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Fitch: Hedge Funds Will Continue “Winning and Keeping” Public Pensions Assets

Fitch Ratings predicts that, despite several high-profile exits by pension funds this year, hedge funds will continue to count public pension funds as major investors.

The ratings agency says exits by funds like CalPERS are “not representative of broader sector trends” and says it believes hedge funds still “deliver competitive returns net of fees, while providing a degree of downside protection and uncorrelated return during periods of stress”.

From Fitch:

Recent decisions by two large US public pension plans to pull back from hedge fund investments, and the likelihood of a sixth consecutive calendar year of return averages underperforming broad equity market returns, are not expected to curb investors’ overall allocations to hedge funds, according to Fitch Ratings.

Barring an unforeseen major market decline, hedge fund assets under management (AUM) should continue on a path toward $3.0 trillion, good growth relative to 2013’s year-end level of $2.6 trillion. The rise is attributable to market appreciation and inflows outpacing redemptions. The AUM flows show significant variation by strategy, with equity-oriented funds attracting more capital in recent periods, but global macro funds falling from favor.

While hedge fund growth has certainly slowed over the past several years, the high-profile pension plan withdrawals seen over the past six weeks are not representative of broader sector trends, in our view.

The Fitch report backs its conclusions with data from several studies conducted this year:

Fitch points to analysis recently compiled by Preqin as an indicator of the progress that hedge funds have made in winning and keeping US public pension assets more broadly. The data generally shows improvements in hedge fund investment allocations by public pensions since 2010. As of June 2014, 269 public pensions in the US made allocations to hedge funds, with an average of about 8.6% of their total AUM allocated to hedge funds.

[…]

Over the past decade and a half, hedge funds have delivered steadier performance relative to the overall market during bear markets, as was seen in 2000 to 2002 and in 2008. This downside protection, however, comes at the expense of limited upside during bull markets, a trend seen in 2003, 2009 and especially 2013.

According to Hedge Fund Research, hedge fund performance averages are set to be nearer to the broad equity market measures in 2014. However, trailing 36- and 48-month annual return levels generally range around low single-digit percentages, which paint the entire sector as under delivering relative to broader equity index benchmarks.

Read the full Fitch release here.

San Francisco Pension Not Expected to Approve Hedge Fund Proposal, But Alternate Plan Could Pass

Trustees of the San Francisco Employees’ Retirement System will vote sometime in the next few weeks on a proposal to invest up to 15 percent of assets – or $3 billion – in hedge funds.

The vote has been proposed and tabled nearly half a dozen times since May.

According to reporting by Pensions & Investments, the proposal isn’t expected to pass a vote – although a toned-down version, where hedge fund investments are capped at 5 percent of assets, has a better chance at passing.

From Pensions & Investments:

The board of the San Francisco City & County Employees’ Retirement System is expected to reject Chief Investment Officer William Coaker’s plan for a 15% allocation to hedge funds at a meeting in the next several weeks and instead limit hedge funds to no more than 5% of the portfolio, sources say.

The board had been scheduled to vote on the hedge fund allocation at a special meeting scheduled for Wednesday.

Board President Victor Makras said in an interview that a new special meeting will be held in the next few weeks. He said he will schedule the meeting as soon as he can poll members for a suitable date.

He said the Nov. 5 meeting was canceled because several board members were traveling out of the country.

The board is also expected, as part of the hedge fund vote, to bar or severely limit the use of leverage by hedge fund managers, a common tactic used by such mangers to increase returns.

Mr. Coaker’s plan would shift assets from fixed income and equities to create the new hedge fund allocation.

If the “15 percent” plan passes, the following allocation changes would occur elsewhere in the fund’s portfolio, according to SFGate:

U.S. and foreign stocks would drop to 35 percent from 47 percent of assets. Bonds and other fixed-income would fall to 15 percent from 25 percent. Real estate would rise to 17 percent from 12 percent. Private equity would rise to 18 percent from 16 percent. And hedge funds would go to 15 percent from zero.

The San Francisco Employees’ Retirement System currently does not invest in hedge funds. It manages $20 billion in assets.

San Francisco Pension To Vote Again On Hedge Funds

The San Francisco Employees’ Retirement System is once again weighing whether to begin investing in hedge funds.

Last Spring, the fund formulated a plan to invest up to 15 percent of its assets, or $3 billion, in hedge funds. But the vote has been tabled three times since then.

This week, the fund will vote again on the issue.

From SFGate.com:

The board of the San Francisco Employees’ Retirement System is scheduled to vote Wednesday on a controversial proposal to invest $3 billion — 15 percent of its assets — in hedge funds. The system, which manages $20 billion in pension money on behalf of about 50,000 active and former city employees, has no hedge funds today.

[…]

A 15 percent allocation would definitely have an impact on the San Francisco pension fund. William Coaker Jr., who joined the system Jan. 30 as chief investment officer, wants to put 15 percent of its assets in hedge funds as a way to protect against a market correction. But some board members and pensioners see them as too expensive and risky.

[…]

Earlier this year Coaker and his staff, along with outside consultant Leslie Kautz of Angeles Investment Advisors, recommended investing 15 percent of the system’s assets in hedge funds as part of a realignment of its portfolio. The goal was to “reduce volatility in investment returns, improve performance in down markets, enhance diversification of our plan assets, increase the flexibility of the investment strategy, and to increase alpha (excess returns),” according to minutes of the June 18 meeting. Coaker did not return phone calls.

A vote on the measure was scheduled for October but shortly before the meeting, board President Victor Makras learned that Kautz’ firm has a fund of hedge funds registered in the Cayman Islands. “That was a material fact,” Makras said. “I continued the item and instructed the consultant to disclose that to my satisfaction.”

If the fund does vote to invest in hedge funds, there would be the following allocation changes, according to SFGate:

U.S. and foreign stocks would drop to 35 percent from 47 percent of assets. Bonds and other fixed-income would fall to 15 percent from 25 percent. Real estate would rise to 17 percent from 12 percent. Private equity would rise to 18 percent from 16 percent. And hedge funds would go to 15 percent from zero.

The San Francisco Employees’ Retirement System manages $20 billion in assets.

Chart: Alternatives Set To Double By 2020

A report recently released by PricewaterhouseCoopers finds that alternative assets held by the world’s largest asset managers will double by 2020 — a trend that will be driven largely by pension funds.

The makeup of alternative assets currently:

Chart credit: Chief Investment Officer and PwC

Surveys: Institutional Investors Disillusioned With Hedge Funds, But Warming To Real Estate And Infrastructure

Two separate surveys released in recent days suggest institutional investors might be growing weary of hedge funds and the associated fees and lack of transparency.

But the survey results also show that the same investors are becoming more enthused with infrastructure and real estate investments.

The dissatisfaction with hedge funds — and their fee structures — is much more pronounced in the U.S. than anywhere else. From the Boston Globe:

Hedge funds and private equity funds took a hit among US institutions and pension managers in a survey by Fidelity Investments released Monday.

The survey found that only 19 percent of American managers of pensions and other large funds believe the benefits of hedge funds and private equity funds are worth the fees they charge. That contrasted with Europe and Asia, where the vast majority — 72 percent and 91 percent, respectively — said the fees were fair.

The US responses appear to reflect growing dissatisfaction with the fees charged by hedge funds, in particular. Both hedge funds and private equity funds typically charge 2 percent upfront and keep 20 percent of the profits they generate for clients.

Derek Young, vice chairman of Pyramis Global Advisors , the institutional arm of Fidelity that conducted the survey, chalked up the US skepticism to a longer period of having worked with alternative investments.

“There’s an experience level in the US that’s significantly beyond the other regions of the world,’’ Young said.

A separate survey came to a similar conclusion. But it also indicated that, for institutional investors looking to invest in hedge funds, priorities are changing: returns are taking a back seat to lower fees, more transparency and the promise of diversification. From Chief Investment Officer:

Institutional investors are growing unsatisfied with hedge fund performance and are increasingly skeptical of the quality of future returns, according to a survey by UBS Fund Services and PricewaterhouseCoopers (PwC).

The survey of investors overseeing a collective $1.9 trillion found that only 39% were satisfied with the performance of their hedge fund managers, and only a quarter of respondents said they expected a “satisfying level of performance” in the next 12-24 months.

[…]

The report claimed this showed a change in expectations of what hedge funds are chosen to achieve. Investors no longer expect double-digit returns, but instead are content to settle for lower fees, better transparency, and low correlations with other asset classes.

Mark Porter, head of UBS Fund Services, said: “With institutional money now accounting for 80% of the hedge fund industry, they will continue seeking greater transparency over how performance is achieved and how risks are managed, leading to increased due diligence requirements for alternative managers.”

Meanwhile, the USB survey also indicated investors are looking to increase their allocations to infrastructure and real estate investments. From Chief Investment Officer:

“Despite the challenges of devising investment structures that can effectively navigate the dynamic arena of alternative markets, asset managers should remain committed to infrastructure and real assets which could drive up total assets under management in these two asset classes,” the report said.

“This new generation of alternative investments is expected to address the increasing asset and liability constraints of institutional investors and satisfy their preeminent objective of a de-correlation to more traditional asset classes.”

The report noted that despite waning enthusiasm for hedge funds, allocations aren’t likely to change for the next few years.

But alternative investments on the whole, according to the report, are expected to double by 2020.

Video: California CIO On Why He Thinks Divesting From Hedge Funds Doesn’t Make Sense

The above video features Sean Bill, CIO of Santa Clara Valley Transportation Authority and trustee for the City of San Jose. During the interview, he touches on CalPERS’ hedge fund exit, why he thinks the move was “political”, and the difficult of handling investments in-house.

Video from Chief Investment Officer magazine.

Deutsche Bank: CalPERS’ Hedge Fund Exit “Has No Bearing” On Allocations Of Institutional Investors

The CalPERS Building in West Sacramento, California.

Deutsche Bank says that after a series of meetings this month with institutional investors, they’ve concluded that CalPERS’ hedge fund exit “has no bearing on most investors commitment to the industry.”

From ValueWalk:

Deutsche Bank prime brokerage notes that hedge funds have been engaged in “extreme protection buying in equities” and said that the recent exit from hedge funds by CalPERS “has no bearing on most investors commitment to the industry.”

After speaking with the institutional investor community regarding their commitment to maintain their hedge fund allocations, Deutsche Bank’s Capital Introductions group reports this positive message that it says was bolstered by recent meetings with Canadian pensions and global insurance companies throughout the month, while a trip to Munich indicated an increase in hedge fund exposure from institutions.

[…]

Separate hedge fund observers, meanwhile will be watching numeric asset flow patterns in December and the first quarter of 2015 to determine on an objective basis if there has been a statistical move away from hedge funds.

Even if institutional investors on the whole aren’t moving away from hedge funds, the exit by CalPERS – and the public debate swirling around the investment expenses associated with hedge funds – has forced some hedge funds to reconsider their fee structures. From the Wall Street Journal:

Two titans of the hedge-fund and private-equity world say they are growing more open to reducing fees in the face of rising scrutiny of the compensation paid to managers of so-called alternative investments.

[…]

Mr. [John] Paulson [founder of hedge fund firm Paulson & Co.] said he feels “pressure” to act in the wake of “enormous numbers in compensation” for hedge fund managers. Mr. Paulson, 58, earned a reported $2.3 billion last year, counting both fees and the appreciation of his own personal investment in his funds.

“Institutions are becoming a little more demanding…they are putting pressure on the management fee and the incentive fee,” he said Monday during a panel discussion at New York University’s Stern School of Business.

Joseph Landy, co-CEO of $39 billion buyout shop Warburg Pincus, echoed Mr. Paulson’s experience.

“There are a lot of private-equity managers out there who can make a lot of money before they return a dime to investors,” Mr. Landy said. “Most of the pressure [to reduce fees] has been on the actual annual management fee.”

Neither he nor Mr. Paulson, however, were too concerned about any widespread threats to their businesses.

“We came out relatively unscathed from the crisis. We’re doing pretty much the same things we did as before [with] very little restrictions on how we invest the money,” Mr. Paulson said.

Paulson said he think more hedge funds will start using “hurdles”, a fee structure which prevents managers from collecting performance fees until they’ve met a certain benchmark return.

Photo by Stephen Curtin

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

Interview: Hedge Fund Mogul Talks CalPERS’ Pullout, Manager Selection and Justifying Fees

Forbes released an interview Thursday morning with Anthony Scaramucci, founder and co-managing partner of alternatives investment firm SkyBridge Capital.

The interview touched on CalPERS’ hedge fund exit, how the pension fund picked the wrong managers and how to pick the right ones. Later, Scaramucci touched on justifying the industry’s fee structure.

On CalPERS’ pullout:

Steve Forbes: Thank you, Anthony, for joining us. To begin, in terms of hedge funds, as you know the overall performance of hedge funds has lagged the market in recent years. CalPERS, the largest hedge fund in the country, made headlines by saying, “We’re getting out of this.” What is that a sign of? Either the hedge fund industry is going away and is only sustained because there’s nothing else around that’s suppressing interest rates or is this a sign of the bottom? When a big one gets out does that mean this is the time to get in?

Anthony Scaramucci: Well, so, the question’s is it going to get easier or harder from here? That was a good start, Steve. But the short answer is that there’s a lot of reasons why the industry’s underperformed. The main one has to do with something you often talk about, which is Federal Reserve monetary policy.

So, the policy since March of 2009 has been to hammer down the rates, artificially stimulate the market. This makes it impossible for about 40% of the hedge fund managers to perform. If you look at the overall hedge fund manager index, 40% of it is in long-short managers.

And so if you’re long something, you’re doing great in this market. But I’ve got to tell you something, Steve. If you’re short something, even if you’re right on the security analytics, you’re going to be wrong on the momentum of the market. And so what’s happened to the long-short managers is the longs are going up, the shorts are going up, and they have this little tight spread. They’re making 3%, 4%, 5% when the market’s rip roaring and the media is writing all these nasty articles about them.

But there are places to make money. There’s structured credit, activism. There’s a whole host of distressed guys that have done well over the last six years. But I think the media has been justified in pointing out that, in general, the hedge funds have not done well.

The CalPERS thing is a little different. They only had 1.5% of their assets there. Joe Dear, who was a legendary guy at CalPERS, when he passed I think it became one of those things where they weren’t going to get bigger for political reasons, and so they decided to get way smaller. But I don’t think it’s a death knell of the industry yet. In fact, I’ll make a prediction that we’ll look back two or three years from now and say that they caught the bottom of the hedge fund performance market.

On manager selection:

Forbes: You said that they [CalPERS] picked the wrong hedge fund managers.

Scaramucci: Yes.
Forbes: How do you pick the right ones? Because it’s fine to say, “Well, if you look at the top 10%, you would have done nifty.”

Scaramucci: Yes.

Forbes: But, like, the top 10% of stocks, how do you do it on a consistent basis?

Scaramucci: Well, okay. So, not to use a baseball analogy, but just think of it this way.

Forbes: You can, I’m a fan.

Scaramucci: Okay. So, well then you’ll probably know this from the Bill James Abstracts. Sixty percent of the everyday players are batting .260 or below, yet every midsummer classic we see 40 guys on the field that are Hall of Famers or the top of what they do. And I think that’s indicative of most industries, frankly, whether it’s the media, the hedge fund industry or, you know, political landscape and so forth. And so there are certain metrics that you can use to identify who’s going to do well. But the number one metric is the macro environment.

If you tell us what the economic dashboard looks like over the next 12 to 18 months, we have pretty high capabilities on the prediction side of what sectors are going to do well. As an example, 2009, if you and I were having this conversation, I would have told you that the residential mortgage-backed security market was going to do very, very well. Those assets were distressed. They were technically oversold by the large institutions. The Federal Reserve monetary policy at that time with Helicopter Ben bringing things down so aggressively, that was going to be an easy place to make money.

And so if you looked at SkyBridge at that period of time, we had about 45% of our assets there. So, the first factor is the macroeconomic factor. The second factor then is, once you figured out what sector you’re going to be in, who are the best guys in that sector and why are they the best? And frankly, a lot of them will be different depending on different markets. Some guys are longer than others. They’ll always be longer. Lee Cooperman is an example of that. If you’re a bull on the market, Lee’s a good bet. It’s that sort of thing.

On the fee structure of hedge funds:

Forbes: You’re a fund of funds, so to speak.

Scaramucci: Yes. Yes.

Forbes: And you know the rap, hedge funds 2%, 20%.

Scaramucci: Sure.

Forbes: Now your fees 1.5%, whatever it is, on top of that.

Scaramucci: Yes. Yes.
Forbes: How do you justify your existence?

Scaramucci: Well, listen. We’re up there with child molesters with most people, so I’ve got a hard time in justifying my existence at times. But I tell people the same thing that I think you would tell them if you were in my seat. Focus on net performance.

If you’re worried about fees, well then you certainly shouldn’t be in the hedge fund industry. But I think what we’ve proven, if you look at our long-term track record, we can help clients get to their actuarial goals by taking less risk, or less beta, if you will.

And so our performance is high single-digit, low double-digit over the last ten years with relatively low volatility. And so I think we’ve been able to justify that. But we did shift our model. I often talk about hedge fund fund of funds 3.0 in the sense that we’re viewing ourselves more like a multi-strat now. We look at the macro environment rather than trying to hug the index, like some of our peers.

The typical fund of funds got a bad rap because they weren’t doing the due diligence. And then they give you 50 managers. They’d give you a 2% in each of those managers. And you’d be hugging the index on your way to mediocrity. What we’ve tried to do, is we’ve tried to concentrate our portfolio on things that we think are working. We have a dynamic approach, where we will move out of securities or move out of hedge funds quickly if we think the market environment has changed. And we believe in concentration.

So, the top ten managers for us, Steve, are about 65% of the assets. And I think that’s differentiated us from our peer group. One last point, if you don’t mind me making it is that, if I’m giving a billion dollars out to somebody, if SkyBridge is giving out a billion dollars, we’re asking for fee concessions. And so we pass those on to our investors. So, even though we have all these loaded fees, so to speak, we’re giving back 75, 80 basis points a year in fee concessions, which I think is meaningful.

The entire interview can be read here.

Pension Funds Need To Stay Out of the “Bargain Bin” When Shopping For Hedge Funds

More than ever, pension funds are negotiating fees with hedge funds in an effort to lower the expenses associated with those investments.

That sounds like a wise course of action. But a new column in the Financial Times argues that pension funds need to stop shopping in the “bargain bin” for hedge funds—because the hedge funds that are willing to negotiate fees are also the ones who deliver lackluster returns.

From the Financial Times:

With many pension funds facing deficits, and needing investments that will generate high returns, the promise of hedge funds has an obvious appeal.

The problem is, like the star chef, the small number of hedge funds that have made staggering amounts of money for their investors over several decades already have too many clients and are closed for business.

Among these are Renaissance Technologies’ Medallion Fund, founded by the mathematician James Simons, which has long been all but shut to new money, and Seth Klarman’s Baupost Group, which last year returned $4bn to clients and has a highly select number of investors.

At the same time investors in hedge funds, such as pension managers, are loath to pay high fees for their services, and must enter into tough negotiations to bring these fees down. This makes sense.

But few of the handful of truly top tier hedge funds have any need to lower their fees for new investors and tend to politely show such requests to the door.

Mediocre hedge fund managers on the other hand cannot afford to be so dismissive, and are more than happy to gather more assets to play with.

The outcome is that many pension funds end up forcing themselves to shop in the hedge fund equivalent of the reduced aisle in a supermarket. They should stop. At the root of this problem is the flawed thinking that a large number of investors have been either seduced into, or institutionally obliged to believe in: the idea that hedge funds constitute an “asset class” all of their own, distinct from other types of active fund management.

[…]

Wholesale shopping for hedge funds is a bad idea. Instead of deciding to bulk invest in hedge funds as a questionable means of diversification (the HFR index shows the majority of hedge funds have underperformed the S&P 500 while being correlated to it), investors should only seek out the select few.

And if the best are closed to new investment they must find something else to do with their money.

The author puts the situation in context by comparing hiring a hedge fund to hiring a caterer. From the column:

You are planning a party and have decided to hire a caterer. A trusted friend has recommended two of the best in the city. One is a famous chef who has won numerous awards for his cooking, and another is a younger caterer who previously worked for one of the best restaurants in the world.

You call them both, only to have second thoughts. The first, the famous chef, is simply too busy with existing work to help you.

The other is unbelievably expensive, costing at least double what a regular caterer would charge. But you need your guests to be fed, so you look for an alternative option. You find a cheaper company on the internet and book them.

Come the party the food arrives late. When you taste it, the hors d’oeuvres are stale and the wine tastes like biro ink. Embarrassed and enraged, you mutter under your breath about the money you have wasted, vowing to never hire a caterer ever again.

This flawed thinking resembles the way too many institutional investors select hedge fund managers.

Pension360 has previously covered studies that suggest problems with the way pension funds select managers.

Photo by Gioia De Antoniis via Flickr CC License

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