diversified portfolio

Chart: The Rise of Hedge Funds In Pension Portfolios

In recent years, hedge funds have solidified themselves as a big part of pension portfolios by two measures:

1) More pension funds than ever are investing in hedge funds

2) Those pensions are allocating more money towards hedge funds than ever before

That bears itself out in the above graphic, and this next one:

A recent Preqin report had this to say about the numbers:

“There are more US public pension funds than ever before allocating capital to hedge funds, and these investors are investing the most they ever have in the asset class. Public pension funds have increasingly recognized the value of hedge funds as part of a diversified portfolio, and although CalPERS’ withdrawal from the asset class will spark some investors to look more closely at their current allocation model, the importance of hedge funds as a source of risk-adjusted returns for these investors is likely to continue to prove attractive for US retirement schemes.

Preqin’s recent research highlights that investors are not using hedge funds to produce outsized returns, but instead to produce uncorrelated, risk-adjusted returns. Over short and longer time frames, hedge funds have in general met investor needs for risk-adjusted returns. However 2014 has been a period of relatively turbulent returns when looking at Preqin’s monthly benchmarks; in times like this, investor calls for changes in fee structures and better alignment of interests become more vocal, and this clearly has had an impact on CalPERS’ decision.”

Chart Credit: Preqin

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.

Pennsylvania Pension Chairman Defends Hedge Funds; Says “Strategy Is Working”

Pennsylvania’s top auditor has publicly wondered whether Pennsylvania’s State Employees Retirement System (SERS) should be investing in hedge funds.

SERS has released formal statements defending their investment strategy, which currently allocates 6.2 percent of assets toward hedge funds.

But today, we got the pension fund’s most in-depth defense yet of the asset class.

Glenn E. Becker, chairman of the SERS Board, wrote a letter to the editor of the Patriot News which was published today in the paper. The letter, in full, reads:

I feel it is important to correct the record and explain how our hedge fund exposure has been working for the state’s taxpayers.

Industry experts generally agree that while hedge funds are not for every pension system, the unique needs of each system must shape their individual asset allocation and strategic investment plans. Therefore, the actions taken by one system may not be appropriate for all systems. Investors need to consider many factors including their assets, liabilities, funding history, cash flow needs, and risk profile.

Our current plan was designed to structure a well-diversified portfolio to meet the needs of a system that is currently underfunded, steadily maturing (has more retirees than active members) and, in the near term, will receive employer contributions below the actuarially required rate.

Those unique characteristics mean we need liquidity, low cash flow volatility, and capital protection. We must plan to pay approximately $250 million in benefits every month for the next 80-plus years. We continuously monitor fund performance, the markets and cash flows for any needed plan adjustments. At this time, our plan uses hedge funds as an integral component of a well-diversified portfolio that is expected to provide risk-adjusted returns over all types of markets.

To date, the strategy has been working. As of June 30, 2014, our diversifying assets portfolio, or hedge funds, made up approximately 6.2 percent of the total $28 billion fund, or approximately $1.7 billion. In 2013, that portfolio earned 11.2 percent or $197 million, after deducting fees of $14.8 million, while dampening the volatility of the fund. That performance helped the total fund earn 13.6 percent net of fees in 2013, adding more than $1.6 billion to the fund.

Certainly, caution is warranted when examining one short period given SERS’ long-term liabilities. Over the long term, as of December 31, 2013, the total fund returned an annualized, net of fees return of 7.4 percent over 10 years, 8.4 percent over 20 years and 9.7 percent over 30 years.

Over the past 10 years, more than 75 percent of the funds’ assets have come from investments. In terms of making up for the past underfunding, that is money that doesn’t have to come from the taxpayers.