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.”