STUMP » Articles » Public Pensions Watch: Reactions to Calpers Pulling Out of Hedge Funds » 17 September 2014, 01:48

Given yesterday’s post on the largest public pension fund in the U.S. pulling out of hedge funds, it is hardly surprising that the investment world (especially institutional investing) are reacting to this.

From Barry Ritholtz at BloombergView:

Though this move may shock some people, it was one of the most-telegraphed actions that the nation’s biggest pension fund has made. The seeds for this were planted last year, when Calpers moved the authority over hedge funds from its equity desk to its fixed-income group. Bond investors look at the world very differently from equity investors.

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From the fixed-income side of things, the focus is on a risk-reward analysis. Hedge funds provide a lot of risk, but they don’t generate a significantly different profile from the rest of the equity universe. During the financial crisis, hedge fund as a group fell 28 percent versus the bottom-of-the- trough drop of 57 percent for the Standard & Poor’s 500 Index. When compared with fixed income, which had strong gains throughout the financial crisis, hedge funds proved they weren’t up to doing what they were supposed to do — providing a hedged bet against adverse market events. Losing almost a third of your value means that there is still a substantial amount of risk embedded within hedge funds. That is an anathema to most bond guys. Hence, the Calpers action was almost inevitable.

This is similar to what I was saying about structured securities at TIAA-CREF. Said structured securities did have higher yield than similarly-rated vanilla corporate bonds. What the risk analysts at TIAA determined was that that extra yield did not pay enough for the risk being taken. That is a fixed income point of view, not an equity point of view.

Ritholtz also has a nice rundown of salient features of hedge funds:

• Hedge funds are a legal structure, not an asset class;

• Dilution of returns and talent was inevitable as the industry grew from $150 billion and a few hundred funds to $3 trillion spread out among almost 10,000 funds;

• Claims of hedge-fund noncorrelation with markets have been greatly exaggerated;

• Selection of outperforming hedge funds appears to be indistinguishable from random picks;

• If you are invested in a fund that is truly generating market-beating alpha (as opposed to the occasional random outperformance), I would be hard pressed to suggest not keeping it;

• The expectation that hedge-funds returns will exceed those of equities is an unsupported fiction created by consultants.

Note that first item. Part of the issue with hedge funds and public pension funds, is that the legal structure is intended to be opaque. They’re trying to keep their particular trades secret, on the theory they don’t want to be undercut. This makes sense if you have some sort of (pseudo)arbitrage strategy. Information is money. Etc.

But it’s not only that hedge funds are opaque — it’s that they also have barriers to the investors getting their money out. They commit to having their money tied up for certain periods of time. I keep harping on illiquidity, which has its uses (going back to the TIAA-CREF theme – for one of its core products, a retirement annuity account, the fastest you can get all of your money out from it is over a 9 year period. There are good reasons for this.)

But the question becomes how good of an idea is having a bunch of one’s portfolio being illiquid if the pensions they’re covering are underfunded?

And how underfunded is Calpers? The most recent funded ratio was about 70%, which isn’t Illinois-levels of underfundedness, but it’s far from whole.

They’re not in asset death spiral territory, but liquidity can be an issue, especially if they have various entities declaring bankruptcy, trying to write down pension debts. They’re going to need cash flow.

Steve Denning at Forbes on the move:

The announcement is dramatic for three reasons. First, Calpers’ size: it is the largest U.S. public pension plan, with some $300 billion in investments and benefits for nearly two million current and retired police officers, firefighters and other public employees.

Second, since Calpers was an early adopter of alternative investment vehicles like hedge funds and led the way for other public funds to invest in them, Calpers’ disillusionment will send shock waves through the community of public funds.

Finally, Calpers is a general trendsetter for other public plans in all areas. If Calpers pulls out of hedge funds, other institutional investors in cities and states are likely to follow suit.

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Public pensions began investing in hedge funds about ten years ago as they tried to close an emerging gap between likely future returns and future obligations to retirees. In the fine tradition of Las Vegas card sharps, hedge fund managers offered fabulous gains and pension funds succumbed to the lure.

The International Monetary Fund IMF has called the practice “gambling on resurrection.” Investing by pension funds in hedge funds was for the most part a feint to conceal the underlying poor performance, or even insolvency of the funds. According to an IMF report issued last year, the moves are part of an alarming trend.

Gambling on resurrection is what happens when a fund starts running into financial trouble. The responsible thing for pension fund managers would be to face up to the problem and discuss what to do, accepting the possibility that they may be held accountable for creating the problem.

Yves Smith at Naked Capitalism:

Now admittedly, on paper, this was not a hard decision for CalPERS. A 1.5% allocation was not enough to have much impact on CaLPERS’ portfolio. CalPERS has finally recognized what was widely known in 2006: hedge funds do not deliver their promised overperformance, nor do they succeed in dampening volatility of returns enough to justify their eyepopping fees.

But despite this move coming over seven years late, CalPERS does deserve credit for finally taking this stand. Its participation in hedge fund investments was low enough to show that CalPERS wasn’t an enthusiast, but there’s a big difference between that and repudiating the strategy entirely.

CalPERS’ move is likely to subject it to considerable consternation and criticism from those who benefit from hedge fund investing, such as pension fund consultants, who can justify higher fees due to the time and difficulty of evaluating complicated alternative investment strategies. And the most difficult and arcane ones happened to be hedge funds.

So as we wrote earlier today, the saying is that as California goes, so eventually goes the US. And in this case, that would prove to be a very positive development.

Tim Worstall at Forbes:

Calpers has decided to pull its investments out of the various hedge funds where it has money. They’re the experts paid to place that pension money where it will do best so possibly better not to try and second guess them. However, we can look back all the way to 1776 and the foundation text of modern economics, Adam Smith’s “Wealth of Nations” and find a reasonable explanation of what’s happening here. Essentially, hedge funds were a great idea but the innate structure of free market capitalism means that no idea stays great over time.

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when the capitalists (investors) spot someone making those above average profits then they’ll move their investments over into that sector so that they can get them some of those excess returns. All of which is entirely fine and is a reasonable enough description of what happened to hedge funds from their small start in the 60s and 70s up to recent times. They were making higher (risk-adjusted) profits and people were moving more of their capital into them in order to get those higher returns.

However, Smith goes on to point out what happens next. That increased capital in that sector introduces more competition into that sector. Such competition, umm, competes away those excess profits and it’s thus, in the end, the very movement of capital (or investment) in chase of higher returns that leads to the higher returns disappearing. This would be a reasonable description of the hedge fund industry in more recent times.

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It’s possible to make much more sophisticated, elegant and detailed arguments about what’s going on, sure it is. But at heart the above is a reasonable theoretical pencil sketch of the background situation. Above average returns get competed away by more people chasing them and that’s happened to this sector just like it has to every other before it.

And at least Calpers is getting out before returns are completely run into the ground.