As Some Pension Funds Phase Out Hedge Funds, Others Phase Them In

11746440113_d1f0f5d333_z

There were big headlines earlier this month when CalPERS announced its decision to chop its hedge fund allocation by 40 percent. The news was big not just because it was CalPERS, but because the decision followed in the wake of similar decisions made by smaller funds around the country.

The Los Angeles Fire & Police Pension System might not be a mammoth like CalPERS, but it was still a big deal when the $18 billion fund decided to phase out hedge funds entirely. The fund says it will save around $13 million in fees annually as a result of the decision, which re-allocated $550 million from hedge funds into other asset classes.

“We need to show that we are willing to walk away from managers that are charging us exorbitant fees,” Emanuel Pleitez said in a video interview with Pensions & Investments.

But it’s not just fees. Past experiences inform future investments, so when the Louisiana Firefighters Pension Fund drastically chopped its hedge fund allocation, it was hard to blame them.

That’s because the Firefighters Fund in 2008 had made a $15 million investment in Fletcher International Ltd, a Cayman Islands-based hedge fund.

Sometime in 2012, Fletcher stopped picking up their phone. The Firefighters later found out that was because Fletcher had gone bankrupt. Just like that, they’d lost 100 percent of their $15 million investment.

As a result, the Firefighters Fund reduced its hedge fund investments by nearly 90 percent. Now, only 0.6 percent of the fund’s assets are dedicated to hedge funds, according to Pensions & Investments.

Anecdotal evidence aside, there’s very little indication the movement away from hedge funds is a larger trend.

In fact, if there is a trend, it may be moving towards more hedge fund investments, not fewer. Sticking with anecdotes for a moment, Pensions & Investments reports that a handful full of pension funds are looking to make their first foray into hedge funds:

Among recent first-time hedge fund investors and searchers:

-Illinois State Universities Retirement System, Champaign, will soon begin a search for either hedge fund or fund-of-funds managers for a new 5% allocation for the $16.9 billion defined benefit plan it oversees;

-The $5.1 billion City of Milwaukee Employes’ Retirement System hired Allianz Global Investors to manage $62.5 million in an absolute-return strategy in July;

-The $1.1 billion St. Paul (Minn.) Teachers’ Retirement Fund Association hired EnTrust Capital Management LP to manage $55 million in a customized hedge fund-of-funds separate account in May.

A recent survey revealed that institutional investors are planning on increasing their alternative allocations by 5 percent annually, as opposed to 1 or 2 percent for traditional investments.

McKinsey, the firm behind the survey, said the prevailing sentiment among respondents was that the bull market won’t last forever. But pension funds’ assumed annual rates of return—which usually sit between 7 and 8 percent—won’t change anytime soon.

It’s for precisely that reason that institutional investors are turning to hedge funds, writes McKinsey & Co:

“With many defined-benefit pension plans assuming, for actuarial and financial reporting purposes, rates of return in the range of 7 to 8% — well above actual return expectations for a typical portfolio of traditional equity and fixed-income assets — plan sponsors are being forced to place their faith in higher-yielding alternatives.”

That doesn’t necessarily translate to investing with hedge funds. But often, it does.

And it’s not just about chasing high returns, the report said:

“Gone are the days when the primary attraction of hedge funds was the prospect of high-octane performance, often achieved through concentrated, high-stakes investments. Shaken by the global financial crisis and the extended period of market volatility and macroeconomic uncertainty that followed, investors are now seeking consistent, risk-adjusted returns that are uncorrelated to the market.”

Only time, and piles of financial reports, will reveal which direction the trend ultimately goes.

Survey: Pensions Funds Will Continue To Increase Alternative Investments

[iframe src=”<iframe height=”298″ src=”http://player.theplatform.com/p/gZWlPC/vcps_inline?byGuid=3000300479&amp;size=530_298″ width=”530″></iframe>”]

 

Often, media narratives don’t properly reflect the reality of a situation.

For example, news has been breaking over the past few weeks of pension funds decreasing their exposure to hedge funds and alternatives. That includes CalPERS, who plan to chop their hedge fund investments dramatically. The reason: high fees associated with those investments are eating into returns.

But according to a new report, pension funds are planning to increase their allocations toward alternatives, more than any other asset class, for years to come.

Consulting firm McKinsey & Co. surveyed 300 institutional investors about their future plans investing in alternatives. (McKinsey defines “alternatives” as hedge funds, funds of funds, private-equity funds, real estate, commodities and infrastructure investments.)

As for the question of whether funds will continue to invest in alternatives, the answer was a resounding yes: the respondents indicated they would like to increase their exposure to alternatives by 5 percent annually.

The reportnotes that pension funds believe their traditional investments, which have been garnering great returns as the bull market saunters on, run the risk of not meeting actuarial return assumptions in the medium-term, or when the market comes down off its high. At that point, pension funds want to be invested in higher-yielding instruments to meet return assumptions. From CFO Magazine:

McKinsey suggests that the bull market, now more than five years old, can’t be expected to continue indefinitely. Indeed, the report says institutional investors that manage money for pension plans are moving more money into alternatives out of “desperation.”

“With many defined-benefit pension plans assuming, for actuarial and financial reporting purposes, rates of return in the range of 7 to 8% — well above actual return expectations for a typical portfolio of traditional equity and fixed-income assets — plan sponsors are being forced to place their faith in higher-yielding alternatives,” McKinsey writes.

But, the consulting firm notes, the rapid growth of alternatives is not simply the result of investors chasing high returns. “Gone are the days when the primary attraction of hedge funds was the prospect of high-octane performance, often achieved through concentrated, high-stakes investments. Shaken by the global financial crisis and the extended period of market volatility and macroeconomic uncertainty that followed, investors are now seeking consistent, risk-adjusted returns that are uncorrelated to the market.”

The Los Angeles Fire and Police Pensions fund is at least one fund going against the grain here: it recently took 100 percent of its money out of hedge fund investments.

Six Years Later, Warren Buffett Is Winning His Bet Against Hedge Funds

at the Fortune Most Powerful Women Summit in Laguna Niguel, CA.

In 2008, Warren Buffett made a $1 million wager with alternatives firm Protégé Partners. The money came from Buffet’s own pocket, not Berkshire’s. Around the country, the ears of pension funds began perking up in anticipation. The bet:

Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.

In other words, Buffett bet that, taking into account investment expenses, an index fund would outperform a fund of hedge funds over a ten-year period. The thinking is in line with what Buffet has publicly said in the past. And, six years later, Buffett is winning his bet.

Screen-shot-2014-08-01-at-10.07.33-AM

(The winner of the bet, by the way, will donate the money to a charity of his choice).

This bet is of particular interest to pension funds because alternative asset classes have increasingly become part of their investment portfolios. Regardless of who wins the bet, however, the results will be largely symbolic.

But the over-arching philosophies behind the wager are still interesting to examine. For Buffett, his dislike of hedge funds comes down to fees.

Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.

A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.

On the other end, Protégé Partners defends hedge funds:

Mr. Buffett is correct in his assertion that, on average, active management in a narrowly defined universe like the S&P 500 is destined to underperform market indexes. That is a well-established fact in the context of traditional long-only investment management. But applying the same argument to hedge funds is a bit of an apples-to-oranges comparison.

Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional “relative-return” investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.

Pension360 has covered the emerging trend of pension funds, including CalPERS, reducing their investments in hedge funds.

 

Photo by Fortune Live Media via Flickr CC

CalPERS To Pull Back 40% of Hedge Fund Investments

640px-Road_Sign_Welcome_to_California

There is a growing desire by funds around the country to avoid large investment fees, and that trend has led many funds to reduce their investments in hedge funds. Now, CalPERS has hopped on that train. From MarketWatch:

[CalPERS’] hedge-fund investment is expected to drop this year by 40%, to $3 billion, amid a review of that part of the portfolio, said a person familiar with the changes. A spokesman declined to comment on the size of the reduction but said the fund is taking more of a “back-to-basics approach” with its holdings.

CalPERS’ decision comes on the heels of a similar move by the Los Angeles Fire and Police Pensions fund. The difference is, the LA fund separated itself from hedge funds altogether. From MarketWatch:

The officials overseeing pensions for Los Angeles’s fire and police employees decided last year to get out of hedge funds altogether after an investment of $500 million produced a return of less than 2% over seven years, according to Los Angeles Fire and Police Pensions General Manager Ray Ciranna. The hedge-fund investment was just 4% of the pension’s total portfolio and yet $15 million a year in fees went to hedge-fund managers, 17% of all fees paid by the fund.

The HFRI Fund Weighted Composite Index, which measured hedge fund performance, indicated hedge funds returned 3.2 percent in the first six months of 2013, compared to a 7.1 return for the S&P 500 index.