state universities retirement system of illinois (il surs) · 2) there is value in combining a...
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Hedge Fund Search & Market Update
March 12, 2015
Doug Moseley, PartnerKristin Finney-Cooke, CAIA, Sr. ConsultantKevin Leonard, Partner
State Universities Retirement System of Illinois (IL SURS)
Exhibit 18
Contents
Executive Summary & Overview 2Hedge Fund Category Overview 5Hedge Fund-of-Funds Manager Selection 15Appendix 22
Page
2
State Universities Retirement System of Illinois
1
Exhibit 18
Executive Summary & Overview
2
Exhibit 18
• SURS Policy portfolio has broad exposure to both traditional, public-markets and alternative assets– Equity allocation diversified across US, non-US; developed and emerging markets– Core and Core plus fixed income mandates provide some exposure to high yield and
non-US fixed income– TIPS positioned as economic hedge against future inflation– Private equity and real estate provide additional diversification and sources of higher
expected return
• Goal of new Policy targets approved in 2014 is to lower the projectedrisk level of SURS portfolio while not giving up significant return
• Hedged Equity strategies represent a better risk vs. return trade offthan a portfolio without Hedged Equity– Diversified group of hedged equity strategies should have bond-like risk profile– Projected returns between stocks and bonds– Expanded opportunity set– Lower sensitivity to interest rates
• Selection of Hedge Fund-of-Funds manager is an important step inimplementing the allocation
Executive Summary – Recap of 2014 Discussion & DecisionsState Universities Retirement System of Illinois
3
Exhibit 18
• NEPC has advocated that SURS implement its Hedged Equityallocation by selecting managers in 2 primary strategy categories– Expected returns
• Traditional Hedge Fund-of-funds manager strategies– Selection of managers and construction of a diversified portfolio delegated to
manager-of-managers– Hedge Fund-of-Funds managers are responsible for negotiating manager contracts,
portfolio guidelines, fees and transparency– Portfolios will provide broad exposure to between 20-45 managers depending on
number of managers selected– Emerging and WMDBE manager programs are available in the marketplace– NEPC recommends that SURS target 3-4% of its allocation to this category
• Hedged equity strategies including Low Beta, Defensive Equity andHedge Fund replication– Newer developing category that includes several sub-categories of products that seek
to limit, hedge or alternatively manage equity risk (or beta)– Strategies use active management and hedging techniques to offer lower risk equity
exposure– Typically offered at lower fee structures with greater transparency– NEPC recommends that SURS target 1-2% of its allocation to these strategies
Executive Summary - Recap of 2014 Discussion & DecisionsState Universities Retirement System of Illinois
4
Exhibit 18
Hedge Funds & Hedged Equity Overview
5
Exhibit 18
NEPC’s Research Suggests That:
1) Building a diversified hedge fund program across strategy sets canprovide stability and enhance the overall risk-reward valueproposition across the portfolio
2) There is value in combining a top-down macro oriented processfocused on themes and broader opportunity sets with a bottom-up,detailed manager selection criteria that results in a portfolio of highconviction ideas and investment managers
3) Hedge fund portfolios can benefit from selecting investmentmanagers from a variety of firm/product sizes to ensure alignmentof interests between LPs and GPs and to pursue niche as well asbroad investment opportunity sets
Summary: How to Invest In Hedge Funds?State Universities Retirement System of Illinois
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Exhibit 18
Hedge Fund StrategiesIndustry Size - $2.63 Trillion
Relative Value(Credit-linked)
10%
Global Macro
Equity Hedged(Equity-linked)
28%
Multi-strategy16%
Trading19%
Event-driven27%
Managed Futures
Distressed Securities
MergerArbitrage
Special Situations
Long/ShortEquity
EquityArbitrage
ShortBias
EmergingMarket Equity
Convertible Arbitrage
Fixed Income Arbitrage
VolatilityStrategiesOther Credit
EmergingMarket Debt
Multi-StrategyEvent-Driven
SyntheticStrategies
• Black strategies as defined by CS and HFR indices• Green strategies represent NEPC Classifications• Percentages represent approximate portion of industry assets dedicated to
each strategy (per HFR)
Hedge Fund Industry StructureState Universities Retirement System of Illinois
7
Exhibit 18
Industry Structure: Strategies and Historical Risk-Returns
Apr 1994- Dec 2013 CS
Strategy Definition Return Risk(Std Dev)
Long/Short Equity
Managers combine a long portfolio with the short sale of stocks. Portfolios range from net short to net long, depending on market conditions. Aggressive funds may capture returns by exceeding 100% exposure while conservative funds mitigate market risk by maintaining net exposures of between 0-50%.
10.0% 9.6%
Credit/Relative Value
Managers seek to profit from the mispricing of related securities; returns are not dependent on the general direction of market movements. Strategy utilizes quantitative and qualitative analysis to identify securities or spreads between securities that deviate from their fair value and/or historical norms. Examples include convertible arbitrage, fixed arbitrage, statistical arbitrage and select global macro strategies.
5.6% 5.5%
Event-Driven
Managers invest in situations with the expectation that a near term event will act as a catalyst changing the market's perception of a company, thereby increasing or decreasing the value of its equity or debt. These events include, bankruptcies, financial restructurings, mergers, acquisitions and spin-offs. There are three types of event disciplines: merger arbitrage, distressed securities and special situations.
9.6% 6.1%
Global Macro
Strategies comprise two sub-segments: discretionary and systematic. Both approaches specialize in trading highly liquid instruments including currencies, commodities, fixed income instruments and equity indices. Systematic strategies are based on computer generated algorithms that analyze historical data while discretionary manager use a broad analysis of economic, financial and political trends to identify investible themes and forecast market movements. These strategies have low correlationsto broader equity and fixed income indices.
12.1% 9.3%
Multi-Strategy
Managers employ a diversified portfolio with various investment approaches. For example, a multi-strategy manager may have a portfolio with convertible arbitrage, merger arbitrage, and fixed income arbitrage positions. The manager can over or under-weight different strategies to best capitalize on current investment opportunities.
8.2% 5.2%
Past performance is no guarantee of future results.
State Universities Retirement System of Illinois
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Exhibit 18
Pros:• Incentive structure focused on performance during all market environments• Potential for non-correlated returns to traditional asset classes• Strategies often reduce overall portfolio volatility and drawdowns• Potentially superior capital preservation vehicles• Strong alignment of interests between manager and investor• Historically has compounded capital net of fees at a greater rate than
traditional investment options
Cons:• Complicated entities, more challenging to evaluate managers• Complex investment structures• Liquidity Constraints• Less transparent• Higher fees, expensive• Access to top managers more limited• Potential for higher “headline risk”• Regulatory environment in flux
Weighing Benefits & Risks vs. Traditional Investment Structures
Use of Hedge Fund of Fund
Manager helps mitigate these
drawbacks
State Universities Retirement System of Illinois
9
Exhibit 18
Risk-Return Comparison as of 12/31/2014
Source: Pertrac, HFR Database, BloombergPast performance is no guarantee of future results.
As of 6/30/2013
Differentiated returns from idiosyncratic positions compared to traditional markets
13.7%
20.4%
15.5%
7.7%
4.9%
15.5%
10.2%
6.0%
3.3%
6.2%
4.6%5.1%
5.9%
2.7%
4.5% 4.7%
0.2% 0.3% 0.3%
2.0%
0.0%
4.0%
8.0%
12.0%
16.0%
20.0%
24.0%
1 Year 3 Years 5 Years 10 Years
Rate of R
eturn (%
)
Annualized Returns
S&P 500 MSCI World HFRI Composite Barclays Agg 3 Month Libor
As of 12/31/2014
10
Exhibit 18
Risk-Return Comparison as of 12/31/2014
HF Industry Volatility is less than 1/2 that of Equity Indices Across Time Periods
Source: Pertrac, HFR Database, BloombergPast performance is no guarantee of future results.
8.3%9.1%
13.0%
14.7%
8.5%
10.4%
14.3%
16.0%
3.2%3.9%
5.2%
6.3%
2.3% 2.7% 2.7%3.2%
0.0% 0.0% 0.0%0.6%
0.0%
5.0%
10.0%
15.0%
20.0%
1 Year 3 Years 5 Years 10 Years
Volatility
% (Std
Deviatio
n)
Annualized Volatility
S&P 500 MSCI World HFRI Composite Barclays Agg 3 Month Libor
State Universities Retirement System of Illinois
11
Exhibit 18
Returns (Rolling 3 Years)
Standard Deviation (Rolling 3 Years)
Risk-Return Comparison as of 12/31/2014
-20.0%-15.0%-10.0%-5.0%0.0%5.0%
10.0%15.0%20.0%25.0%30.0%
S&P 500 (TR) MSCI WORLD - Net - USD HFRI Fund Weighted Composite Index Barclays Aggregate Bond Index
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
S&P 500 (TR) MSCI WORLD - Net - USD HFRI Fund Weighted Composite Index Barclays Aggregate Bond Index
Source: Pertrac, HFR Database, BloombergPast performance is no guarantee of future results.
12
Exhibit 18
Fund of Hedge Funds: Resurgence
Source: HFR 3Q, 2014
-60.0%
-40.0%
-20.0%
0.0%
20.0%
40.0%
60.0%
2003-2014 2003-2008 2009-2011 2012-2014
HFRI Up and Down Capture of S&P 500
FoF Up Capture Direct Up Capture FoF Down Capture Direct Down Capture
State Universities Retirement System of Illinois
13
Exhibit 18
Fund of Hedge Funds: Asset Levels & Flows
-$40.9
-$118.4
-$11.8 -$7.9 -$22.2 -$20.2 -$0.4 $0.6 -$2.2
$593.2 $571.3
$646.3 $629.6 $638.2 $663.1 $665.1 $672.2 $671.8
-300
-100
100
300
500
700
900
2008 2009 2010 2011 2012 2013 Q1-2014 Q2-2014 Q3-2014
Estimated Growth of Assets/Net Asset FlowFund of Funds 2008 - Q3 2014
Net Asset Flow Estimated Assets
Source: HFR
State Universities Retirement System of Illinois
14
Exhibit 18
Hedge Fund-of-Funds Manager Selection
15
Exhibit 18
• Nature of manager selection in the Hedge Fund category is more complex than traditional asset classes– Opportunity set is broader, encompassing multiple asset classes– Strategies more opportunistic and tactical– Private commingled vehicles governed by different terms and liquidity provisions– Lack of transparency creates additional challenges in evaluating past performance and
monitoring existing portfolios
• Hedge Fund-of-Funds managers typically require additional resources over & above a traditional Fund-of-funds manager– Research professionals with experience evaluating complex trading strategies that are
implemented with long- and short-positions– Risk management systems to evaluate prior track records & monitor existing portfolios– In-house or strong external legal advice to assist in evaluation of fund structures and
negotiation of key terms– Portfolio construction tools for managing multi-manager portfolios– Operational due diligence team to meet with key vendors and perform background
checks on key principals
• Hedge Fund-of-Funds manager category has continued to experience change since the global financial crisis– Better matching of asset & investor liquidity provisions– Trend towards larger investors demanding separately managed accounts
• Pros & cons for investors and managers– Downward pressure on investment management fees
Executive Summary – Hedge Fund-of-Funds role & manager selectionState Universities Retirement System of Illinois
16
Exhibit 18
Role of Hedge Fund-of-Funds Manager
As of 6/30/2013
HFOF Manager
State Universities Retirement System of Illinois
Manager Evaluation
Evaluation of Capital Markets
Operational Due Diligence
Risk Management
Strategy Selection
Reporting & Back office
Portfolio Construction
Negotiation of Terms &
Fees
17
Exhibit 18
• Investment Strategy Evaluation & Due Diligence– Evaluation of the investment team
• Structure & roles• Decision-making process
– Review of strategy & investment process– Analysis of performance track record & attribution– Competitive analysis & negotiation of fees and key terms– Trading strategies & use of derivatives– Background checks & review of litigation history
• Operational Due Diligence– Understanding organizational structure
• Ownership• Financial condition• Corporate governance
– Internal controls and procedures• Trading & movement of cash• Pricing of derivatives and illiquid securities
– Review of key service provider• Custodian / Administrators• Prime Brokers• Auditors
Different Levels & Types of Hedge Fund Manager Due DiligenceState Universities Retirement System of Illinois
18
Exhibit 18
Fund of Hedge Funds: Maximizing Portfolio Alpha Through Creative Portfolio Construction
FOHF Edge Alpha Source
Actively Negotiate Fees with underlying managers Fee Savings
Co-Investments with managers in/out of FOHF’s research universe Opportunistic
Separate Accounts with underlying managers Structural
Invest with emerging/capacity constrained managers Life Cycle
Invest in volatile markets e.g. Asian equities, commodities Capital Preservation
State Universities Retirement System of Illinois
19
Exhibit 18
S&P 500
MSCI WorldHFRI Composite
Barclays Agg
3 Month Libor
60 ‐ 40 Stock Bond
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Rate of R
eturn %
Standard Deviation (Risk) %
Source: Pertrac, HFR Database, BloombergPast performance is no guarantee of future results.
As of 6/30/2013
Last Five Years
Risk-Return Comparison as of 12/31/2014State Universities Retirement System of Illinois
20
Exhibit 18
S&P 500
MSCI World
HFRI Compsite
Barclays Agg
3 Month Libor
60 ‐ 40 Stock Bond
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Rate of R
eturn %
Standard Deviation (Risk) %
Risk-Return Comparison as of 12/31/2014
Source: Pertrac, HFR Database, BloombergPast performance is no guarantee of future results.
As of 6/30/2013
Last Ten Years
State Universities Retirement System of Illinois
21
Exhibit 18
Appendix
22
Exhibit 18
• HF Strategies have meaningfully different Risk/Return characteristics
As of 6/30/2013
Source: Pertrac, HFR Database
Industry Structure: Strategies’ Historical Risk-Returns as of 12/31/2013
Past performance is no guarantee of future results.
DJCS Hedge Fund Index
Fixed Income Arb Index
Multi‐Strategy Index
Event‐Driven Index Long‐Short Equity Index
Global Macro Index
S&P 500
Barclays AggHFRI Fund of Funds Composite
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
13.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Compo
undRO
R
Standard Deviations (risk) %
Since April 1994 Return and Volatility
State Universities Retirement System of Illinois
23
Exhibit 18
• NEPC has typically recommended Hedge Fund Policy mixes in a range of between 3-10% for public funds– Current client allocations range from 0 – 18%+– Median allocation in InvestorForce Public Fund (DB) universe = 8.6%
• Based on sample size of 42 public plans with Hedge Fund Policy Allocations
• Other Illinois public funds with target allocations include the following:– Illinois State Board of Investments (Policy target 10.0%)– Illinois Municipal Retirement Fund (Policy target 2.5%)– Teachers Retirement System of Illinois (Policy target 6.0%)– Municipal Employees’ Annuity & Benefit Fund of Chicago (Policy target 10.0%)– Public School Teachers’ Retirement System of Chicago (Policy target 2.0%)– Chicago Police Annuity & Benefit Fund (Policy target 7.0%)– Laborers’ & Retirement Board Employees’ Annuity & Benefit Fund of Chicago (Policy
target 8.0%)
Public Fund Peer Group Allocations to Hedge FundsState Universities Retirement System of Illinois
24
Exhibit 18
• NEPC, LLC is an investment consulting firm. We provide asset-liability studies for certain clients but we do not provide actuarial services. Any projections of funded status or contributions contained in this report should not be used for budgeting purposes. We recommend contacting the plan’s actuary to obtain budgeting estimates.
• The goal of this report is to provide a basis for substantiating asset allocation recommendations.
• Any projection of liabilities in this report uses standard actuarial projection methods and does not rely on actual participant data. Asset and liability information was received from the plan’s actuary, and other projection assumptions are stated in the report.
• Assets are projected using a methodology chosen by the client. Gains and losses are estimated through investment returns generated by applying NEPC’s 5-7 year asset class assumptions and scenario assumptions for the current year.
• This report is based on forward-looking assumptions, which are subject to change.
• This report may contain confidential or proprietary information and may not be copied or redistributed.
DisclosuresState Universities Retirement System of Illinois
25
Exhibit 18