Institutional Investor's Alpha Magazine - March 2009 - (Page 46) Paul Lawler Hedge funds are a fee structure, not an asset class.” And Lawler’s team says it sees growing pressure on hedge funds to lower those fees. “The business model is broken,” says investment director Goepfert. “It’s not sustainable.” The hedge fund managers Kellogg hires get a 1 to 2 percent management fee and a 20 percent performance fee, an expense Lawler questions. “Our hedge funds have preserved capital better than long-only managers and broader markets,” he says, “but they’re not all up.” Goepfert puts it more bluntly: “Why pay one and 20 when most hedge funds are facing redemptions?” Lawler sometimes considers fees a make-or-break issue. He has rejected managers despite his interest in their strategies after concluding that their fees were too high to allow a reasonable return. But he has a strong kinship, in some respects, with the psychology of hedge funds. Most of the investments under Lawler’s care are less than transparent; he believes, as do most fund managers, that revealing exact investments is giving away the keys to the kingdom. He rarely says which managers he hires, so the description of his holdings tends toward the generic. Within the foundation’s three primary portfolios — asset preservation, stable cash flow and capital appreciation — are subcategories and sub-subcategories. For example, liquidity, inflation protection and deflation are lumped under asset preservation. Drill into the inflationprotection sub-subcategory to find natural resources — which can be traded publicly — are part of the capital appreciation portfolio: Avenue Capital, Davidson Kempner Institutional Partners and Angelo Gordon & Co. The foundation invests too in nonmarketable distressed funds, including six run by Los Angeles–based Oaktree Capital Management, which offers both hedge funds and private equity funds. Kellogg favors the latter, recently investing in three Oaktree offerings: a power infrastructure fund, a mezzanine fund and a fund that invests in European distressed corporate debt. Lawler doesn’t like paying hedge fund fees but says that some are worth it. “Our goal is not to mimic the market, not to generate market returns, but to produce a stable level of earnings, so we’re willing to sacrifice,” he explains. He considers it acceptable that hedge funds finished 2008 so far down (the Hedge Fund Research composite index was off by 18.65 percent). “We would expect their return in a down market to be half the decline of the market,” he says. “Nobody’s immune to a market downturn unless you’re an aggressive short-seller.” Still, losing money in hedge funds may be particularly painful to investors like Lawler, who have always taken a wary view of hedge funds — avoiding leveraged ones, for instance, and their promise of high returns. Kellogg maintains a big cash buffer — 5 percent of the diversified assets — and keeps 70 percent in holdings that can be quickly converted to cash. Lawler is openly critical of the recklessness that has characterized much of institutional investing in recent times. “It hasn’t been popular in the past 15 years to look at the balance sheet,” he says. Lawler cut his teeth at the Columbia University job, developing an in-house investment management style, buying stocks, bonds and real estate rather than farming out the decision making. “I think we’re actually coming back to this — institutions may start investing for themselves again,” he notes, arguing that many external managers have proved too costly and too unproductive. The key to the in-house approach, he says, is to have an exceptional staff and to persuade trustees that there is a cost advantage. Lawler says the foundation is especially alert now to opportunities that come out of the credit crisis. Redemption-related asset losses at hedge funds, for instance, have opened the doors to formerly hard-to-access funds. “We’ve talked about the potential opportunity to upgrade the managers we have, but we haven’t pursued that yet,” says Goepfert. “We’ll probably do that over the next year. We want to get into strategies we think longterm are a better fit for the portfolio.” Lawler and company are looking in particular at longonly fund managers that may be able to take advantage of a stock market that by mid-February had fallen some 40 percent in a few months’ time. His team is on it already, spending 30 to 40 percent of its time visiting managers who rarely come to Battle Creek. Lawler prefers it that way — he says managers need to keep their noses to the grindstone and let his people come to them. “I couldn’t tell you how much in alternatives we have. It’s all embedded, it’s everywhere.” — PAUL LAWLER, THE KELLOGG FOUNDATION 7 percent of the total diversified portfolio — and there you will also find three hedge funds: one energy fund and two natural-resources funds. The majority of Kellogg’s hedge fund holdings, however, are in the capital appreciation portfolio, which in midJanuary contained almost two thirds of the foundation’s diversified assets. A subcategory there — global marketable equity — has 43 percent of all diversified assets. It includes holdings in five hedge funds: one global core fund and four long-short equity funds, one of which is dedicated to emerging markets. The emerging-markets category is long-short rather than long-only, in hopes of dampening the risks in that arena. (This manager was down 25 percent in 2008, which sounds bad but was better than the 50 percent losses across most of that sector.) Three New York–based special-situations, distressedasset hedge funds that invest in marketable assets — 46 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2009
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