Rhode Island’s pension plan has decided to halve the money it puts in hedge funds, as retirement systems across the US re-evaluate their strategies for generating the returns they need to pay participants.
Over the next two years, the $7.7bn Employees Retirement System of Rhode Island will cut its allocation to hedge funds to 6.5 per cent from the 12 per cent it set in 2011 — joining a growing list of large investors who are dissatisfied by performance and pulling money from the sector.
“This wasn’t something we woke up one day and decided to do — it wasn’t something we did in response to headlines or political pressure,” said Seth Magaziner, general treasurer for the US state.
“We put a lot of work into this, a lot of modelling, a lot of testing and retesting of assumptions, and this was the result that the process led to,” he said: “We came to the conclusion that Rhode Island and many other states have been doing the process backward by starting with an assumed rate of return and trying to hit it.”
Instead, he said, Rhode Island set a risk tolerance “defined by real economic factors” such as the odds that certain costs may spike or that the fund would drop to less than 50 per cent funded. From there, it chose allocations designed to generate the most money possible at that risk level, and, working with the Pension Consulting Alliance, tested its conclusions against “thousands” of scenarios.
Many pension funds adopted alternative investment managers like hedge funds and private equity as high valuations across markets and low interest rates threatened returns from conventional long-only mutual funds. But hedge funds have struggled to generate returns in volatile markets, and their high fees have prompted some investors including the New Jersey and the New York City retirement systems to scrap or reduce their programmes.
Investors have already pulled more than $50bn from hedge funds this year, according to eVestment.
The total assets under management of the hedge fund industry exploded in size from $500bn at the turn of the millennium to almost $3tn by 2015. As assets have grown performance has suffered, with hedge funds as a whole failing to beat the S&P 500 over the past four years.
Rhode Island — which has less than 60 per cent of the assets it needs to pay its liabilities — is turning to passive trend-following strategies and private equity to help it claw back to a level where it can pay out its obligations. It is boosting its allocation to private equity from 7 to 12 per cent, over five years or more, to spread out exposure across different fund years and to avoid being forced to choose managers in a hurry, Mr Magaziner said.
Rhode Island will jettison its equity-focused hedge funds, but keep strategies categorised as “absolute return” with managers who have demonstrated that they are not correlated to the broader markets, and who will generate positive returns, he said.
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“We’re going to stay passive when it comes to long public equity,” Mr Magaziner said. “We just didn’t have faith that active management could consistently achieve equity-like returns, so that’s that.”
Eight per cent of the plan has also been dedicated to a new strategy called “crisis offset” or “crisis protection” — long-duration Treasuries and passive momentum or trend-following strategies, assets that historically have made money in downturns.
“This is the part of our portfolio that we think is going to help us control against risk better than the bulk of our hedge funds have,” Mr Magaziner said. “If there really are strategies out there that will achieve positive performance at a time when everything else is dropping, that can be tremendously valuable.”