At the end of 2014, CalPERS announced that it would no longer invest in hedge funds and would exit its current investments. This development was reported extensively in the financial media and was depicted a sea change at the time, since CalPERS has often been a trend-setter among investors.
As we commented then, this move was long overdue. Even though CalPERS took the position that the reason for its action was that it was too hard to find suitable funds, our very first post in late 2006 was about the fact that CalPERS had experienced underperformance in its hedge fund investments for several years. Yet it said it was going to stick with the strategy was because it provided useful diversification.
The problem with that rationalization is that no one should pay hedge fund fees (a prototypical 2% annual management fee plus a 20% over for mere diversification is bollocks. The justification for this rich fee structure is that hedgies are supposed to deliver “alpha,” as in manager outperformance. However, as of 2006, it was already fairly reported in the financial trade press that hedge funds did not deliver much if any alpha. Indeed, the hedge funds were increasingly acknowledging that and stressing that irrespective of that nasty little lack of any real alpha problem, they were still an essential addition to any savvy investor’s portfolio by virtue of providing “alternative” or “synthetic” beta.
But there’s no justification for paying “2 and 20” for alternative beta. And as we noted in early 2007, investment products were being launched that delivered alternatve beta at much lower fee levels.
Thus even though the fact that hedge funds didn’t begin to live up to their promise, it has taken nearly a decade of confirmation for investors to start to wean themselves of the habit. The fact that hedge funds did poorly in the crisis, and many quant funds closed, was a first wake up call. One of the supposed advantages of hedge funds, of not being correlated strongly with the stock market, was shown to be false. And in the post-crisis era, hedge funds generally have become even more strongly correlated with the stock market than they were historically (in part likely due to greater mobility of capital cross markets, recall, for instance, the year-plus period of risk on/risk off trades), and even worse, either underperformed stocks or only modestly out-performed.
Mind you, it wasn’t as if investors stood completely pat. CalPERS, for instance, had only $4 billion in hedge fund investments at the time of its exit, reflecting its lack of enthusiasm for the strategy. And investors had been negotiating down performance fees for newer funds to a mere 14% average as of 2015, while in the past, a hot trader from a prestigious fund or a respected Wall Street firm like Goldman could raise money quickly and on attractive terms.
But pension fund managers, even more so than commercial bankers, are loath to be too much out of step with the herd. So it has taken nearly a decade for them to build up the never to stop paying Cadillac prices for a mere Buick. From the Wall Street Journal last week:
Pension funds, insurers and university endowments helped pump up hedge funds to a record $3 trillion in assets over the last decade. But with results falling behind a more traditional mix of stocks and bonds for six straight years and the high-fee structure now politically sensitive in some states due to uneven results, many of them are pulling back.
From New Mexico to New York, big investors are dramatically reducing their commitments and opting for cheaper imitations. Investors globally asked for more money back from hedge funds than they contributed in the fourth quarter of 2015, according to HFR Inc.—the first net quarterly withdrawal in four years. They pulled an additional $15.3 billion in this year’s first two months, according to eVestment….
Others are retreating because some of the investment strategies once available only at hedge funds can now be purchased at a fraction of the cost from other asset managers. These products, coined “liquid alternatives” or “multi-asset,” can make bets on low volatility or the direction of interest rates without using as much leverage, or borrowed money, to supercharge returns.
Hedge funds typically charge higher fees than other money managers, historically an annual 2% of assets under management and 20% of profits. Some new competitors say they offer similar techniques for less than 1% of assets and a zero cut of any profits…
The proliferation of lower-price alternatives is one reason the Illinois Municipal Retirement Fund decided last month to end its $500 million hedge-fund program….
Hedge-fund commitments as a percentage of U.S. public pension-plan portfolios have dropped from a peak of 2.31% in 2012 to 1.37% at the end of 2015, according to Wilshire….
AQR Capital Management is among the large hedge-fund firms that now offer cheaper alternatives to their main funds. The California Public Employees’ Retirement System, the nation’s largest public pension, has kept $578 million invested with AQR in a lower-cost product that relies on automated bets even as it announced an exit from all hedge funds in 2014.
The risk with the these new clones is similar to the one that took place with traditional hedge funds: unintended herding. This took place during the crisis with quant funds, which in some cases were believed to have similarities in approaches due to the fact that a meaningful proportion of fund principals had learned their trade at a small handful of elite shops.
Another danger is that the more the trading activity shifts to computerized strategies, the more it can increase market fragility. From the Financial Times last November:
Immense progress in computing has revolutionised every industry in recent decades, including asset management and market-making. So-called “quantitative” approaches, long-considered the preserve of physicists and mathematicians who had stumbled into finance, are now the norm. Meanwhile, high-frequency traders have muscled out banks from their previous pre-eminence in equity market dealing. As a result, algorithms now account for a huge chunk of trading in financial markets.
That is causing some angst among regulators and some investors. They fear that hyper-fast, “black box” automated investment and trading strategies are making markets more fragile. A glitch in one market can reverberate in others at speeds that would have been unimaginable a decade ago…concern over the complexity, potential fragility and interlinkages the rise of algorithmic trading has brought is entirely rational.
For example, one danger that is frequently overlooked — including by regulators often mostly obsessed with malfeasance like spoofing — is something quants call “systems risk”, or dangers that emerge from the system itself rather than the individual components.
With systematic trading strategies multiplying and swelling in size and complexity, and HFT increasingly influential in a range of markets, the risk is that some of these algos interact in unforeseen, dangerous ways when released into the wild. This is already happening, but could worsen as algos become even more widespread.
The flip side to this concern is since the hedge fund clones in at least some, and perhaps in many cases will be replacing hedge funds that engaged in automated trading, so there might not be much net increase in algo-driven activity as a result. But it’s important to keep in the back of one’s mind as an issue.
The chief lesson here is how the managers of pension funds, endowments, and foundations are exceedingly resistant to information that impugns a mainstream investment strategy. For many, hedge funds were the shiny new toy of the early 2000s, made respectable by Greenspan-induced negative real interest rates making even stodgy investors more willing to walk on the wild side. Having only recently developed the expertise, in institutional terms, to invest in hedge funds, many were simply not willing to rethink the newfound conventional wisdom until the evidence on the other side became not just considerable but embarrassing. News stories disclosing pension funds paying huge fees for mediocre to terrible performance clearly played a big role in this attitude change. But for readers in states and localities whose pension funds are still wedded to the bad old orthodoxy, you can help cautious or cognitively captures officials make the break with hedge funds by turning on the heat. As we saw even with a fund as big as CalPERS, letters and e-mails from the public to elected officials who also fund trustees can make a real difference.