State had funds in raided firms

No money was lost, but new treasurer will reassess holdings

Steve Grossman plans to examine the state’s hedge fund holdings. Steve Grossman plans to examine the state’s hedge fund holdings.
By Beth Healy
Globe Staff / December 28, 2010

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When the FBI raided three hedge funds last month, Massachusetts pension officials weren’t immediately sure if they had a problem.

By the end of the day, they knew they potentially did: The pension fund had nearly $66 million invested with two of the firms swept up in an insider-trading investigation. The money was in so-called funds-of-funds, vehicles that invest across many hedge funds but disclose little about exactly where the money ends up.

The funds at stake represented just a 2 percent slice of the $46.8 billion pension fund, but the raid exposed the potential risks that institutions take when they turn control of their investments over to these funds for the promise of higher returns.

“By definition, there’s a lack of transparency’’ with funds-of-funds, said Alexander E. Aikens III, a pension board member, in a recent interview. “That means we as trustees are always in the dark about what is happening with the beneficiaries’ money.’’

Not knowing what’s in these portfolios can surprise and hurt the state. In 2008, for instance, the pension fund lost $12 million when another fund-of-funds, Austin Capital Management, invested with Bernard Madoff, mastermind of the largest Ponzi scheme of all time. In 2007, the state lost $30 million with the collapse of Sowood Capital Management in Boston; it lost $50 million in the failure of Amaranth Advisors of Greenwich, Conn., the year before.

As a result of the FBI raid, state pension officials say they will evaluate their fund-of-funds holdings. “As part of our strategic review, we intend to look at these and other investments,’’ said Michael Trotsky, the fund’s executive director since summer.

Steve Grossman, who in January takes office as state treasurer, as well as chairman of the pension board, said in an interview, “There’s no doubt that the hedge funds are one of a number of areas that we’ll look into.’’

The state hasn’t lost money as a result of the fund raids. But at issue is whether the funds-of-funds are working hard enough to find lucrative investments and justify their fees. The state pays five firms, including K2 Advisors and Arden Asset Management, about $35 million annually, or 1 percent of assets, to carefully place money in hedge funds for 290,000 current and former state employees, and to monitor those investments.

But it doesn’t always work out that way. The state fired Austin Capital after learning that the Austin, Texas-based firm had not physically visited Madoff’s operation since 2005, despite a promise to do so yearly.

The pension fund first embraced hedge funds in a big way in 2004, under Treasurer Timothy P. Cahill. Trustees decided not to invest directly in the sector, and instead to rely on middlemen firms. Today, those firms handle $3.5 billion for the state, or nearly 8 percent of the total portfolio — up from 6 percent, or about $2 billion, in early 2009.

The performance, however, has sometimes disappointed. The funds-of-funds have returned a combined 3.7 percent over the five years ended Oct. 31. That’s better than the broad stock market, but less than the board’s 6.5 percent goal for the hedge fund portfolio. The past 12 months have been stronger; the hedge funds are up 6.5 percent, but stocks have far outshone them, with a 16.5 percent gain.

Cahill, whose term as treasurer and pension chairman board ends Jan. 19, defended the fund-of-funds program in an interview last week, saying, “It’s a less risky way to invest in hedge funds,’’ because there are no big bets on a single firm.

The firms managing the state’s hedge fund investments disclosed their holdings in response to client concerns about the insider-trading investigation. Three of the state’s five fund-of-funds have stakes in one of the raided hedge funds, Level Global Investors in New York, according to a public information request by the Globe. The sums of money are relatively small — Level Global has $24.7 million of the state’s money through K2 of Stamford, Conn., $13.3 million through the Rock Creek Group in Washington, D.C., and $10.7 million through Grosvenor Capital Management in Chicago.

A fourth firm, Arden Asset Management of New York, invested $11.6 million of the state’s money in another of the raided firms, Diamondback Capital Management of Stamford, Conn. (The state had about $5.4 million more in Diamondback through yet another firm, but has received those funds back because it previously fired the firm for poor performance. The total now at stake in the raided firms is $60.3 million.)

All of the firms declined to comment. The state has no investments in a third firm involved in the FBI raid, Loch Capital Management in Boston.

No charges have been brought against the raided firms. Both Level Global and Diamondback have said they are not targets of the government’s investigation. But hedge fund investors are notoriously skittish, and it’s been widely predicted that some customers will withdraw their investments due to the scrutiny.

Trotsky, well aware of that looming risk, said in a letter to trustees that his office is monitoring the situation closely. The pension fund staff, he wrote, will do “everything we can to avoid a permanent loss of capital.’’

Beth Healy can be reached at