Recent Items

Investment Bombshell: CalPERS Exiting Hedge Funds

Posted on by

CalPERS, the largest public pension fund in the US, is widely seen as an industry leader and its practices are emulated by other public pension funds. CalPERS has just announced that it is withdrawing from hedge fund investing entirely.

This is a major development in investing-land. Having the giant California investor repudiate the premise that hedge funds are an asset class and therefore a prudent investor is obligated to invest in them will legitimate other investors, including endowments and foundations, questioning the logic of putting funds with hedge fund managers.

Ironically, the very first post on this website, on December 19, 2006, Fools and Their Money (Hedge Fund Edition), chided CalPERS for its continued loyalty to hedge funds. The full text of our post:

Hedge funds continue to attract boatloads of money, despite humdrum performance. And worse, people who should know better persist in investing in them for the wrong reasons.

In the New York Times a sophisticated institutional investor explains the logic:

This year ”is the third straight year that the global equity markets and long-only managers outperformed hedge funds,” said Christy Wood, senior investment officer for global equities at the California Public Employees’ Retirement System. ”If you threw all these in an index fund net of fees, you would have done better than if you put it in the hedge fund industry.”

So is Calpers pulling back? Not at all. Ms. Wood helps to oversee $4 billion in hedge fund investments and has another $3.5 billion to invest. She is satisfied that hedge funds have delivered exactly what Calpers wants from them: equitylike performance with bondlike risk.

”We are looking for a return stream that doesn’t behave like any others we have,” she said.

Superficially, this argument sounds unassailable (if one ignores the fact that hedge funds have not generated equity-like returns). Calpers likes hedge funds because they offer an attractive and distinctive risk/return profile. But there is no need to pay hedge fund fees (typically 2% annual management fees plus 20% of the upside) for that.

The rationale for hedge funds’ eyepopping fees is that investors are paying for “alpha,” that is, the excess return (meaning the return in excess of the “market” return). Investors are willing to pay for alpha because it is considered to reflect an investment manager’s skill, and managers who can regularly outperfrom the market are rare indeed.

But Ms. Wood is talking about something completely different. Targeting a particular risk/return tradeoff isn’t an alpha proposition at all. It is instead “synthetic beta,” (or “alternative beta”). And synthetic beta can be produced comparatively cheaply.

A 2005 survey (http://www.edhec-risk.com/edhec_publications/RISKArticle.2005-08-10.3923/view, free subscription required) found that 70% of the investors recognized the role of alternative beta in overall hedge fund results. But this knowledge hasn’t yet translated into a recognition that they are overpaying.

But some of the providers do, and are launching clones) to undercut hedge funds. Merrill Lynch introduced its Passive Factor Index earlier this year and claimsGoldman Sachs launched its “hedge fund replication tool,” Absolute Return Tracker Index (http://www.ft.com/cms/s/5b8331c0-82fc-11db-a38a-0000779e2340.html), earlier this month. Experts believe they offer the same

Now synthetic beta can be very valuable (http://www.allaboutalpha.com/blog/2006/11/16/an-alphabeta-framework/) to investors like Calpers, who are managing retirement funds (they have to worry about meeting specific long-term commitments). But for an institution as savvy as Calpers to be frittering away its assets on unnecessary fees says that hedge funds seem likely to continue to pull in more assets.

Back to the current post. So it’s good to see CalPERS finally coming around. Key sections of the New York Times account (hat tip Dave Dayen):

The $300 billion pension fund said on Monday that it would liquidate its positions in 24 hedge funds and six hedge fund-of-funds — investments that total $4 billion and about 1.5 percent of its total investments under management.

The decision,…is likely to reverberate across the investment community in the United States, where large investment funds look to Calpers as a model because of its size and the sophistication of its investments.

“Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale at Calpers’ size,” the hedge fund program “doesn’t merit a continued role,” Ted Eliopoulos, the interim chief investment officer of Calpers, said in a statement.

Now admittedly, on paper, this was not a hard decision for CalPERS. A 1.5% allocation was not enough to have much impact on CaLPERS’ portfolio. CalPERS has finally recognized what was widely known in 2006: hedge funds do not deliver their promised overperformance, nor do they succeed in dampening volatility of returns enough to justify their eyepopping fees.

But despite this move coming over seven years late, CalPERS does deserve credit for finally taking this stand. Its participation in hedge fund investments was low enough to show that CalPERS wasn’t an enthusiast, but there’s a big difference between that and repudiating the strategy entirely.

CalPERS’ move is likely to subject it to considerable consternation and criticism from those who benefit from hedge fund investing, such as pension fund consultants, who can justify higher fees due to the time and difficulty of evaluating complicated alternative investment strategies. And the most difficult and arcane ones happened to be hedge funds.

So as we wrote earlier today, the saying is that as California goes, so eventually goes the US. And in this case, that would prove to be a very positive development.

Update: One of my interlocutors said “Oh my God, hedgies will be jumping out of floor to ceiling glass windows in fancy modern skyscrapers after throwing artsy pieces of furniture through them. There aren’t enough dumb enough rich investors to go around once the hedgies have lost the pension fund business. Short yachts, watch markers, GT cars, and Greenwich real estate.”

Print Friendly, PDF & Email

Subscribe to Post Comments
46 comments

  1. frosty zoom

    good news. however, it won’t be long for the “sludge fund” or the “squint fund” or something to come along and “replace” the now obsolete hedge fund.

    1. Moneta

      I’m not so sure they can keep all those balls in the air much longer … something tells me that over the next decade, many pensions will be restructured… converted into DC or benefits cut.

      Don’t shoot the messenger… perma-optimism has led to corruption and gross mismanagement… I have been saying this since the 90s and everyone has been calling me a fool or a negative person.

  3. Larry

    One can only hope this will genuinely reverberate through the pension business. The stories of New Jersey’s gross misallocation of funds suggests that plenty of state pension systems will continue to get taken for rides by Wall St. for years to come.

    1. susan the other

      New Jersey might be more a case of political extortion. It looks like CalPERS was just a “dumb enough investor.”

    2. ewmayer

      Actually, if we’re going to denote years in hexadecimal, we’ll need 6192 (decimal) years to find out just how good a year 200e (hex) will be.

      And, yes, I am indeed a huge geek. :)

  7. Brian M

    I see no problems here. The hedge funds will just shove millions into California elections and eliminate all those pesky public pensions.

    That will teach them to defy the Masters of Manipulation!

    They have already tried to get rid of teacher tenure (because the biggest reason for dumb kids is teachers, not dumb parents and poorly funded schools, dontcha know?

    1. Yves Smith Post author

      They have nothing to gain by eliminating public pension funds. The workers who are in those funds won’t be able to save enough as individuals to qualify to invest in hedge funds. Hedgies are if nothing else brutally rational. Vengeance is not a way to make money. They’ll just work harder at selling to sovereign wealth funds and rich individuals. There is social cachet in being an investor in hedge funds, believe it or not.

      And in ten years, this change should be salutary. Way too much money has gone into hedge funds. If the industry shrinks, some of the survivors have a better shot at outperformance. Nothing kills performance in an investing strategy faster than having too much money committed to it.

      1. steelhead23

        “There is social cachet in being an investor in hedge funds”
        Yes, I have noticed that the greatest thieves on Wall Street sit at the head of prestigious philanthropical organizations like the Met, etc. where they attend glitzy galas, wear their tux and show off the wife. “Pillars of the community, they become” spits Yoda.

      2. susan the other

        I guess there are no socially responsible investments which hedge funds do. Too little profit I would imagine. But that would be an interesting turn for their industry. Because there is so much money to put to use right now. They’d prolly invest in socially responsible projects in South Asia somewhere. How can our retirees benefit from better living standards in Bangladesh? And Mississippi.

  8. alex morfesis

    congrats princess…they heard your feet stomping…don’t let anyone tell you otherwise…pop open the pol roger churchill…great job…breakfast at the metropolitan club for you…

  9. ex-PFC Chuck

    There are going to be a lot of people who have had their sand box kicked over who are going to be POed at those they perceive to have been involved in the kicking. Watch your back, Yves.

    1. Yves Smith Post author

      Please, no credit where credit is not due.

      As indicated above, when I posted in 2006 that CalPERS would do itself a favor by not investing in hedge funds, no one, and I mean NO ONE, was reading this blog. So that piece falls in the category of being what Lambert calls “prematurely correct”. It in no way, shape or form was noticed by CalPERS, and even if they had noticed it, it would most certainly not have influenced them.

      However, had they heeded that advice and put the money in their S&P index fund (which they run in house incredibly cheaply), they would have saved over a half a billion dollars in fees.

      2. tim s

        aah, but Yves, you’re no one-post wonder. You’ve got many CalPERS posts under your belt and many eyes have seen those.

      3. proximity1

        RE: … “prematurely correct” …

        You set yourself a really high bar in that respect. If they only had enough good sense to recognize it, a lot of people would be very grateful for any variety of “correct,” premature or even just woefully late, but at long last, correct. But, then, since you’re in the world of investing, I guess the “prematurely correct” looks very much like or sometimes exactly like the “timely and incorrect” which is to be avoided if possible.

        Steve Eiseman was prematurely correct about the markets prior to the last big slump–but he had generous reserves of nerve which served him well and in the end, markets came to a reconciliation with the rest of the reality-based world.

        For purposes of my interests, being “prematurely correct” is the ideal, the highest hoped-for outcome.

        2. Yves Smith Post author

          Except this was not a market call, this was a management call. Completely different.

          CalPERS would have saved over a half billion dollars in fees and had better returns if they had gotten out of hedge funds and put the money in their in-house equity index fund when I said they were wasting their money, as opposed to now.

  12. Adam

    So where is CalPERS going to park all those funds? Publicly traded equities and fixed income securities? I worry that the quest for yield is going to just mean the remaining options are equally problematic (private equity, e.g.).

    1. Yves Smith Post author

      As indicated earlier in the thread, CalPERS is also cutting its allocations to private equity.

      Hedge funds were only 1.5% of their portfolio, so even if they were to move it pro-rata into other strategies (which they aren’t as far as PE is concerned), it won’t make an enormous difference.

  13. psychohistorian

    Yves,

    I am glad to read that your pressure on CalPERS has resulted in reduced risk with their investment strategy which will reverberate through the pension and financial industry.

    Maybe the PE folks will go after each other for illusions of yield and we can watch.

    Will you continue to try and shine light on their history of investment management?

    It sure would be nice to see some financial perps go to jail……keep pushing dear woman, and thanks for doing so.

      1. MyLessThanPrimeBeef

        Still, if any of us has a chance to be seven years early, we would all seize the opportunity.

        Keep reading Naked Capitalism and tell you friends!

  14. Dannyd

    I wonder if this has anything to do with public pressure to divest from certain business practices, which hedge funds and PE firms have gotten flak for the past few years. CALPERS had been the tool of choice the last couple years in California when trying to make a statement about businesses not necessarily in the state. I seem to recall bills and calls recently about not letting the pension fund invest in gun manufacturing, oil extraction via fracking, and companies that invert for tax purposes. I’m sure there are more.

    1. Yves Smith Post author

      If you read the articles, this really appears to be a pure investment decision. CalPERS concluded hedge funds aren’t worth the fees they charge. They claimed it wasn’t about performance but the inability to deploy enough capital in hedge funds to have an impact of a portfolio of their size.

      However, CalPERS’ results say otherwise. Bloomberg pointed out that CalPERS’ return target is 7.5%, while CalPERS’ hedge funds over the preceding ten years delivered only 4.8% average annual returns after fees. (For some bizarre reason, CalPERS seems loath to hurt the feelers of hedgies by pointing out that they haven’t delivered the goods in terms of performance).

      And hedge funds are pretty agnostic (they don’t invest in sectors as sectors: strategies include stuff like “event driven” meaning M&A speculation, distressed debt, global macro, although there are also long/short and market neutral funds) and many trade their portfolios a lot, so they’d not be likely fall afoul of any of the hot buttons you mention, at least for any period of time. By contrast, give the large size of CalPERS’ in-house index fund, it’s almost certain are investing way more in socially irresponsible companies than they were via hedge funds.

        1. just bill

          a pure investment decision based upon twenty twenty hindsight (and high school algebra) after a five year bull market in which any dope who ignored reality and risk could have made a killing with a newspaper in one hand and five darts in the other.

  17. RUKidding

    YAY!!! Congrats, Yves. Perhaps your earlier posts were not read by anyone, but nonetheless, you have been nipping at CalPers’ heels over these years. I think they felt at least some pressure from you. Way to go!

    CalPers has HAD to figure out new strategies after the 2008 crash left them with their willies in their collective hands. There have been some changes at CalPers, as you know, including the criminal charges against Alfred Villalobos (who, like Ken Lay, is now in “poor health” cough cough):

    http://www.sacbee.com/2014/08/07/6613859/new-charges-filed-against-villalobos.html

    Keep ’em coming, Yves! This is great news!

  18. diptherio

    Eventually reality catches up with everyone. There were no doubt many factors involved–and Yves’ added chiding may have been one of them–but please people, a little perspective. Correlation is not causation, after all, even if it makes us feel good to think so. Just sayin’…

    The real question for me is can we claw back some of those ridiculous fees? If not, this seems like something of a pyhrric victory.

  20. Jim A

    Two things i wonder…How much effect will them (and possibly other pension funds) selling hedgies have on the price that they can get for these investments…Sometimes getting out quiet is better than a big announcement. Which makes me speculate (and this is PURE speculation) that there may be a kickback investigation in the works….

Comments are closed.