State Universities Retirement System of Illinois (IL SURS) · 2) There is value in combining a...

Hedge Fund Search & Market Update

March 12, 2015

Doug Moseley, PartnerKristin Finney-Cooke, CAIA, Sr. ConsultantKevin Leonard, Partner

State Universities Retirement System of Illinois (IL SURS)

Exhibit 18

Contents

Executive Summary & Overview 2Hedge Fund Category Overview 5Hedge Fund-of-Funds Manager Selection 15Appendix 22

Page

2

State Universities Retirement System of Illinois

1

Exhibit 18

Executive Summary & Overview

2

Exhibit 18

• SURS Policy portfolio has broad exposure to both traditional, public-markets and alternative assets– Equity allocation diversified across US, non-US; developed and emerging markets– Core and Core plus fixed income mandates provide some exposure to high yield and

non-US fixed income– TIPS positioned as economic hedge against future inflation– Private equity and real estate provide additional diversification and sources of higher

expected return

• Goal of new Policy targets approved in 2014 is to lower the projectedrisk level of SURS portfolio while not giving up significant return

• Hedged Equity strategies represent a better risk vs. return trade offthan a portfolio without Hedged Equity– Diversified group of hedged equity strategies should have bond-like risk profile– Projected returns between stocks and bonds– Expanded opportunity set– Lower sensitivity to interest rates

• Selection of Hedge Fund-of-Funds manager is an important step inimplementing the allocation

Executive Summary – Recap of 2014 Discussion & DecisionsState Universities Retirement System of Illinois

3

Exhibit 18

• NEPC has advocated that SURS implement its Hedged Equityallocation by selecting managers in 2 primary strategy categories– Expected returns

• Traditional Hedge Fund-of-funds manager strategies– Selection of managers and construction of a diversified portfolio delegated to

manager-of-managers– Hedge Fund-of-Funds managers are responsible for negotiating manager contracts,

portfolio guidelines, fees and transparency– Portfolios will provide broad exposure to between 20-45 managers depending on

number of managers selected– Emerging and WMDBE manager programs are available in the marketplace– NEPC recommends that SURS target 3-4% of its allocation to this category

• Hedged equity strategies including Low Beta, Defensive Equity andHedge Fund replication– Newer developing category that includes several sub-categories of products that seek

to limit, hedge or alternatively manage equity risk (or beta)– Strategies use active management and hedging techniques to offer lower risk equity

exposure– Typically offered at lower fee structures with greater transparency– NEPC recommends that SURS target 1-2% of its allocation to these strategies

Executive Summary - Recap of 2014 Discussion & DecisionsState Universities Retirement System of Illinois

4

Exhibit 18

Hedge Funds & Hedged Equity Overview

5

Exhibit 18

NEPC’s Research Suggests That:

1) Building a diversified hedge fund program across strategy sets canprovide stability and enhance the overall risk-reward valueproposition across the portfolio

2) There is value in combining a top-down macro oriented processfocused on themes and broader opportunity sets with a bottom-up,detailed manager selection criteria that results in a portfolio of highconviction ideas and investment managers

3) Hedge fund portfolios can benefit from selecting investmentmanagers from a variety of firm/product sizes to ensure alignmentof interests between LPs and GPs and to pursue niche as well asbroad investment opportunity sets

Summary: How to Invest In Hedge Funds?State Universities Retirement System of Illinois

6

Exhibit 18

Hedge Fund StrategiesIndustry Size - $2.63 Trillion

Relative Value(Credit-linked)

10%

Global Macro

Equity Hedged(Equity-linked)

28%

Multi-strategy16%

Trading19%

Event-driven27%

Managed Futures

Distressed Securities

MergerArbitrage

Special Situations

Long/ShortEquity

EquityArbitrage

ShortBias

EmergingMarket Equity

Convertible Arbitrage

Fixed Income Arbitrage

VolatilityStrategiesOther Credit

EmergingMarket Debt

Multi-StrategyEvent-Driven

SyntheticStrategies

• Black strategies as defined by CS and HFR indices• Green strategies represent NEPC Classifications• Percentages represent approximate portion of industry assets dedicated to

each strategy (per HFR)

Hedge Fund Industry StructureState Universities Retirement System of Illinois

7

Exhibit 18

Industry Structure: Strategies and Historical Risk-Returns

Apr 1994- Dec 2013 CS

Strategy Definition Return Risk(Std Dev)

Long/Short Equity

Managers combine a long portfolio with the short sale of stocks. Portfolios range from net short to net long, depending on market conditions. Aggressive funds may capture returns by exceeding 100% exposure while conservative funds mitigate market risk by maintaining net exposures of between 0-50%.

10.0% 9.6%

Credit/Relative Value

Managers seek to profit from the mispricing of related securities; returns are not dependent on the general direction of market movements. Strategy utilizes quantitative and qualitative analysis to identify securities or spreads between securities that deviate from their fair value and/or historical norms. Examples include convertible arbitrage, fixed arbitrage, statistical arbitrage and select global macro strategies.

5.6% 5.5%

Event-Driven

Managers invest in situations with the expectation that a near term event will act as a catalyst changing the market's perception of a company, thereby increasing or decreasing the value of its equity or debt. These events include, bankruptcies, financial restructurings, mergers, acquisitions and spin-offs. There are three types of event disciplines: merger arbitrage, distressed securities and special situations.

9.6% 6.1%

Global Macro

Strategies comprise two sub-segments: discretionary and systematic. Both approaches specialize in trading highly liquid instruments including currencies, commodities, fixed income instruments and equity indices. Systematic strategies are based on computer generated algorithms that analyze historical data while discretionary manager use a broad analysis of economic, financial and political trends to identify investible themes and forecast market movements. These strategies have low correlationsto broader equity and fixed income indices.

12.1% 9.3%

Multi-Strategy

Managers employ a diversified portfolio with various investment approaches. For example, a multi-strategy manager may have a portfolio with convertible arbitrage, merger arbitrage, and fixed income arbitrage positions. The manager can over or under-weight different strategies to best capitalize on current investment opportunities.

8.2% 5.2%

Past performance is no guarantee of future results.


8

Exhibit 18

Pros:• Incentive structure focused on performance during all market environments• Potential for non-correlated returns to traditional asset classes• Strategies often reduce overall portfolio volatility and drawdowns• Potentially superior capital preservation vehicles• Strong alignment of interests between manager and investor• Historically has compounded capital net of fees at a greater rate than

traditional investment options

Cons:• Complicated entities, more challenging to evaluate managers• Complex investment structures• Liquidity Constraints• Less transparent• Higher fees, expensive• Access to top managers more limited• Potential for higher “headline risk”• Regulatory environment in flux

Weighing Benefits & Risks vs. Traditional Investment Structures

Use of Hedge Fund of Fund

Manager helps mitigate these

drawbacks


9

Exhibit 18

Risk-Return Comparison as of 12/31/2014

Source: Pertrac, HFR Database, BloombergPast performance is no guarantee of future results.

As of 6/30/2013

Differentiated returns from idiosyncratic positions compared to traditional markets

13.7%

20.4%

15.5%

7.7%

4.9%

15.5%

10.2%

6.0%

3.3%

6.2%

4.6%5.1%

5.9%

2.7%

4.5% 4.7%

0.2% 0.3% 0.3%

2.0%

0.0%

4.0%

8.0%

12.0%

16.0%

20.0%

24.0%

1 Year 3 Years 5 Years 10 Years

Rate of R

eturn (%

)

Annualized Returns

S&P 500 MSCI World HFRI Composite Barclays Agg 3 Month Libor

As of 12/31/2014

10

Exhibit 18


HF Industry Volatility is less than 1/2 that of Equity Indices Across Time Periods


8.3%9.1%

13.0%

14.7%

8.5%

10.4%

14.3%

16.0%

3.2%3.9%

5.2%

6.3%

2.3% 2.7% 2.7%3.2%

0.0% 0.0% 0.0%0.6%

0.0%

5.0%

10.0%

15.0%

20.0%

1 Year 3 Years 5 Years 10 Years

Volatility

% (Std

Deviatio

n)

Annualized Volatility

S&P 500 MSCI World HFRI Composite Barclays Agg 3 Month Libor


11

Exhibit 18

Returns (Rolling 3 Years)

Standard Deviation (Rolling 3 Years)


-20.0%-15.0%-10.0%-5.0%0.0%5.0%

10.0%15.0%20.0%25.0%30.0%

S&P 500 (TR) MSCI WORLD - Net - USD HFRI Fund Weighted Composite Index Barclays Aggregate Bond Index

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

S&P 500 (TR) MSCI WORLD - Net - USD HFRI Fund Weighted Composite Index Barclays Aggregate Bond Index


12

Exhibit 18

Fund of Hedge Funds: Resurgence

Source: HFR 3Q, 2014

-60.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

2003-2014 2003-2008 2009-2011 2012-2014

HFRI Up and Down Capture of S&P 500

FoF Up Capture Direct Up Capture FoF Down Capture Direct Down Capture


13

Exhibit 18

Fund of Hedge Funds: Asset Levels & Flows

-$40.9

-$118.4

-$11.8 -$7.9 -$22.2 -$20.2 -$0.4 $0.6 -$2.2

$593.2 $571.3

$646.3 $629.6 $638.2 $663.1 $665.1 $672.2 $671.8

-300

-100

100

300

500

700

900

2008 2009 2010 2011 2012 2013 Q1-2014 Q2-2014 Q3-2014

Estimated Growth of Assets/Net Asset FlowFund of Funds 2008 - Q3 2014

Net Asset Flow Estimated Assets

Source: HFR


14

Exhibit 18

Hedge Fund-of-Funds Manager Selection

15

Exhibit 18

• Nature of manager selection in the Hedge Fund category is more complex than traditional asset classes– Opportunity set is broader, encompassing multiple asset classes– Strategies more opportunistic and tactical– Private commingled vehicles governed by different terms and liquidity provisions– Lack of transparency creates additional challenges in evaluating past performance and

monitoring existing portfolios

• Hedge Fund-of-Funds managers typically require additional resources over & above a traditional Fund-of-funds manager– Research professionals with experience evaluating complex trading strategies that are

implemented with long- and short-positions– Risk management systems to evaluate prior track records & monitor existing portfolios– In-house or strong external legal advice to assist in evaluation of fund structures and

negotiation of key terms– Portfolio construction tools for managing multi-manager portfolios– Operational due diligence team to meet with key vendors and perform background

checks on key principals

• Hedge Fund-of-Funds manager category has continued to experience change since the global financial crisis– Better matching of asset & investor liquidity provisions– Trend towards larger investors demanding separately managed accounts

• Pros & cons for investors and managers– Downward pressure on investment management fees

Executive Summary – Hedge Fund-of-Funds role & manager selectionState Universities Retirement System of Illinois

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Exhibit 18

Role of Hedge Fund-of-Funds Manager

As of 6/30/2013

HFOF Manager


Manager Evaluation

Evaluation of Capital Markets

Operational Due Diligence

Risk Management

Strategy Selection

Reporting & Back office

Portfolio Construction

Negotiation of Terms &

Fees

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Exhibit 18

• Investment Strategy Evaluation & Due Diligence– Evaluation of the investment team

• Structure & roles• Decision-making process

– Review of strategy & investment process– Analysis of performance track record & attribution– Competitive analysis & negotiation of fees and key terms– Trading strategies & use of derivatives– Background checks & review of litigation history

• Operational Due Diligence– Understanding organizational structure

• Ownership• Financial condition• Corporate governance

– Internal controls and procedures• Trading & movement of cash• Pricing of derivatives and illiquid securities

– Review of key service provider• Custodian / Administrators• Prime Brokers• Auditors

Different Levels & Types of Hedge Fund Manager Due DiligenceState Universities Retirement System of Illinois

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Exhibit 18

Fund of Hedge Funds: Maximizing Portfolio Alpha Through Creative Portfolio Construction

FOHF Edge Alpha Source

Actively Negotiate Fees with underlying managers Fee Savings

Co-Investments with managers in/out of FOHF’s research universe Opportunistic

Separate Accounts with underlying managers Structural

Invest with emerging/capacity constrained managers Life Cycle

Invest in volatile markets e.g. Asian equities, commodities Capital Preservation


19

Exhibit 18

S&P 500

MSCI WorldHFRI Composite

Barclays Agg

3 Month Libor

60 ‐ 40 Stock Bond

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

Rate of R

eturn %

Standard Deviation (Risk) %


As of 6/30/2013

Last Five Years

Risk-Return Comparison as of 12/31/2014State Universities Retirement System of Illinois

20

Exhibit 18

S&P 500

MSCI World

HFRI Compsite

Barclays Agg

3 Month Libor

60 ‐ 40 Stock Bond

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%

Rate of R

eturn %

Standard Deviation (Risk) %



As of 6/30/2013

Last Ten Years


21

Exhibit 18

Appendix

22

Exhibit 18

• HF Strategies have meaningfully different Risk/Return characteristics

As of 6/30/2013

Source: Pertrac, HFR Database

Industry Structure: Strategies’ Historical Risk-Returns as of 12/31/2013

Past performance is no guarantee of future results.

DJCS Hedge Fund Index

Fixed Income Arb Index

Multi‐Strategy Index

Event‐Driven Index Long‐Short Equity Index

Global Macro Index

S&P 500

Barclays AggHFRI Fund of Funds Composite

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Compo

undRO

R

Standard Deviations (risk) %

Since April 1994 Return and Volatility


23

Exhibit 18

• NEPC has typically recommended Hedge Fund Policy mixes in a range of between 3-10% for public funds– Current client allocations range from 0 – 18%+– Median allocation in InvestorForce Public Fund (DB) universe = 8.6%

• Based on sample size of 42 public plans with Hedge Fund Policy Allocations

• Other Illinois public funds with target allocations include the following:– Illinois State Board of Investments (Policy target 10.0%)– Illinois Municipal Retirement Fund (Policy target 2.5%)– Teachers Retirement System of Illinois (Policy target 6.0%)– Municipal Employees’ Annuity & Benefit Fund of Chicago (Policy target 10.0%)– Public School Teachers’ Retirement System of Chicago (Policy target 2.0%)– Chicago Police Annuity & Benefit Fund (Policy target 7.0%)– Laborers’ & Retirement Board Employees’ Annuity & Benefit Fund of Chicago (Policy

target 8.0%)

Public Fund Peer Group Allocations to Hedge FundsState Universities Retirement System of Illinois

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Exhibit 18

• NEPC, LLC is an investment consulting firm. We provide asset-liability studies for certain clients but we do not provide actuarial services. Any projections of funded status or contributions contained in this report should not be used for budgeting purposes. We recommend contacting the plan’s actuary to obtain budgeting estimates.

• The goal of this report is to provide a basis for substantiating asset allocation recommendations.

• Any projection of liabilities in this report uses standard actuarial projection methods and does not rely on actual participant data. Asset and liability information was received from the plan’s actuary, and other projection assumptions are stated in the report.

• Assets are projected using a methodology chosen by the client. Gains and losses are estimated through investment returns generated by applying NEPC’s 5-7 year asset class assumptions and scenario assumptions for the current year.

• This report is based on forward-looking assumptions, which are subject to change.

• This report may contain confidential or proprietary information and may not be copied or redistributed.

DisclosuresState Universities Retirement System of Illinois

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Exhibit 18

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