was advice what was given to me by Dan McDonald at Ontario Teachers; they had a managed account for probably 10 years, and he said they started off trying to do all this internally – onboarding of managers, the prime brokerage agreements, the swap agreements. He said there was so much brain damage from that process that, in hindsight, they should have just paid the few basis points or whatever it was to an outside provider who has a real skill in doing this to help them. We took that advice to heart and it was a lifesaver, because there was no way we could have done this without them.”
This article was updated on 26/09/16 to correct the byline.