Monday, May 12, 2014

CalPERS Chopping Hedge Fund Allocation?

Randy Diamond of Pensions & Investments reports, CalPERS chopping hedge fund allocation:
CalPERS portfolio managers have begun cutting the system's $5.3 billion hedge fund allocation in half, signaling a shift away from the asset class for the nation's largest defined benefit plan, say multiple sources familiar with the pension plan's operations.

The $289.1 billion California Public Employees' Retirement System's hedge fund program has been under review by top investment staff since January, spokesman Joe DeAnda confirmed in an interview with Pensions & Investments.

But Mr. DeAnda said no decision will be made on the future of the pension fund's hedge fund program until recommendations are presented to the CalPERS board sometime in the third quarter. Asked how cuts could be made in the meantime, Mr. DeAnda just repeated no decision had been made about the program.

Nevertheless, Curtis Ishii, a senior investment officer for fixed income who is conducting the hedge fund program review, in late March ordered Egidio G. “Ed” Robertiello, CalPERS' senior portfolio manager for absolute-return strategies, to start making major cuts, said the sources, who declined to be quoted by name because they are not authorized to talk about the issue.

Neither Mr. Robertiello nor Mr. Ishii returned phone calls for comment for this story.

The pension fund board's investment committee was informed in closed meetings during March and April that the cuts were being made, said two sources familiar with the discussions.

Other sources said portfolio managers for the absolute-return strategy made phone calls to all 13 CalPERS hedge fund managers in the past several weeks, telling them about the reduction. Three hedge fund managers will be terminated, and the remaining 10 will see their allocations cut.

The process of redeeming hedge fund assets varies among managers and can take several months. But by September, the sources say, the CalPERS hedge fund program will be reduced to around $2.5 billion.

In addition, the hedge funds-of-funds program is being reduced to two funds of funds from five, the sources said. Mr. Robertiello already has terminated four other hedge funds-of-funds managers during his nearly two years at CalPERS.

The hedge funds-of-funds segment has been a particular drag on performance, the sources said. They said that portion eventually will be cut to 15% to 20% of the portfolio from about 30%.

It is unclear why Mr. Ishii decided to reduce allocations while the program review is underway. The hedge fund program has underperformed in the past, but performance has improved under Mr. Robertiello.

The hedge fund portfolio returned 9.2% for the year ended Dec. 31, compared to the CalPERS custom hedge fund benchmark of 5.3%, CalPERS statistics show. The custom benchmark is the one-year U.S. Treasury note plus 5%.

But for the three-year period, the hedge fund portfolio returned an annualized 3.3%. vs. 5.4% for the benchmark. For five years, the hedge fund portfolio returned an annualized 6.2% and the benchmark, 5.6%.

The hedge fund program over the 10 years ended Dec. 31 returned an annualized 4.9%, compared to the benchmark's 7.3% return.

Sources say Mr. Ishii was appointed to review the hedge fund program by acting Chief Investment Officer Theodore “Ted” Eliopoulos in early January, right after Mr. Eliopoulos took over for Joseph Dear, who was ill at the time. Mr. Dear died on Feb. 26.

Around the same time, Mr. Robertiello, who had reported directly to Mr. Dear, began reporting to Mr. Ishii.

Mr. Dear supported an expansion of the hedge fund program, but Mr. Ishii has been a key opponent of the program. At a CalPERS asset allocation workshop in November, Mr. Ishii advocated scrapping the program, saying the risk of investment losses was too great.

Tense closed-door reviews have occurred twice monthly since February, sources said, with Mr. Ishii dominating the meetings and repeatedly attacking the hedge fund program. They said Mr. Ishii said he plans to take about $2.5 billion from the hedge fund program and redirect it to fixed income.

Hedge fund pioneer

In 1992, CalPERS became one of the first U.S. public pension funds to invest in hedge funds. Since then, the program has been restructured multiple times in hopes of developing a winning formula.

The latest restructuring was occurring under Mr. Robertiello's watch, as he reduced hedge funds of funds and invested in three hedge funds focused on Asian investments, and looked for new investment strategies.

Mr. Robertiello joined CalPERS to lead the absolute-return program in June 2012, following stints at Russell Investments and Credit Suisse. Mr. Robertiello had been pushing for expansion of the program that had only accounted for 2% of CalPERS' total assets. He had argued at staff meetings that the program could not meet one of its key goals, an efficient diversifier of CalPERS large equity risk, with such a small allocation, the sources said.

In an interview with Pensions & Investments in March 2013, he argued the same point.

“When you put all of the ingredients in a sausage-making machine and look at the results, the role of hedge funds in the portfolio is to add diversification,” Mr. Robertiello said. “To do that effectively, the allocation has to be much larger than the current 2%.”

After the cuts, the total hedge fund allocation at CalPERS will amount to just 1% of the pension fund's total assets.

CalPERS' hedge fund cuts run counter to increased investments by other large pension plans.Investments in hedge funds among the 200 largest U.S. retirement plans jumped 20.3% in the year ended Sept. 30, to $134.7 billion, according to data from P&I's Feb. 3 special report.

Despite those inroads, fee issues have had the opposite effect, Stephen Nesbitt, CEO of Cliffwater LLC, an investment consulting firm in Marina del Rey, Calif.

“The recent attention given to fees puts pressure (on pension funds) to cut hedge fund allocations to lower expense ratios, particularly among those systems that haven't clearly been able to demonstrate their value proposition, ” Mr. Nesbitt said in an e-mail.
CalPERS' hedge fund portfolio has been lacklustre for a very long time. Craig Dandurand recently left CalPERS after 13 years to join Australia's Future Fund where he will take up the role of director of debt and alternatives.

So who is right, Ed Robertiello or Curtis Ishii? Robertiello claims that the diversification benefits of hedge funds only kick in once allocation hits 5% but the fees are enormous and the so-called diversification benefits are grossly exaggerated.

I would love to have a buddy of mine -- a quant expert -- conduct a thorough examination of CalPERS' hedge fund portfolio to see who is really adding alpha and who is just collecting big fat beta fees, enriching overpaid hedge fund gurus. I bet you there is tons of beta in that portfolio.

Mr. Ishii should contact Ron Mock at Ontario Teachers. Along with ABP, Ontario Teachers runs the best hedge fund portfolio among all public pension funds. And even Teachers got clobbered in 2008 when a lot of their "uncorrelated, niche" and highly illiquid alpha strategies got decimated (Northwater Capital, a fund of funds Teachers helped seed, almost got wiped).

After 2008, Ontario Teachers' moved most of their hedge fund investments on a managed account platform. They use the National Bank and BNP Paribas's Innocap platform and have muscled the fees down to ridiculous levels. I've already covered Ontario Teachers' hedge fund strategy here and more recently here when I went over their 2013 results.

But CalPERS has a lot of work to do to revamp its hedge fund portfolio. I would immediately terminate funds of funds (should have been done a long time ago) and really dig deep into which funds are adding alpha as opposed to disguised beta.

Their hedge fund benchmark -- T-bills + 5% -- is what Ontario Teachers' uses but I wonder if the underlying portfolio represents the risks of this benchmark. Go back to read an older comment of mine, it's the benchmarks, stupid, to understand how pension fund managers can easily manipulate their benchmarks in all asset classes, especially alternative investments.

Basically, if you're using T-bills + 5% as your hedge fund benchmark, you should be investing mostly in liquid market neutral hedge funds, not global macro or L/S Equity.

CalPERS isn't only looking at its hedge fund portfolio. It's also revamping its private equity portfolio and recently struck fear in PE firms saying it will cut allocations and slash fees. There is a lot of work left to clean up that portfolio too.

Finally, I was saddened to learn that Joe Dear, CalPERS' CIO, died at the end of February at the age of 62. Mr. Dear was diagnosed with prostate cancer which is typically treatable if detected early. Dear’s wife, Anne Sheehan, is director of corporate governance for the second-biggest public pension, the California State Teachers’ Retirement System. He had two children, Annie and Ben, with his first wife, Leslie Owen.

Below,  Sebastian Mallaby of Council on Foreign and Columbia University’s Fabio Savoldelli discuss the future of hedge funds and what it takes to run a successful fund on Bloomberg Television’s “Market Makers.”