Recent decisions by major asset owners to eliminate or significantly curtail exposures to hedge funds should renew concern about their generally high fees, lack of transparency, illiquidity, complexity and expectations of exceptional performance.
The New York City Employees' Retirement System plans to liquidate its $1.4 billion or 2.8% allocation to hedge funds, following the Illinois State Board of Investment's move to reduce hedge funds to a 3% allocation from 10%, or $1.5 billion. Those actions come after the 2014 decision by the California Public Employees' Retirement System to drop its $4 billion exposure to hedge funds.
In a low interest rate environment especially, pension funds have looked to hedge funds to help improve funded levels by offsetting rising obligations through increased investment returns, while also reducing risk.
Many asset owners saw hedge funds as an essential piece of the holy grail of combining stability and return-seeking assets.
But reality has intervened, leading some asset owners to conclude hedge funds haven't delivered results in tune with expectations.
The terminations should put pressure on hedge fund managers to reduce fees, while increasing transparency to help make the complexity of the investment process better understood. But the departures also put pressure on asset owners to develop clear expectations about their objectives and ability to oversee hedge fund allocations.
Some pension funds have fallen short in doing so, and it is unacceptable to allocate to an asset class without having the internal oversight resources in place.
In considering such exposure, asset owners should make sure they clearly understand the risk and return performance benchmarks for hedge funds as well as the fees. The fees should come as no surprise.
At ISBI, hedge fund fees totaled $180 million over the three years ended last Dec. 31, while performance was worse than a mix of U.S., international equity and fixed-income index funds, Marc Levine, ISBI chairman, said regarding its decision to reduce its hedge fund exposure by more than two-thirds and consolidate the remaining assets with a single manager.
“To earn 2 and 20, you have to be great,” he said of hedge fund fee percentages.
Henry Garrido, NYCERS trustee, said in a recent Pensions & Investments report, “We have not seen the results that we had expected.”
In an article in the March/April issue of the Financial Analysts Journal, William W. Jennings and Brian C. Payne found a hedge fund allocation before fees has a 60% chance of delivering alpha in a given year. But considering fees, “this probability drops to 52%, a margin sufficiently close to a coin toss to make investors think twice about the proposed investment.”
If recent returns were better, some asset owners might be willing to give hedge fund managers more time, but poor returns and high fees coupled with headline risk was too much to accept.
In an example of headline risk, a recent report produced by the American Federation of Teachers and the Roosevelt Institute called for NYCERS, ISBI and other pension funds, including the New Jersey Pension Fund,, to review their hedge fund strategies.
But Christopher Santarelli, New Jersey State Treasury Department spokesman, said in the Pensions & Investments report, “We wish that the partisan groups leading the charges against these investments would not prioritize politics over what is best for the financial security of public pension fund beneficiaries.”
He's correct that politicizing exposures won't improve returns or funded status.
Asset owners should ask whether hedge fund performance below expectations is the result of a misguided allocation policy to an overpromised asset class or the result of implementation risk, a poor choice of managers correctable by better manager selections.
Among other questions, asset owners should ask whether the transparency issue at hedge funds is a result of a lack of detail about portfolios or a lack of understanding about what key elements to monitor, such as ranging from daily positions in securities to leverage details and counterparty risks to operational risks. How should the elements be prioritized?
For many public pension funds, hedge funds have outperformed. In the year ended Sept. 30, 57% of public pension fund hedge fund portfolios topped their benchmarks, compared with 81% the previous year, according to a Pensions & Investments survey reported Dec. 14.
Hedge funds have won new asset owners as clients, such as Illinois State Universities Retirement System, which made its first allocation in October.
But asset owners have other allocation choices, even in a challenging market environment, and should make sure they explore all of them.
A Callan Associates Inc. review for the New York retirement systems concluded “that hedge funds can be removed from the NYCERS asset mix to achieve target levels of return and maintain consistent levels of volatility.”
Concerning other choices, eight years into his contest with hedge funds, Warren E. Buffett “is holding strong,” wrote Andrew Clarke, principal and senior investment strategist, investment strategy group, Vanguard Group, in an April 11 posting on Vanguard's website.
As Mr. Clarke noted, in 2007 Mr. Buffett, chairman and CEO of Berkshire Hathaway Inc., making a case for buy-and-hold investing, offered $1 million to any hedge fund taker that the Standard & Poor's 500 would outperform any 10 hedge funds an opponent might choose. Protégé Partners LLC, a hedge funds-of-funds manager, accepted the challenge. Since the start of the contest, Jan. 1, 2008, the S&P 500 has returned a cumulative 65.67%, while the average return of the Protégé's picks is 21.87%, Mr. Clarke wrote.
Vanguard research, released in September and examining a period from Jan. 1, 2000, to Oct. 31, 2013, found 76% of hedge funds of funds underperformed a 60% equity/40% bond allocation.
Such underperformance might explain a recent net outflow from hedge funds. In the quarter ended March 31, assets managed in hedge funds globally fell 1.4% to $2.856 trillion, a result of a $15.1 billion net outflow of assets, the largest quarterly withdrawal from hedge funds since the second quarter of 2009, according to data from Hedge Fund Research reported in Pensions & Investments.
Asset owners embracing hedge funds must understand risks, return, key transparency issues, fees and benchmarks, and commit to bringing to bear resources for manager selection and monitoring. What gets measured gets managed. As Keith P. Ambachtsheer, well-known pension fund consultant, wrote in his new book “The Future of Pension Management,” if asset owners measure the wrong things, they manage the wrong things. n
