A Revolt Against Hedge Funds?

Dan Fitzpatrick of the Wall Street Journal reports, Calpers Pulls Back From Hedge Funds:

Public pensions from California to Ohio are backing away from hedge funds because of concerns about high fees and lackluster returns.

Those having second thoughts include officials at the largest public pension fund in the U.S., the California Public Employees' Retirement System, or Calpers. Its hedge-fund investment is expected to drop this year by 40%, to $3 billion, amid a review of that part of the portfolio, said a person familiar with the changes. A spokesman declined to comment on the size of the reduction but said the fund is taking more of a "back-to-basics approach" with its holdings.

The retreat comes after many pension funds poured money into hedge funds in recent years in hopes of making up huge shortfalls.

The officials overseeing pensions for Los Angeles's fire and police employees decided last year to get out of hedge funds altogether after an investment of $500 million produced a return of less than 2% over seven years, according to Los Angeles Fire and Police Pensions General Manager Ray Ciranna. The hedge-fund investment was just 4% of the pension's total portfolio and yet $15 million a year in fees went to hedge-fund managers, 17% of all fees paid by the fund.

"We were ready to move on," Mr. Ciranna said.

Before 2004, public pensions favored plain-vanilla investments and avoided hedge funds almost entirely, according to data compiled by consultant Wilshire Trust Universe Comparison Service. Public pensions began wading into hedge funds roughly a decade ago as they sought to boost long-term returns and close the gap between assets and future obligations to retirees.

Hedge funds typically bet on and against stocks, bonds or other securities, often using borrowed money. Hedge funds also charge higher fees, usually 2% of assets under management and 20% of profits.

Many hedge funds dropped less than the overall market during the financial crisis, and some even posted outsize gains by anticipating the collapse. That performance accelerated the flow of pension money into hedge funds.

The move was part of a wider embrace of alternative investments, including private equity and real estate, as pension officials looked to diversify holdings in case more conventional investments faltered. They also hoped bigger investment gains would help them avoid extracting larger contributions from employees or reducing benefits for current or future retirees.

With many hedge funds, that sort of outperformance hasn't materialized in recent years: Average public-pension gains from hedge funds were 3.6% for the three years ended March 31 as compared with a 10.9% return from private-equity investments, a 10.6% return from stocks and 5.7% from fixed-income investments, according to a Wilshire review of public pensions with more than $1 billion in assets.

After peaking at 1.81% in 2011, pension allocations to hedge funds dipped to 1.21% of total portfolios as of March 31, according to Wilshire's review.

The average amount committed to private equity, by comparison, still is climbing. Those investments jumped to a decadelong high of 10.5% as of March 31, according to Wilshire. Stocks and bonds are still the dominant investments for all public pensions.

The reconsideration of hedge funds as an investment option hasn't produced significant shifts inside all funds. Some big public pensions said they are holding firm on commitments or increasing allocations as they worry about how stocks will perform in any future downturn. About half of the U.S. public pensions still have some sort of hedge-fund investment, according to data tracker Preqin.

"We are seeing a little moving away from hedge funds," but so far it's "just on the margin," said Verne Sedlacek, the chief executive of Commonfund, a nonprofit that manages money for pension funds, endowments and other nonprofit groups.

How far Calpers goes with its hedge-fund review may influence decisions at other public pensions because of its size in the industry. The current value of its assets is roughly $301 billion. The examination began in March as officials inside the fund began raising questions about whether hedge funds are too complicated or can effectively balance out poor-performing stocks during a market crash, said a person familiar with the situation.

A Calpers spokesman said the investment staff will make a formal recommendation to the board in the fall. But some cuts already have been made, said the person familiar with the situation. Hedge funds represented 1.5% of Calpers's total assets, or $4.5 billion, as of June 30.

Other states have made reductions as well. The School Employees Retirement System of Ohio decided to lower its hedge-fund allocation to 10% by fiscal 2015 as compared with roughly 15% in fiscal 2013 after investment gains were lower than expected, according to a spokesman. New Jersey's State Investment Council lowered its planned allocation to hedge funds to 12% from 12.25% as part of its fiscal 2014 plan, according to a spokesman.

The debate in San Francisco is indicative of those under way nationwide.

Board members of the San Francisco Employees' Retirement System are considering whether to invest 15% of assets into hedge funds for the first time. A debate about that strategy dominated a June meeting, in which board member Herb Meiberger argued hedge funds have blown up in the past and aren't the only investment alternative. The fund's executive director couldn't be reached for comment Wednesday.

Mr. Meiberger said at the meeting that he had sought out Warren Buffett's advice on the matter. The billionaire investor's handwritten response: "I would not go with hedge funds—would prefer index funds."

A handwritten note from Buffett may cause a hedge fund exodus but the truth is many institutions have been reflecting on their allocation to all alternatives, not just hedge funds.

But this could be the beginning of a revolt against hedge funds and CalPERS' interim CIO, Ted Eliopoulos, didn't bother discussing the hedge fund portfolio when he went over their fiscal year results:

The California Public Employees’ Retirement System’s (CalPERS) interim CIO lauded its performance for the recent fiscal year in public equities (24.8%), private equity (20%), and even fixed income (8.3%). All together, CalPERS’ assets returned 18.4% in 2013-14.

One asset class notably did not get a shout-out from Ted Eliopoulos in his discussion of the results: hedge funds, or—as CalPERS refers to the bucket—absolute return strategies.

The $4 billion allocation made up only a small portion of CalPERS’ $302 billion portfolio, but that slice may get even smaller.

Citing an unnamed source, the Wall Street Journal reported July 23 that the pension fund planned to cut hedge fund allocation by 40%, to $3 billion. Given CalPERS’ July 23 valuation of its hedge fund portfolio, a 40% cut would in fact leave a $2.4 billion bucket.

CalPERS spokesperson Joe DeAnda also disputed that a decision had been reached about its hedge fund program, but confirmed to CIO that changes may be afoot: “The program is under review and has been discussed by the board several times in open session. No decisions have been made about the program at this time. During the review, the ARS portfolio may change in size and structure but conclusion of the review, and formal decisions about the program, likely will not occur until end of Q3 2014 at the earliest.”

In the fiscal year ending June 30, CalPERS’ hedge fund portfolio returned 7.1%, according to preliminary results, which was the weakest of any asset class except cash.

Eliopoulos, who has led the US’ largest public pension fund during its CIO search  remarked that the last year had been “so far, so good.” He noted that CalPERS had posted double-digit returns for four out of the last five years, but cautioned that 2013-14 was “unusual” on two counts.

“One: This sheer magnitude”—25%—“of the public equity performance… That’s a big number. And that’s unusual,” he said.

Secondly, “What you’d expect in a year like that when our equity portfolio is doing so well is that the other asset classes—and in particular, fixed income—would have a less robust or even a negative return,” Eliopoulos explained. CalPERS’ fixed income program in fact beat its hedge fund investments and returned 8%.

“Having all of the major asset classes return positive numbers is somewhat unusual.”

Indeed, having all the major asset classes post positive numbers is very unusual and it actually argues for increasing, not decreasing, their allocation to hedge funds.

But the problem is most hedge funds stink and many high profile hedge funds are nothing more than glorified asset gatherers being managed by overpaid gurus collecting fat fees no matter how well or poorly they perform.

This is one reason why institutions are embracing private equity because unlike hedge funds, PE funds have to recoup expenses and cross a hurdle rate before they can charge a performance fee (they still charge a management fee no matter what). But private equity is more illiquid than hedge funds and its trillion dollar hole is yet another fresh sign of a PE bubble.

In his Bloomberg column, Barry Ritholz writes, Getting Over Hedge Funds:

During the past few months, we have posted a few words here on the quandary that is hedge funds. The first such effort was titled “The Hedge-Fund Manager Dilemma,” and it explored the public’s fascination with the hedge-fund crowd. The second, “Why Investors Love Hedge Funds,” looked at why, despite stunning underperformance during the past decade, so much money was still flowing to the hedge funds.

Now, we are seeing early signs that some institutional investors are losing patience. Case in point: California Public Employees' Retirement System. The Wall Street Journal noted that the pension fund is looking to reduce hedge-fund holdings by as much as 40 percent. “Public pensions from California to Ohio are backing away from hedge funds because of concerns about high fees and lackluster returns.” 

Although this might be a rational response to issues of costs and performance, I would hasten to add that this is only anecdotal evidence. When we look at data such as money flows, it suggests hedge funds are continuing to pull in cash at an astounding pace. The hedge-fund-industrial complex now commands more than $3 trillion in assets. That is up from $2.04 trillion in 2012, and a mere $118 billion in 1997.

Calpers has a reputation for being a thought leader in the institutional-investment world. I have spoken with various pension funds and foundations over the past few years, and while the issue of hedge funds is under discussion, there is no consensus. Based on what various folks in the U.S. and Europe say, there still is great interest in hedge funds. Many investors are more than willing to forsake beta (returns that match the market) in the mad pursuit of alpha (above-market returns).

Still, this looks like it might be the start of something interesting. Given hedge-fund performance relative to the costs, I assumed a shift would have happened years ago. That it hasn’t likely reflects some combination of institutional inertia at big institutional and pension funds and perhaps the impact of consultants.

The Wall Street Journal noted that before 2004, “public pensions favored plain-vanilla investments and avoided hedge funds almost entirely.” The attempt to “boost long-term returns” was driven by the funding gap between assets and future obligations.

This is the crux of the issue: Expected returns. For reasons that remain unexplained, anticipated returns for hedge funds are always far higher than those of bonds and equities. There is no evidence for this erroneous assumption. Unless you are one of the lucky few in a top-performing hedge fund -- that means a small fraction of that $3 trillion in assets -- there is simply no logical or statistical basis for this expectation. It is false, a demonstrably wrong perception, yet one that has become widely accepted.

If anyone has an explanation for how these unfounded expectations came about, or why they persist, please let me know. I am well aware that politicians have embraced these false numbers, as it reduces the amount of contributions they need to make each year to public-pension funds. But it also kicks the can down the road, creating an even bigger hole in future budgets. At this stage, I shouldn't be surprised at irrational policies from innumerate politicians -- but I am.

Regardless, this is a trend that bears watching. The top funds in each category of alternative investment -- venture capital, private equity and hedge funds -- likely have little to fear. The remaining 90 percent of the players in this space should pay close attention. Some changes might be coming.

Go back to read my last comment on Leo de Bever discussing the next frontier of investing. In his excellent presentation, Leo discusses how by definition expected returns have a 50% chance of being wrong and how important it is to be a first-mover in any asset class or investment activity (provided you get the governance right).

There are so many misconceptions on hedge funds and like Ritholz, I blame useless investment consultants who have effectively hijacked the entire investment process in the United States and elsewhere. Also, faced with a looming disaster, many U.S. pension funds are increasingly gambling on alternatives to get them out of their pension hole (instead of fixing their lousy governance).

I know what you're all thinking. There are excellent hedge funds worth investing in and wait till the next crisis, you'll see hedge funds outperform. I'm not convinced and think most hedge funds taking leveraged beta bets in equity and credit markets will get clobbered when the next crisis hits.

As always, please remember to contribute to my blog via Paypal at the top right-hand side. If you have any comments, email me (LKolivakis@gmail.com) or post them at the end of this comment.

Below, David Harding, founder and president of Winton Capital Management, says the market is rigged against his hedge fund. Harding is one of the sharpest managers I ever met, listen to him carefully.

And on “Charlie Rose,” a conversation with Jim Chanos, president and founder of Kynikos Associates. Chanos is one of the best short sellers of all-time (he exposed the fraud at Enron) and is still short China. I don't agree with everything he says but take the time to listen to this conversation (full interview is available here).