Professor: Pension Funds Need To Rethink Manager Selection

Wall Street

A few hours after news broke of CalPERS cutting ties with hedge funds entirely, one anonymous hedge fund manager opined: “I think it’s not hedge funds as an asset class [that are underperforming]. It’s the ones they invest in.”

But was it really manager selection that was the root cause of CalPERS’ disappointment with hedge funds?   Dr. Linus Wilson, a professor of finance at the University of Louisiana, thinks so.

Particularly, he thinks pension funds are ignoring data that suggests newer, smaller managers perform better than the older, larger hedge funds that pension funds typically prefer. He writes:

CalPERS and other institutional investors such as pensions, endowments, and sovereign wealth funds have ignored the wealth of data suggesting that their manager selection criteria is fatally flawed. Hedge Fund Intelligence estimates that on average hedge funds have returned 3.7% year to date. Yet the S&P 500 (NYSEARCA:SPY) has returned over 8% over that period.

Most institutions and their consultants implicitly or explicitly limit their manager selection criteria to hedge funds with a multi-year track record (three years or more) and assets under management in excess of $250 million. The AUM screen is probably higher; $1 billion or more. Unfortunately, all the evidence shows that choosing hedge funds with long track records and big AUM is exactly the way to be rewarded sub-par returns.

A recent study by eVestment found that the best absolute and risk-adjusted returns came from young (10 to 23 months of performance) and small (AUM of less than $250 million) hedge funds. My anecdotal evidence is consistent with this fact. My young and small fund, Oxriver Captial, organized under the new JOBS Act regulations, is outperforming the bigger more established funds.

More data on the performance of newer hedge funds:

One study eventually published in the top-tier academic journal, the Journal of Financial Economics, found that, for every year a hedge fund is open, its performance declines by 0.42%. The implication is that hedge fund investors should be gravitating to the new managers if they want high returns. Yet another study by Prequin found that even when established managers launch new funds, those funds underperform launches by new managers.

The Prequin study found that managers with three years or less of track record outperformed older managers in all but one of seven strategy category. The median strategy had the new managers beating the older ones by 1.92% per annum. Yet, that same study found that almost half of institutional investors would not consider investing in a manager with less than three years of returns.

Pension funds have repeatedly justified forays into hedge funds by pointing out the potential for big returns, as well as the portfolio diversification hedge funds offer.

Dr. Wilson doesn’t deny those points. But to truly take advantage of hedge funds, he says, pension funds need to rethink their approach to manager selection. That means investments in smaller, newer hedge funds.