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CalPERS is largest investor to exit hedge funds, but decision isn’t a surprise to some

Performance 'not an issue' in decision

CalPERS is the first large institutional investor to completely shut down its hedge fund investment program, industry sources said.

At an investment committee meeting on Monday, Theodore “Ted” Eliopoulos, interim chief investment officer of the $298 billion California Public Employees' Retirement System, Sacramento, secured trustee support for staff's decision to wind down its $4 billion hedge fund portfolio within a year and redeploy the assets and the internal investment officials to other parts of the fund's massive portfolio.

Mr. Eliopoulos stressed that CalPERS' reasons for cutting hedge funds were complexity, cost and scale. Performance, he said, was not an issue.

After a rigorous internal review, the fund's investment staff reached “the tipping point” about hedge funds when it became clear that given CalPERS' size, it wouldn't be possible to build a hedge fund portfolio large enough to make a material difference to the pension fund's overall returns, Mr. Eliopoulos said during a Bloomberg TV interview on Tuesday.

Consultants and other industry watchers said CalPERS is the largest pension fund they know to give up on hedge funds. Other smaller institutions to decrease or drop hedge fund investments are the $18.3 billion Los Angeles Fire & Police Pension System; the $11.3 billion New Mexico Educational Retirement Board, Santa Fe; £1.6 billion ($2.7 billion) Oxfordshire County Council, Oxford, England; and the $1.3 billion Louisiana Firefighters' Retirement System, Baton Rouge.

Sources were for the most part not surprised about CalPERS' decision.

“I think they had a constantly muddled approach,” said a source who spoke on condition of anonymity.

Echoing the sentiments of other observers contacted for this story, the source said CalPERS' hedge portfolio was hobbled over the years by ineffective portfolio construction choices, including:

  • direct investments in “a lot of third-tier firms'” hedge funds and inappropriate sizing of the mandates;
  • too much money invested through “obscure” hedge funds-of-funds managers;
  • too big a weighting to emerging and women-, minority- and disabled-veteran-owned hedge fund firms; with too-large mandates;
  • an expensive additional layer of fees paid for consulting advice to hedge funds-of-funds managers A&Q Hedge Fund Solutions (UBS) and Pacific Alternative Asset Management, that also manage part of the CalPERS portfolio.

“We observe that hedge fund investors vary significantly in their philosophies and practices in building portfolios of hedge funds and are not surprised to find a wide range of performance outcomes,” said Stephen L. Nesbitt, CEO of alternatives consultant Cliffwater, in an e-mail.

“For some, like CalPERS, with unfavorable results, abandonment might present the best option,” Mr. Nesbitt said, noting that many other institutions' hedge fund efforts have achieved “favorable outcomes … defined as high single-digit net-of-fee returns, low volatility and low correlation to equities.”

Mr. Eliopoulos' two reasons for getting out of hedge funds — complexity and cost — are “not credible,” said Michael Rosen, chief investment officer at consultant Angeles Advisors, in a statement. “It is unlikely that the largest pension fund in the country would find hedge funds too complex to understand. The costs of hedge funds haven't changed from the outset (if anything, fees have dropped),” he said. He added that CalPERS pays similar or even higher fees for private equity investments, “so cost does not seem a credible explanation for dropping hedge funds.”

Only scale, Mr. Rosen said, “makes any sense. CalPERS is so big that they are unable to extract any alpha. There is overwhelming evidence that scale is the enemy of performance … for large institutions and money managers, trying to invest hundreds of billions of dollars … alpha is very nearly impossible (to achieve).”

“Scale is hard to achieve,” agreed a CEO at a hedge funds-of-funds manager who asked not to be identified, in an e-mail. “To move the dial, CalPERS would need to have $20 billion-$30 billion invested in hedge funds. That's tough to do effectively. We know (staff is) extremely fee sensitive so not all managers will work with them. Assuming political and process constraints and limited resources, achieving decent performance at this scale within this structure is probably unattainable,” the source said.

Bloomberg contributed to this story.