alternative investments | Pension360

What Does CalPERS’ Hedge Fund Pullout Mean For the “Average” Investor?

Larry Zimpleman, chairman and president of Principal Financial Group, has written a short piece in the Wall Street Journal today detailing his reaction to CalPERS cutting hedge funds out of their portfolio and what the move means for the average investor.

From the WSJ:

I was very interested (and a bit surprised) to read about the decision of Calpers (the California Public Retirement System) to move completely out of hedge funds for their $300 billion portfolio.

While I haven’t visited directly with anyone at Calpers about the reasons for their decision, from the stories I’ve read, it seems to be a combination of two things. First, it’s not clear that hedge-fund returns overall are any better than a well-diversified portfolio (although the management fees of hedge funds are much higher). Second, hedge funds had only about a 1% allocation in the overall portfolio. So even if they did provide a superior return, it would have a negligible impact on overall performance.

What’s the takeaway for the average investor? First, if you have “alternatives” (like hedge funds) in your own portfolio, they need to be a meaningful percentage of your portfolio (something like a 5% minimum). Second, take a hard look at the recent performance against the management fees and think about that net return as compared to a well-diversified stock and bond portfolio. Hedge funds are, as their name implies, set up more for absolute performance and outperformance during stressed times. If you’re a long-term investor that believes in diversification and can tolerate volatility, hedge funds may be expensive relative to the value they provide, given your long-term outlook.

Principal Financial Group is one of the largest investment firms in the world and also sells retirement products.

Zimpleman’s post was part of the WSJ’s “The Expert” series, where industry leaders give their thoughts on a topic on their choice.

Dan Primack: All Alternatives Are Not Created Equal

Pension funds have been receiving flak from all sides lately regarding alternative investments.

The criticisms have been varied: the high fees, opacity, underperformance and illiquidity.

But, outside of official statements from pension staff defending their investments, it’s not often we get to here from the people on the other side of the argument.

Dan Primack argues in a column this week that not all alternatives are created equal—and the fight against the asset class has been “oversimplified”.

From Fortune:

Hedge funds are considered to be “alternative investments.” So is private equity. And venture capital. And sometimes so is real estate, timber and certain types of commodities.

A number of public pension systems have increased their exposure to “alternatives” in recent years, at the same time that they either have curtailed (or threatened to curtail) payouts to pensioners. The official line is that the former is to prevent more of the latter, but many critics believe Wall Street is getting rich at the expense of modest retirees.

The complaint, however, generally boils down to this: Alternatives have underperformed the S&P 500 in recent years, even though many alternative funds charge higher fees than would a public equities index fund manager. In other words, state pensions are overpaying for underperformance.

Great bumper sticker. Lousy understanding of investment strategies.

The simple reality is that not all alternatives are created equal. Some, like private equity, are more tightly correlated to public equities than are others. Some are designed to chase public equities in bull markets without collapsing alongside them (that’s where the name “hedge” name from). Real estate is largely its own animal. Same goes for certain oil and gas partnerships.

Lumping all of them together because of fee strategies makes as much sense as arguing that a quarterback should be paid the same as an offensive lineman. After all, they both play football, right?

Primack uses New Jersey as an example:

For those who want to criticize public pensions for investing in alternatives, be specific. New Jersey, for example, reported alternative investment performance of 14.21% for the year ending June 30, 2014. That trailed the S&P 500 for the same period, which came in at 21.38% (or the S&P 1500, which came in at 16.99%). But that alternatives number is a composite of private equity (23.7%), hedge funds (10.2%), real estate (12.74%) and real assets/commodities (6.12%). The sub-asset class most tightly correlated to public equities actually outperformed the S&P 500 (net of fees).

Would New Jersey pensioners have been better off without private equity? Clearly not for that time period. Having avoided real estate or hedge funds, however, would be a different argument. But even that case is tough to prove until New Jersey’s relatively immature alternatives program experiences a bear market. For example, both hedge funds and the S&P 500 went red last month, but the S&P 500’s loss was actually a bit worse. And macro hedge fund managers actually had positive returns. Does that make up for years of the S&P 500 outperforming hedge? Likewise, should real estate performance receive an indirect bump from recent rises in venture capital performance, just because they are both “alternatives?”

Again, that’s a judgment call that should be based on voluminous data, rather than on knee-jerk anger that alternative money managers are getting paid while retiree benefits are getting cut. If alternative managers are helping to stem the severity of those cuts, then everyone wins. If not, then the state pension needs a change in policy. But, in either case, the specific alternative sub-asset classes should be analyzed on their own merits, rather than as one homogeneous bucket. Otherwise, critics may throw out the baby with the bathwater.

Read the entire column here.

Photo by 401kcalculator.org

Chart: How Kentucky’s Alternatives Allocation Compares To Other Funds

The Kentucky Retirement Systems, more than almost any pension fund in the country, allocates a significant chunk of its assets toward alternatives.

But how does KRS compare to other pensions funds in that area? Check out the chart above.

The data is from the Public Fund Survey, which polls 98 pension funds every year on a variety of topics, including asset allocation.

Only 4 funds in that 98 fund sample allocated a higher percentage of its assets toward alternatives than Kentucky.

Chart is courtesy of the Kentucky Center for Investigative Reporting.

Research Shows Pension Funds Are Biggest Owner of Alternatives Among Institutional Investors

New research from Towers Watson reveals that pension funds are the largest buyer of alternative investments among institutional investors (a designation that includes insurance companies, banks, endowments, etc.).

The research also details the rapid rise of alternatives as a major part of pension fund portfolios—globally, alternatives make up 18 percent of pension portfolios. That number has more than tripled since 1999, when pensions allocated 5 percent of assets toward alternatives.

From HedgeCo.net:

The research — which includes data on a diverse range of institutional investor types — shows that pension fund assets represent a third (33%) of the top 100 alternative managers’ assets, followed by wealth managers (18%), insurance companies (9%), sovereign wealth funds (6%), banks (3%), funds of funds (3%), and endowments and foundations (3%).

“Pension funds continue to search for new investment opportunities, and alternative assets have been an area where they have made, and continue to make, very significant allocations. While remaining an important investor for traditional alternative managers, pension funds are also at the forefront of investing in new alternatives, for example, in real assets and illiquid credit. But they are by no means the only type of institutional investor looking for capacity with the top alternative managers. Demand from insurers, endowments and foundations, and sovereign wealth funds is on the rise and only going to increase in the future as competition for returns remains fierce,” said [Towers Watson head of manager research Brad] Morrow.

[…]

“Pension funds globally continue to put their faith in diversity via increasing alternative assets to help deliver more reliable risk-adjusted returns at the total fund level. This is evidenced by the growth, significant in some instances, in all but one of the asset classes in the past five years. Most of the traditional alternative asset classes are no longer really viewed as alternatives, but just different ways of accessing long-term investment themes and risk premiums. As such, allocations to alternatives will almost certainly continue to increase in the long term but are more likely to be implemented directly via specialist managers rather than funds of funds, although funds of funds will also continue to attract assets, as borne out by this research,” said Morrow.

The research was part of the Global Alternatives Survey, an annual report produced by Towers Watson.

Major Pension Fund Backs London Mayor’s “Megafund” Idea

We covered yesterday the plan proposed by London Mayor Boris Johnson to merge the country’s 39,000 public sector pension plans into one scheme, which would invest in building and updating the UK’s roads, airports, railroads and other infrastructure.

Today, one of the UK’s largest pension funds has come out in support of the plan. From the Financial Times:

The £4.9bn London Pensions Fund Authority (LPFA) said it supported the London Mayor’s call for tens of thousands of public sector schemes to merge, with the money used for infrastructure investment.

[…]

“The overhead costs of running a large number of pension funds can run into billions of pounds,” said Edmund Truell, chairman of the LPFA.

“We have been trying to go direct with our investments and cut the layers of costs. I would consider it ‘job done’ if we were absorbed into a sovereign wealth fund.”

Pension investment advisers said it was far from perfect that so many small funds manage their investments individually but they would be concerned about the creation of one enormous fund.

“Many local authority funds are too small to be able to make individual investments in alternative assets or to have a bespoke liability-driven risk management strategy,” said Ros Altmann, a pensions expert.

“However, I would be concerned about too much concentration as well and would prefer to see a number of large funds, not just one or two.”

The Mayor originally proposed his plan in a weekend op-ed in the Telegraph, which can be read here.

Photo By Andrew Parsons/ i-Images

Chart: Asset Allocation Over Time and the Rise of Alternatives

Check out the fascinating graphic [above] detailing the different between alternatives allocations between 2006 and 2012. In six short years, alternative investments as a percentage of pension assets have doubled.

Now, compare that to the allocation of a public pension fund in 1980 [below].

Today, no pension system in its right mind would adhere to the allocations we saw in 1980, and for good reason. Still, it’s an interesting exercise to look back at how things have changed.

Patriot News: Are Hedge Funds Right For Pennsylvania?

Last week Pennsylvania’s auditor general publicly wondered whether hedge funds were a sound investment for the state’s “already stressed” pension systems.

The crux of the auditor’s concern was the millions in fees paid by the system. In an editorial Monday, the Patriot News also questioned the fees incurred by hedge fund investments – including the fees that the public doesn’t know about. From the Patriot News:

The Pennsylvania State Employees’ Retirement System (PSERS) paid about $149 million in fees to hedge funds in fiscal year 2013, according to WITF, the public broadcasting station.

The Philadelphia Inquirer has noted that “It’s hard to know how much Pennsylvania SERS paid, since some SERS hedge fund fees aren’t included in the agency’s annual report.”

WITF also noted that it’s not clear what the pension fund got after paying all that money, which is the point raised by Auditor General DePasquale.

[…]

Pennsylvania has been one of the most aggressive states investing in “alternative” vehicles like hedge funds. In 2012, The New York Times reported that Pennsylvania’s state employees pension fund had “more than 46 percent of its assets in riskier alternatives, including nearly 400 private equity, venture capital and real estate funds.”

Those investments cost Pennsylvania $1.35 billion in management fees in the previous five years, according to the Times report.

The editorial wondered whether the state was really getting what it paid for performance-wise. From the Patriot News:

During that time, it appears Pennsylvania paid more and got less than other states did.

Over the five-year period, Pennsylvania’s annual returns were 3.6 percent. During that time, the New York Times report said the typical public pension fund earned 4.9 percent a year. And Georgia, which was barred by law from investing in high-fee alternative funds, earned 5.3 percent a year.

Georgia’s fees were a lot lower, too. For a pension fund about half the size of Pennsylvania’s, it paid just $54 million in fees over the five years. Pennsylvania paid 25 times as much for results that were significantly worse.

Pennsylvania’s two big pension funds are tens of billions of dollars short of being able to pay all the money they’ll owe to retirees.

One has to wonder whether one reason is that the funds are spending too much money on supposedly sophisticated investments that aren’t worth the cost.

It’s a question the Legislature needs to answer.

SERS allocates 7 percent of its assets, or $1.9 billion, towards hedge funds. PSERS, meanwhile, allocates 12.5 percent of its assets, or $5.7 billion, towards hedge funds.

North Carolina Pension To Stick With Hedge Funds As Major Union Calls For Divestment

A few days after CalPERS pulled out of hedge funds, the State Employees Association of North Carolina (SEANC) called on North Carolina’s pension fund to do the same.

The pension fund, however, has shown no willingness to follow in CalPERS’ path, and recently doubled down on its support of hedge funds as part of its portfolio.

Originally, SEANC released this statement:

“Other institutional investors around the world could potentially follow CalPERS’ lead and finally dump these high-risk funds,” said SEANC Executive Director Dana Cope. “Those who wait to cash in may find the money’s gone. That’s not a risk state workers are willing to take. It’s time to pull out of these investments now before the cart starts going downhill too fast for us to jump off.”

Hedge funds are notorious for high fees. Pension funds and investors pay these fees in hopes that the payoff will be higher, but for the past decade, hedge fund performance has been lacking. Cowell has the power to invest of 35 percent of the $90 billion state retirement system in “alternative investments,” a term that includes hedge funds.

But North Carolina hasn’t budged, and pension officials have supported their hedge fund allocation. From the News & Observer:

Kevin SigRist, chief investment officer of North Carolina’s $90 billion fund, said that the state is by and large pleased with the performance of its hedge fund investments and plans to stay the course.

North Carolina’s hedge fund investments generated an 11.48 percent return for the fiscal year that ended June 30, as well as a three-year return of 6.86 percent and a five-year return of 7.59 percent. That 11.48 percent return bests the 7.1 percent return that CalPERS reported from its hedge fund portfolio and compares to the state’s 15.88 percent overall return for its latest fiscal year.

“We would expect to continue to evaluate (hedge funds) and use them where appropriate and where we think there are benefits to the trust fund,” SigRist said.

[…]

SigRist said that the fact that hedge fund investments cut across asset classes is at the heart of why North Carolina doesn’t disclose how much of its pension fund is allocated to hedge funds – a practice that has drawn SEANC’s ire. Although the pension fund has stipulated the allocation to hedge fund strategies, he added, that’s only a piece of the pie because it’s based on an antiquated concept of what a hedge fund is.

Currently, North Carolina’s pension system has $3.9 billion in hedge funds, or 4.3 percent of total assets. They paid $91 million in fees to those funds in 2013.

Report: Maryland Fund Lost Billions Due To Underperformance

The Maryland State and Retirement Pension System returned 14.4 percent last fiscal year – a return that the Chief Investment Officer praised as “strong” and that doubled the fund’s expected rate of return of 7.75 percent.

But a new report from the Maryland Public Policy Institute claims that the returns weren’t good enough From the Maryland Reporter:

In a report, Jeffrey Hooke and John Walters of the Maryland Public Policy Institute say the failure to match the 17.3% return on investment made by over half the public state pension funds cost the state over $1 billion. As they have in the past, they also complained about the high fees paid to outside managers of some of the funds used by the State Retirement and Pension System, which covers 244,000 active and retired state employees and teachers and their beneficiaries

“As the table shows, the underperformance trend is not only continuing but worsening as the percentage divide widens,” said Hooke and Walters. “Part of problem may be due to the fund’s large exposure to alternative investments, such as hedge funds and private equity funds, that have tended to perform worse in recent years than traditional investments such as publicly traded stocks and bonds.”

A spokesman for the Maryland pension fund offered his response to the report:

[Spokesman] Michael Golden said the institute’s report was “flawed,” “not supported by facts,” and mischaracterized the agency’s investment performance.

“These returns have resulted in greater progress toward full funding of the system that was projected last year,” Golden said. The five-year return on investment was 11.68%, while the target for the fund is 7.7%.

[…]

Golden admitted that Maryland’s investment performance is “unimpressive” compared to other state funds.

“However, the reason for this ranking is not due to active management and fees,” Golden said. “After the financial crises of 2008-2009, the board determined that the fund had too much exposure to public equities, which historically has been one of the riskiest, most volatile asset classes, and wanted a more balanced and diversified portfolio.”

See the chart at the top of this post for a comparison between the returns of Maryland’s pension fund versus the Wilshire’s Trust Universe Comparison Service (TUCS), a widely accepted benchmark for institutional assets.

Georgia Candidate Wants Pension Funds to Invest In Start-Ups

Jason Carter, Georgia’s Democratic candidate for governor, released his economic plan this month, and in it there’s an idea of particular interest to pensions: Carter wants to make it easier for the Teachers Retirement System of Georgia to invest in Georgia-based start-ups.

From the Atlanta Journal-Constitution:

The Democrat argues in his economic pivot that he wants teacher pensions to be able to pump funds into local startups “so long as we’re making sure that we can manage the risk in ways that make sense.” He sees it as a way to boost a state-backed effort to invest in venture capital firms that, as you’ll see in today’s AJC, has lagged.

“The things that concern the teachers is to make sure you’re stewarding the pension appropriately. So it’s crucial to make sure that we are managing the risk in ways that works,” he said. “But we shouldn’t have those pension funds losing out on higher growths and higher returns just because of artificial caps on what it can do.”

Georgia lawmakers cleared the way for pension funds to invest up to 5 percent of their assets in alternative investments, such as venture capital firms, that had at least $100 million on the books. But the law excluded the Teachers Retirement System of Georgia, the state’s largest public pension with nearly $59 billion in assets.

North Carolina and other nearby states allow their teachers’ fund to invest in startups, but Gov. Nathan Deal and other Republicans have raised red flags. Lawmakers signaled they were reluctant to include the teachers fund in the 2012 legislation because the group’s board hadn’t approved the changes.

Critics are wary of the risk attached to investing in unproven companies. Other critics say it would open the door for cronyism and make pension investments increasingly political.

A 2012 state law enabled most Georgia pension funds to invest in alternatives for the first time. But the law prohibits alternatives from making up more than 5 percent of total assets.

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