CalPERS Moving to All-Passive Investments?
Pensions & Investments ran a story yesterday about how the California Public Employees' Retirement System is considering moving to an all-passive portfolio. You probably didn't read it, because stories about pensions are boring.Investment News also covered this story, providing more details on trends in passive investing in their article, Passive investing: If it's good enough for CalPERS ...:
But this story only looked boring. In fact, it was probably the most important Wall Street development you'll read this week. It's an undeniably good sign for people who care about the retirement funds of teachers, firefighters, and other public-sector employees. And it should strike terror into the heart of every hedge-fund manager and private-equity executive in midtown.
The backstory is that, for many years, public pension funds have had a love affair with so-called "active investments" — basically, hedge funds, venture capital funds, private-equity funds, mutual funds, and assorted other outside money managers who charge a fee for managing other people's money. Every year, pensions plow more and more millions of dollars into these funds, hoping for better returns than they could get by buying low-risk index funds and exchange-traded funds on their own. They're happy to pay through the nose for the privilege — most alternative asset managers charge at least a 2 percent management fee and 20 percent of profits — under the assumption that since these complex, active investments make better returns than simple, passive investments, the fees are worth it.
Except that they're usually not. In aggregate, and especially in recent years, most active management firms don't perform any better than a simple, passively managed index fund that costs nearly nothing to buy, and many expensive funds perform significantly worse. As P&I says:
Over the past 10 years, just 38% of large-cap-equity managers have beaten the S&P 500. Over five years, it shrinks to 31%, and over three years, it is just 18%, according to Morningstar Inc. Making things even harder for those trying to pick active managers is that just 9% of large-cap managers outperformed the S&P 500 over all three time spans.Private-equity firms and hedge funds, in particular, tend to love pensions, which typically provide a majority of the money they manage. (In fact, many private-equity firms and large hedge funds couldn't exist without pensions.) But they haven't held up their end of the deal. Start with their subpar returns, and subtract their onerous fees, and you get a very bum deal for the average pension fund.
But CalPERS — a large and influential fund, which can act as a Pied Piper for lots of smaller pensions — is waking up to the fact that it's paying too much to active managers and not getting enough in return. After years of pushing for lower and lower fees from the private-equity firms and hedge funds who manage its money, CalPERS is considering saying, "You know what? Never mind," and giving up on active management altogether.
This would be a good thing! Most pension funds should not be in the business of selecting active managers, and I would cheer any pension fund that followed CalPERS's example and put more of their money in index funds and passive bond funds. Risky investing isn't always a bad thing, and it's true that some private-equity firms, hedge funds, and mutual funds have done well for their pension investors.
But if they want to handle the retirement money of America's retirees, these firms have to prove they're worth the fees they charge. And so far, they haven't measured up.
Passive investing has reached a watershed moment.Indeed, the future of active management does depend on where the market is going over the next five years. If it tanks or goes sideways, a few good active managers which don't gouge investors on fees will be in very high demand.
The second-largest pension fund in the United States is considering a move to an all-passive portfolio while at the same time, the largest brokerage firms are falling over themselves to push passively managed exchange-traded funds.
The California Public Employees' Retirement System's investment committee started a review of its investment beliefs last week, with the main focus on its active managers, according to sister publication Pensions and Investments.
CalPERS oversees about $255 billion in assets, more than half of which already is invested in passive strategies.
“It's sort of an exclamation mark on a trend that most are aware of,” said Chris McIsaac, managing director of the institutional investor group at The Vanguard Group Inc.
Fidelity Investments, meanwhile, has responded to the enthusiasm for passive strategies by doubling down on its agreement with BlackRock Inc.'s iShares unit. Fidelity increased the number of iShares ETFs that trade commission-free to its clients to 62, from 30, two weeks ago.
Fidelity's move came just a month after The Charles Schwab Corp. launched an ETF platform that offers investors more than 100 commission-free ETFs.
TD Ameritrade Inc., the third leg of the online brokerage world, has been offering more than 100 commission-free ETFs since 2010.
“We see don't see it as either passive or active, we see it as both. In a low-return environment, fees matter a lot,” said Scott Couto, president of Fidelity Financial Advisor Solutions.
“That's getting interest in passive investing over the short term. Over the long term, active management adds a lot of value,” Mr. Couto said.
“There will continue to be a growing interest in the passive side because cost matters to investors,” said Beth Flynn, vice president and head of third-party ETF platform management at Schwab.
“Virtually all our adviser clients use ETFs in some way, shape or form,” she said. “Usage is much lower on the individual-investor side, but growing at a pretty steady and rapid clip.”
More than 40% of individual investors plan to increase their use of ETFs over the next year, for example, according to a recent Schwab survey.
TD executives couldn't be reached for comment.
SHIFTING PREFERENCE
Passive investing is nothing new. Vanguard founder John Bogle launched the first index mutual fund in 1975. But the fund world has always been dominated by active management.
A decade ago, 86% of the $4.4 trillion in mutual funds and ETFs were in active strategies, according to Lipper Inc.
Investors' preference is clearly shifting, though. Active management's market share was down to 72% as of the end of last month, and passive funds clearly have all the momentum now.
As investors have gotten back into stocks this year, they have done so largely through passive funds. Passive funds took in $65 billion in the first two months of the year, while active funds took in $40 billion.
For anyone who has been watching fund flows over the past few years, the surge in passive strategies shouldn't come as a surprise.
Since 2003, investors have pulled $287 billion from actively managed equity funds, while investing just over $1 trillion in passive funds.
Even though the preference for passive strategies has been most dramatic in equity funds, passively managed bond strategies are gaining steam, as well.
Passive bond strategies have had $260 billion of inflows since the beginning of 2008. Between 2003 and 2007, they had $73 billion of inflows, according to Lipper.
“Indexing has proven to be a very compelling investment strategy, especially for investors with an extended investment horizon,” Mr. McIsaac said.
Costs have played a big part. They are, as Mr. Bogle likes to point out, the only thing that an investor really can control, and passive strategies are much cheaper than their active counterparts.
U.S. equity ETFs have an average expense ratio of 40 basis points, compared with an average expense ratio of 134 basis points for actively managed mutual funds, according to a recent Morgan Stanley Wealth Management research note.
What's more, a number of large-capitalization ETFs charge less than 10 basis points, while the cheapest actively managed large-cap fund charges 50 basis points.
Active managers haven't given investors much reason to stick around.
“Being active over the past 15 years has not been rewarding,” said industry consultant Geoff Bobroff.
The percentage of managers beating their benchmark has been shrinking.
Over the past 10 years, just 38% of large-cap-equity managers have beaten the S&P 500. Over five years, it shrinks to 31%, and over three years, it is just 18%, according to Morningstar Inc.
Making things even harder for those trying to pick active managers is that just 9% of large-cap managers outperformed the S&P 500 over all three time spans.
The inconsistency of actively managed returns is what prompted the review by CalPERS.
As P&I reported: “CalPERS investment consultant Allan Emkin told the investment committee that at any given time, around a quarter of external managers will be outperforming their benchmarks, but he said the question is whether those managers that are doing well are canceled out by other managers that are underperforming.”
'EVALUATING MANAGERS'
Rick Ferri, founder of Portfolio Solutions LLC, ran into the same problem while he was working at a brokerage firm early in his career.
“I spent a lot of time and money evaluating managers,” he said.
“It was a revolving door for most of them,” Mr. Ferri said. “You can't win unless you get very, very lucky.”
Mr. Ferri now runs an all-index portfolio for his clients' equity exposure. On the bond side, he still favors active management — when it is cheap.
“Sometimes that's the best way to get market representation,” Mr. Ferri said.
The $39.2 billion Vanguard Intermediate-Term Tax-Free Bond Fund (VWITX) owns 3,854 bonds and charges 20 basis points, for example. The $3.6 billion iShares S&P National AMT-Free Municipal Bond ETF (MUB), the largest municipal bond ETF, holds 2,196 bonds and charges 25 basis points.
CalPERS is expected to decide the fate of its active managers in about five months. At this point, it looks as though it could go either way.
Chief operating investment officer Janine Guilot told P&I that 27 preliminary interviews of CalPERS staff members, board members, money managers and external consultants showed a “wide disparity of views” on active management.
Mr. McIsaac isn't ready to write off active management altogether.
“There will come a period of time when active managers will do much better,” he said.
That is, if good active management can be found at a low cost.
“It's hard to find both,” Mr. McIsaac said.
The market ultimately will have the biggest say in the future of active management, Mr. Bobroff said.
“Is this the end of a trend?” he asked. “It depends where the market is going over the next five years. Your guess is as good as mine.”
But if the bull market that gets no respect keeps trending up, the percentage of active managers that beat their benchmark will keep shrinking. This will be great news for large banks offering 'index solutions' to their clients but it will be bad news for the active management industry struggling to compete, especially after the 2008 financial crisis.
Will CalPERS move to an all-passive portfolio? While that would please those who are disgusted with the latest indictment involving their former CEO and a middleman charged with defrauding a private equity fund, doubt CalPERS will go all-passive.
Instead, I think CalPERS will reevaluate all their external managers in public, private and absolute returns strategies, scrutinizing the fees they've paid out and the value added (alpha) these funds have actually produced, net of fees and costs.
I can tell you that the biggest problem at CalPERS for the longest time was they wanted to invest with everyone. When you invest with everyone, you end up paying huge fees and getting back mediocre benchmark returns. This is what happened in their large private equity portfolio before Réal Desrochers joined a couple of years ago to clean it up. He's halfway done but still cleaning it up.
And this is what is going on in their large real estate and hedge fund portfolios. They're is a lot of cleaning up that needs to be done as these portfolios are dolling out huge fees and not getting the value added to justify such big allocations to external managers.
Think CalPERS can learn a lot from small and large funds. Last week, I wrote on HOOPP's stellar 2012 results where Jim Keohane, their president and CEO, stated that they add value internally by focusing primarily on arbitrage opportunities in fixed income markets and by engaging in trades -- like their long-term volatility strategy -- which just make sense but don't fall under benchmark or absolute return strategies.
CalPERS can also learn a lot from Ontario Teachers', CPPIB and other large Canadian pension funds which run active management internally but also invest with external managers where it makes sense, typically in strategies where they cannot reproduce the alpha internally.
Admittedly, this will be hard because CalPERS and other US pension funds are not governed the same way and do not compensate their managers as well as their Canadian counterparts but this doesn't mean they can't implement similar approaches to these Canadian funds.
Finally, CalPERS can learn from smaller US pension funds engaging in flexible approaches with their active managers. Dawn Lim of Money Management Intelligence recently reported, Philly Rethinks Approach On Hedge Funds, Seeks Flexibility:
The City of Philadelphia Board of Pensions & Retirement has rethought its approach to hedge fund investing and will seek to weave the funds throughout its $4.3 billion portfolio as a style rather than a separate asset class.Among pension consultants, Cliffwater provides excellent advice to its institutional clients and they know the alternative investment space extremely well. There are a few others who provide equally sound advice.
The more open framework, which was adopted after a portfolio review late last year, also calls for higher investment targets to private equity and hedge funds. The new portfolio mix is expected to be implemented this year.
“We have a more flexible model than most public plans that permits us to use hedge fund in real estate or bonds or equity,” CIO Sumit Handa said at IMN’s Public Funds Summit in Huntington Beach, Calif., last week. By introducing long-short strategies into buckets that have traditionally been long-only, the pension fund can more easily slot strategies to dampen volatility into its portfolio, documents indicate.
Consultant Cliffwater played a role in the asset allocation review and will assist in the execution. The asset allocation review raised the fund’s hedge fund target to 12% from 10%.
While fund officials have as yet disclosed no manager searches in connection with the new strategy, they note that they have been in talks with managers to create special accounts. “We’ve tailored an opportunistic vehicle and we believe we have more coming,” Handa said. Private equity targets will get a boost to 14% from 9.75% and the pension plan is reviewing its pacing schedule.
Fund documents indicate that Philadelphia was working last year with managers to create private equity and hedge fund vehicles that will help it mitigate possible J-curve losses and get earlier distributions. Within the fixed-income bucket, the pension has also done away with the specificity of sub-asset classes such as “high yield,” “non-U.S.” and “emerging markets” and implemented broader categories such as “investment grade” and “non-investment grade.”
In December, Philadelphia made a $30 million commitment to structured credit-focused Axonic Credit Opportunities Overseas fund, as the first public pension to commit to Axonic Capital, a $1.7 billion New York hedge fund that had previously only raised endowment and private pension dollars, fund documents indicated.
The pension is looking to reduce the number of managers for better risk control and higher returns. “We have too many positions for a $4.3 billion fund,” Handa said at the panel, “We’ll be scaling back on this.” The fund, which has 130 managers, has moved to make higher commitments, generally in the range of $30 million - $50 million. It also shifted 1% of portfolio assets in-house to be managed tactically.
The latest fund manager Philadelphia disclosed it terminated was credit hedge fund manager Regiment Capital, axed in December for sitting on cash and failing to ride on the high yield and levered loan rally in 2012. Regiment didn’t immediately respond to queries.
The pension fund also restructured its real assets bucket as part of the portfolio overhaul. The target for master limited partnership was raised to 3% from 1.75%. The real estate bucket was reduced and brought under real assets; it had previously been a standalone asset class. In line with the new targets, the pension fund exited J.P.Morgan’s and INVESCO’s core real estate funds, in the view that the core real estate market was overvalued and it was time to redeem cash from both mandates.
Separately, a push to bring smaller managers into the portfolio may be brewing. “We are exploring methods to increase the number of women, minority, disabled and emerging managers into the areas of private equity, real estate and hedge funds,” according to an email from Executive Director Francis Bielli. There is currently no time frame for implementation, he stressed.
One of them is Simon Lack, founder of SL Advisors and author of "The Hedge Fund Mirage," who recently appeared on CNBC stating that outsized risks by hedge funds and fees could imperil pensions.
You bet, these are treacherous times for hedge funds but in the pension world, memories are short and many have already forgotten about the pensions' alternatives albatross which hit them hard four years ago. They should listen carefully to Simon Lack below as he knows what he's talking about.