MassPRIM: Removing FoFs Moves Us Closer to Peers

(February 25, 2011) — In the $48.7 billion Massachusetts Pension Reserves Investment Management (MassPRIM) Board’s comprehensive asset allocation review, the fund has decided to shift from a fully fund-of-funds investment strategy to incorporating more direct hedge funds, reflecting the need to adapt as circumstances change.

“Tim Cahill, our previous treasurer, felt that having a fund-of-funds approach would achieve better diversification,” MassPRIM spokesman Barry Nolan confirmed with aiCIO. “But there’s also the argument that with a fund-of-funds strategy, you can reach a point of diversifying too broadly, leading to diminishing returns,” he said, noting the while Cahill, who suffered a tarnished reputation over accusations of political influence, achieved solid returns as treasurer, concern centered on the middle layer of management that his fund-to-funds approach created 

MassPRIM’s Executive Director Michael Trotsky, who succeeds Michael Travaglini, has jumpstarted the push toward relying less heavily on Cahill’s fund-of-funds strategy. “Trotsky is a former hedge fund manager with real world experience, and in this highly competitive atmosphere he believes it’s worthwhile pursuing a direct investment strategy because there are $30 million in fees out there that could be turned into returns,” Nolan said, explaining the fund’s endeavor to achieve the right balance between a fund-of-funds and direct approach. The idea is that by eliminating an additional layer of management and management fees and utilizing Trotsky’s experience, the fund will be able to maintain the level of returns as well as its safety of security, according to Nolan.

The shift in investment style by MassPRIM highlights ever-changing investment environments and opportunities. To be truly responsible to taxpayers and pension recipients, the shift shows the need to be willing to change thinking, strategy, allocation, and management guidelines as circumstances change, Nolan told aiCIO. Furthermore, MassPRIM’s decision signals an effort by the fund to eliminate millions of dollars in fees as well as the threat of over-diversification that often comes from relying solely on a fund-of-funds approach. Currently, the public fund invests in about 200 hedge funds via fund-to-funds, yet it aims to significantly reduce the number by increasingly incorporating direct investment. The pilot program approved by the board calls for issuing a request for proposal (RFP) for a direct hedge fund consultant in February, picking a consultant by April and hiring the fund’s first hedge fund managers in the last quarter of the calendar year.

“There are lots of schools of thought out there,” Tim Barron, president and chief executive officer of Rogerscasey, told aiCIO in a telephone interview. “One reason to use a hedge fund-of-fund strategy is to build a diversified platform of hedge funds, so you get protection from that diversification. Second, is to have a robust form of due diligence to get the best hedge funds, which could be difficult for some consultants and staff who lack that capability. The third reason is to harness the abilities of these investment vehicles to make tactical decisions — leaving global macro for distressed debt for example — more quickly and effectively.” Fees, he said, should reflect the expectation that funds will get greater returns for greater skills. He added that moving from a pure fund-of-fund strategy to a direct or combined strategy has been increasingly common as plan sponsors build diversification and become more familiar with this arena. “You can look at a fund-of-fund as a general contractor,” Rogerscasey’s Barron noted. “They assemble the parts of the house that you don’t want to build yourself. Each fund has the option of deciding whether or not the fees are worth it.”

With approximately 1,900 fund-to-funds on the market with over $500 billion in assets, the fund-of-funds business is predicated on the notion that they’re successful enough at adding value to justify their fees, Barron said. “The whole key to this is finding the right ones — via multiple meetings, assessing exactly what they do and how they do it, looking at their historical track record, for example,” he asserted.

Six years after launching its hedge fund-of-funds program, MassPRIM’s board members have decided to pursue the pilot program of greater direct investment. In an effort to become increasingly proactive in suggesting changes to achieve the fund’s actuarial rate of return of 8.25%, MassPRIM felt the decision to increase the percentage of direct investments into hedge funds translates to an attempt to make more intelligent decisions on asset allocation and rebalancing. Currently, MassPRIM expects to pay around $30 million in fees this year to its five hedge fund-of-funds providers — Arden Asset Management, K2 Advisors, Grosvenor Capital Management, PAAMCO and The Rock Creek Group — which collectively oversee roughly $3.6 billion, or 7.5% of MassPRIM’s total assets. The board aims to take about $100 million from each of those five managers for the direct investment program for a total of $500 million, which would amount to about 1% of the fund’s total assets, potentially slashing the program’s fees by $4.2 million. Further shifts out of fund-of-funds and into direct hedge fund investments could follow if successful, Nolan confirmed with aiCIO.

As of earlier this month, among the nation’s 10 public funds with the largest allocations to hedge funds, MassPRIM and the Pennsylvania State Employees’ Retirement System were the only two funds to remain solely invested in funds-of-funds, according to materials provided by MassPRIM’s board. On the flip side, according to those materials, the hedge fund allocations of five of the top 10 — Pennsylvania Public School Employees’ Retirement System, Virginia Retirement System, the Teacher Retirement System of Texas, the New York State Common Retirement Fund and the Texas County & District Retirement System — are entirely invested directly in hedge funds. Others have a mixed approach. “This brings us more in line with the strategy of the majority of our peers,” Nolan said. “We’re not going to do things just because other funds are doing it, but we’re doing it on the belief that performance will be enhanced. We’re putting our toe in the water. We’re not doing a cannonball off a cliff.”