Hedge funds have fallen out of favor with institutions in recent years. But South Carolina’s approach shows how a once-popular hedge fund strategy could bring them back into vogue.
The South Carolina Retirement System Investment Commission attributes the success of its bond portfolio to its combination of market-neutral, low-volatility, and low-beta hedge fund investment strategies. In practice, this means that a portion of the fund’s fixed income portfolio is invested in hedge fund strategies that add no additional beta – or volatility and systemic risk – to the plan.
The approach is what the South Carolina plan calls its portable alpha structure, a term more common 10 to 15 years ago. Specifically, 26% of the plan’s overall portfolio is dedicated to fixed income securities. Of that 26%, 13% goes to power the portable alpha plan.
RSIC’s portable alpha overlay includes a range of hedge fund strategies that keep the fixed income portfolio low beta. These strategies include a healthy mix of macro (29%), a multi-strategy approach (28%), relative equity value (22%) and commodity trading advisors (10%).
In the portable alpha plan, the hedge funds are part of a “collateral mix” for the pension’s fixed income allocation. The collateral mix is made up of cash and hedge fund exposures. Instead of holding cash and investing it with a long-term equity manager, RSIC holds a segment — specifically 11% — of its portfolio in “low-volatility, market-neutral hedge funds.” Marlet “. In short, RSIC takes some of its collateral and puts it into hedge funds.
“The whole point of our bond allocation is to be an element of diversification,” said Bryan Moore, managing director of public markets at RSIC. Institutional investor. “In a world where fixed income returns are 2.5% or 2.75% over the next seven years…that won’t help us when we have to try to generate 7% returns for the plan.”
Moore said hedge fund allocations add additional value to the fixed income portfolio. He explained it this way: A bond portfolio has two ways to gain exposure: the first is to hire a long-only active manager, which Moore believes could yield about 50 basis points above average.
“But the scale just isn’t there,” Moore said.
Instead of funding, say, $100 to a long-only active manager where RSIC would earn 50 basis points – about 50 cents on that $100 – RSIC’s Portable Alpha program invests that $100 in a fixed-income index and reserves 20% of the investment in cash. Simply put, the plan essentially uses part of its portfolio as collateral to borrow more money, which it then invests in uncorrelated hedge funds. This additional portfolio is another way to add growth to annuity returns.
“Now you’re making three to five percent on that 80 percent coin,” Moore said. “On this whole play, we’re gaining the return [of the Bloomberg Barclays Aggregate] and then we earn that three to five percent on the 80 percent we had left in cash.
The $41.7 billion pension plan made its first hedge fund investment in 2007. In 2016, Geoffrey Berg, the new chief investment officer, implemented the portable alpha program, to reduce the complexity of the plan portfolio.
“The big push for implementing portable alpha was we had these hedge funds, we had this beta. How could we be more efficient with how we take risk in the portfolio? Moore said.
The term portable alpha is different for every investor and institution. It is more a philosophy than a specific strategy. While a portable alpha approach isn’t a new concept, Moore said RSIC spent a lot of time thinking about how to minimize risk to keep the portfolio afloat. Moore said portable alpha programs peaked before the Great Financial Crisis of 2008, which is how they came to emphasize low beta. Although the approach can still be implemented, the terminology has fallen out of favor.
According to RSIC’s investment report for fiscal year 2021, hedge funds cannot exceed 20% of total plan assets, but the target allocation is 10%. In 2021, the portable hedge fund alpha plan occupied 11.2%, with a market value of $4.4 billion, of the entire portfolio.
Also in 2021, portable alpha hedge funds returned 17.11%.
“We’re really trying to use the portable alpha hedge fund portfolio as an excess return driver for our portfolio,” Moore said.
RSIC’s success was bolstered by a strong year for hedge funds over the past fiscal year. In fact, in 2021, 62% of allocators responding to a BNP Paribas survey said they had already achieved their average return target of 8.3% for their 2021 hedge fund portfolios in November 2021, II Previously reported. While some asset owners have reduced their allocations to hedge funds in recent years, the strength of 2021 could mean that hedge funds are a good investment for institutions going forward.
RSIC’s hedge fund approach is based on the central assumption that if hedge funds generate a net return of 2.5% over the cost of funding embedded in futures and swaps, the alpha program portable will add approximately 25 basis points to the plan. That’s about $100 million a year, according to RSIC.
In 2018, Moore said RSIC had 22 different asset and sub-asset classes. Today, RSIC presents its portfolio as a five-asset-class portfolio with allocations to private equity, private debt, private real estate, public equities and government bonds.
“The early success of the portable alpha led us down the path of simplification,” Moore said.
To avoid risk, Moore said RSIC is aiming for less than 0.1% beta. From 2019 to 2021, RSIC reduced its beta exposure from 0.12% to 0.01%.
Overall, the hedge fund industry has suffered from some volatility throughout the past year, recovering in particular in the fourth quarter, according to hedge fund service provider Citco. Nevertheless, the RSIC reduced its volatility from 5.3% in 2019 to 3.7% in 2021.
RSIC tries to minimize its correlation with negative stock markets. In fact, like many pension plans, Moore said the plan’s biggest risk is equity risk.
“We wanted something that could sit in our portfolio that wouldn’t add to that risk,” Moore said.
Last year, Portable Alpha Hedge Funds included Blackstone SAF II, Bridgewater PA II, DE Shaw Low Beta Hedge Fund, GCM Low Beta Hedge Fund, GSO Mixed Credit Hedge Fund, Lighthouse PA, Man Alt Beta Strategies, MS’s low-beta hedge fund. , and Strategic Reservoir.
“I think it just simplifies our portfolio,” Moore said. “We have 12 hedge fund managers who are diversified across different relative value strategies, CTA, trend following, multi-strategies – the very low beta strategies.”
Moore said that over the years since its implementation, the portfolio has added more than $1.1 billion to the plan’s excess returns.