Robert C. Lee III is a director of hedge funds for the Employees' Retirement System of Texas, which has $26 billion in assets under management. He works across asset classes to manage its liquid alternatives, hedge funds and hybrid allocations. He joined ERS in 2011 to design and implement its new hedge fund program. Prior to this, he was an associate director of portfolio management for Riverside Portfolio Management and HFR Asset Management. Lee is a chartered financial analyst and certified hedge fund professional. He has a bachelor's degree in mathematics and economics from Texas State University and a master's in econometrics, international financial management from Universität Konstanz.
Mr. Lee was recently named on Trusted Insight’s ranked list of Top 30 LPs Investing In Hedge Funds. He graciously spoke with Trusted Insight on July 12, 2016.
Trusted Insight: How has your previous experience at a fund of funds helped in your role as director of investments at the Employees’ Retirement System of Texas?
Robert C. Lee: When I came here to the Employees’ Retirement System of Texas (ERS), I brought with me an understanding of the hedge fund industry’s ins and outs. It's more relationship-driven than a lot of people realize, so just being in the industry can provide you with a lot of valuable information. ERS has been a great unique experience for me, because there were no pre-existing hedge fund allocations when I joined in 2011. We had no fund of funds. We have a progressive and supportive board that wanted to create a state-of-the-art investment program from Day 1 through direct investing, and that is how we have built out the program over the last five years. The ability to do that is what I brought to the table, but the support that it takes to achieve this within a public plan was established for me by our chief investment officer, Tom Tull. It really took both of those things to be able to implement the hedge fund program that we have today.
Trusted Insight: How did you go about that process of establishing the system’s hedge fund program?
Robert C. Lee: When we started, we had the mandate of a single absolute return hedge fund portfolio, which I think is quite common as a first step. We still manage that absolute return portfolio today. It is everything that the name implies; cash plus return target, low volatility, low correlation and so forth. But importantly, it was a controlled experiment for the board and staff to figure out “what is a hedge fund, how can it be useful to the plan and what are the ancillary benefits of having hedge funds as part of our investment group?”
Over the last five years, we've gone through a lot of education with the board and staff to show them the “synergies” of having these types of investments. We've been successful in doing that. We've built up the absolute return portfolio to its target allocation of 5%, and more importantly, we're using hedge funds within the other asset classes. This is very commonly the second step for an institutional investor. You start off with a single portfolio and then branch out to put equity long-short within your public equity, for example -- we have done that. Or you put fixed income hedge funds strategies within your fixed income book or your credit book -- we have done that too. We are now building on these successes with additional portfolios and hedge fund exposures.
Trusted Insight: What benefits do you see in making those hybrid allocations?
Robert C. Lee: We manage about 60% of all our assets internally, which probably distinguishes us from a lot of our peers. As you would expect, the largest portion of that is public equity. We have a large public equity staff, and we do our trading internally. They are the portfolio management and analyst teams that drive the bulk of our public equity exposure. They're very good, but it is still a set team. You would expect that we have certain strengths and, of course, weaknesses in our ability to cover the public equity universe.
The hedge funds that we add to our public equity portfolio are never meant to replace the very good public equities team that we have, they are meant to supplement or complement their skills. We bring in managers who have expertise in a strategy, sector or region where we lack the resources internally to execute well. Of course, the result of having those external managers on the platform is a higher quality excess return, which is what we're all looking for, and that shows up in a better Information Ratio. The synergy is the sharing of ideas between our public equity staff and the external investment manager that we invest with. Sharing those ideas makes us a better group and ultimately increases the quality of our returns.
Trusted Insight: Hedge fund managers have had a tough time lately. Do you think it will become more difficult to achieve those high returns?
Robert C. Lee: No. I think people have begun to do a better job of assessing managers’ returns. There is more understanding of hedge fund strategies. There are all types of alternative betas that have explained away the mythology of hedge fund returns, and people can better understand where those returns are coming from. I think that's helped the industry overall, but there is still some disillusionment out there.
For some reason, some investors may expect hedge funds to outperform a long-only equity index, for example. In 2014, markets were ripping and hedge funds trailed behind as a group. That is held up as a negative, but it's not when you really consider what the risk of adjusted returns are and what the purpose of hedge fund allocations is within your portfolio. We, as a trust, have become more educated on how they properly fit within our trust.
Our own experience with hedge funds has been quite positive. Our public equity hedge funds are more of a hybrid structure than anything else. Our public equity exposures have done very well -- several hundred basis points of annual excess return -- and that is a big win for us. Similarly, our absolute return portfolio has had a very good performance.
Trusted Insight: What kind of innovation do you think you're going to see in the hedge fund industry going forward? Are hedge funds looking to move toward things like smart beta?
Robert C. Lee: You touched a nerve there, I'm not a fan of smart beta! I think it's a buzzword. Where do I see innovation? I see more strategic partnerships. I've seen more and more custom solutions with larger institutional investors. Unfortunately, this limits the conversation to the larger types of institutions that can support this type of partnership. I see more of the bespoke mandates and customized exposures with managers. The number of hybrid draw structure funds is exploding, for instance, a credit fund that is 3 to 5 years in its life, maybe 2 to 5 year draw structure and 1 to 3 year roll-off. That's not quite private equity, but it's not your standard hedge fund either. The permutations in how you structure this vary to the number of funds that are out there.
We've seen so many of those, and not only on the credit side. There's a lot happening in direct lending, factoring, trade finance and all types of very interesting and innovative strategies, but we're also seeing those on the equity side too. I think this is a big change in the industry. It stretches the definition of “hedge fund,” but I see it as an overall positive because you're getting a higher alignment of interest between the end investor and the hedge fund manager.
Trusted Insight: Taking that into consideration, how are you looking to reposition your portfolio going forward?
Robert C. Lee: We have been taking advantage of some of these structures and recently some of our more innovative investments have looked like the hybrid structure that I have just described. I think one aspect that sets us aside is the performance of the absolute return portfolio, of which I'm very proud. The way that we manage that portfolio is not in the standard “fill the strategy bucket” type of composition, where you seek to achieve your excess return through manager selection. We really don't look at it that way. We have much more of a top-down view.
We have three to five macro themes in our portfolio that we developed internally and are quite varied. The real art comes down to picking strategies to exploit these themes, regardless of the underlying strategy bucket, so that the risk factors of each theme become orthogonal to one another. You can express a single theme, perhaps equity long-short, or macro, or debt. By constructing your portfolio from that very top-down perspective, without a focus on filling strategy buckets, what falls out is a well-diversified portfolio. It is concentrated -- we only have 15 investments, which I think is a very good number -- but without a lot of focus on the underlying strategy exposures.
A lot of the themes that we have been expressing lately are results of the changing regulatory environment and the role of traditional banks in terms of how they have stepped away from certain markets. We find a lot of value in stepping into some of these markets, and often the structure that is most suitable for that is one of these hybrids I discussed earlier. These could be completely unhedged strategies. If you think about a direct lending strategy, for example, there's really no short, so there's no hedge. One might question whether or not you can call it a hedge fund, but it does have one of these hybrid structures where it's maybe a 2 to 3 year call structure with a 1 to 3 year roll-off period. We've been doing several of those. We've been finding lots of niche smaller odd opportunities, where there's significant value in long-term capital like ours.
Trusted Insight: What might some of those niche opportunities be?
Robert C. Lee: I'm always happy to give you my second best idea! Some of the opportunities that we've already identified include small domestic stubs of liquidating entities, factoring of various types of receivables and regulatory capital. We are currently looking at trade finance -- we have found some very interesting domestic and Asian opportunities there.
Trusted Insight: You have quite a bit of European experience as well -- you studied for your master’s degree at Universität Konstanz in Germany and you were a hedge fund analyst for 47 Degrees North Capital Management in Switzerland. How do you think the current European investment market differs to the United States, particularly for hedge funds?
Robert C. Lee: There's far more uncertainty in Europe these days. There's uncertainty everywhere, but you can see it in everybody's exposure and their attitude toward Europe post-Brexit. I think the tenuous state of the European Union has a lot of people on edge. Events are going to drive markets, and that could come from political events like elections, or from the central banks. That's a very difficult market to take any beta exposure, but it certainly creates a lot of opportunity. You'll see a higher dispersion of manager performance because the dispersion of the risk factors is lower, so therefore the dispersion of the performance that comes on the back of that is higher. That is a distinct opportunity that we continue to look at.
Trusted Insight: How is uncertainty in Europe advantageous to other regions?
Robert C. Lee: There is a lot to be done in Asia right now, generally because the risk appetite is lower these days. I think a lot of people have started to pull out of some markets prematurely, and it has created quite a bit of opportunity. Oddly enough among the emerging markets, South America looks like a bastion of strength! How often can you really say that? We do continue to look at all emerging markets, including South America, but we are getting pretty bullish on some Asian opportunities that we're finding. These are just good old-fashioned arbitrage-like trades that are available to us in the Asian markets right now.
There's far more uncertainty in Europe these days. There's uncertainty everywhere, but you can see it in everybody's exposure and their attitude toward Europe post-Brexit.
Trusted Insight: You're achieving this with a very small team of investment professionals. What attributes do you look for within an investment team?
Robert C. Lee: We're a team of four people, and it's a very flat group. We work together as a team without a very strong hierarchy. I look for team players from various backgrounds who throw in their point of view. The more points of view you have the better, but it requires somebody to be able to act as a good team member. That's the number one thing that I look for. Beyond that, there are all types of the usual credentials that definitely help. We have a very, very strong team. It’s one that I'm extremely proud of, and I would put us up against anybody else's in the market.
Trusted Insight: Are you generalists or specialists?
Robert C. Lee: We are all generalists, and we are all encouraged to source and look at new strategies. Everybody here is really on top of that and goes outside of the standard consultants’ approved lists and the standard databases. Turn over a lot of rocks and kiss a lot of frogs. That is certainly encouraged, as well as building relationships with not only the hedge funds but other allocators who are thought-leaders within the industry. I think that ultimately helps us gain an edge in sourcing.
Trusted Insight: Is there anyone who has particularly influenced your approach to managing your investment team?
Robert C. Lee: One of my mentors is Tom Tull, our chief investment officer. He has encouraged us to build the quality program and team that we have and has been extremely supportive. The willingness to get everybody out there and develop these opportunities or relationships is something that he has taught me and supported.
Trusted Insight: Outside of investing, what else are you passionate about that gets you out of bed in the mornings?
Robert C. Lee: Outside of investing? Shoot, I love coming to the office every morning! I have two little girls that are just the light of my life. I met my wife when I was studying for my master’s in Germany. We have a wonderful family and nothing gets higher on my list than that.
Something I also enjoy talking a lot about is beekeeping. It's something I get great enjoyment out of and I think more people should do. My wife and I have a “hobby farm” to the south of Austin, where we have bees, chickens, a little vineyard and an orchard. We grow our own vegetables and what-not -- it's a lot of fun. It's a lifestyle that we very much enjoy. But beekeeping is one of the things I find myself talking to other investors about quite a bit!
Trusted Insight: Are there any transferable lessons from beekeeping that help in the investment industry?
Robert C. Lee: I suppose I'm going to get stung every once in awhile, so it's not something I should fear!
To learn more about hedge fund investing, view the full list of Top 30 LPs Investing In Hedge Funds.