Hedge Funds May Be Affected By Ruling To Reduce Detroit’s Pension Benefits

Dec 5 2013 | 9:25am ET

By Don Steinbrugge
Chairman, Agecroft Partners

Judge Steven W. Rhodes’ ruling that the City of Detroit is officially bankrupt and that pension benefits for public pension fund beneficiaries may be reduced will have major repercussions throughout the public pension fund industry. Historically, many public pension funds’ assets have not always been managed to generate the highest risk adjusted returns. This was partially driven by the fact that those responsible for managing the pension assets believed pensioners would get their benefits regardless of how the fund performed, because the municipality could increase taxes to pay for the benefits. This ruling is a shot across the bow to all public pension fund investment professionals that their actions could impact thousands of retirees who depend on their monthly benefit checks. 

One implication of this development will be a greater focus on maximizing investment returns of the pension fund portfolio in order to meet or exceed their actuarial return assumptions which currently average approximately 7.5%. Since 2008, pension funds have been increasing their allocations to alternative investments and this trend will accelerate as long as interest rates remain near historic lows. Part of this alternative investment allocation includes hedge funds. Most public pension funds are using return assumptions of 4% to 7% on a diversified portfolio of hedge funds, which is significantly higher than the approximately 3% return assumption on a diversified fixed income portfolio. In addition, pension funds believe hedge funds add diversification to their portfolio and provide some down side protection during market corrections. Since pension funds have been the major source of growth for the hedge fund industry since 2008, this ruling could have a major impact on the hedge fund industry, because it should accelerate the evolution of how pension funds invest in hedge funds.

This hedge fund evolution process for pension funds typically begins with a small initial allocation to hedge funds via hedge funds of funds. This allocation is gradually increased every few years as a pension plan enhances its knowledge of hedge funds. The second phase of the process is pension funds investing directly into hedge funds, which may often include assistance from a consultant or a fund of funds acting in an advisory role. An overwhelming majority of the hedge funds a pension plan will invest in at this stage of the process are the largest, “brand name” hedge funds with long track records. Performance is of secondary consideration to perceived safety and a reduction of headline risk. A vast majority of pension plans that have a hedge fund allocation are currently in these initial two phases. After a few more years of making direct investments in hedge funds, pension plans move to the third phase and begin to build out their internal hedge fund staff, which shifts the focus from name brand hedge funds to alpha generators. These tend to include small and midsized hedge funds that are more nimble. In a 2012 study done by Pertrac focusing on the past 16 years, small hedge funds out performed large hedge funds in 13 out of 16 years with an annualized compound ROR for the average small fund of 12.5% compared to that of large funds of 9.16%. Simply put, it is much more difficult for a hedge fund to generate alpha with very large assets under management. Some pension funds are also allocating a portion of their hedge fund investments to niche oriented funds of funds.

The final step of this evolution occurs when pension plans stop viewing hedge funds as a separate asset class and allow hedge fund managers to compete head-to-head with long-only managers for each part of the portfolio on a best-of-breed basis. Many of the leading endowments and foundations have evolved to this point. Their portfolios are primarily invested in alternative managers, with large allocations to midsized hedge funds. This allocation strategy is now being called the “endowment fund approach” to managing money.

As pension funds increase their share of the hedge fund industry assets, there will also be other implications for the hedge fund industry including downward pressure on fees, greater transparency of security positions and more demand for managed accounts.

Don Steinbrugge is Chairman of Agecroft Partners, a global consulting and third party marketing firm for hedge funds. Agecroft Partners has won 18 industry awards as the Third Party Marketer of the Year. Highlighting Don’s 28 years of experience in the investment management industry is having been the head of sales for both one of the world’s largest hedge fund organizations and institutional investment management firms. Don was a founding principal of Andor Capital Management where he was Head of Sales, Marketing, and Client Service along with being a member of the firm’s Operating Committee. When he left Andor, the firm ranked as the second largest hedge fund firm in the world. Previous Don was Head of Institutional Sales for Merrill Lynch Investment Managers (now part of BlackRock). Don was also Head of Institutional Sales for NationsBank (now Bank of America Capital Management). At both Merrill Lynch Investment Managers and NationsBank a large percent of the firms’ assets were large pension funds.

Don is a member of the Investment Committees for The City of Richmond Retirement System, a member of the Board of Directors of the Hedge Fund Association, Lewis Ginter Botanical Gardens and the University of Richmond’s Robins School of Business. In addition, he is a former two term Board of Directors member of The Richmond Ballet (The State Ballet of Virginia), The Science Museum of Virginia Endowment Fund and The Richmond Sports Backers Scholarship Fund.

In Depth

Q&A: Neil Azous Talks Global Macro Investing

Nov 24 2014 | 12:41pm ET

Neil Azous is the founder and managing member of Rareview Macro, an advisory firm...


Griffin Selling Chicago Apartment

Nov 26 2014 | 11:40am ET

Citadel Investment Group’s Kenneth Griffin is making clear to his estranged wife...

Guest Contributor

Why The Big Money Is Going To Europe

Nov 14 2014 | 6:03am ET

Peer-to-peer lending was invented with the individual investor in mind. But despite...


Sponsored Content

    For Hedge Funds, Mastering Data Is Key To Success

    Nov 4 2014 | 9:45am ET

    Data management is important to every business, but for hedge funds, it is critical. FINalternatives recently asked Peter Sanchez, CEO of Northern Trust Hedge Fund Services, how fund managers can deal with the demands of managing data while at the same time remain transparent and abide by operational best practices. Read more…

Editor's Note

    Guidelines for Guest Articles

    Oct 22 2014 | 9:46am ET

    We are always looking for guest articles from hedge fund managers and buy-side firms.

    If you are interested in submitting a contributed piece for possible publication on FINalternatives, please take a look at the specs. Read more…


Futures Magazine

November 2014 Cover

Building a better market

Reg NMS created a huge bifurcation in equity markets and while much of what has followed has been positive, in terms of lower fees and greater liquidity, many traders would like to see the market come...

The Alpha Pages

TAP July/August 2014 Cover

The Alpha Pages Interview: Senator Rand Paul

Senator Paul sat down in the debut series of the Alpha Pages Interview to discuss the broken tax code, regulation surrounding Bitcoin, and his plans for the 2016 Presidential election.