COMMENTAR Y
Five Results of CalPERS Divesting of Hedge Funds Surprise move puts focus on alternative allocations DONALD A. STEINBRUGGE, CFA, MANAGING PARTNER, AGECROFT PARTNERS
T
he announcement by CalPERS that they plan 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 five main outcomes.
Pressure on 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 five 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 include 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. The average fee for these shares is approximately 1% management fee and 12.5% performance fee. Some smaller managers are also willing to offer “seed investments” to investors. Both “founders shares” and “seed investments” should be attractive to highly sophisticated pension funds because, in addition to the favourable fee structure, research has shown that smaller, more nimble managers outperform large funds over time.
Continued increased allocations Although there will be a few less sophisticated public funds that will follow CalPERS’s 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 favourably to core fixed income, where the expected return is only 2.5% to 3.0%. As
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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 five years ago during the market sell-off 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 sell-off.
More focus on smaller hedge funds 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 marketplace. 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 brand- name hedge funds to alpha generators. These tend to include small and mid-sized hedge funds that are more nimble. In a study conducted from 1996 through 2009 by PerTrac, 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 mid-sized hedge funds. This allocation strategy is now being called the “endowment fund approach” to managing money.
“Kmart shoppers” shift 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 relating 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 to justify hedge fund investments 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 or city council. It is important that they are prepared to clearly and concisely articulate their reasons.
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. THFJ
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