A new scholarly paper addresses the puzzle: which institutional investors are best informed?
Zhe Chen, of the University of New South Wales, David Forsberg, Macquarie Graduate School of Management, and David R. Gallagher, UNSW Australia Business School, compare hedge funds, mutual funds, pension funds, and private banking firms to determine which type is best at picking industries and stocks, and which is best at forecasting returns over various time horizons.
They found that hedge funds outperform the other types, and that this outperformance “is not explained by a liquidity premium.”
Consider the Squeeze
This is an important bit of news, given the squeeze in which many pension funds, public and private, now find themselves. It indicates (though Chen et al don’t explicitly draw this inference) that pension funds might be well advised to increase their allocations to hedge funds, who are on this finding better informed as to what to do with it.
Also, by serendipity, Brandywine Asset Management has just published a white paper on “combating pension fund failure.” The gist of it is that many state pensions are heavily dependent on equity performance, and that equity prices are at record highs. Thus, the pension managers have to cure their addiction to equities, they must look for the available options that will “truly diversify a pension portfolio [and] result in both reduced risk and increased returns.”
Brandywine’s paper, which unsurprisingly reaches the conclusion that Brandywine products can assist with the problem, is itself largely based on a study by Wilshire Consulting.
Source: Wilshire Consulting, 2016 Report on State Retirement Systems (February 25, 2016). Exh. 4, “Market Value Funding Ratios by Fiscal Year for 131 Plans.”
A Bloody Crossroads
Hedge funds are politically volatile terrain, especially as parts of a public pension’s portfolio. As Donald Steinbrugge has written here, “[A]sset allocation and management selection decisions should always be made in pursuit of enhancing the risk adjusted return of the total portfolio….”
But politics does impinge.
Since CalPERS’ decision to pull out of hedge funds a little more than two years ago, public pension managers who stay in HFs seem to bear a burden of persuasion, as if they’re investing retirement accounts in tobacco companies.
More recently, the New York City Employees Retirement System (NYCERS) voted to get out of hedge funds. One of the trustees, Henry Garrido, explained this decision perhaps too simply: “We have not seen the results that we had expected.”
But such bland observations seem to stand-in for a more contentious reality. Hedge funds have a public image for being both opaque and high-risk. The image-making sometimes rises (or sinks) to the level of demonization.
Switching Cash Into Alternatives
Two examples don’t really make a “trend,” though, and there has been movement in the other direction. The Illinois State Universities Retirement System, for example, in February 2016 dropped two equity portfolio managers in order to free up money to make its first ever allocation to the hedge fund space.
Specifically, SURS decided to drop Jacobs Levy, with whom it has $322 million under management, and PIMCO’s StocksPlus strategy, where it had another $254 million. That should free up $576 million, most of which will go either to KKR Prisma or to the Pacific Alternative Asset Management Co., both fund of fund managers.
This reduces SURS’ exposure to U.S. equities from 29% of its portfolio to 26%. It says that it hopes to get that number down to 23%.
Why? Because SURS, like other public pension funds, faces a gap between what it is making and what its commitments are. Just four months before this decision to move into the hedge fund world, its chief investment officer, Daniel L. Allen, had warned, “SURS faces the real risk that assets could be depleted in less than 10 years.”
Disclosure and Smoothing
Such funds have been turning to hedge funds, then, because traditional investments aren’t doing the job, and a more aggressive approach to achieving return has become necessary. That is going to remain the case, and it will continue to provide a counterweight to the CalPERS and NYCERS examples.
One difficulty, in engaging in an informed public discussion of such matters, is that public retirement systems do not in general offer the level of timely and uniform disclosure that one can rely upon in studying the pension obligations of private pensions, especially those affiliated with publicly traded companies.
Another problem (until quite recently) was that there were accounting conventions that allowed plan sponsors to smooth actuarial values of assets over forecast periods , thus obscuring matters for analysts. Fortunately, GASB has done good work addressing that latter point since 2014.