Wednesday, October 1, 2014

CalPERS Drops a Hedge Fund Bomb?

While I was away in Greece (more on that trip later this week), there was one big bombshell that got everyone's attention. Michael B. Marois of Bloomberg reports, Calpers to Exit Hedge Funds, Divest $4 Billion Stake:
The California Public Employees’ Retirement System plans to divest the entire $4 billion that it has with hedge funds, saying they’re too expensive and complex.

The decision to eliminate 24 hedge funds and six hedge fund-of-funds, isn’t related to the performance of the program, said Ted Eliopoulos, the interim chief investment officer. The board of the $298 billion pension, known as Calpers, hasn’t decided where to invest the money after the pullout, which will take about a year, he said.

“We concluded that we would eliminate the hedge fund program in order to reduce the complexity, reduce the costs in the program, particularly in relation to our view that given the scale of Calpers, we would not be able to scale a hedge fund program to a size that would really move the needle,” Eliopoulos said today in an interview.

The largest U.S. pension is getting out of hedge funds even as other large public plans such as New Jersey’s add to the private portfolios. Calpers has been working to reduce risk after the global financial crisis wiped out more than a third of its wealth, forcing it to increase contributions from taxpayers to cover losses. Calpers first invested in hedge funds in 2002 to help meet target returns to cover the growing cost of government retiree benefits.

Fund Fees

The pension fund paid $135 million in fees in the fiscal year that ended June 30 for hedge fund investments that earned 7.1 percent, contributing 0.4 percent to its total return, according to Calpers figures.

Calpers earned 18.4 percent in the fiscal year as global stock indexes rose to records. The fund’s market value reached $300 billion for the first time July 3, making it bigger than all but two companies on the Dow Jones Industrial Average.

The pension invests in funds run by Och-Ziff Capital Management Group LLC, Bain Capital LLC’s Brookside Capital, Lansdowne Partners LP and Canyon Partners LLC, according to a report from Calpers. Its fund-of-funds investments include funds run by Rock Creek Group LLC and Pacific Alternative Asset Management Co.

Calpers’ return goal is 7.5 percent. The annualized rate of return on its hedge fund investments over the last 10 years is 4.8 percent.
Alternative Investments

Hedge funds have amassed a record $2.8 trillion in assets as institutional investors pour money into alternative investments. McKinsey & Co. said last month that assets in alternatives, which also include real estate and private equity, may reach $14.7 trillion by 2020, double the current level.

Unlike traditional money managers, hedge funds can bet on rising as well as falling prices of securities, aiming to make money in any market environment. They generally charge fees of 2 percent of assets and 20 percent of returns, a level of remuneration that some institutions have balked at.

While Calpers was one of the earliest pension funds to invest in hedge funds it has lagged behind many of its peers in increasing investments. The $60 billion Massachusetts fund has 9.5 percent of assets in hedge funds.

New Jersey’s state plan, with $81 billion in assets, has added more than $1 billion in new hedge-fund investments in fiscal year 2014.

Calpers’ former chief investment officer, Joe Dear, who died in February from prostate cancer, restructured the pension’s portfolio after he was hired in 2009 to steer the fund through the recession. He shed speculative real estate investments and focused on private equity, emerging markets, hedge funds and public-works projects to help meet the fund’s targets. Dear’s permanent replacement has yet to be named.

Calpers has more than 1.6 million members in its retirement system and more than 1.3 million in its health plans. The fund administers health and retirement benefits for 3,090 public school, local agency and state employers.
In his article, Justin Lahart of the Wall Street Journal reports, Calpers Shows Masters of Hedge-Fund Universe Have No Clothes:
The most surprising thing about the California Public Employees' Retirement System's announcement Monday that it will be exiting its $4 billion investment in hedge funds over the next year may not be the decision itself, but that it took so long.

In the fiscal year that ended this June, the pension fund's hedge-fund investments returned just 7.1%. That compares with a 12.5% return for the Vanguard Balanced Index Fund, which follows the allocation of 60% stocks, 40% bonds that pension funds have historically followed. In the prior year, Calpers's hedge-fund investments returned 7.4% versus 10.8% for the index fund.

It isn't just Calpers. Hedge-fund tracker HFR's composite index, which measures the equal-weighted performance, after fees, of over 2,000 funds, has been underperforming the passive bond-and-stock portfolio since 2009. During the crisis year of 2008, it lost 19%, only marginally better than the index fund's 22.2% loss. That performance made it a bit harder to accept the idea that hedge funds' ability to offer downside protection justifies the hefty fees they charge—typically a 2% management fee and 20% of investment profits.

What has happened to the onetime masters of the investing universe? Hedge funds may have become a victim of their own success. With assets under management tripling to $2.8 trillion from their 2004 level, according to HFR, the field has become so crowded that it isn't as easy for managers to consistently deliver strong performance. Indeed, just as actively managed mutual funds struggled to deliver returns commensurable with their fees and expenses as they boomed in the 1990s, hedge-fund returns have suffered over the past decade.

Certainly, within the broad universe of hedge funds there are managers who can consistently deliver strong performances. But within an increasingly crowded field, picking them is a skill in itself. That further reduces their allure for big investors like Calpers. Such funds can hire outside managers to do this, and incur additional fees, or develop that expertise in-house, and incur additional costs.

Indeed, Calpers said it wasn't hedge-funds returns, but the costs and complexity of running a portfolio of hedge-fund investments that drove its decision. Hedge funds represent just a tiny fraction of the $298 billion Calpers manages, so regardless of whether they performed very well or very poorly, they wouldn't do much to move the needle. For hedge funds to be worth the effort, the pension fund would have had to dedicate a far larger chunk of its portfolio to them.

Given how big Calpers is, and how crowded many hedge-fund strategies have become, such a move would further cut into hedge-fund returns. That is a particular risk since other pension funds, seeing Calpers as a bellwether, might have followed suit.

Instead, other pension funds may follow Calpers's lead and cut or reduce their hedge-fund exposures. One place the money might go is lower-cost strategies that mimic the aggregate returns of various hedge-fund strategies—something that Calpers has begun doing. These promise to provide institutional investors index-like investments that can round out the risk profile of their portfolios like hedge funds do—but without the high fees.

Calpers's move is hardly a death knell for hedge funds. There will always be smaller, sophisticated investors with the patience and experience to find great hedge-fund managers. And there will always be others, seduced by the mystique hedge funds offer, who invest in them even though they shouldn't.

But the high-water mark for hedge funds may have passed. Increasingly, investors will question why hedge funds charge so much for what they do. Hedge-fund managers who don't have a performance-based answer will be in trouble.
A lot of investors are rightly questioning why they're enriching overpaid hedge fund managers who have become nothing more than glorified asset gatherers charging 2 & 20 (or more like 1.5 and 15) for leveraged beta.

Interestingly, one of the UK’s most influential public pension funds has branded high hedge fund fees as unjustifiable, adding to pressure on the industry to lower them further:
Edmund Truell, chairman of the £4.5bn London Pensions Fund Authority, said that hedge funds could no longer justify their so-called “2 and 20” fee structure, and that he understood why Calpers, the largest US public pension fund, decided to ditch its hedge fund programme.

Traditionally hedge fund managers have amassed vast personal wealth by charging their investors a fixed fee of 2 per cent of the assets entrusted to them, and then 20 per cent of any profits they make.

“In a low interest rate environment you cannot justify the traditional hedge fund fee structure, and as a steward of public money we cannot pay those fees,” said Mr Truell. “The move by Calpers reflects investor concerns about the way hedge funds are structured. We have regular conversations with other pension funds and this is a very big issue for them.”

Last year the world’s 25 best paid hedge fund managers made an estimated $21.1bn.

Calpers is not only one of the largest US public pensions funds but was also one of the first to invest in hedge funds, so its withdrawal has dealt a bloody nose to an industry that has become increasingly reliant on inflows from the public sector.

The head of another large UK public pension fund said: “Calpers is an organisation that the US pensions industry looks to for leadership and its decision to withdraw entirely from hedge funds will make people stop and think”.

Earlier this year a report commissioned by the UK government on the country’s £178bn local authority pension funds questioned the benefits of their investments in active managers such as hedge funds because of high fees and underwhelming performance.

Mr Truell, who was appointed by the London mayor Boris Johnson in 2012 following a career in private equity, said that hedge funds should lower their fees to reflect their true expenses, but added that he remained happy to pay for good performance.

“We have no problem with paying people for success, but we want much more transparency on how hedge funds spend our money, such as using budget-based fee structures, and organising club deals,” he said.

Over the past two decades, the profile of investors in hedge funds has shifted from risk-seeking wealthy individuals and family offices to state-backed funds, forcing secretive hedge fund managers to adjust to life as a form of public sector contractor.

Under Mr Truell, the LPFA withdrew its investment in Brevan Howard, a $37bn hedge fund manager run by the Geneva-based British citizen Alan Howard, after it refused to comply with the level of transparency requested by the pension fund.

“There is a lot of recognition that [the hedge fund sector] has not delivered what it promised and the returns have been very disappointing,” said Nick Tomas, a partner at the Edinburgh-based investment group Baillie Gifford, which does not invest in hedge funds.
Other major UK pension funds, including the Railway Pension Scheme and BT Pension Scheme, are looking to scale back on hedge funds as well.

But rest assured, CalPERS' decision does not represent a "watershed moment" or the "death knell" for hedge funds. In fact, the decision won't stop the flood of money going into hedge funds. At the end of the day, pension funds are all chasing yield to achieve their actuarial rate of return and they're hooked on hedge funds and alternative investments regardless of what CalPERS does.

From my vantage point, I can't say I'm shocked with CalPERS' decision. They were openly discussing chopping their hedge fund allocation in half. I guess after several intense meetings, they came to the conclusion that their hedge fund program wasn't worth the fees and effort to salvage, so they cut it.

Let me give you some background. CalPERS was never known as a major player in hedge funds among the large global public pension funds. The two best hedge fund investors in the world are ABP, the large Dutch plan, and the Ontario Teachers' Pension Plan.

APG Investments is ABP's asset manager. New Holland Capital (NHC) is the independent investment company with a small team of investment professionals based in New York that manages a $15 billion portfolio of hedge fund investments exclusively on behalf of APG Investments. NHC was founded in October 2002 by Ira Handler as ABP's internal fund of hedge funds team and completed a spinout in 2006.

Ron Mock, Ontario Teachers new leader, was hired by Claude Lamoureux to start a hedge fund program back in 2001 and quickly became one of the biggest and best fund of hedge funds in the world. I recently discussed Ron's harsh hedge fund lessons and how they shaped his thinking.

The difference between CalPERS and these two is significant. First, these two funds have a dedicated team of operational, investment and risk analysts overlooking billions in hedge funds. They really focus exclusively on alpha and are very active in their hedge fund portfolio, adding and removing funds that are not delivering alpha.

The other major issue with CalPERS is scale. Hedge funds did not represent a big enough chunk of the overall portfolio to make a significant difference in overall results. Again, this is because they never staffed up their team properly and taken their absolute return program very seriously. When I see a major public pension fund like CalPERS investing in funds of hedge funds, I shake my head in disbelief.

The other issue is complexity and cost. All those fees going to pay sub-performers can pay a lot of excellent salaries of an internal staff that can generate alpha from within. Why pay some hot shot hedge fund manager huge fees when you can mimic most of the strategies internally at a fraction of the cost?

Sure, there are excellent hedge funds out there but it's increasingly more difficult to find the true outperformers, ie. managers that can consistently deliver real alpha over a very long period. Most investors end up chasing the latest hottest hedge fund and that's why most get burned.

Finally, let me defend CalPERS from all those detractors criticizing this latest move. There are plenty of excellent pension funds -- like bcIMC and HOOPP -- that never invested a penny in hedge funds and they're doing just fine. All this nonsense that "you have to invest in hedge funds" is pure rubbish that the industry, investment consultants and brokers love to peddle.

My advice is if you don't have a proper team overlooking your hedge fund portfolio, follow CalPERS and get out while you still can. Never mind all the doomsayers warning you about another market crash coming in October, I still maintain the real risk in the stock market is a melt-up, not a meltdown. And if we do crash, a lot of hedge funds leveraged on beta are going to get wiped!

Every pension fund needs to assess the cost, complexity and risk of each investment portfolio and gauge whether it's worth maintaining that investment program. I think it was brave and smart of CalPERS to ask some tough questions and cut its allocation to hedge funds. Others should follow their lead but most will follow the herd and invest in hot hedge funds promising them "absolute returns." We shall see who wins out over a very long period.

Below, Ted Eliopoulos, chief investment officer of the California Public Employees’ Retirement System, talks about the pension's decision to divest the entire $4 billion that it invested with hedge funds. Eliopoulos speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "Market Makers." Columbia University’s Fabio Savoldelli also speaks.

And Christopher Ailman, chief investment officer of the California State Teachers' Retirement System, talks about the decision by the California Public Employees’ Retirement System to divest the entire $4 billion that it had invested in hedge funds. Ailman, speaking with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "Market Makers," also discusses DuPont Co. activist investor Nelson Peltz's call for a breakup of the third-largest U.S. chemical company.

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