But CalSTRS was not shying away from the slick, impenetrable hedge fund game, choosing to pay Lyxor a premium to do the leg work and decision-making. No, CalSTRS' experimental innovation and risk unit wanted a partner—an extension of its team with the expertise to guide its venture into hedge funds. Lyxor, the group concluded, could do that better than any firm with "Advisors" or "Consulting" in its title.
"Why Lyxor? The breadth of their services really impressed us," says Carrie Lo, a CalSTRS investment officer with the innovation and risk team. "Setting up managed accounts, and trying to understand all of that, was something we were very interested in. They already have the infrastructure and experience to do that. Also, their analysts are really top-notch. Coupling those touch points, we knew it was a good fit." Plus, she adds, "We like that they are institutionally oriented."
Lo brought her own expertise to the search. Prior to joining the $167 billion pension fund in 2008, Lo spent four years at Algert Coldiron Investors, a San Francisco hedge fund founded just two years before she arrived. "I joined when they just had one fund," she recounts, "and I got to see all of the aspects of actual trading and risk management." The head of the innovation and risk group, 20-plus-year CalSTRS veteran Steven Tong, brought deep institutional knowledge to the new unit. Together, Tong and Lo knew they were going against the grain by hiring—not firing—a hedge fund-of-funds.
The number of funds-of-funds has dropped every year since the financial crisis, although the hedge fund industry overall has boomed. The total number in operation has dropped by more than 20% in five years, from a pre-crisis high of roughly 2,400 to fewer than 1,900, according to Hedge Fund Research's latest industry report. More capital has flowed out of the sector than into it for each of the last three years. In 2012's final quarter, less than one in five funds-of-funds secured more new money than it lost in withdrawals. For hedge funds themselves, however—as the infographic here illustrates—-business has been booming. Total assets under management hit $2.69 trillion at the end of April, up 39% since 2008, according to eVestment data. Most of that money has come from institutions, which a Preqin survey found were responsible for 65% of total industry assets in 2012. Like CalSTRS, many endowments, foundations, sovereign funds, and other pensions are simply cutting out the middleman.
"The word on the street with funds-of-funds is 'OK, how are we going to create value in the future?'" says Lyxor's Head of North American Business Development Mike Bernstein. He recently did the rounds at industry conferences, and found the sector is all too aware of its tenuous position. But as he sees it, the last five years have been a Darwinian stage for funds-of-funds: Survival of the fittest. "There has been quite a shakeout. If you've made it up until this point, I think you have a good chance of surviving. You're going to have the large funds-of-funds competing on their ability to negotiate fees and terms, and the small specialized ones that continue to deal in places that are just too painful for investors to do themselves."
Lyxor is one of the big ones: With $22.5 billion under management, the Société Générale offshoot came in sixth on Towers Watson's latest ranking of funds-of-funds. But as an advisor, Lyxor was far from the obvious choice. "It is to CalSTRS' credit that they chose us in the first place," Bernstein says. "We were by no means a household name, and it shows independent thinking."
The Sacramento-based pension issued its request for proposals for a global macro hedge fund consultant on April 6, 2010, the culmination of more than a year of research and strategizing by the innovation and risk team. The unit had been set up to determine what was missing from CalSTRS' portfolio, and to act as an incubator or lab for testing out new ideas on a small scale. Its first mission: hedge funds. A number of other large public funds had already entered the space, and they proved to be a font of practical advice when Tong and Lo came calling. The pair also did extensive quantitative analysis to select the single best hedge fund strategy for diversifying CalSTRS' portfolio. Global macro, they found, had little correlation to equities, and performed well during market downturns. It was 2009, and those were very appealing qualities. "We went to the board and presented our findings, focusing in on global macro," Tong recounts, "and the board said 'That's great, we agree, but we're concerned with investing in the hedge fund space,'"—again, 2009—"And so they asked us to hire a consultant."
More than 10 firms applied for the job, including traditional advisories, consultants, and at least two funds-of-funds. Five applicants made the final round. Lo and Tong knew what they were looking for: Expertise with global macro investing, foremost, as well as capability in portfolio construction, manager selection, and investment term design. They required an advisor willing to have skin in the game as a fiduciary, but insisted that the fund stay in control of manager selection. At no point did the role resemble a typical hedge fund-of-funds arrangement, where asset owners describe their goals, sign the checks, and leave the investment decisions up to the firm.
But over the 15-month-long search process, Tong and Lo say they began to realize that a number of CalSTRS' problems with investing in hedge funds could be solved or lessened by the managed account structure. These pools separate custody of the assets from the manager who invests them, thus reducing an asset owner's exposure if it turns out that "hedge fund" is more of a Ponzi scheme. A hedge fund may also be willing to provide more transparency or reporting to investors in managed accounts than for its main pool. Typically, the structure does make for a more costly investment. "It's important for us to get a certain return," Tong says, "but the risks are tantamount"—headline risk being enemy No. 1.
For all of the advantages managed accounts offer a major public institution like CalSTRS, simplicity is not one of them. Managed accounts are logistically complex, involving a web of counterparties and legal agreements. They can be set up for one investor exclusively or a number of them with similar needs. Some hedge funds will do them happily while others may not-it depends who's asking and what, exactly, they're asking for. If Tong and Lo felt their team could go it alone with basic global macro allocations, they knew CalSTRS could really use an expert hand with managed accounts. Lyxor, one of the five finalists, has an entire platform set up for arranging these side bets. Before the advisory contract had even been finalized and signed, the Innovation and Risk unit was already touting global macro investments via managed accounts in a business plan for the 2011 to 2012 fiscal year.
Mike Bernstein remembers the precise moment when he found out Lyxor would be the lead advisor for CalSTRS' venture into hedge funds. "It was Friday night. I was with a colleague of mine who had offered to give me a ride home. We were in the parking garage, I believe, and a macro manager sent a congratulatory note. Then I saw one of the trade rags had broken the story: 'CalSTRS has awarded Lyxor the mandate,'" he recalls. "It was a big breakthrough for us in the US." Bernstein joined Lyxor in 2009, specifically brought aboard to attract institutional capital to the firm's new US-based fund-of-funds. "It was a big win."
With Lyxor's guidance, the unit has allocated its entire $200 million global macro budget into four managed accounts. Bridgewater Associates' Pure Alpha Major Markets took $50 million into a pre-existing side account. Alphadyne Asset Management and MKP Capital Management each received $50 million. Lo says the group has selected a manager for the remaining $50 million, but couldn't yet reveal its identity. If these and the rest of the group's investments suitably impress CalSTRS' board, hedge funds may go from an experiment to a full investment program in the coming years. "We're already having dialogue with Lyxor about expanding into the total space," Tong says.
Lyxor had something to offer the California pension giant that regular advisors didn't. As an asset allocator, it knows managed accounts and hedge fund investing in practice, not just in theory. But Lyxor also won the contract through sheer effort. Institutional investors in general, and major public pension funds in particular, make demanding and picky clients. At a recent hedge fund conference, one of CalSTRS' investment officers likened the organization to a "high-maintenance girlfriend," needing endless phone calls, reassurance, and attention to be kept happy. Lo, Tong, and Bernstein laugh at the comparison, but they don't deny it.
"It is a credit to us that we could withstand the due diligence," Bernstein says. "It was extreme—a full, open-kimono kind of situation where they saw the good, the bad, and the ugly." Lyxor took a risk in thrusting resources behind its bid for the advisory slot, particularly as an unconventional candidate. The gamble paid off, of course: As an advisor to an institution going direct with its hedge fund investments, Lyxor is capitalizing on a trend that beat up its core business as a fund-of-funds. CalSTRS has not disclosed how much it is paying for the advising—the fund's most recent public report on external investment consulting fees covers the 2010 to 2011 fiscal year. But according to Tong, the fee arrangement with Lyxor is based on assets under advisory. At just $200 million thus far, Lyxor must be crossing its fingers for CalSTRS' board to expand hedge fund investing beyond the incubation stage.
CIOs tend to have the same single complaint about funds-of-funds: the extra layer of fees. One of the first actions Steven Grossman took as Massachusetts state treasurer and chairman of the public pension system was to begin pulling nearly all of its assets from funds-of-funds. “We were paying an extra 84 basis points over standard direct management fees,” Grossman told aiCIO in an August 2012 interview. “On $5 billion, that’s $36 million. We hadn’t been particularly happy with our returns on those investments.” Besides saving on fees, he also wanted to bring the due diligence process in-house. Roughly two years into the transition to direct investing, the number of active funds-of-funds investments in the portfolio has dropped from more than 200 to three—but one of them will be spared from the slaughter. Out of all 200-plus relationships, why is the $53.6 billion Massachusetts retirement system willing to keep paying a premium to Pacific Alternative Asset Management Co.? Exposure to emerging managers, according to Grossman. “That’s an area we want to broaden our outreach to, and we’re doing it through PAAMCO.”
Research backs up Grossman’s bullishness on small and early-stage hedge funds. A 2012 PerTrac study found that funds with less than $100 million under management returned a cumulative average of 558% from 1996 through 2011. Funds with between $100 million and $500 million returned 356%, while those managing more than $500 million gained an average of 307%. (This study and others have attracted criticism for survivorship bias, which industry experts say is difficult to completely control for.) Researchers argue new managers have more incentive to beat benchmarks and deliver alpha, since unlike established giants, they cannot coast on management fees.
If the last five years have been harder on any group in finance than funds-of-funds, it may well be new hedge fund managers. (OK, besides prop desks.) The lion’s share of new institutional allocations goes to funds with more than $5 billion under management, according to Preqin data, and the lion’s share of new capital is institutional. “Pension funds are tough for new managers, unless you connect with one such as CalPERS with a seeding program,” says David Fry, the former head of global markets for Deutsche Bank Canada. Fry and a partner launched credit-focused hedge fund Lawrence Park Capital Partners in March 2012. The eight-person team now manages $250 million in a long-only mandate and $52 million from limited partners. Based on his experience as an early stage manager, Fry points to funds-of-funds as an important conduit for securing capital. “The funds-of-funds”—and he’s met with many—“know how to evaluate a manager starting for zero. Anybody can find Och-Ziff and Bridgewater, but to pick out the new strategies, the niche strategies, and the up-and-comers takes much more work. It is not necessarily feasible for most institutions to take on a direct search in this space.”
Just as Lyxor’s expertise in managed accounts sealed the deal for CalSTRS, funds-of-funds specializing in new managers offer most investors something they can’t do at home. One such firm, Larch Lane Advisors, has been operating this model since 1999. President and COO David Katz says new managers’ appealing fee structures and flexible terms continue to attract investors, despite the industry’s overall malaise. “A lot of the smaller funds offer founders’ shares for discounted fees as a way to reward early investors,” he says. As with Lyxor, Larch Lane has actively sought “value-add” services to compensate for the dreaded extra fee layer and to diversify its business. Katz doesn’t just select promising newcomers—he develops and occasionally bankrolls them. If a fund is not equipped to meet institutional compliance standards, Larch Lane connects it with the right people to bring it up to snuff. Finally, since 2001 the firm has invested nearly $4 billion in seed capital with 26 of the best managers it has come across. In return, Larch Lane gets a share of future revenue.
Both Lyxor’s Bernstein and Larch Lane’s Katz naturally make a point of defending the traditional funds-of-funds model as relevant and still in demand. And yet both firms have ridden out the last five years by edging away from that structure. “Advisory” is a much more common term on their firms’ websites than “fund-of-funds”. Neither man argues that this post-crisis period is just a rough patch for the industry. But perhaps there is more at play than a faulty structure. As Bernstein added just as our interview came to a close, “My real take on all of this is that funds-of-funds have gotten a lot of criticism on all sorts of matters. Funds-of-funds might be the obvious whipping boy, but the fact is hedge fund performance hasn’t been all that good.”