COMMONWEALTH OF MASSACHUSETTS

PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION

GUIDELINES FOR HEDGE FUND INVESTMENT

Massachusetts public retirement systems may consider hedge funds as a way to achieve additional diversification in their portfolios. The term hedge funds generally refers to unregulated investment products that seek absolute returns through the use of specialized investment strategies that are expected to have low correlation to the major financial markets. Products that involve strategies basically similar to those of traditional active management approaches will not be approved. Retirement systems seeking to invest in hedge funds should incorporate this sector into their long-term asset allocation plan.

Retirement boards with investment assets in excess of $150 million may request authorization to conduct a search for hedge fund of funds. The Commission will consider requests from retirement boards with assets below $150 million on a case by case basis and the Commission will consider, among other factors, the retirement boards overall performance record, its experience in alternative asset classes, the level of expertise utilized by the board, and the clarity and strength of its written submission. The Commission may deny any retirement board the authority to invest in Hedge Funds if circumstances warrant.

Total investment in hedge funds, based on market valuation at the time of investment, cannot exceed the existing combined percentage of the PRIT Core Fund allocated to Absolute Return and Portable Alpha. Any amount in excess of 50% of the maximum hedge fund allocation must be invested in the PRIT Absolute Return segment.

Retirement boards below the $150 million asset minimum may invest up to the percentage of portfolio assets established by the PRIT Fund in the PRIT Fund Absolute Return segment without PERAC regulatory action , up to the combined percentage of the PRIT Core Fund that is currently allocated to Absolute Return and Portable Alpha.

Because diversification—both among strategies and among managers—is crucially important in hedge fund investing, it should be a primary focus for retirement boards. Retirement boards that invest on their own must use funds of funds exclusively for their hedge fund investments. By investing in funds of funds, retirement systems also benefit from another layer of professional expertise in the selection and monitoring of individual hedge funds.

Emphasizing the importance of diversification, systems that invest on their own should seek to have a sufficient number of funds of funds so that no single fund of funds represents over 2% of the systems total investment portfolio (or 40% of the total hedge fund position if the hedge fund allocation represents 5% of the systems total portfolio). Systems should be aware of the extent of overlap in the various funds of funds holdings of separate hedge funds.

The total number of separate, underlying hedge funds in a systems total portfolio should be at least 75. The market value of any single hedge fund held within one or more of a systems fund of funds should not represent more than 2.5% of the market value of the retirement boards total hedge fund portfolio. This would represent 0.125% of the boards total portfolio if hedge funds represented a 5% position.

Retirement boards must invest in hedge fund products that invest primarily in relative value, non-directional strategies as opposed to strategies where performance is largely influenced by general market movements or by movements in specialized markets like energy or commodities. Hedge fund products should be reasonably diversified among major strategy groups such as equity hedge (long/short equity), relative value and event driven. The R-squared, beta and correlation statistics for the product should indicate that past performance has not been related to or correlated with any of the major financial markets to a significant degree. The products volatility, as measured by the standard deviation of returns, should not be greater than 7.5% (which means that the performance of the product is expected to be within plus or minus 7.5% of the annualized return about two thirds of the time). These and any related statistics should be included in the retirement boards submission of regulatory documents to PERAC.

In developing the basic parameters for their hedge fund search, retirement boards should work with their consultants to restrict their search to respondents who offer reasonable overall transparency that is generally consistent with industry best practices. Acceptable transparency generally represents a compromise between an investors right to know and a managers need to protect his fund from possible competitive disadvantage. Under todays best practices, retirement boards should not expect or insist on disclosure of individual portfolio securities or positions in all underlying hedge funds, but they should expect and insist on detailed discussion and explanation of portfolio strategies and major risk factors inherent in the portfolios. Investors in funds of funds should receive a current listing that identifies all underlying funds and be kept informed periodically on hedge funds that have been liquidated and/or added to the portfolio.

Retirement boards should understand the extent to which leverage is used in hedge fund products under consideration. While it is to be expected that some hedge funds within a fund of funds structure may employ strategies where substantial use of leverage is essential to the implementation of the strategy, the effective leverage in the composite product must not be more than one time existing capital.

Notwithstanding the courts overturning of the SECs right to require hedge fund registration, hedge fund products that have registered with the SEC or other federal agency should be preferred over those that have not, wherever possible.

Boards must work with an investment consultant who has experience in analyzing, conducting searches for, and monitoring hedge funds, preferably for institutional clients. For some boards, this may involve retention of a consultant separate from the one it currently uses for traditional asset classes. While using the consultant for educational purposes and for assistance in conducting a search, the retirement board should 1) have a basic understanding of the investment strategies involved; 2) be committed to making final decisions on its own relative to any investment in hedge funds; and, 3) be committed to working with the consultant to closely monitor hedge fund investments.

Boards should work with their consultant to determine various parameters that would govern their search, such as what minimum levels of assets under management or length of investment track records should be applied to prospective fund of funds or other managers. At the minimum, such standards should establish that the firms in question have proven themselves to be going concerns in terms of both asset growth and management capability.

An appropriate benchmark by which to monitor and evaluate hedge fund performance should also be determined.

Boards are encouraged to consider whether prospective vendors have existing public fund clients, although this need not be a requirement for selection.

Before contemplating a search for hedge funds, retirement boards are expected to have received basic education on hedge funds from their consultant. Such education should present a balanced view of the risks as well as the opportunities inherent in hedge fund investing. Before beginning a search, the board must submit a letter to PERAC staff summarizing its objectives in investing in hedge funds, discussing how this fits into overall asset allocation, and explaining how its hedge fund investments would be structured in order to accomplish those objectives. In considering whether to authorize a system to conduct a search for hedge funds, PERAC may take into account such factors as the retirement boards past investment performance, the systems funded ratio, and the boards record of compliance with PERAC regulations and guidelines. If the board has not received notice from PERAC within ten business days, it may commence its search process.

A fair and open competitive process is required for selection, commencing with the issuance of an RFP. These guidelines should be distributed to potential managers as part of the RFP. As in all searches for investment-related vendors, the boards need not limit their consideration to firms that respond to the advertised RFP. Proposals may be solicited from firms that the board and its consultant consider to be qualified.

By nature, a search for hedge fund product managers is uniquely challenging in that it involves manager risk (as opposed to market risk) to a far greater extent than in traditional asset classes. Prospective investors must carefully examine not only the backgrounds of the managers and their investment record but also the firms business infrastructure and operational capability. Even for funds of funds, taking such steps as checking references and making site visits is highly recommended. Analyzing the firms risk management procedures and valuation policies should be top priorities.

After completing its search, the retirement board must submit a letter to PERAC which certifies that the hedge fund product was selected as a result of a competitive process (a summary of and timeline for the process should be included). The board will maintain a complete file containing documents on the major steps (interviews, site visits, reference checks, etc.) included in the due diligence process conducted by the board and its consultant.

Selected hedge fund product managers will complete PERAC Disclosure Statement and Vendor Certification forms as part of the RFP process. Besides clearly stating the structure of management fees inherent in the product, managers must disclose any financial arrangements between themselves, consultants, and any other third parties. On an Application for Exemption, managers will submit detailed information to PERAC staff on their key personnel, assets under management, investment strategy, investment process, risk control, organizational structure, performance record, et al. PERAC will refuse to issue regulatory approval for managers it deems to have clearly insufficient or questionable credentials and who fail to meet reasonable standards of experience and capability. The Commission will also deny an application if the process used to select the manager was flawed or where financial arrangements raise concerns regarding the selection process. As with any proposed investment, The Commission may withhold approval of an exemption if it is in the best interests of the retirement system. (840 CMR 19.02-3)

All managers will transmit quarterly performance and strategy review reports to the board and to PERAC. Reports from fund of funds managers should include information on each constituent fund. The retirement board and its consultant should meet with its fund of funds managers for a performance and strategy review at least once a year.

At the time of investment and at any time during the holding period, a particular Massachusetts retirement fund should not represent more than 10% of a hedge fund products total assets and Massachusetts public funds together should not represent more than 50% of the total assets in the product.