Assets fall despite better returns than stocks, bonds

More U.S. pension plans had lower hedge fund assets as of Sept. 30 compared with the prior year due in part to challenging market conditions and because some asset owners lowered their hedge fund allocations in favor of other asset classes.

Pensions & Investments' annual U.S. retirement plan survey showed that aggregate hedge fund assets for defined benefit plans were down 17.2% to $138.3 billion for the year ended Sept 30 and were down 13.3% from five years ago.

Hedge funds did their job during a rocky year ended Sept. 30, with HFR Inc.'s HFRI Fund Weighted Composite index returning -5.91% compared with the much larger decline of the S&P 500 Total Return index, which was down 15.5% over the same period.

Asset owners utilizing a more traditional 60% equity/40% fixed-income portfolio model last year found that they needed a new construct, given market conditions, industry sources said.

Pension fund investment teams using the 60/40 portfolio construction sought diversification due to the fact that "these portfolios struggled in 2022 because traditional correlations did not hold up between equities and bonds," said Victoria Vodolazschi, the New York-based director of investments and hedge fund research at Willis Towers Watson PLC.

Investors were "looking for true diversifying strategies in 2022 to add uncorrelated alpha. The value proposition for hedge funds is that they provide alpha when other strategies are not," Ms. Vodolazschi said.

Among the hedge fund strategies that asset owners favored in the year ended Sept. 30 were macro strategies, which were buoyed by big moves in interest rates and foreign exchange; systematic commodity trading adviser funds that rely on managed futures; and relative value approaches, said Patrick Ghali, co-founder and managing partner of London-based consulting firm Sussex Partners U.K. Ltd.

Hedge fund strategies that did not do well in 2022 were long/short equity and momentum trading, Mr. Ghali said.

"Markets persistently did not value fundamentals in 2022 and markets were driven by inflation and liquidity issues," Mr. Ghali stressed.

Los Angeles County Employees Retirement Association, Pasadena, Calif., mainly uses multistrategy hedge funds as a risk mitigator for the $67.6 billion system and increased its hedge fund portfolio to 6% from 4% in May of 2021.

The fund also launched a hedge fund emerging manager program at that time with an allocation range up to 15% of the overall hedge fund program in 2021, said CIO Jonathan Grabel in an email.

LACERA's hedge fund AUM totaled $4.3 billion as of Sept. 30, up 38.2% compared to the same date in 2021.

Just $34 million was invested in hedge funds of funds, according to the survey data.

Mr. Grabel said LACERA's fund is broadly diversified across five asset classes and the fund's hedge fund portfolio is within the fund's risk-mitigation category.

"These hedge fund investments seek to deliver return outcomes that are uncorrelated to equity markets, are frequently positive and provide downside protection to the whole portfolio in periods of market stress," he said.

"LACERA's risk-mitigation fund portfolio has returned an annualized 7.1% over the last three years — through Sept. 30. 2022 — while having a risk-and-return profile that is uncorrelated to equity markets," Mr. Grabel added.

Other asset owners that changed their asset allocation lineups in 2021 included the $61.4 billion Maryland State Retirement and Pension System, Baltimore, which "as part of its regular asset allocation review in 2021, the system reduced the target for the absolute return portfolio from 8% to 6%," said CIO Andrew C. Palmer in an email.

"Other asset classes were adjusted up or down by 1%-3%. Overall, the changes improved the inflation responsiveness of the portfolio and the probability of achieving the required return in many market environments. These changes were based on long-term return, risk and correlation expectation," Mr. Palmer said.

As of Sept. 30, the Maryland fund had $4.3 billion invested in hedge funds, down 25.2% compared with the same date in 2021.

Data from P&I's survey showed that as of Sept. 30, the Maryland fund had $1.5 billion in relative-value hedge funds, $1.4 billion in tactical trading funds, $995 million in event-driven funds, $259 million in equity hedge funds and $130 million in multistrategy funds. Each portfolio was down about 25% from the prior year.

Texas Municipal Retirement System, Austin, with total assets of $34.8 billion, had $2.7 billion invested in hedge funds as of Sept. 30 and was down 23.3% from the same date the previous year. Hedge fund-of-funds assets were down to $3 million from $60 million.

"TMRS' hedge fund allocations were adjusted in response to the TMRS board of trustees' reallocation of the fund's target allocation for hedge funds in June 2021 from 10% to 5%," a spokeswoman for the Austin-based fund said in an email.

As of June 30, Texas Municipal had $988 million invested in multistrategy hedge funds, $638 million relative-value funds, $626 million in equity hedge funds and $464 million with tactical trading funds. The pension plan did not provide hedge fund strategy breakouts in 2021.

The $288.6 billion California State Teacher's Retirement System, West Sacramento, remained the largest investor in hedge fund strategies for a second year, P&I's survey data showed.

Assets invested in hedge funds totaled $23 billion as of Sept. 30, up 26.5% from the prior year compared with growth of 34.9% in the year ended Sept. 30, 2021.

A representative for CalSTRS declined a request to speak with the fund's investment team about the system's portfolio.CalSTRS showed on its P&I survey that the system invested $13 billion in tactical trading as of Sept. 30, down 25.4% from the previous year, while in contrast, the system invested $1 billion in relative-value hedge funds, up 33.3% from Sept. 30, 2021.

Aggregate assets in hedge funds of funds totaled $7.6 billion as of Sept. 30, down 18.3% from a year earlier and down 72.3% during the five-year period.

Part of the reason for the decline in investment in hedge funds of funds is that public pension funds are "anti-fee and put pressure on both hedge funds and hedge funds of funds for lower fees," said Stephen L. Nesbitt, the New York-based CEO of alternatives investment consultant Cliffwater LLC, in an interview.

While hedge fund fees average between 2% to 3%, funds-of-funds managers charge an additional management fee of between 0.25% to 1%. These fees are difficult to justify when the absolute return for hedge funds has been below 5% over the last decade, Mr. Nesbitt said.

"On a go-forward basis, many of the high-performing hedge funds are not accessible to asset owners and hedge funds of funds because they are capacity constrained," he said.

"The expected return and risk profile for hedge funds that most consultants use in asset allocation studies is not attractive enough to warrant meaningful allocations." Mr. Nesbitt added.