On Nov. 13, the 24th Annual National Pension and Institutional Investment Summit convenes in Dallas Texas. CAIA is a sponsor of this event.
Panayiotis Lambropoulos, portfolio manager of hedge funds at the Employees Retirement System of Texas, will offer his insights at a panel on emerging hedge fund managers. Lambropoulos’ duties for the Texas ERS involve sourcing, analyzing, and evaluating hedge fund managers.
Portfolio for the Future spent some one-on-one time with him to get a sense of what the world of alternative investments looks like in 2018 from the office of the managers of a public pension portfolio.
PFTF: Could you start by describing for us the ERS of Texas's approach to hedge funds, and alternative investments more broadly? How large is your allocation to them within the total portfolio? What is your understanding of how that stands vis-a-vis analogous institutional investors in other states? What approach do you take toward selecting positions? Is it, for example, driven by style/strategy, or do you look for "star" managers?
Lambropoulos: We definitely do not chase “star” managers, however that is defined, which is also an industry term I find puzzling if not amusing. In my opinion simply looking for these types of managers can perhaps lead to performance chasing and allocator crowding.
At ERS there has been a migration from the traditional 60/40 equity/bond portfolio, which is something we have observed with other institutional investors, to one that includes additional investment conduits such as alternatives. The majority of the Trust’s capital is still managed in-house in a passive and enhanced index manner. Alternatives, including hedge funds, utilize actively focused strategies in a number of ways, which vary from risk mitigation to return enhancement to portfolio completion.
The Trust’s main hedge fund allocation, the Absolute Return Portfolio, is—at the moment—around 4% of total Trust assets, with a targeted allocation of 5%. There is an additional 2% allocated to what we internally call the Directional Growth Portfolio so in total, current hedge fund allocations represent about 6% of total Trust assets. Looking ahead, the internal hedge fund team may oversee an additional 1% of Trust assets for what will be called Opportunistic Credit.
An internal Trust capital allocation from passive to active rests on the desire to introduce exposures and capabilities that cannot be replicated in-house and are driven on the understanding that depending on the investment cycle either passive or active strategies will perform well. For ERS it’s not an “either or” approach. Both styles have a place within the Trust.
When there is a decision to be made on a particular actively-based strategy, the threshold for inclusion in the Trust is definitely high. ERS is looking for a consistent and unique source of alpha that will add value to the Trust’s overall return profile. The definition of alpha isn’t always simple to point out and is dependent on the strategy. For example, a distressed-focused strategy relies on relationships to find and work out investment opportunities. That takes time and could be defined as “sourcing alpha.” That’s not easy to quantify right away with a mathematical formula but it is there. Of course, fees are part of that alpha consideration as well and that is something we really pay attention to and work diligently on when discussing and negotiating terms with any new and potential GPs.
PFTF: Please tell us a little about yourself—when and why you came to the ERS and what were your educational and professional qualifications before that?
Lambropoulos: Prior to moving to Austin, I lived in Chicago for about 15 years and prior to that I lived in Massachusetts. I moved to Massachusetts at the age of 13 from Athens, Greece. I received by undergraduate degree in Finance at Boston College Carroll School of Management and my MBA degree at Northwestern University’s Kellogg School of Management. In addition, I hold the CFA, CAIA and FRM certifications.
I entered the alternative investment industry when I joined Grosvenor Capital Management in Chicago. This was my initial introduction to alternative investments, hedge funds and fund of funds. I was fortunate to join another private company, a Tokyo-headquartered fund of funds, in Chicago called MCP Alternative Asset Management. It was at MCP that I really gained a wide range of exposures across all sorts of alternative investment strategies. It was at MCP that I really learned how to evaluate hedge fund strategies, interact with global clients and think about institutional portfolio construction.
I joined ERS a bit over three years ago as the team was being built. It was still a new internal investment program and the appeal was that investments would be direct, meaning not through fund of funds, which was a clear new direction within the institutional landscape. This gives someone like me an opportunity to make a real impact from an investment and intellectual capital point of view as we continue to build this and new programs within the Trust.
PFTF: Could you tell us something about what factor modela you use? Do you benchmark your results with your hedge funds against Fama-French's three (or five) factors? Or do you use another model? And when was your model, whatever it is, adopted? Did you inherit a benchmark when you arrived at ERS or is it a decision that was made on your watch?
Lambropoulos: For the main hedge fund allocation, the Absolute Return Portfolio, we don’t benchmark against any specific factors. We target a return of T-Bills plus 400-500 basis points. More importantly, given the risk mitigation purpose of the portfolio, we target a beta of 0.4 or less for this portfolio against the rest of the Trust.
Within the Directional Growth portfolio, all of our current investments are short-extension structures (ie 150/50 or 130/30). These investments are more return-seeking in nature. All of these investments are measured against a pre-agreed upon benchmark. The benchmark in question is based on strategy and is mutually agreed-upon after discussions with the manager. For these structures, given their “beta of one” nature, performance fees are based only on “alpha” simply defined as the portfolio’s return less the benchmark’s return.
PFTF: There is a good deal of discussion today of human judgment vs. the use of computer-driven algorithms. Is it your view that people with positions such as your own are likely soon to be replaced by robots? Where is the human/machine interface headed?
Lambropoulos: There is definitely an “arms race” to take advantage of the new powers that technology provides and the voluminous data that is available for pretty much anyone to access and analyze. There is definitely an urgency, it seems, to adapt to these phenomena, which creates stress, uncertainty and a lot of chatter of what the future may look like and why. Without doubt, those that don’t embrace the changes and don’t adapt will fall behind or perish. Having said that, I think we are many years away from robots simply taking over tasks currently executed by humans. I say that as both a personal belief and necessity as I don’t want to lose my job!
Technology will definitely become a more integral tool for asset managers, asset allocators and risk mitigators. The one challenge I see and ponder upon though is this: within the investment landscape, algorithms are more often than not associated with “quant” investing. These are strategies based on codes, algorithms, numbers that are strung together by humans. These humans tend, in most cases, to have similar backgrounds and education. These humans seek to take advantage of the same observations within the investment ecosystem. Therefore, the potential risk I foresee is a massive algo or quant beta. Many of the same algorithms written in similar fashion, reacting to similar existential variables or events, which only leads to further reactions and a negative feedback loop or in investment nomenclature increased volatility. Human judgment will be necessary to control this phenomena after it, perhaps, becomes aware of its existence.
PFTF: Related, but looking in the rear-view mirror: how much has the relevant technology really changed since, say, you graduated from the Kellogg School in 2011? Has the human/algorithm relationship been roughly the same over those seven years?
Lambropoulos: I think the human/algorithm relationship has become more intimate I would like to think that seven years is a short period of time if not for any other reason, I don’t want to feel old! I am not a “techie” by any means, so I can’t speak with great confidence of any real or relevant changes within technology itself at least as it pertains within the investment world. What I can speak about though is the usage of technology. What I have seen and observed through my career is a technological migration from the fringes to the core of investment management, analysis and risk management.
In the not-so-distant past, perhaps a bit longer than seven years, new technology was more heavily used, adapted and quickly embraced within the quantitative investment landscape. Technology was more synonymous with your typical “black box” strategies. What we have seen over the years though is technology being embraced and utilized across all strategies and all aspects of a GP operation, which includes investment as well as operational aspects. Technology has been augmented as part of idea sourcing, data analysis, portfolio management, risk oversight at a greater and greater pace, in an effort to gain that “edge” and generate that incremental unit of return in a faster, more efficient and cheaper manner.
For example, in the past we talked about fundamental investing, today we hear about quantamental investing. Yesterday, technical analysis was a separate investment methodology reserved only for CTAs or global macro funds. Today it is part of risk management. Singular market “beta” is no longer a singular factor under scrutiny, but rather multi-factor analysis is presumed to be under observation and all potential returns carved into granular details all because of technology.
PFTF: Finally: tell us something about the due diligence process. What might trigger a review of ERS' investment in the XYZ Capital LP? If a big name leaves the roster of XYZ's management team, or another big name arrives, does that trigger a review? And how do you keep tabs on the issue of style drift? I'm assuming that if you invest in a long/short equity fund, it’s because you want a long/short equity fund, and if there were some reason to believe it was becoming a merger-arb fund, you might reconsider your part in it. Can you tell me about such an incident in your tenure?
Lambropoulos: At ERS we manage a rather concentrated portfolio. Our Absolute Return Portfolio will, on average, have 15-18 total relationships, when fully allocated. Given the average size of our investment (ie ~$100M), along with our long-term investment view, we work hard to establish good and trusting relationships with our General Partners. These relationships lead to constant and open communication along with transparency. This is an integral part of our ongoing due diligence process in addition to reviewing monthly letters and data. This helps us monitor performance attribution, sources of return (both good and bad) as well as style drift. It becomes easier to monitor style drift once we are able to receive information on top positions, portfolio exposures, return attribution etc.
A number of events might trigger a review as a result of that constant monitoring. Yes, key individuals departing or joining a team is one such event as there are many more. For example, a reduction in assets under management, operational shortfalls or failures, large drawdowns, changes in risk management parameters etc. Since joining ERS we haven’t really noticed any of our managers “style drift,” but we have had instances where a review was warranted because as assets under management continued to decline due to disappointing performance.
Our managers are under constant review. We take the constant re-underwriting mentality approach. We constantly ask ourselves the question as to whether or not there is a better option for investment compared to our current one and whether or not we would invest in the current manager today, again. The decision to redeem is taken with care because we want to make sure we are as close to possible in making the right decision for the right reasons at the time of question.
PFTF: Thank you for your time.