The news this week that the California Public Employees’ Retirement System was liquidating its hedge fund portfolio brought accusations from critics of these private, unregulated funds that their time in the sun was finally over. For the anti-hedge fund crowd, these vehicles are more akin to gambling at a casino than actual investment, and the lucrative 20% performance fees that their managers charge are simply a way of enriching a few at the expense of investors who would probably be better off putting their money in a low-fee index fund.
The CalPERS exit is clearly an important development that will inevitably be scrutinized by both the hedge fund industry and the public pension plan world. CalPERS, the largest U.S. public pension plan, was an early entrant into hedge fund allocations and is seen by many as a trendsetter when it comes to innovative investment policies.
However, CalPERS’ commitment level to hedge funds was always relatively small — about $4 billion — under 1.5% of its total portfolio. Other public pension plans have allocated significantly higher proportions of their overall portfolios to hedge funds, and the overall amount of money being put in these funds is going up, not down.
Clearly, it is too soon to write the obituary for hedge funds. These highly entrepreneurial firms will certainly need to evolve in the coming years to ensure that they meet the expectations of their investors for high returns. And the question of fees is one that cannot be dismissed out of hand. In fact, CalPERS’ interim chief investment officer said the reason for the system’s move is because hedge funds are too “complicated and expensive” for its needs.
Despite the great latitude that hedge funds theoretically have to structure themselves and their economics, there has always been an unusually high level of “clustering” around the so-called 2 & 20 formula — that is, the 2% management fee paid each year and 20% incentive allocation paid to the fund’s managers only when profits are earned on actual investments.
In recent months, it has been particularly fashionable to point out that hedge funds as a group have underperformed the major stock indexes. This is put forward as a way to undermine hedge fund managers’ claims to be the best of the best. However, it falls victim to what I would call aggregation error.
When we create an index for a portion of the stock market, we seek to derive one number that can serve as a proxy for the entire basket. This number goes up, we deduce it’s been a good day for the market. This number goes down, we judge that it has been a bad day for the market. When you are looking at hundreds of companies, each being driven by the decisions of thousands of individual executives and employees, aggregating this universe into a single number can make sense.
However, at their heart, hedge funds are simply a way to access the talents of particular portfolio managers. An investment in a fund is not so much a generalized pick of an investment strategy, such as equity long/short or merger arbitrage or activism, as it is a decision that this man or woman (or this small identifiable group of men and women) who will invest the money has unique talents.
In that light, to aggregate all hedge fund managers into a single index makes as much sense as aggregating everyone who happens to be swinging a golf club on a Saturday and taking that value as the best way to measure, week to week, whether the quality of golf playing in the United States is increasing or decreasing. The much more interesting pool of golfers to focus on would probably be those golfers on the PGA Tour, who represent the best examples of tested and proven players.
Similarly, the state of the hedge fund industry is better grasped by looking at the top quartile of hedge fund managers and seeing how their performance varies over time. All hedge fund managers are not created equal. Simply calling yourself a hedge fund manager is no guarantee that you will actually produce eye-wateringly high returns for your investors.
The most successful investors are backing the most successful managers. Simply put, the case for backing proven investment talent remains strong.
CalPERS’ decision will be intensely analyzed in the weeks and months to come, and it may ultimately prove to be the right move for its beneficiaries. But hedge funds are far from dead, since hedge fund managers have the flexibility to evolve their funds and adapt their terms to meet concerns over fees, complexity and transparency.
Timothy Spangler is a lawyer, academic and author of “One Step Ahead: Private Equity and Hedge Funds after the Global Financial Crisis.”
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