General Motors Corp., the company that gave the world the Oldsmobile, the Buick and the Saturn, has long been known along Wall Street as more of an innovator in investment than in automobile design. In 1950 the Big Three carmaker shocked the pension world, and its button-down bond men, when it became the first major U.S. company to buy stocks for its retirement plan. Three decades later, in 1982, GM created a portfolio of foreign stocks well before the idea of investing abroad had even crossed most pension managers’ minds.
The automaker is at the design table again. This time GM Asset Management CEO Allen Reed is putting into gear what may be the most ambitious and far-reaching alternative investment strategy any company has employed. A cornerstone of the plan is a more than doubling of GM’s already substantial investment in hedge funds, from $1 billion to as much as $2.5 billion or more of its $80 billion U.S. defined-benefit-pension portfolio. That could very well make GM’s pension fund the biggest corporate investor in hedge funds. By comparison, the biggest public plan investor, the $24 billion Pennsylvania State Employees’ Retirement System, currently invests $3 billion in hedge funds; Harvard University’s endowment devotes about $2.5 billion to this asset class.
Altogether, GM is steering $14 billion in fresh funds into its pension plan -- and not one dime is destined for U.S. stocks or investment-grade bonds. The idea is to direct it all into a broad category GM calls “alpha,” encompassing everything from private equity and global tactical asset allocation to absolute return strategies. The goal is to boost returns, increase diversification and -- here’s the tricky part -- lower the pension plan’s risk profile. The audacious program will be executed by GMAM, which runs the automaker’s defined benefit plan, as well as $29 billion in non-U.S. retirement plans and insurance portfolios, and $21 billion for outside clients such as Xerox Corp. and Delphi Automotive. Only the GM pension plan is part of the alpha scheme.
GM engineered this dramatic shift in its investment partly because of necessity. Like many of its corporate counterparts, the carmaker watched its pension plan become drastically underfunded during the three-year bear market following the collapse of the technology-fueled stock bubble of the 1990s. The one-two punch of falling stock prices and meager interest rates eroded the GM plan’s funding ratio (the gap between assets and liabilities calculated in present value terms). By December 2002, GM was 23 percent underfunded, or, put more starkly, $19 billion in the hole. By comparison, the typical big corporate plan was about 18 percent underfunded at the end of that year, according to actuarial firm Milliman & Robertson. And even after 2003’s stock market recovery, underfunding for corporate plans still totals more than $300 billion.
The pension burden weighed on GM like a rock. Between June 2002 and March 2003, its share price tumbled 60 percent to $30, in no small measure because investors were worried that the tab for shoring up the pension plan would cut deeply into GM’s revenue and profits.
So last summer the company met the problem head-on. In June, GM floated $17.9 billion in debt -- the biggest bond issue ever -- to close the funding gap. Some $14 billion of that was earmarked for alpha investments to bring the plan up to nearly fully funded status.
“Our investment mix is already broader than [that of] any pension fund in America,” points out GMAM CEO Reed, the driving force behind alpha. “We feel we’ve got no other choice but to go further out on the curve.”
Between last November and late January, GM doled out a whopping $7 billion, mostly to the 80 money managers in its existing stable. Some of that -- GM won’t say how much -- has gone into hedge funds. And a portion has found its way into GMAM Absolute Return Strategy Fund I (GMAMARSF I), an internally managed fund of hedge funds that holds about $800 million of the roughly $1 billion that GM’s pension plan had invested in hedge funds before the advent of alpha. All told, $1.5 billion of the $14 billion in new assets is expected to wend its way into hedge funds.
“This is major-league validation for hedge funds,” says Lee Schultheis, chief investment strategist with Alternative Investment Partners in White Plains, New York.
Reed isn’t tipping his hand about GM’s hedge fund presence, but sources expect money to move into a variety of long-short equity strategies. Some long-short managers will seek to neutralize market exposure, while others will choose some defined market exposure. GM is also expected to invest in risk arbitrage strategies and convertible arbitrage.
One firm recently hired as a broad-scope provider of alpha strategies is AQR Capital Management. The six-year-old quantitative-geared hedge fund group in New York, headed by former Goldman, Sachs & Co. global arbitrage star Clifford Asness, already manages several funds, including multistrategy arbitrage, for the GMAM fund of hedge funds. In the coming months GMAM is also expected to give more funds to Goldman Sachs Asset Management, which GMAM hired in November for broad-scope alpha strategies, including absolute return and global tactical asset allocation.
IF GMAM DESIGNED GM CARS, THEY WOULD ALL come with manual transmissions: The automaker’s money arm is an aggressive advocate of active management. Whereas the average corporate plan manages 13 percent of its assets passively, according to research firm Greenwich Associates, GM has nothing whatsoever invested in index funds. And although GM was not the first large company to manage other companies’ pension assets -- General Electric Co. broke that ground in 1988 -- the carmaker was quick to stake out its turf when it got into that realm a decade later.
Now, with its $14 billion commitment to alpha strategies -- and especially that bold $2.5 billion bet on hedge funds -- the carmaker is once again galvanizing its pension peers. To be sure, GM was not the first to embark on an alphacentric investment program -- Verizon Communications, Eastman Kodak Co. and Weyerhaeuser Co. have all developed relatively modest alpha portfolios -- but the sheer scale of GM’s commitment to alternatives makes it special as a precedent.
Certainly, the quest for alpha has never been more urgent. “Pension funds are at a crossroads today, similar to the one they faced after the 1970s bear market,” Joanne Hill, co-head of derivatives at Goldman Sachs, contended in a February 2004 report. “The strong equity return environment of the 1980s and ‘90s was consistent with high equity allocations and a preference for beta risk over alpha risk. With lower expected returns, and stock and bond return correlations, that needs to be changed today.”
GM has been in the alpha-chaser vanguard for a while. In October 2000 the company made its first dedicated allocation to hedge funds, committing about $700 million, or 1 percent of its assets, to this still-emerging asset class. The move reflected the unanimous judgment of GMAM’s senior investment officers: CEO Reed, who had joined the company’s Hughes Electronics subsidiary from Delta Air Lines in 1984, becoming GMAM CEO ten years later; Myra Drucker, Reed’s top lieutenant and head of GMAM’s external client effort, who joined GMAM in October 2001 when GM took over the management of Xerox’s $8 billion pension plan; and thenresearch chief Edgar Sullivan, a 30-plus-year company veteran who got his start in the treasurer’s office as a junior analyst.
GM had had a small presence in market-neutral strategies as part of a hedge on its North American equity portfolio, beginning in May 1999. These hedgelike products were managed by two firms, Martingale Asset Management and AXA Rosenberg Investment Management. Unfortunately, the combined portfolio was long value and short growth -- precisely the wrong combination for the speculative market of late 1999. The market-neutral portfolio lost around 20 percent in its first full year, from May 1999 through May 2000, according to a reliable source. (GM declines to offer performance data on its hedge funds.)
Reed, meanwhile, had been following the hedge fund sector for a decade or so and was impressed as it matured and grew, from less than $100 billion in assets in 1990 to $500 billion in 1999. He thought the equity markets were looking frothier and frothier as the Nasdaq composite index flirted with 5,000. In addition, the GMAM CEO was influenced by leading academics, such as Duke University finance professor David Hsieh, who were advocating a greater role for hedge funds in pension plans with long investing horizons.
At the time, GM’s alternative investments consisted chiefly of private equity, global tactical asset allocation and futures and options. All of these were generally overseen by research chief Sullivan, who was initially skeptical of hedge funds. In late autumn 1999, Reed asked Sullivan to form a six-person task force to evaluate the pros and cons of investing in the funds. The group’s report made a compelling case for absolute-return strategies in GM’s pension portfolio, based on risk-return attributes and low correlation with traditional markets. “I became a believer,” says Sullivan, who now works as director of absolute-
return strategies.
Since the mid-1980s GMAM had maintained a substantial allocation to futures and options strictly as an inflation hedge. Feeling that inflation was no longer a palpable threat, Reed figured, as he studied the task force’s report, that it would make sense to liquidate the futures and options positions to fund a new absolute return portfolio. He recommended as much to GM’s corporate board, which in October 2000 approved an allocation of 1 percent to absolute-return strategies.
Reed had signed up Chicago-based Glenwood Partners, part of U.K.-based Man Group, as GMAM’s strategic consultant for hedge funds. Simultaneously, GM committed $100 million to one of Glenwood’s funds of funds. With Glenwood’s help, GMAM identified a dozen or so hedge funds that would ultimately form its own fund of funds. GMAMARSF I was officially launched in summer 2001 and ultimately grew to contain about $800 million in GM pension money. GMAM would later market the fund of funds to other pension plans.
Among the funds on the wide-ranging manager roster: three convertible arbitrage funds, managed by Aristeia International, Bear Stearns Convertible Offshore and Shepherd Investments International; one fixed-income arbitrage fund, Obsidian (Offshore) Fund; and 13 long-short equity funds, including some managed by Black Bear Offshore Fund, Itros Offshore and Redsky Horizon Fund.
“They’re an extremely innovative group at GM,” says Asness, co-founder of AQR, which currently manages $500 million of GM pension money, including a recently assigned broad-scope-mandate portfolio as part of GM’s alpha push. “The whole pension world is faced with the problem of meeting growing obligations in a world of lower prospective returns for traditional investments and traditionally structured investment mandates,” Asness continues. “Unlike many others, GM isn’t just monitoring this situation -- they’re coming up with a plan.”
At first the new strategy seemed disturbingly like GM’s infamous Corvair. In a tough investing environment for all asset managers, GMAM’s fund of hedge funds underperformed its peers, as measured by the Altvest sub-index of fund of funds, a universe of some 500 absolute-return funds of funds. From March 31, 2002, to March 31, 2003, GM’s fund of funds was down 48 basis points, compared with a 2.09 percent gain for the Altvest index.
The fund of funds has bounced back. Between March 31, 2003, and the end of the year, it gained 6 percent, compared with 6.1 percent for Altvest.
Of GMAMARSF I’s current assets of $1.2 billion, $800 million belongs to the GM pension plan. The rest is split among external clients and other GM affiliates for which GMAM manages money, such as GM’s non-U.S. pension plans. GMAM still has an additional $200 million invested with some outside funds of funds, among them Glenwood and UBS O’Connor.
LIKE OTHER BOLD VENTURES, GM’S ALPHA strategy was inspired by adversity. Heading into 2003, GM anticipated that it would need to contribute $15 billion over five years to its pension plan just to meet minimum funding requirements under ERISA. The obligations had become a serious threat to GM’s profits.
In May 2003, GM CEO Richard Wagoner Jr. approved CFO John Devine’s recommendation to issue a massive $17.9 billion debt offering, of which $14 billion would be used to shore up the company’s pension fund. Then Wagoner handed Reed a clear mandate: Invest the $14 billion in such a way that the overall volatility of the pension fund would decline, even as the fund met its targeted annual return of 9 percent. Specifically, GM wanted to reduce the probability of a negative return in any given year from 20 percent to 10 percent. “If they really are able to reduce volatility in this way, it will be quite a significant accomplishment,” says Saul Rubin, an automobile company analyst for UBS. “That kind of reliable, stable return from the fund is more valuable than if they were to shoot the lights out.”
“It’s not every day you get handed $14 billion and are told to go design a brand-new asset allocation,” says Reed.
Adds Drucker, “Getting $14 billion in one shot is a rare opportunity to do something totally drastic.”
Under the direction of Reed, Drucker and Sullivan, director of absolute-return strategies, GMAM’s staff of 120 investment professionals studied the interaction of different asset classes to determine the ideal mix for higher returns and lower volatility.
Initially, Reed considered increasing GM’s allocation to fixed-income investments -- a sure way to reduce volatility. But that option was quickly shelved, because it could never provide an adequate return for GM to meet its pension obligations. “We knew that a shift from equity to bonds was not optimal, due to low fixed-income returns,” Reed explains.
The GMAM staff, working with three outside consultants, whom Reed will not identify, came up with a strategy to meet the plan’s 9 percent long-term expected return target as well as lower its overall volatility. Their notion: Reduce exposure to domestic and global equities and increase allocations to asset classes in which alpha can really shine, such as emerging-markets equity and debt, real estate, private equity and hedge fund strategies. GM also includes in its alpha category U.S. high-yield bonds and small-cap stocks, asset classes that others would view as more traditional.
Once the $14 billion is put to work, GM’s target range for global stocks will fall from about 50 percent to 40 percent. The pension fund will be transformed: The percentage of plan assets invested in high-alpha strategies will soar from 15 percent to roughly 35 percent. “GM is really leading the way into absolute return, and I expect we very well could follow,” says William Einhorn, executive director of the $1.2 billion Teamsters Pension Trust Fund of Philadelphia and Vicinity, which invests in some GMAM real estate funds.
“No one is saying you can eliminate risk,” says Reed. “But you can control it. The only sure way to control risk is through diversification. In our opinion there is no such thing as being too
diversified.”
Of course, strong returns with modest risk are the ambition of every pension investor -- always easier to articulate than to execute. “Alpha is an elusive little devil,” says Craig Israelson, a finance professor at the University of Missouri-Columbia. “Because alpha is linked to secular cycles among different asset classes, you have to get in before they heat up. That’s called market timing, and it can hurt you.”
Although Reed won’t identify prospective hedge fund managers, GM is looking for firms that can articulate and strictly follow a clear investment philosophy. Certainly, GM will insist on risk management discipline. Some of its hedge fund management will likely come from broad-scope alpha providers and asset managers who use absolute-return and market-neutral strategies. AQR and Goldman Sachs’ alpha mandates will probably grow, and GM is expected to hire four more broad-scope providers, probably by June. Firms that might join the GM caravan: New Yorkbased Morgan Stanley Investment Management; Greenwich, Connecticutbased FrontPoint; and Bridgewater Associates in Westport, Connecticut.
“We’re making a big bet on being able to identify managers that can generate higher expected returns,” says Reed. “That’s our challenge.”
