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Pension board wants better hedge fund results

Direct investing may cut costs, boost returns

By Beth Healy
Globe Staff / February 2, 2011

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In a move to save $30 million in fees and improve investment results, the state pension fund is looking to cut middlemen out of its approach to hedge fund investing.

The pension board yesterday voted to start investing directly in hedge funds, rather than farming out those decisions to so-called funds-of-funds, which tend to be secretive and costly. About 8 percent, or $3.6 billion, of the retirement fund’s $48.3 billion in assets is currently invested with hedge funds, all of it through funds-of-funds that spread money across a number of hedge funds.

“We can do better,’’ said Steven Grossman, the new state treasurer and chairman of the pension board. He said the fund is looking both to save management costs and to invest in a better group of hedge funds. “We think we can save significant fees, and we think we can eliminate significant manager overlap,’’ he said.

Hedge funds, which are lightly regulated, can invest in a broad array of securities and other vehicles, and sometimes use exotic techniques to make profits.

The state would at first invest about $500 million with managers of individual hedge funds by the end of the year, Grossman said. The pension fund is seeking bids for a consultant to help place that money. If the test is successful, the state would place much more of the hedge fund money directly, Grossman said. Among the 10 largest public pension funds in the country, only one other — Pennsylvania — invests all its hedge fund money through funds-of-funds. Half go entirely direct.

Hedge funds were laggards in the state fund’s performance last year. The total fund rose 13.6 percent in 2010, slightly outpacing the fund’s goals, and adding $5.7 billion in value. While bonds, private equity, and stocks all made high double-digit gains, the hedge funds returned just 6.3 percent.

State officials said the hedge funds beat their benchmark, but acknowledged the performance was unimpressive. Of the 10 worst performances in the fund last year, relative to similar investments, two were funds-of-funds. The state does business with five funds-of-funds.

The review of funds-of-funds was sparked in part by November’s FBI raids on a number of hedge funds for alleged insider trading. The state learned that three of the funds-of-funds it does business with all had small amounts of money with one of the raided firms. The firms have denied wrongdoing, but even so, such events can cause problems for funds and investors.

The state had $66 million at stake, a tiny sliver of the fund. But it has lost small amounts of money in a number of other hedge fund scandals and failures in recent years. Michael G. Trotsky, a former hedge fund manager who became executive director of the pension fund last summer, has questioned whether the state is getting its money’s worth from funds-of-funds. Many of the top hedge funds don’t do business with these middlemen.

The move to invest directly in some hedge funds comes as the new treasurer starts his review of the pension fund. Former treasurer Timothy P. Cahill led the charge for hedge fund investments starting in 2004, but he championed funds-of-funds, arguing they were the least risky way to invest in the sector.

Grossman, citing the recent FBI raids, said, “I don’t think you avoid the risk by going though the fund-of-funds approach.’’

He noted that the pension fund already deals directly with dozens of private equity and venture capital managers. The pension staff said the state presently has a stake in 200 hedge funds; they believe they could run a diversified hedge fund portfolio with fewer than half that number.

Beth Healy can be reached at bhealy@globe.com.