Public Pension Funds Starting to Abandon Hedge Funds….More Than a Decade Late

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.

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  1. Northeaster

    “But there’s no justification for paying “2 and 20” for alternative beta.”

    Could someone please call The MBTA Retirement Fund and remind them of this? They have invested over 20% of their entire fund into hedge funds. The good news? It’s down from 25%. Then again, there’s no point as so many pension funds have matured already.

    1. rfam

      The answer is, and this is the problem that hedge funds were meant to address, that the assumed return is 7-8% for your fund (as well as most other public and multi-employer pensions). If a realistic rate of return were used your pension could do what they should have been doing all along with their investments: Buy Bonds!

      If the return assumption was lowered the pension’s funding level would appear too poor to be acceptable (honestly its a bit more complicated than this but its the simple way of thinking about it). So a pension fund’s investments should be much more conservative (and cheaper fee wise) but benefits and funding are based on a high rate of return so risky investments are required – hedge funds…

      The promises made by politicians to public unions were either unrealistic or not properly funded at the time, that’s not the pensioners fault. So whats happening in Chicago with the teachers is a byproduct. The pension shortfall is taking all the money away form current needs. So raising taxes and or cutting services is just imposing the burden of past mistakes on the current and future populace…hence that evil word AUSTERITY.

      1. SomeCallMeTim

        Thanks Yves for the post and rfam for the comment. The more I read about this subject the more I see that my state pension-based retirement is lodged in an alternative reality.

  2. Scott Pardo

    Calpers refusal to stick with the initial, well thought out goal for the hedge fund program formulated back in 2002 led to its demise. That and politicians/failed lawyers maquerading as investment professionals cowtowing to every critique and headline.
    I’m sure the plan is in capable hands now, current leadership seems top-notch.

    1. Yves Smith Post author

      Sorry, your comment completely ignores the information in the post, which is that it had been demonstrated by academics and independent analysts before 2006 that hedge funds delivered no alpha. That means there is no justification for paying a 2% management fee and a 20% success fee. CalPERS under the California Constitution is required to meet “duty of care” standards that track ERISA standards. That means among other things, they have to assess the reasonableness of fees and expenses for each investment strategy and product. Hedge funds were known not to meet this standard as of 2006-2007, if not earlier. There were also substitute products that were cheaper that delivered the diversification benefit that CalPERS said it desired as of then. Yet it took CalPERS the better part of a decade to act. And you defend investing in hedge funds despite this? Honestly, this looks like pure trollery.

      Moreover, despite your handwave, you fail to present any evidence that CalPERS’ disappointing results as of its 2005-2006 fiscal year (ended June 30 2006) resulted from a deviation from policy. The pay to play was taking place in private equity, not in hedge funds. If you are trying to insinuate that the pay to play scandal had anything to do with the disappointing hedge fund results you are really making stuff up. The onus is on you to prove your claims.

      Your comment about who is making the investment choices also shows considerable ignorance about or deliberate misrepresentation of how the process works at CalPERS and pretty much any adequately-run pension fund, public or private. They hire outside experts. Nothing of any consequence is done without the Expert Seal of Approval.

      And I’m at a bit of a loss to understand your praise of current management given that the CEO, Anne Stuasboll, and the CIO, Ted Eliopolous, both come out of politics, not investing, both are proteges of Phil Angelides, and both are lawyers by training. I sincerely doubt that Eliopoulos could tell you want negative convexity means, for starters.

  3. tegnost

    Thanks for this, the deep finance posts help me keep my feet on the ground amidst the vagaries of the political world even if I have no incisive commentary to add. There’s safety in numbers.

  4. flora

    “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. ” Yes.

    Better late than never, as the saying goes. I think your excellent reporting helped change pension fund managers’ outlook and assumptions. Thanks again for your reporting.

  5. RUKidding

    Thanks for the update. It’s good to see that pension plans are backing off risky expensive hedge funds as investment vehicles. As a CalPers contributer and future annuitant, I am grateful for all of the detailed reporting you have done on this important topic. Very helpful for all concerned. Keep it up!

    It’s important not just for those who are fortunate enough to benefit from a pension, but for all taxpayers who pay into these funds. They must be managed appropriately with fiscally sound practices. We are watching and paying attention.

  6. Jim Haygood

    ‘The risk with the these new clones is similar to the one that took place with traditional hedge funds: unintended herding.’

    In a 2012 book titled Following the Trend, Swiss-based fund manager Andreas Clenow defines a quant strategy for managed futures. It’s modeled on the Turtle Trader strategy pioneered by legendary commodities trader Richard Dennis.

    Clenow demonstrates that by adjusting simple parameters such as lookback period and leverage, his trend-following strategy closely correlates with several prominent managed futures programs with published results going back as far as the 1970s.

    Clenow shows that trend-driven strategies end up in the same trades. If the US dollar is strong, they are all short foreign currencies. If interest rates are plunging, they’re long bonds in all the major countries. If stocks are rocketing, they’re long equities in all the major markets. And so forth.

    While one could actually “do this at home” using Clenow’s fully-disclosed strategy, the herding problem is a deeply unattractive feature. It certainly applies to hedge funds as well.

    Most of the players in a given hedge fund strategy are going to be positioned the same way, in the same vehicles. But investors aren’t permitted to know what those positions are. It isn’t clear to me how a fiduciary could even accept such an investment. Hiring a defense attorney now (before the rush) seems prudent.

  7. Stephen Verchinski

    After seening the fee structure that accompanied the hedge funds I expressed outrage.

    New Mexico PERA had invested in these funds and worse yet most if I recall of the managers of the find were offshore where the long arm of the law would have difficulty dealing with pirates. Think BVI and Bermuda for starters.

    They set themselves up there to also escape and hide their income from the countries like the USA that taxed the income at a really really high 17% (lol). So not only were the returns to the pension plans questionable over other instruments but tens of millions generated were systematically lost state by state to managers that paid little or no taxes in the states struggling to make their returns and to fund those same pension plans.

    Go Bernie. Its time to get some of our board game money back and circulating in the economy.

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