That big thunderclap you might have heard Monday afternoon rumbling from California to the New York island (apologies to Woody Guthrie) was the sound of CalPERS, the nation’s largest public pension fund, dumping its entire portfolio of hedge fund investments.
The faint murmur that followed was a chorus of investment market analysts wondering, “What took it so long?”
The announcement that CalPERS would shed its entire $4-billion holding in hedge funds is notable, because the giant institutional investor had long been a fan of what it had come to categorize as “absolute return strategies” funds. In fact, CalPERS was a pioneer, launching its hedge fund portfolio back in 2002.
Its turnaround now has the flavor of the disclosure that the emperor -- for hedge funds once reigned over the institutional and affluent client market -- has no clothes. The CalPERS announcement stated that the decision was “not based” on the program’s performance. This is a little odd, because the hedge funds’ performance stinks.
In the most recent fiscal year ended June 30, the program returned 7.1%, the worst among all the categories of CalPERS investments except for cash and forest land, which both are minimal portions of the $300-billion fund. The best performance (24.8%), came from the stock market portfolio, about two-thirds of which is managed passively, like an index fund.
Where the hedge fund managers excelled was in collecting fees -- in 2012-13, hedge fund managers collected about $115 million in management and performance fees. This came to about 9.8% of all the fees CalPERS paid to outside investment managers, although the hedge funds accounted for only about 2% of the portfolio. In 2013-14, the hedge fund fees are expected to reach $135 million. The ratio to all fees will be about the same 10%, a CalPERS spokesman says, though the hedge fund portion of the portfolio was down to only about 1.5%.
Indeed, it’s those fees that have eaten away at hedge fund returns over the years, and apparently one element of the category that most irked CalPERS management. The hedge funds’ sins, as listed by Ted Eliopoulos, CalPERS’ interim chief investment officer, are "their complexity, cost, and the lack of ability to scale at CalPERS’ size.” Translation: they’re too complicated, the fees are too high, and the bigger they get, the worse they perform.
None of these issues is new. Hedge funds trailed the Standard & Poor’s 500 benchmark in 2013 for the fifth straight year, according to data compiled by Bloomberg. They last beat the U.S. stock market in 2008, when the sector lost 19% -- a great showing in a disastrous market year in which the S&P 500 lost 37%.
In fact, hedge fund promoters assert that it’s in bad years that the sector proves its virtues, by hedging against downturns. But that effect isn’t very visible in the CalPERS figures, which show that over the last 10 years, a period that spans the 2008 crash, its hedge fund investments returned only 4.75% annualized, well behind public equities (7.56%) and fixed-income investments (7.04%).
The hedge funds beat real estate in that period (as well they should, given the depths of the real estate crash), but they trailed their own benchmark -- based on the one-year Treasury bill yield plus five percentage points -- by nearly two and a half percentage points.
Results like this underscore the deadening effect of hedge fund fees, which are typically set at 2% of assets under management and 20% of gains, over a certain threshold. When a fifth of your profits are snarfed up by the manager, it takes a consistent run of huge gains to beat the broad market.
That’s difficult under any circumstances. Year after year, studies show that active managers of investment portfolios fail to match passive investments in the market averages. In its most recent survey for the year ended June 30, Standard & Poor’s found that less than 40% of investment managers beat their index benchmarks. Large-cap investment funds got smoked by the S&P indexes 85% to 90% of the time.
CalPERs has heard this from its own advisors. Last year, investment consultant Allan Emkin told its investment committee that about one-fourth of active managers will beat their benchmarks at any given time -- but their gains may well be canceled out by underperforming managers. And then there’s the problem that the roster of outperforming managers is constantly changing -- a star one year may be a goat the next. That’s why CalPERS keeps two-thirds of its stock investment under passive management.
There’s certainly a place in any fund CalPERS’ size for alternative investments such as real estate and private equity. The goal is to find counter-cyclical investments -- those that rise when the stock market falls, for example -- or those that respond well to hands-on management, like some private equity-owned companies.
The mystery is why hedge funds retain their magic for many institutional money managers. Despite years of poor performance, U.S. pension funds continued to pile into hedge funds, increasing their investments by 20% through 2012, according to the journal Pensions & Investments.
The disconnect between returns and investment enthusiasm suggests that something else might be at work, such as unsavory connections between pension fund managers and politicians with influence over asset allocation. Investigators are nosing around the links between New Jersey Gov. Chris Christie and the operators of hedge funds that have received investments from that state’s public retirement fund, as David Sirota of International Business Times has ably reported.
But more often than not, the experience of hedge fund investing, like active management in general, evokes the old joke about the Wall Street broker escorting a friend around his local marina, showing off all his fellow brokers’ yachts.
“I see,” the friend responds. “But where are the customers’ yachts?"
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