The Universities Superannuation Scheme

Innovation leads £1.3 billion hedge fund investment programme

Originally published in the November/December 2009 issue

The implementation of a £1.3 billion hedge fund investment scheme by the Universities Superannuation Scheme (USS) shows why the pension fund has developed an unrivalled reputation for innovation among British institutional investors. Mike Powell, the head of alternative investments, joined USS in late 2006 and quickly put in place the underpinning for a wide ranging alternatives investment programme.

From early 2007, USS began investing in private equity, commodities and infrastructure, which together with the hedge fund allocations will eventually see the pension fund have a 20% weighting to alternatives from a pension fund pot that now totals £27 billion. A further 10% of the fund is run by a separate real estate team.

So far, the alternatives allocation has risen to about 9% of the pension fund’s assets as it pursues a five year roll out of the investment programme. Only two single manager hedge funds have received allocations, but exploratory talks are underway with around20 other managers as USS looks to get its hedge fund exposure established over the next two years. But since the pension fund’s overriding aim is to be opportunistic it could roll out the capital quicker if opportunities demand that.

“The initial strategic plan was to invest across all those asset classes with the initial focus on private equity,” Powell says in an interview at USS’s City base. “We had some concerns about the overall financial markets and some of the issues in hedge funds themselves including passive liability issues. At the end of 2008 we decided the time was right to start making the hedge fund allocations. That decision was opportunistic. A lot of the concerns we had with the hedge fund industry, including asset-liability miss-match issues, had really been cured by the market. Concerns about the excessive amount of beta in hedge funds and their move into illiquid assets had also been cured by the financial crisis. It looked like a good opportunity to start rolling out the programme.”

Diversification and active management
Two funds of hedge fund portfolio managers have joined USS to run the programme, reporting to Powell. Emily Porter, formerly of Key Asset Management, is working with Luke Dixon, formerly of JP Morgan, managing the portfolio. It is being structured as a customised internal fund of funds with a core, tactical and satellite approach to allocations.

The aim is diversification with some active management between the core strategies of trading oriented global macro and variable bias long/short equity. The satellite strategies will include long/short oriented credit and catalyst/event driven managers.

The return mandate is LIBOR plus 500 basis points. The return target shows a far from conservative approach to hedge fund investing. The portfolio will, for example, be able to take directional exposures and will eventually look at investing in a distressed single manager fund. The main criteria is that the portfolio should have a beta limit of 0.2 to listed equity markets across the cycle to help dampen the long-bias of USS’s long-only equity investments. The portfolio’s target volatility is 50% of listed equity markets on a monthly basis.

“The original strategy for the alternatives programme is for each of the alternative asset classes to bring something different so that at the portfolio level it would achieve the overall returns,” says Powell. “For alternative assets we have a 5% real target return. All the components of the alternatives programme have to have risk and return attributes which would enable us to reach that. I see the hedge funds pitched in between two extremes: a bond substitute Libor plus a couple of percentage points with very low volatility and an equity substitute with higher volatility and higher returns. The USS programme is a moderate hedge fund risk/return target. From the modelling we’ve done LIBOR plus 500 basis points is possible over the long run and is achievable with a constrained beta approach.”

The USS portfolio will be conservative in the use of hedge fund strategies employing leverage, though the aim isn’t to shy away from volatility. “You can help control or mitigate that through portfolio construction but the volatility of underlying funds is what you need to generate returns,” says Dixon. “It makes sense to have much more realistic return-volatility expectations for the portfolio. A lot of institutions were employing funds of hedge funds as bond substitutes in portable alpha strategies and that market has completely blown up.”

Rather than focus exclusively on minimising volatility, the portfolio construction model will be careful to avoid tail risk. Powell says there is generally a trade off in getting the balance right. “If you minimise volatility you tend to be maximising some other form of risk in the portfolio,” he says. “As far as we can tell if you try to minimise the volatility of a hedge fund portfolio you are likely to maximise the tail risk within that portfolio. If you look at very low ex ante or realised volatility strategies like arbitrage, they tend to exhibit big left tails. Our view is that even though we may have a higher volatility when we put the programme together on a forecast basis, the actual history of the programme once it gets up and running will show the risk to be lower. We won’t have those left tails. We will be more exposed to directional strategies, but using macro and equity long-short type strategies will constrain our beta and we will have less exposure to event driven and arbitrage strategies.” The assertion is that using a hedge fund portfolio as a bond substitute is wrong-headed in light of events during the past year. Investors may have been earning bond like returns, but with higher risks than bonds and indeed, in light of the typical illiquidity of many such strategies, higher risk than most investors could imagine.

Responsible investment
USS is well known in Britain and overseas for its commitment to responsible investment. The pension fund has a dedicated team that looks at responsible investment issues across all its funds and strategies. Powell is matter of fact in saying that responsible investing and related concerns has been one of the key defining characteristics in the development of the alternatives programme. A central aspect of this is integrating governance issues into the appraisal of an investment opportunity. “We truly believe that having a proper governance structure in place is very important,” says Powell. “The experience of the last 12 months has proved that. I have found it quite surprising that investors don’t look at these governance issues when they invest in hedge funds. Often we are told that we are the only people to have asked to talk to the directors on the board of a hedge fund. We believe it is very important.”

The USS alternatives team believes the Hedge Fund Standards Board is very useful to investors and is a sure step in the right direction. But USS wants to push hedge funds further on how corporate governance actually operates in a fund structure. A key focus is whether directors of a fund are truly independent. How does a fund appoint its directors? Does a director have personal or past professional ties to an investment manager? But the process doesn’t end there. “Directors, in theory, may be independent but they won’t necessarily embody the characteristics we want to see if they are not as diligent, competent or experienced in the strategy and able to really bring to bear the types of oversight you would like to have,” says Porter. Directors, for instance, should have the wherewithal to know if a manager has strayed from his strategy and report it. In particular, USS wants the role of independent directors to devolve to individuals with the experience and competence to exercise a major oversight role in governance.

Dixon observes, wryly, that many directors do a good secretarial job but are less able to understand the nitty gritty of a particular fund. Indeed it is common in some quarters of the industry for directors to sit on so many boards that it is impossible for them to really know what is going on with a particular fund. “When directors need to stand up and fight for investors’ rights they need to know what is going on in the fund and be able to track an evolution of a fund over time to be able to take informed decisions and question a manager,” he says. “Over the last 18 months to two years, funds were taking decisions that favoured the manager’s interest over the investors’ interest so we are very sensitive to that.”

Dialogue with managers
One procedure that USS insists on is directors having direct communications with the auditors and the administrators in resolving pricing disputes. A board may have good access to the hedge fund but the terms of engagement need to be appropriate to ensure that governance is satisfactory. Directors are also expected to be responsible for material changes to offer documents and should be sufficiently experienced to review the balance sheet of a fund and its risk metrics. “We want to see them having a dialogue with the manager and offering tough, intelligent questions,” says Dixon, who adds that the two funds USS has allocated to are at the top level of corporate governance.

Another area where USS is active is on speaking out about the proposed Alternative Investment Fund Managers Directive. The pension fund has taken a pro-active role in writing to the European Commission expressing concerns about the Directive even though it supports prudent and proportionate regulation. “For us it really comes down to access,” says Powell. “We need the ability to access the top managers, whether or not they are based in Europe, the US or elsewhere. As the Directive is currently drafted, it is impossible for us to access non-EU managers. That really needs to change to give US managers the ability to market in Europe as is currently allowed under the private placement rules.” He is also critical of the additional costs of the Directive being passed on to investors but says this is a commercial matter for USS to take up with hedge funds it allocates to.

Core allocations
The pension fund envisages allocating £75 million to £100 million to its core managers, mainly in macro and variable bias long/short equity. Tactical allocations to satellite strategies will be for a minimum of £25 million, while niche strategies, which by their nature are capacity constrained, are likely to be written tickets of less than £25 million.

Proportionally large allocations to one hedge fund are likely to be done through a managed account. Given the size of the core allocations, however, it is expected that most of the funds USS allocates to will have AUM of $1 billion-plus.

With trading oriented macro and variable bias long/short equity getting core allocations, the portfolio will be avoiding strategies with a sustained long directional bias. This rules out short-biased managers, activist funds, value investors and most sector specific funds. Though market neutral equity funds could find their way into the portfolio’s rather large basket of long/short equity funds, Porter and Dixon are really looking to find funds that can move their gross and net exposure around quite actively to take advantage of opportunities.

USS is also keen on long/short trading orientated credit. “Most credit managers come from the long-only world – buying and owning bonds and carry investing,” says Dixon.

“We are looking for managers who actually trade it. There is a very pleasing asymmetry to investing short in credit particularly when there are a number of managers out there who have traded very successfully over a number of years predominantly from the short side. We like the trading orientation of that. Even though it is a limited universe there are some good managers in that strategy.” The portfolio is also looking to invest in catalyst/event driven funds; not multi-strategy or high leverage users, but funds investing predominantly in equity and corporate debt.

Once the core elements of the portfolio are established, Porter says the portfolio will consider allocating to distressed fund managers. “We do think that distressed, in particular, is something you time the entry and exit from,” she says. “We do want to have that tactical element to our positioning. If we feel we are going to build out the core parts of our portfolio for the next year or so then in a year’s time if the distressed environment looks particularly strong we might take a tactical weighting in it.” Since the alternatives segment of USS is run on a single pool of capital basis, the illiquid characteristics of distressed funds will auger against a high level of allocations given the tranche of the portfolio committed for the long-term to private equity funds. Last year, in fact, the single capital pool model saw funds earmarked for hedge funds allocated instead to residential real estate loans using a private equity structure.

Porter, Dixon and two analysts do manager sourcing, with an additional support person assisting on operational due diligence. Powell, who has a veto power, meets all managers that are being considered for allocations and each allocation goes before the USS alternatives investment committee. Porter, Dixon and Powell are on the committee with further voting members drawn from other portfolio managers across the alternatives programme as well as the head of UK equities and the chief investment officer of USS. Since the pension fund uses an open committee format any member of the alternatives team can attend proceedings as do the head of risk and the pension fund’s in-house counsel thought they do so in a non-voting capacity. Getting a manager on board, if it is a priority, can occur in about two months.

Getting transparency from hedge fund managers, rather than negotiating fee reductions, is the central focus of the portfolio managers. “I think at the beginning of the year people thought there would be a lot of power in the hands of investors and we’d be able to negotiate pretty aggressive fee breaks,” says Porter. “But some of the power has shifted back to the funds. The very good hedge funds that were raising money last year have closed. We will try to get better terms or better liquidity if the mandate merits it and we might want to use a managed account. What we are pushing on most is transparency which is something we can push quite hard on. It won’t stop us accessing the very good managers who are now willing to provide very high levels of transparency. We think that is the most practical thing to push in the current environment.”