This was the big news yesterday out of California:
The California Public Employees’ Retirement System (Calpers) today announced that it will eliminate its hedge fund program, known internally as the Absolute Return Strategies (ARS) program, as part of an ongoing effort to reduce complexity and costs in its investment program.
The staff recommendation, supported by the Investment Committee, will exit 24 hedge funds and six hedge fund-of-funds valued at approximately $4 billion.
Though this move may shock some people, it was one of the most-telegraphed actions that the nation’s biggest pension fund has made. The seeds for this were planted last year, when Calpers moved the authority over hedge funds from its equity desk to its fixed-income group. Bond investors look at the world very differently from equity investors.
The criticism of hedge funds from the equity side of the investing universe typically focuses on performance and fees, to a lesser extent. Charging high fees — hedge funds usually collect fees equal to 2 percent of the assets under management plus 20 percent of any gains — is a pretty big drag on long-term performance. However, a handful of funds have managed to accomplish high returns over long periods of time. That is the promise of alternative investments. The reality is much different, as the industry as a whole and most of its components underperforms the broader market. Not surprisingly, paying high fees for a lack of performance has become a difficult investment practice to defend.
But that is the equity view. From the fixed-income side of things, the focus is on a risk-reward analysis. Hedge funds provide a lot of risk, but they don’t generate a significantly different profile from the rest of the equity universe. During the financial crisis, hedge funds as a group fell 28 percent versus the bottom-of-the-trough drop of 57 percent for the Standard & Poor’s 500 Index. When compared with fixed income, which had strong gains throughout the financial crisis, hedge funds proved they weren’t up to doing what they were supposed to do — providing a hedged bet against adverse market events. Losing almost a third of their value means that there is still a substantial amount of risk embedded within hedge funds. That is an anathema to most bond guys. Hence, the Calpers action was almost inevitable.
Back in April, because of two columns in these pages (“The Hedge-Fund Manager Dilemma” and “Why Investors Love Hedge Funds”), I spoke with several bond portfolio managers at Calpers. They were curious about some of the data I had used for those two articles, as well as some general investment philosophy on hedge funds. Our conversation was off the record, but I can share with you what I told them, all of which has been pretty much detailed in these pages during the past year:
• Hedge funds are a legal structure, not an asset class;
• Dilution of returns and talent was inevitable as the industry grew from $150 billion and a few hundred funds to $3 trillion spread out among almost 10,000 funds;
• Claims of hedge-fund noncorrelation with markets have been greatly exaggerated;
• Selection of outperforming hedge funds appears to be indistinguishable from random picks;
• If you are invested in a fund that is truly generating market-beating alpha (as opposed to random outperformance), I would be hard pressed to suggest not keeping it;
• The expectation that hedge-fund returns will exceed those of equities is an unsupported fiction created by consultants.
Understanding why Calpers did this is less obvious than you might have imagined: Sure, it was paying very high fees for a group of investments that underperformed every single benchmark it looked at. But what it actually did was far more significant. Instead, it made a broad decision that it wasn’t worth embracing the correlated risk of hedge funds. Fees and performance were certainly a concern, but I suspect this issue mattered just as much.
Even so, I was expecting Calpers to reduce its hedge-fund holdings by as much as 40 percent, mostly by cutting the underperformers. This is a huge change beyond the $4 billion in hedge-fund investments Calpers will now shed. It has enormous potential for disrupting the consultants and infrastructure of the 2 & 20 firmament.
What it means for the rest of the investment world is an even more fascinating subject. Consider these three questions:
1. What will other pension funds do? Calpers has long been known as an industry thought leader. Along with its sheer size, it also has used its status and location in the progressive and experimental state of California to manage things a little differently from the pack.
2. What might this mean for venture capital and private equity? Recent studies have shown that VCs are surprisingly correlated to equity, reducing one of its key rationales. (Private equity is much less correlated.) But like hedge funds, there also are concerns about liquidity, redemption gates, fees and performance. Will big pension funds like Calpers reduce their VC and PE exposure?
3. What does this do to the belief that hedge funds deliver higher returns than equities? This expectation, of course, has proven to be a myth. But state treasurers bought into this fiction because it allowed them to make much smaller contributions to employee-retirement accounts, keeping local tax rates down. This short-term patch is setting up much bigger shortfalls in the future.
The hedge-fund world is changing. I suspect we may be surprised by just how radical the change will be.