CalPERS' decision on Sept. 15 to close its $4 billion hedge fund program will lead to a lot of re-examination of the investment strategy by other asset owners.
On Sept. 19, soon after the announcement of the CalPERS decision, the State Employees Association of North Carolina called for Janet Cowell, North Carolina state treasurer and sole trustee of the $90 billion North Carolina Retirement Systems, to immediately liquidate its $298 million hedge fund portfolio, citing CalPERS' action and the “high risk and high fees” of hedge funds.
A week before the CalPERS decision, the $20.6 billion San Francisco City & County Employees' Retirement delayed for the second time a plan to implement a hedge fund program, seeking more time to debate the issue of risk.
Re-evaluation is a good thing; an impulsive reversal without a thorough review, as proposed in North Carolina, is not.
Action by the California Public Employees' Retirement System might be an indication that asset owners haven't figured out how to use hedge funds, how to integrate them into their overall strategic investment objectives.
CalPERS executives consider hedge funds an asset class, but found it too small to be material. The Florida State Board of Administration looks at them as opportunistic investments, not as an asset class. Other asset owners haven't yet allocated to hedge funds.
Investing involves predicting outcomes based on expectations, and second-guessing, examining with the advantage of hindsight.
Asset owners should constantly challenge their investment program, its assumptions and beliefs, as the market shifts and their own experience and capabilities change. One asset owner with a 10% hedge fund allocation, the $15.1 billion Illinois State Board of Investment, did so last year and restructured its hedge fund program to reduce correlations of its hedge fund managers and allow more investment flexibility.
Because of its size, CalPERS has long been viewed as a leader. With $298 billion in assets, it is the biggest U.S. pension fund, and it has been a leader in many areas of investing. But a leader can have faults and difficulties.
It currently is recovering from a scandal that rose all the way to then-CEO Federico Buenrostro, who pleaded guilty to accepting bribes to steer the pension fund to invest in particular private equity investments. It is also regrouping after an upheaval in leadership caused by the death in February of Chief Investment Officer Joseph Dear. Theodore Eliopoulos, interim CIO since June 2013, was named permanent CIO on Sept. 17.
But conditions that apply to CalPERS and led to its hedge fund decision don't necessarily apply to other asset owners.
CalPERS cited three reasons for shutting down its hedge fund program: costs, complexity and scalability.
In terms of cost, fees have been coming down because of pressure applied by hedge fund clients. The Illinois State Board of Investment in the past couple of years has renegotiated its hedge fund fees to reduce them, terminating a hedge fund-of-funds manager who refused to come down enough.
Because of its size, CalPERS has clout unlike other asset owners to put pressure on fees, but costs are rising generally as markets and strategies have become more complex.
As Karl Koch, chief investment officer of the $27.6 billion Iowa Public Employees' Retirement System, pointed out in a recent commentary in Pensions & Investments: “Costs are important, but you can't focus on costs alone when running an investment program. Certain asset classes can be very expensive, but can also produce high returns and valuable diversification. For example, the private equity program accounts for about 50% of IPERS' annual investment management costs.” But it has outperformed a passive approach, justifying the high costs.
Fiduciaries should analyze investment fees not just in absolute terms but in term of the effectiveness in achieving objectives.
Complexity is a challenge. Critics have derided the idea of hedge funds being too complex for the biggest pension fund. But in assessing the impact of the 2008 financial market crisis, a lot of asset owners blamed the complexity of asset-backed fixed-income securities that were rated AAA and nevertheless unraveled quickly. But was complexity the reason for losses, or was it failure to do sufficient analysis?
Some asset owners deal with complexity by using a hedge fund-of-funds structure, letting a manager handle complex investment oversight, or by using an investment consulting firm, or relying on internal staff. CalPERS relied on some combination of all of them, but claims hedge funds are still too complex.
Size is one element that makes CalPERS different from other U.S. asset owners, which are smaller and can be more nimble and flexible. CalPERS concluded hedge funds don't have the scalability to enable it to build its allocation large enough to make a material different in the pension fund's overall return.
But that reasoning doesn't apply to most other funds, which can achieve scale. The executive director of a fund less than one-tenth the size of CalPERS, but still with multiple billions of dollars in assets, noted his fund's current 10% hedge fund allocation is of sufficient scale to have an impact on its overall return and risk profile.
But scalability should not have been a surprise to CalPERS. The question is how CalPERS evaluated the asset class as it built and revised its hedge fund program over the years to determine its scalability.
Anyway, do hedge funds have to have the kind of scalability CalPERS was seeking to be an effective diversifier and contributor to return?
The $179.9 billion Florida State Board of Administration doesn't consider hedge funds an asset class. It places them as part of its strategic investments allocation, which has a 12% allocation target.
The issues of cost and complexity might also be issues for other funds, but scalability should not be, and the returns and diversification benefits might make hedge funds useful investments for them.
Hedge funds, like other alternative investments, deserve more scrutiny than conventional asset allocations. One reason is their lack of transparency. Another reason is the challenge of measurement and comparison. There is no investible benchmark as there is for conventional equity portfolios, making comparisons a challenge.
Fiduciaries need to evaluate the reasons for the drive to alternative investments to help reach objectives and what it can control. Is the allocation market-driven over return and risk prospects? Is it sponsor-driven over insufficient contributions?
Despite the CalPERS retreat on hedge funds, other tax-exempt funds should not emulate it without thoroughly examining their own hedge fund programs in the context of the roles they play in their risk/return profiles, and whether they have been successful enough to warrant the costs and complexity.
Terminating a hedge fund investment program without such an examination would be a breach of fiduciary duty.