Top 5 Ramifications of CalPERS’ Hedge Fund Exodus

donsteinbrugge52014By Don Steinbrugge

 
CalPERS’ announcement to divest of hedge funds has created a significant buzz in the media with many people wondering what impact this will have on the hedge fund and pension fund industries going forward.  Agecroft Partners believes we will see the following 5 outcomes:
 
Continued pressure on hedge fund fees for large mandates
 
Although the media often comments that hedge fund fees are 2 and 20, the reality is that most large public pension funds on average pay significantly less than this for large investment amounts. Over the past 5 years there has been a strong trend of hedge funds increasingly offering fee breaks for large pension funds and the clients of institutional consulting firms. These fee breaks began with a discount on management fees only, but now often includes performance fees.  Fee breaks vary by manager, but for a typical hedge fund with a 2 and 20 fee structure the discount is often 25% off standard fees.
 
In addition, smaller managers are increasingly willing to offer “founders shares” to early investors in the fund. These shares average fee is approximately 1% management fee and 12.5% performance fee. Some smaller managers are also willing to offer “seed investments” to investors.  With seed investments,  the investor not only earns the performance of their assets invested in the fund, but  they also share in the profitability of the hedge fund organization. These investments can be very profitable if the hedge fund organization generates strong returns and can effectively grow its assets. Both “founders shares” and “seed investments” should be attractive to highly sophisticated pension funds because in addition to the favorable fee structure, research has shown that smaller more nimble managers outperform large funds over time.
 
Pension funds will continue to increase their allocation to hedge funds
 
Although there will be a few less sophisticated public funds that will follow CalPERS lead, the average public pension fund will continue their long term trend of increasing their allocation to hedge funds in order to enhance returns and reduce downside volatility of their portfolio.
 
Unlike ERISA pension funds, whose actuarial rate of return assumptions are tied to current interest rates and have declined over time, public pension funds rarely alter their return assumptions which currently average around 7.5%. In order to meet this return hurdle and not have to increase contributions to the fund, public pension funds typically meet annually to determine what their optimal asset allocation should be going forward to generate the highest risk adjusted return. For each component of their asset allocation, they forecast an expected return based on a combination of long term historical returns for an asset class, current valuation levels, and economic expectations. Most institutions are currently using a return assumption, after fees, of between 4% and 7% for a diversified portfolio of hedge funds which compares very favorably to core fixed income, where the expected return is only 2.5% to 3.0%. As long as the expected return is higher for hedge funds than fixed income, we will continue to see money shift from fixed income to hedge funds.
 
Returns are only part of the story. It was only a little more than 5 years ago during the market selloff in 2008 that pension funds lost a large percentage of their market value. Many pension funds saw their equity portfolio decline by more than 40%. The average hedge fund declined less than half of this amount, with some strategies actually up in 2008. A diversified hedge fund portfolio should have a low correlation to long only benchmarks, which can improve portfolio diversification and provide downside protection during a market selloff.  With interest rates and credit spreads near historic lows, along with equity valuations above historical averages many pension funds are concerned about protecting their pension fund beneficiaries capital if there is a market decline.
 
More focus on smaller hedge fund managers
 
As pensions struggle to enhance returns to meet their actuarial assumptions, we will also see an increase in the speed of the evolution of pension funds’ hedge fund investment process. This process typically begins with a very small initial allocation to hedge funds via hedge funds of funds. This is gradually increased every few years as the pension plan enhances its knowledge of the hedge fund market place. The second phase of the process is investing directly in hedge funds, which may often include assistance from a consultant or a fund of funds acting in an advisory role. An overwhelming majority of the hedge funds a pension plan will invest in at this stage of the process are the largest, “brand name” hedge funds with long track records. Performance is of secondary consideration to perceived safety and a reduction of headline risk.  What is interesting about this stage is that when some pension funds hedge fund portfolio performance is not up to expectations, they blame the hedge fund industry versus their own hedge fund selection capabilities.
 
After a few more years of making direct investments in hedge funds, pension plans move to the third phase and begin to build out their internal hedge fund staff, which shifts the focus from name brand hedge funds to alpha generators. These tend to include small and midsized hedge funds that are more nimble. In a study conducted from 1996 through 2009 by Per Trac, small hedge funds outperformed their larger peers in 13 of the past 14 years. Simply put, it is much more difficult for a hedge fund to generate alpha with very large assets under management.
 
The final step of this evolution occurs when pension plans stop viewing hedge funds as a separate asset class and allow hedge fund managers to  compete head-to-head with long-only managers for each part of the portfolio on a best-of-breed basis. Many of the leading endowments and foundations have evolved to this point.   Their portfolios are primarily invested in alternative investment managers with large allocations to midsized hedge funds. This allocation strategy is now being called the “endowment fund approach” to managing money. 
 
CalPERS shifts from industry leader to “attention, Kmart shoppers” management
 
CalPERS historically was viewed as a very innovative public pension fund investor that had been a first mover among public pension funds in new investment strategies, asset classes and investment concepts. Now that their assets have swelled to above a quarter trillion dollars, their investment philosophy seems to have evolved to focusing more on a generic asset allocation with low fees. This philosophical strategy shift might have been enhanced by the recent corruption and fraud issues surrounding CalPERS relative to their former CEO. As a highly political entity, these issues could be influential in how they manage their portfolio.  The one question few people seem to be asking CalPERS, as they reduce the “complexity” of their investments, is where will these assets be reinvested? Will they be invested in the stock market trading near an all-time high or the bond market with tight credit spreads and the 10 year treasury yielding approximately 2.6%?  Going forward, CalPERS will no longer be viewed as a market leader by most sophisticated institutional investors.
 
Pressure on pension funds to justify why they are invested in hedge funds
 
Public pension funds are highly political which is complicated by the fact that they are responsible for investing public money in strategies the average person does not understand. It was only two decades ago that some public pension funds were prohibited from even investing in stocks. When the largest public pension fund divests from hedge funds, it may cause many less sophisticated people to question why their public fund is not doing the same. Over the next month or two, many public pension funds will be asked to justify why they continue to invest in hedge funds by the  local media and members of the state legislature/city council. It is important that they are prepared to clearly and concisely articulate their reasons. The following article has helpful information to answer some of these questions.
 
In summary, the average public pension fund is significantly under-funded based on a high actuarial assumed rate of return of 7.5%. If they do not  achieve a 7.5% rate of return, their unfunded liability increases and so does the possibility that the plan beneficiaries  may one day see their retirement benefits reduced, like we recently saw with the City of Detroit. Hedge funds can provide many positive attributes to a multi-asset class portfolio.  This includes better potential risk adjusted returns, enhancement of downside protection,  low correlation with long only benchmarks which improves diversification, and most importantly, enhancement of forward looking returns to better match their actuarial assumed rate of return.
 
 
Donald A. Steinbrugge, CFA, is the Founder and Managing Partner of Agecroft Partners, a global hedge fund consulting and marketing firm. Agecroft is in contact with over two thousand hedge fund investors on a monthly basis and devotes a significant amount of time performing due diligence on hedge fund managers. Don frequently writes white papers on trends he sees in the hedge fund industry, has spoken at over 80 hedge fund conferences, has been quoted in hundreds of articles relative to the hedge fund industry and is a regular guest on business television including Bloomberg Television, Fox Business News, CNBC, Reuters Insider, Al Jazeera America and CCTV. 
 

 

 

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2 Comments

  1. Brad Case, PhD, CFA, CAIA
    September 29, 2014 at 9:51 am

    So, we see one of the expected punishments for CalPERS’ rejection of hedge funds: when CalPERS was investing in hedge funds, the hedge fund managers called them “very innovative,” but now they “will no longer be viewed as a market leader by most sophisticated institutional investors.”
    Here’s another way to look at it: CalPERS has finally pointed out that the emperor has no clothes. That’s a conclusion that is supported by a growing body of empirical work looking at the actual experience of pension fund investors in hedge funds.
    Dichev & Yu (http://www.people.hbs.edu/gyu/HigherRiskLowerReturns.pdf): “We find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the S&P 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.”
    Aragon (http://www.sciencedirect.com/science/article/pii/S0304405X06001425): “The average alpha of all hedge funds is negative or insignificant after controlling for lockups and other share restrictions.”
    Hedge funds certainly seem to have had a heyday, long ago, and CalPERS seems to have recognized that it’s unlikely to come again.
    Fung, Hsieh, Naik & Ramadorai (http://intranet.sbs.ox.ac.uk/tarun_ramadorai/TarunPapers/fung_hsieh_naik_ramadorai.pdf): “While the average fund-of-funds delivers alpha only in the period between October 1998 and March 2000, a subset of funds-of-funds consistently delivers alpha. The alpha-producing funds … experience far greater and steadier capital inflows than their less fortunate counterparts. These capital inflows attenuate the ability of the alpha producers to continue to deliver alpha in the future.”
    Naik, Ramadorai & Stromqvist (file:///C:/Users/bcase/Downloads/00b7d521b00299b3ee000000%20(1).pdf): “Hedge funds have generated significant absolute returns (alpha) in the decade between 1995 and 2004. However, the level of alpha has declined substantially over this period. We investigate whether capacity constraints at the level of hedge fund strategies have been responsible for this decline. For four out of eight hedge fund strategies, capital inflows have statistically preceded negative movements in alpha, consistent with this hypothesis. We also find evidence that hedge fund fees have increased over the same period.”
    It’s the same with private equity (buyouts and venture capital): fund managers have continued to receive enormous fees based on performance in the 1990s and before, but investors are finally becoming aware that they haven’t been earning those fees for, oh, 15 years or so.


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