Portfolio choices doomed CalPERS' hedge fund program

Scale also limited investments' effect on pension fund's overall returns

CalPERS officials made ineffective portfolio construction choices for a dozen years before throwing in the towel on hedge funds, sources say.

At the same time, the program was too small — a mere $4 billion — to have any meaningful effect on overall returns, Theodore “Ted” Eliopoulos, the new chief investment officer of the $298 billion California Public Employees' Retirement System, Sacramento, said in a Sept. 25 interview.

Mr. Eliopoulos secured trustee support at a Sept. 15 investment committee meeting for the staff's decision to wind down the portfolio within a year and redeploy the assets and the internal investment personnel to other asset classes. The pension fund currently invests directly in 24 hedge funds and six hedge funds of funds.

To make the investment meaningful, Mr. Eliopoulos said in the interview, CalPERS would need to invest at least $30 billion, which was seen as too risky and too expensive. He said just running a $4 billion program cost CalPERS $135 million in fees a year.

Industry observers agree that scale was an issue, but only one of several. “I think they had a constantly muddled approach,” said a source who spoke on condition of anonymity.

Sources said the portfolio suffered from:

  • direct investments in “a lot of third-tier firms” 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 mandates that were too large; and
  • 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 Co., that also manage part of the CalPERS portfolio.

CalPERS is the first large institutional investor to completely shut down its hedge fund program, sources said, a decision that didn't surprise them and one they don't expect to spark an institutional investor exodus from hedge funds and hedge funds of funds.

That's because CalPERS has long been an outlier, the one big investor that observers said simply couldn't create a viable hedge fund investment program.

“We considered the fact that it is an expensive program to run ... and it's a complex program to run,” Mr. Eliopoulos said. “And because of the cost and the complexity of the program, we were not comfortable at the end of the day scaling up the program to a size that would have a meaningful impact,” he said.

Mr. Eliopoulos and his staff first gave a glimmer of their assurance about hedge fund-free investing to the outside world in February.

Confident enough

In fact, staffers were confident enough to construct three-year strategic asset allocation options that demoted hedge funds as a separate asset class and zeroed out a formal allocation. They were presented at a Feb. 18 investment committee meeting, confirmed Joe DeAnda, a CalPERS spokesman.

Trustees selected an asset allocation that increased global fixed income and real estate slightly and increased the allocation to infrastructure and forestland to 3% each from 1% each. That gave Mr. Eliopoulos the tools he needs to produce a 7.15% expected compound return over the one- to 10-year period beginning July 1 and 7.56% over the one- to 60-year period — with 11.76% volatility.

“Can you hit a 7.5% expected rate of return in a low-return environment without hedge funds? Yes, you can, but you have to concentrate more in equity, take on more growth risk and endure a bumpier ride,” said Timothy F. McCusker, partner and CIO at investment consultant NEPC LLC, Boston.

Mr. Eliopoulos' reasons of complexity and cost are “not credible,” Michael Rosen, CIO at consultant Angeles Investment Advisors LLC, Santa Monica, Calif., said in an e-mail. He noted “it is unlikely that the largest pension fund in the country would find hedge funds too complex to understand.”

Mr. Rosen added that hedge fund costs for all large institutional investors have steadily dropped and 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).”

While it's true that CalPERS would not have any peers in the more than $30 billion hedge fund investor category, other large U.S. institutional investors with substantial hedge fund portfolios have been able to achieve not only scale, but also good performance and alpha generation. CalPERS' then-$4.5 billion hedge fund portfolio returned an annualized 3.94% for the three years ended June 30. The return trailed the pension fund's internal benchmark by 136 basis points, rather than providing the alpha — outperformance over the index — hedge funds are designed to do.

By contrast, six big U.S. institutions with hedge fund investments greater than $5 billion produced significantly better annualized returns and alpha than CalPERS over the three-year period ended June 30, according to a Pensions & Investments analysis.

For example, the $5.1 billion directional hedge fund portfolio of $130.2 billion Teacher Retirement System of the State of Texas, Austin, returned 10.2%, capturing 4.6% alpha; the $5.3 billion hedge fund portfolio of the $81.2 billion New Jersey Retirement System, Trenton, managed by the New Jersey Division of Investment, returned 7.1%, also generating 4.6% alpha; and the $5.5 billion hedge fund portfolio of the $36.4 billion endowment of Harvard University, Cambridge, Mass., returned 8.6%, producing 4.5% alpha. (Returns are annualized.)

CalPERS' alpha woes
Excess return generated by hedge fund programs similar in size to CalPERS. Asset size is in millions as of June 30, 2014.
Fund3-year alpha vs. fund's benchmark3-year hedge fund returnHedge fund assetsHedge fund assets as % of total assets
Texas Teachers*4.60%10.20%$6,4424.9%
New Jersey Division of Investment4.56%7.08%$5,2896.5%
Harvard University4.51%8.59%$5,46015.0%
Missouri Public School and Education3.88%7.90%$5,15413.6%
Texas County & District3.80%7.10%$6,00424.5%
MassPRIM3.63%6.93%$5,8189.6%
Michigan Retirement Systems3.50%6.40%$2,6734.4%
Texas Permanent School2.49%6.01%$3,05310.0%
Alaska Permanent1.31%5.52%$3,9447.4%
CalPERS-1.36%3.94%$4,5481.5%
Texas Teachers**-1.60%3.70%$5,1934.0%
*Directional. **Stable value for diversification.
Notes: CalPERS' benchmark is T-bills plus 5%, Alaska Permanent uses CPI plus 4%. Michigan is invested 100% in funds of funds. Harvard hedge fund assets estimated based on policy portfolio.

High performer

Another high-performing hedge fund portfolio is that of the $38.2 billion Public School and Education Employee Retirement Systems of Missouri. Over the three years ended June 30, the portfolio returned an annualized 7.9%, capturing 3.9% of alpha.

The staff of the Jefferson City-based pension fund relies on hedge funds to “bridge the gap between bonds and stocks” in the current environment of historic low bond yields and expensive equities in order to meet its 8% long-term expected return, Craig Husting, CIO and executive director of investments, said in an e-mail.

In addition, the pension fund invests in hedge funds to gain “competitive returns, diversification and lower volatility (risk) than stocks,” goals that the portfolio has met, Mr. Husting said. Returns as of June 30 were solid with 15.8% for the 12-month period and 11.8% annualized for the five-year span, with about 40% of the volatility of a global equity index.

Randy Diamond contributed to this story.

This article originally appeared in the September 29, 2014 print issue as, "Portfolio choices doomed CalPERS' program".