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

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.

CalPERS Responds To Criticism Of Plan To Boost Pensions

CalPERS is holding a hearing today seeking public comment on a set of potential rules that would open the door for many workers to increase their pensions.

The rules would introduce 98 new forms of “pensionable compensation”, or income that is counted when calculating a worker’s ultimate pension benefit.

But many interested parties didn’t wait until the hearing to voice their opinions. California Gov. Jerry Brown was among the first to voice his displeasure at the potential rules, as they contradict certain sections of the reform law he passed in 2012.

“This disregards the rule that pensions will be based on normal monthly pay and not on short-term, ad hoc pay increases,” Brown wrote in a letter to the CalPERS board. “I urge the board to vote against these regulations and instead request a new draft that excludes temporary pay upgrades from employee pension calculations.”

Other big players weighed in as well. Jon Ortiz writes:

Public pension-change advocates, including Democratic San Jose Mayor Chuck Reed, say the proposal is another sign that the union-dominated CalPERS board “is doing what they can to resist reforms. … They’re in favor of anything that expands benefits.”

Elk Grove City Manager Laura Gill said including temporary upgrade pay “really does invite spiking” and threatens to erode savings from pension changes the Sacramento suburb has enacted the past couple of years, such as city employees paying their share of pension costs.

If such practices became standard, “it would put us backward from all the work we’ve done to have a sustainable and sound pension system,” Gill said.

Unions responded as well, but they were receptive to CalPERS’ plan. From the Sacramento Bee:

Mike Durant, president of the union-backed Peace Officers Research Association of California, dismissed those kinds of concerns. If a city or the state needs pension relief, he said, “they can bargain it.”

Instead, he said, government employers expect CalPERS to save them from themselves.

“They want to put it on the backs of someone else to make those decisions rather than making it themselves,” he said.

You can bet CalPERS is listening to all this. And the pension fund responded to the criticisms in a statement sent out to numerous newspapers, including the Daily Bulletin:

CalPERS has approached this issue with full transparency and sought stakeholder input along the way, including employee and employer feedback. The purpose of the public hearing is to seek even greater input on what compensation should and should not be counted toward pensions.

While reasonable people may disagree about what aspects of a public servant’s compensation should count toward a pension, an editorial should stick to the facts and not try to inflame readers with inaccurate terms like pension spiking. Pay for a service is still compensation at the end of the day. Our staff made a recommendation based on a good-faith interpretation of the law. If changes need to be made, we welcome the public’s input.

CalPERS is holding a hearing today to gather the public’s comments on the proposed rules. Once the hearing is wrapped up, the full CalPERS board will vote on the rules, likely on Wednesday.

CalPERS Is Proposing 98 Ways To Boost Member Pensions

CalPERS is drafting new regulation that could boost worker pensions, but critics say the rules would fly in the face of much of Gov. Jerry Brown’s 2012 reform efforts. CalPERS is holding a public hearing on the issue tomorrow (Tuesday August 19) to seek the public’s feedback.

The new regulations could increase pension benefits for many workers by adding 98 new types of “pensionable compensation”—or, in other words, types of pay that can be counted toward pension benefits.

For example, workers would receive pension boosts for holding various professional certifications, for being bilingual or for working at the same job for a long period of time.

[Read the full list of types of pensionable compensation at the bottom of this post].

From a CalPERS press release:

The proposed new regulation is intended to clarify the types of pensionable compensation items that state, public agencies, and school employers report to CalPERS as part of a new member’s retirement benefit. The most common items excluded as pensionable for new PEPRA members are bonuses, uniform allowance, and any ad hoc payments. Members who were hired on or after January 1, 2013 are considered new members under PEPRA.

Compensation that is reportable for classic members is unaffected under the new regulation.

One category of pensionable compensation would be Incentive Pay.

A few other interesting special pay items:

As the CalPERS released indicates, these changes would only apply to new hires. But critics say the new rules would directly undermine California 2012 pension reforms, which also only dealt with new hires. From a LA Daily News editorial:

At issue is what counts as income on which pensions are calculated. The 2012 law was clear: Pensions for new employees should be based on their “normal monthly rate of pay or base pay.” Whereas current employees can boost their pension calculations by also including “special compensation” for “special skills, knowledge, abilities, work assignment, workdays or hours, or other work conditions,” the Legislature didn’t include those sorts of extra pay items for new employees.

The hearing over the draft regulations will be held on Tuesday at 9:30 am pacific time.

It will also be live-streamed at www.calpers.ca.gov.

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San Diego Pension Fund Pays “Big” Price For Big Office Space

One of California’s largest city pension funds is not only paying a “big” sum for its huge, high-end office space—it’s also locked into a long lease.

An investigation by a ABC10 found that the San Diego City Employees’ Retirement System is locked into a 10 year lease for the office space it rents, and the System will pay over $10 million in rent over that period. From ABC10:

The San Diego City Employees’ Retirement System manages a $7 billion fund. A review of office leases by Team 10 found SDCERS will spend $10.1 million renting office space at 401 West A Street in downtown San Diego. The lease is for 26,000 square feet over 10 years, and an SDCERS spokeswoman said 58 employees use the space — which breaks down to roughly 450 square feet per employee.

“I have to wonder why more than 20,000 square feet. Forget whether you own or lease it. Why that big a space?” real estate appraiser and San Diego State University lecturer Dana Kahn asked after reviewing the SDCERS lease.

Those numbers fall roughly in line with what SDCERS has reported publicly for years; according to its latest financial report, the System spent $998,000 on rent in 2013.

The investigation also looked into office space rented by the California Public Employees Retirement System.

CalPERS—the nation’s largest public fund—has eight offices around the state, although its staff is much larger than that of SDCERS.

CalPERS is a bit more secretive about its rental costs, as its financial reports don’t specifically disclose the cost of rent for its offices.

Its latest financial report does disclose that the System pays $3,789,000 for “facilities operations”, which may include rent as well as utility costs associated with its office spaces.

ABC10 managed to get a hold of SDCERS’ spokesperson over email, and she answered a few questions.

1. Why did SDCERS choose to rent office space?

SDCERS has been renting office space for many years. We’ve been in the current locating for the past seven, and then rented space in other downtown office building locations for many years before that.

2. Did SDCERS considering buying space?

No. The only investments in real estate done by SDCERS are as part of the fund’s real estate holdings in our investments portfolio.

3. How many employees work in the office?

There are 58 budgeted staff positions at SDCERS.

4. How much of SDCERS portfolio consists of real estate?

Real estate holdings in our investments portfolio account for 9.1 percent of the fund, or approximately $630 million.

5. Who negotiated the lease?

The original lease for SDCERS’ space at 401 West A Street was signed in April 2007. Signing for SDCERS were its then CEO and Board President. SDCERS was assisted in finding space by broker Irving Hughes. The first amendment to the current lease was signed in October 2013, again by its current CEO and Board President. SDCERS was assisted in negotiating the amendment by broker Hughes Marino.

Photo by Justin Brown via Flickr CC License

VP of CalPERS Board Faces Repeated Discipline from State Ethics Panel

Priya Mathur is the Vice President of the CalPERS Board of Administration, and she is currently seeking re-election to serve a fourth term on the Board. Her tenure requires her to submit semi-annual campaign financial statements and statements of economic interest.

But the Fair Political Practices Commission (FPPC), California’s political watchdog agency, says Mathur failed to submit her campaign financial statements in a timely manner four separate times in 2012 and 2013.

And it’s not the first time Mathur has failed to turn in required documentation in a timely manner—the FPPC has fined Mathur three times in the past for similar offenses after she failed to submit statements on time in 2002, 2007, 2008 and 2010. From the LA Times:

This is not Mathur’s first run-in with the ethics panel. The commission has taken enforcement actions against Mathur three other times in the last nine years, fining her a total of $13,000.

The fines could become an issue in her current reelection campaign, with mail-in balloting running from Aug. 29 to September 29.

“I find it interesting that she feels she doesn’t have to comply with these standards,” said Mathur’s opponent, Leyne Milstein, the finance director of the city of Sacramento. “We all need to be held accountable if we want to represent the public.”

The fine and settlement agreement follow a series of filing lapses by Mathur that were investigated and prosecuted. The commission fined her $3,000 in April 2010, and $4,000 in May of that year for failing to file on time legally required statements of economic interest for 2007 and 2008.

As a result, Mathur’s board colleagues punished her by stripping her of a chairmanship of the health committee and temporarily suspending her travel privileges. However, they subsequently voted to make her vice president of the board.

In 2006, Mathur paid a $6,000 fine for not properly filing financial documents after her initial 2002 election to the CalPERS board.

The FPPC is expected to formally approve the charges against Mathur at its next meeting on August 21. Mathur is not disputing the charges.

Gary Winuk, the FPPC’s chief of enforcement, had this to say:

“Failing to file a campaign statement is a serious violation of the Act because it deprives the public of important information about a candidate’s financial activities,” he told the LA Times.

Photo by Blake O’Brien via Flickr CC License

Survey: Pensions Funds Will Continue To Increase Alternative Investments

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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.

Could Climate Change Deplete Your Pension?

If oil, gas and coal companies were to face serious financial difficulty, the average person might anticipate the annoyance of a higher heating bill, or having to cough up more cash to fill up at the gas station.

They probably don’t think about their pension—but maybe they should.

Earlier this year, members of the British Parliament sent out a clear warning to the Bank of England and the country’s pension funds: watch out for the carbon bubble.

The “carbon bubble”? Here’s a quick explanation from the Guardian:

The idea of a carbon bubble – meaning that the true costs of carbon dioxide in intensifying climate change are not taken into account in a company’s stock market valuation – has been gaining currency in recent years, but this is the first time that MPs have addressed the question head-on.

Much of the world’s fossil fuel resource will have to be left unburned if the world is to avoid dangerous levels of global warming, the environmental audit committee warned.

To many, it probably sounds like a silly term. But its potential implications are serious enough that many in the UK are starting to worry about its effect on the global economy, and that includes pension funds—UK pension funds are particularly exposed to fossil fuel-based assets, as some estimates say 20 to 30 percent of the funds’ assets are allocated toward investments that would be seriously harmed by the burst of the “carbon bubble”.

But some experts say pension funds in the US should be worrying about this, too, because it’s a global issue. From The Ecologist:

If the impetus to prevent further climate change reaches the point where measures such as a global carbon tax are agreed, for example, then those fossil fuel reserves that have contributed to the heady share price performance of oil, gas and coal companies will become ‘unburnable’ or ‘stranded’ in the ground.

But even if we continue business as usual, value could begin to unravel.

Because to continue with business as usual would require an ever increasing amount of capital expenditure by the industry to explore territories previously off limits – the Arctic, for example and the Canadian Tar Sands – tapping these new resources, quite apart from being a bad idea environmentally, is hugely expensive.

Dividends – the payments earned by shareholders as a reward for keeping their shares, have come under increasing pressure as companies have had to spend their money on more exploratory drilling rather than rewarding shareholders.

So some shareholders are already feeling the impact and rather than see their dividends further eroded, might prefer to sell their shares in favour of a more rewarding dividend stock.

Some don’t have the stomach for all those hypotheticals. But it’s hard to deny the policy shifts in recent years leading us towards a lower-carbon world. That includes regulation in the US, Europe and China that cuts down emissions and encourages clean energy.

That trend doesn’t look to be reversing itself in the near future, and those policies are most likely to hurt the industries most reliant on fossil fuels.

There’ve been calls in the US for public pension funds to decrease their exposure to those industries. From the Financial Times:

US pension funds have ignored calls from city councils and mayors to divest from carbon-intensive companies, despite concern about the long-term viability of their business models.

At least 25 cities in the US have passed resolutions calling on pension fund boards to divest from fossil fuel holdings, according to figures from 350.org, a group that campaigns for investors to ditch their fossil fuel stocks.

Three Californian cities, Richmond, Berkeley and Oakland, urged Calpers, one of the largest US pension schemes, with $288bn of assets, and which manages their funds, to divest from fossil fuels. Calpers has ignored their request.

Calpers said: “The issue has been brought to our attention. [We] believe engagement is the best course of action.”

Pension fund experts point out that it is difficult to pull out of illiquid fossil fuel investments, or carbon intensive stocks that are undervalued, provide stable dividends or are better positioned for legislative change.

CalPERS isn’t the only fund that doesn’t want to divest. Not a single public fund has commited to divesting from carbon-reliant companies.

To some, CalPERS’ policy of “engagement” rather than divestment probably sounds like a cop-out. But some experts think the policy could be effective.

“With divestment you are not solving the problem necessarily, you are just not part of it.” Said George Serafeim, associate professor of business administration at Harvard Business School. “With engagement you are trying to solve the problem by engaging with companies to improve their energy efficiency, but you are still part of the mix.”

Photo: Paul Falardeau via Flickr CC License

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

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.

(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 Rescinds $700 Million Investment With Private Equity Fund Headed By Doctor With No Private Equity Experience

You probably trust your doctor with your life. But with your money? Many people might balk at the notion of their doctor making their investment decisions for them.

But back in 2007, CalPERS made a big bet: a $705 million investment in a private equity fund, Health Evolution Partners Inc., specializing in health care companies.

The CEO of the fund, David Brailer, is a nationally renowned physician who had previously been the “health czar” under George W. Bush. But this was his first foray into the investment space, and he had no experience running an investment fund or making private equity investments.

Still, he reportedly promised the CalPERS board healthy returns in excess of 20 percent.

But through seven years, the fund has never managed to exceed single-digit returns. And portions of CalPERS’ investment have actually experienced negative returns.

That has led CalPERS to cut ties with the fund, according to Pensions & Investments:

CalPERS is ending its unique experiment as the sole limited partner of Health Evolution Partners Inc., a private equity firm that focuses on health-care companies.

…

CalPERS data show the HEP Growth Fund had an internal rate of return of 6.5% from its inception in mid-2009 through Dec. 31, 2013. By contrast, the $5.3 billion growth fund portion of CalPERS’ private equity portfolio returned 12.72% for the five years ended Dec. 31, the closest comparison that could be made with the data the pension fund made available.

The HEP fund of funds has had more serious performance problems. Its IRR from inception in 2007 through Dec. 31, 2013 was -5.2%, show CalPERS statistics. CalPERS also wants out of that investment, but sources say a complicated fund-of-fund structure may make that difficult.

Mr. Desrochers would not comment on HEP, telling a Pensions & Investments reporter the matter was too sensitive to discuss.

CalPERS spokesman Joe DeAnda, in an e-mail, said, “We continue to evaluate all options relating to Health Evolution Partners.”

Mr. Brailer did not return several phone calls.

CalPERS paid the fund over $18 million in fees in the fiscal year 2011-12, according to the System’s financial report.

Meanwhile, CalPERS is gearing up for another large investment partnership, to the tune of $500 million, that will focus on infrastructure investments. FTSE Global Markets reports:

The California Public Employees’ Retirement System (CalPERS) today announced a new $500m global infrastructure partnership with UBS Global Asset Management.

CalPERS, the largest public pension fund in the US, will contribute $485m to the newly formed company, while UBS will contribute $15m and act as managing member.

The partnership will operate as Golden State Matterhorn, LLC and is set to pursue infrastructure investment opportunities in the US and global developed markets.

“UBS brings extensive experience and a proven track record in global infrastructure investing that makes them a great fit for this partnership,” says Ted Eliopoulos, CalPERS Interim Chief Investment Officer. “We’re excited to work with them as we identify and acquire core assets that will provide the best risk-adjusted returns for our portfolio.”

The CalPERS Infrastructure Program seeks to provide stable, risk-adjusted returns to the total fund by investing in public and private infrastructure, primarily within the transportation, power, energy, and water sectors.

Infrastructure investments returned 22.8% during the 2013-14 fiscal year and 23.3% over the past five years, outperforming the benchmark by 17.23 and 16.6 percentage points, respectively.

CalPERS holds about $1.8 billion in infrastructure assets.

Photo by hobvias sudoneighm via Flickr CC License

Video: The Evolution of Allocating to Hedge Funds

Bloomberg TV sat down with Agecroft Partners founder Don Steinbrugge to talk about pension fund investments in hedge funds and what it means for both sides.

Other topics touched: hedge funds facing the reality of having to settle for less fees and more transparency to play ball with pension funds, and paying pension fund staff market rates. Watch the video here:

Pension360 has also covered the recent counter-evolution of hedge fund allocation, a trend in which many pension funds across the country are pulling back their hedge fund investments.

CalPERS, for instance, plans to pull back 40 percent of their hedge fund investments in the near future.

Photo by Simon Cunningham via Flickr CC License

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