The decision of the California Public Employees' Retirement System to pull out of its hedge-fund investments continues to attract lots of attention, and understandably so.
Calpers is, after all, the largest U.S. pension fund and is among those that continue to seek a relatively high rate of return to help pay the health and retirement benefits of millions of public employees. It is also highly respected.
The observers who analyzed the Calpers withdrawal focused on three drivers cited by the institution itself: cost, complexity and scale. These factors also warrant consideration by other investment committees around the world, with implications for the allocation of assets and the ability to meet investment objectives.
The cost argument is the most straightforward. Most hedge funds still try to apply a “2 and 20” model in which they charge their investors a fee of 2 percent of assets they manage and keep 20 percent of the gains above a specified level.
For this, clients have access to services that use an extensive array of instruments to provide greater responsiveness and flexibility. These include the ability to leverage, customize derivatives, and to take long or short positions on particular securities (as well as in the market as a whole).
As such, these investments have the potential to generate positive (or “absolute”) returns regardless of cycles and market conditions — be it by leveraging market returns (“beta”), protecting against sudden drawdowns (“hedging”) or generating value in excess of returns on investments tied to a passive benchmark index (“alpha”).
The 2 percent fee is harder to sell to investors in a world of lower expected returns — which is the case today given the significant recent rise in equity valuations, together with repressed levels of interest rates and credit spreads for bonds. It becomes even harder when clients also face the challenge of continuously identifying top-performing managers to invest with.
The selection of an investment manager is a complex science, as well as an art. It is consequential given the considerable gap in performance between top-quartile managers and the rest. Only a small number of firms (such as the Baupost Group under the leadership of Seth Klarman) have been able to maintain consistently superior performance over time.
Then there is the issue of scale. For hedge funds to make a material difference, Calpers needed to invest significant dollars in a space where incremental returns could easily have zero-sum characteristics — meaning a loss for every gain.
As Ted Eliopoulos, the chief investment officer of Calpers, noted last month, its hedge-fund investments were only a tiny fraction of its overall portfolio: about $4 billion of a total of some $300 billion.
"One of our prime considerations in reviewing the program is whether we believe we could scale the program to a much more significant part of the overall portfolio," he said.
All these elements speak to a broader historical phenomenon. The use of hedge funds became popular in the last decade as many institutional investors sought to replicate the “endowment model” first pursued by foundations and universities. This model seeks to go where others aren’t, taking advantage of the long-term nature of the investible funds (“permanent capital”).
But the resulting migration, which has been considerable in recent years, has inevitably eroded its potential for generating revenue — as have the increasingly “winner takes all” outcomes that now dominate some particularly enticing investment destinations.
Outperforming others by diverging from the consensus becomes a lot more difficult if the consensus is joining you. That is what occurred to Calpers and other investors that had looked to hedge funds as a reliable source of superior absolute returns. This is similar to what happened to early movers in natural-resource investments, which, at one time, offered both high returns and considerable diversification benefits.
This is all the more reason that investors have to do an even better job in their selection of managers. While the result is likely to be lower growth in the overall allocations to hedge funds, the substitutes should not be limited to traditional public markets where valuations are already stretched and where prospective returns may not readily match the requirements of the liability structures against which investments are managed, as well as appetites for risk.
Given today’s realities, investors need to be more imaginative in populating their “absolute return” bucket. In doing so, many may need to develop greater in-house expertise to invest opportunistically in a bigger range of one-off single assets — particularly those done directly.
In that way, they can take advantage of the coming disposal of assets by the restructuring European banks, of the enormous need for infrastructure development, and of the opportunity to better match demand and supply in the more stable emerging economies.
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