CalPERS divests hedge fund investmentsOctober 6, 2014
In mid-September, the California Public Employees’ Retirement System (CalPERS) announced that it would eliminate hedge funds from its investment program, planning to divest all of its hedge fund investments over the next year. CalPERS officials stated that the hedge fund program was not being eliminated because hedge funds underperformed relative to expectations, rather the program was considered too expensive relative to the benefits received.
Hedge funds do tend to be expensive – an oft-cited fee arrangement is “2 and 20” – a management fee of 2% of assets under management and 20% of performance. CalPERS cited an expense of $138 Million on an investment of $4 Billion (out of CalPERS nearly $300 Billion,) or about 3.5% in fees. Since effective hedge funds may depend on their idiosyncratic strategies, hedge funds may quickly be capacity constrained, especially relative to a large investment pool such as CalPERS. Then, due diligence, including selecting viable hedge fund investments, either directly or through funds of funds, can become an expensive activity, particularly considering associated monitoring costs. One can see the concern for expenses, especially for an investment area involving only a little more than 1% of total assets, which is generally considered too small to have significant effects on either risk or return.
On the other hand, FDx Advisors concentrates its efforts on selecting investments organized under the “1940 Investment Company Act,” that is, mutual funds and exchange traded funds that provide hedge fund and related strategies, and other alternative investments. These alternatives provide the returns and diversification benefits of many hedge fund strategies, and other alternatives. These investment vehicles generally have lower fees, and higher liquidity than typical hedge funds, without the investor qualifications necessary for the private placements ordinarily involved.
CalPERS had adopted an investment program including hedge funds in the early 1990’s, but had not increased its proportionate allocation much over the years, and actually began reducing its investments in hedge funds some months ago. CalPERS hedge fund investments are only part of their alternatives investments, with commodity, private equity, and real estate investments remaining, for example.
As such a large pool of investable assets, CalPERS has been considered a bellwether in investment policy and asset allocation, and indeed, was an early adopter of alternative investments. As mentioned, though, CalPERS did not expand its use of hedge funds as much as other pension plans, public and private. These and other institutions continue to expand their use – hedge fund investment flows have reached new heights this year. Over the years, liquid have expanded and now represent a broadened investment palette for smaller institutions and private clients of a wide range of wealth.
Some commentators have speculated that CalPERS was disappointed in returns because, for example, hedge funds recently have underperformed the equity markets, say, the S&P 500. While true, that is not an apt comparison.
The worth of hedge funds is better reflected by considering “risk-adjusted” returns, measured by the Sharpe ratio, for example. Due to their relatively low level of volatility, hedge funds typically may show better risk adjusted returns than equities. By nature, hedge funds may offer lower but less volatile returns than equities – therefore, hedge funds often have lower correlation with equities than some other asset classes, thus providing diversification benefits.
One of the prominent and unusual features of the current investment environment is the long lasting low level of interest rates. While analysts may differ when explaining the causes and persistence of low rates, it seems likely that interest rates have more room to move upward than downward. Because interest rates and bond prices move in opposite directions, capital losses in bonds appear almost inevitable for longer maturity bonds, and shorter maturities have rates near zero. Since some hedge funds or funds of funds have relatively low levels of volatility and diversification benefits with higher levels of returns, relative to bonds, hedge funds may be a valuable substitute for fixed income investments, especially in an environment, like today, where many domestic equity investment opportunities are near historically high values.
Although it is notable that an early adopter and well-experienced user, such as CalPERS, has begun to disinvest in hedge funds, this is unlikely to signal a long lasting move away from hedge funds. As a matter of fact, hedge fund investments in aggregate are nearing $2.8 Trillion, a high point in assets under management. Hedge funds continue to provide the opportunity for increased diversification benefits, and to moderate the volatility of a well-managed portfolio that includes a significant allocation to a variety of alternatives.