Hedge funds have fallen in and out of favor with institutions in recent years. But South Carolina’s approach shows how a once popular hedge fund strategy could bring them back into vogue.
The South Carolina Retirement System Investment Commission chalks up the success of its fixed income portfolio to its mix of market neutral, low-volatility, and low-beta hedge fund investment strategies. In practice, that means a portion of the fund’s fixed income portfolio is invested in hedge fund strategies that don’t add any extra beta — or volatility and systemic risk — to the plan.
The approach is what the South Carolina plan calls its portable alpha structure, a term more common 10 to 15 years ago. Specifically, 26 percent of the overall plan-wide portfolio is dedicated to fixed income. Of that 26 percent, 13 percent goes to fueling the portable alpha plan.
RSIC’s portable alpha overlay includes a range of hedge fund strategies that keep the fixed-income portfolio low-beta. These strategies include a healthy mix of macro (29 percent), a multi-strategy approach (28 percent), equity relative value (22 percent), and Commodity Trading Advisors (10 percent).
In the portable alpha plan, hedge funds are part of a “collateral mix” for the pension’s fixed income allocation. The collateral mix is comprised of cash and hedge fund exposures. Instead of holding cash and investing it with a long-only equity manager, RSIC holds a segment — specifically 11 percent — of its portfolio in “low volatility, market neutral hedge funds.” In short, RSIC is taking some of its collateral and putting it into hedge funds.
“The whole point of our bond allocation is to be a diversifier,” Bryan Moore, RSIC’S managing director of public markets, told Institutional Investor. “In a world where fixed income returns are 2.5 or 2.75 percent over the next seven years…that’s not going to help us when we have to try and generate 7 percent returns for the plan.”
Moore said the hedge fund allocations are an incremental value-add to the fixed income portfolio. He explained it like this: A fixed income portfolio has two ways of getting exposure: One is by hiring a long-only, active manager, which could generate, Moore said, about 50 basis points above the average.
“But the magnitude is just not there,” Moore said.
Instead of funding, for example $100 to a long-only active manager where RSIC would earn 50 bps — about 50 cents on that $100 — RSIC’s Portable Alpha program invests that $100 into a fixed income index and reserves 20 percent of the investment in cash. Put simply, the plan is essentially using part of its portfolio as collateral to borrow more money, which it then invests in uncorrelated hedge funds. This additional portfolio is another way to add growth to the pension’s returns.
“Now you’re earning three-to-five percent on that 80 percent piece,” Moore said. “On that whole piece, we’re earning the return [of the Bloomberg Barclays Aggregate] and then we’re earning that three-to-five percent on that 80 percent we had remaining in cash.”
The $41.7 billion pension plan made its first hedge fund investment in 2007. In 2016, Geoffrey Berg, the freshly minted chief investment officer, implemented the portable alpha program, to reduce the complexity of the plan’s portfolio.
“The big push for the portable alpha implementation was that we had these hedge funds, we had this beta. How could we be more efficient with how we’re taking risk in the portfolio?” Moore said.
The term portable alpha looks different on each investor and institution. It’s more of a philosophy than a specific strategy. While a portable alpha approach is not a new concept, Moore said RSIC spent a long time thinking about how to minimize risk to keep the portfolio afloat. Moore said portable alpha programs saw their heyday before the great financial crisis in 2008, which is how they came to place an emphasis on low beta. While the approach may still be implemented, the terminology has fallen out of favor.
According to RSIC’s fiscal year 2021 investment report, hedge funds may not exceed 20 percent of total plan assets, but the target allocation is 10 percent. In 2021, the hedge fund portable alpha plan occupied 11.2 percent, with a market value of $4.4 billion, of the entire portfolio.
Also in 2021, the portable alpha hedge funds generated a return of 17.11 percent.
“We are really trying to use the portable alpha hedge fund portfolio as our engine of excess returns for our portfolio,” Moore said.
RSIC’s success was bolstered by a strong year for hedge funds in the last fiscal year. In fact, in 2021, 62 percent of allocator respondents to a BNP Paribas survey said they had already met their average return target of 8.3 percent for their 2021 hedge fund portfolios in November 2021, II previously reported. While some asset owners decreased their allocations to hedge funds in recent years, the strong 2021 could mean that hedge funds are a good investment for institutions moving forward.
RSIC’s hedge fund approach lies in the central assumption that if hedge funds generate a 2.5 percent net return over the cost of funding embedded in futures and swaps, the portable alpha program will add around 25 basis points to the plan. That’s about $100 million a year, according to RSIC.
In 2018, Moore said RSIC had 22 different asset and sub-asset classes. Today, RSIC touts its portfolio as a five-asset class portfolio with allocations to private equity, private debt, private real estate, public equities, and public bonds.
“The early success of portable alpha led us down the path of simplification,” Moore said.
To avoid risk, Moore said RSIC aims for less than 0.1 percent beta. From 2019 to 2021, RSIC reduced its beta exposure from 0.12 percent to 0.01 percent.
Overall, the hedge fund sector endured some volatility throughout last year, picking up particularly in the fourth quarter, according to hedge fund services provider Citco. Nevertheless, RSIC reduced its volatility from 5.3 percent in 2019 to 3.7 percent in 2021.
RSIC tries to minimize its correlation to negative equity markets. In fact, like many pensions, Moore said the plan’s biggest risk is equity risk.
“We wanted something that could sit in our portfolio that wouldn't be adding to that risk,” Moore said.
Last year, the Portable Alpha hedge funds included Blackstone SAF II, Bridgewater PA II, DE Shaw’s low beta hedge fund, GCM’s low beta hedge fund, GSO’s mixed credit hedge fund, Lighthouse PA, Man Alt Beta Strategies, MS’ low beta hedge fund, and Reservoir Strategic.
“I think it just simplifies our portfolio,” Moore said. “We have 12 hedge fund managers that are diversified across different relative value strategies, CTA, trend-following, multi strategy — the very low-beta strategies.”
Moore said over the years since its implementation, the portfolio has added over $1.1 billion to the plan’s excess returns.