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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

What Types of People Should Manage Institutional Money?

What traits does it take to be a successful manager of institutional money? A high IQ? A steady temperament? A penchant for going on lucky streaks?

Jack Gray, of the Paul Woolley Centre for Capital Market Dysfunctionality at University of Technology, Sydney, dives deep into this question in a recent article published in the Rotman International Journal of Pension Management.

From the article:

Successful investors are likely to be overweight on several the following traits:

• A paradoxical blend of arrogance, to discover and arbitrage opportunities ahead of the market, and humility, to simultaneously be skeptical about those discoveries.

• A commitment to the principle “know thyself” – for instance, recognizing when previously justified contrarianism has degenerated into unjustified stubbornness.

• The ability to make effective decisions under uncertainty, ambiguity, and pressure. A temperament that seeks comfort and stability will likely be ill-suited to investing.

• The confidence to encourage and absorb dissent yet to know when to act. Almost all organized human endeavors have at their core a paradigm of broadly agreed beliefs, stylized facts, and patterns of thought that impose a uniformity of views.

Ideas that challenge the paradigm tend to be ignored, not absorbed: Markowitz’s thesis was not rated as genuine economics, while Akerlof’s ground-breaking paper on the pricing impact of information asymmetry (Akerlof 1970) was twice rejected. Both eventually won Nobel prizes.

• The wisdom to know when to cooperate, a rare trait in a culture that has elevated competition to quasi-religious status. Much (though not all) investment information is “non-rival,” so that its value increases through sharing, as evident in open-source ventures. Yet by temperament, training, and incentives, many have an antipathy to sharing. In a study that engaged students in a game in which participants do better by cooperating, 60% of general students cooperated while only 40% of economics students did (Frank et al. 1999).

• The self-control to value patience, and so resist the short-term imperative and its eternal concomitant, being busy.

• A willingness to question and be curious, traits lacking in many boards that oversee other people’s money. After spending time embedded in American pension funds, the anthropologists O’Barr and Conley (1992) reported “a surprising lack of interest in questioning and surprisingly little interest in considering alternatives.”

Gray goes on to write that we can put people into two categories: hedgehogs and foxes. And while the investment world has plenty of the former, it is short on the latter. From the article:

Isaiah Berlin (1953) bequeathed us a crude but useful typology of people: hedgehogs view the world through the lens of a single defining, and usually substantial, idea; foxes view it through multiple lenses. Both types are needed in investing, but we are over-populated with hedgehogs who better fit compartmentalized corporate structures and are more fecund. We need more foxes, people with broader perspectives willing to trespass—a notion coined by Albert Hirschman (1981)—into foreign fields.

[…]

Cultural change is needed to recognize, support, and reward foxes, who tend to be spurned by tribal hedgehogs as soft-headed dilettantes. To Charlie Munger (1994), having different mental models is the most important thing in investing, because they expose new opportunities and drive a dialectic of risk. Investment organizations should seek more people with “contrary imaginations,” as the psychologist Liam Hudson (1967) phrases it: people with exceptional intelligence in alternative but meaningful ways; people with intelligence about the humanities, especially history and psychology, the disciplines that underlie and drive markets; people with emotional intelligence to direct and manage others; and people with organizational intelligence to get things done.

Gray provides much more analysis in the full article, which can be read here.

Photo by Nick Wheeler via Flickr CC License

Research Shows Pension Funds Are Biggest Owner of Alternatives Among Institutional Investors

New research from Towers Watson reveals that pension funds are the largest buyer of alternative investments among institutional investors (a designation that includes insurance companies, banks, endowments, etc.).

The research also details the rapid rise of alternatives as a major part of pension fund portfolios—globally, alternatives make up 18 percent of pension portfolios. That number has more than tripled since 1999, when pensions allocated 5 percent of assets toward alternatives.

From HedgeCo.net:

The research — which includes data on a diverse range of institutional investor types — shows that pension fund assets represent a third (33%) of the top 100 alternative managers’ assets, followed by wealth managers (18%), insurance companies (9%), sovereign wealth funds (6%), banks (3%), funds of funds (3%), and endowments and foundations (3%).

“Pension funds continue to search for new investment opportunities, and alternative assets have been an area where they have made, and continue to make, very significant allocations. While remaining an important investor for traditional alternative managers, pension funds are also at the forefront of investing in new alternatives, for example, in real assets and illiquid credit. But they are by no means the only type of institutional investor looking for capacity with the top alternative managers. Demand from insurers, endowments and foundations, and sovereign wealth funds is on the rise and only going to increase in the future as competition for returns remains fierce,” said [Towers Watson head of manager research Brad] Morrow.

[…]

“Pension funds globally continue to put their faith in diversity via increasing alternative assets to help deliver more reliable risk-adjusted returns at the total fund level. This is evidenced by the growth, significant in some instances, in all but one of the asset classes in the past five years. Most of the traditional alternative asset classes are no longer really viewed as alternatives, but just different ways of accessing long-term investment themes and risk premiums. As such, allocations to alternatives will almost certainly continue to increase in the long term but are more likely to be implemented directly via specialist managers rather than funds of funds, although funds of funds will also continue to attract assets, as borne out by this research,” said Morrow.

The research was part of the Global Alternatives Survey, an annual report produced by Towers Watson.

The Case For Long-Termism in Pension Investments

Pension funds, more so than other investors, operate on a particularly long time horizon.

But that doesn’t mean funds can’t succumb to short-term thinking.

Keith Ambachtsheer, Director Emeritus of the International Centre for Pension Management at the University of Toronto, makes the case for more long-term thinking at pension funds in a recent paper published in the Rotman International Journal of Pension Management.

He lays the groundwork of short-term thinking at pension funds by presenting this statistic:

My 2011 survey of 37 major pension funds found that only 8 (22%) based performance-related compensation on measures over four years or more.

In other words, pension funds aren’t rewarding long-term thinking. But how can that be changed? From the paper:

A good start is to insist that the representatives of asset owners become true fiduciaries, legally required to act in the sole best interest of the people (e.g., shareholders, pension beneficiaries) to whom they owe a fiduciary duty….the resulting message for the governing boards of pension and other long-horizon investment organizations (e.g., endowments) is that they must stretch out the time horizon in which they frame their duties, as well as recognizing the interconnected impact of their decisions on multiple constituents to whom they owe loyalty (e.g., not just current pension beneficiaries but also future ones).

Increasingly, fiduciary behavior and decisions will be judged not by a cookie-cutter off-the-shelf “prudent person” standard by a much broader “reasonable expectations” standard.

A logical implication of these developments is that the individual and collective actions of the world’s leading pension funds are our best hope to transform investing into more functional, wealth-creating processes.

It will take work, but a shift to long-termism will be worth it, according to the paper:

Institutional investors around the globe, led by the pension fund sector, are well placed to play a “lead wagon” fiduciary role as we set out to address these challenges. Indeed, the emerging view is that pension sector leaders have a legal obligation to look beyond tomorrow, and to focus the capital at their disposal on the long term.

Will the effort be worth it? Logic and history tell us that the answer is “yes.” Qualitatively, long-termism naturally fosters good citizenship; quantitatively, a 2011 study that calculates the combined impact of plugging the upstream and downstream “leakages” in conventional investment decision making with a short-term focus found that the resulting shift to long-termism could be worth as much as 150 basis points (1.5%) per annum in increased investment returns (Ambachtsheer, Fuller, and Hindocha 2013).

Read the entire paper, titled The Case for Long-Termism, here [subscription required].

How Should Investors Manage Climate Change Risk?

CalPERS is measuring the carbon footprint of its portfolio. CalSTRS is helping to fund a study on the market impact of climate change.

For the first time, institutional investors are beginning to wonder: How will climate change impact the value of our investments?

Howard Covington of Cambridge University and Raj Thamotheram of the Network for Sustainable Financial Markets tackled that question in a recent paper, titled How Should Investors Manage Climate Change Risk, in the most recent issue of the Rotman International Journal of Pension Management. From the paper:

The consequences of high warming, if we collectively go along this path, will emerge in the second half of this century; they are therefore remote in investment terms….Capital markets anticipate the future rather well, which suggests that investment values may respond strongly over this time scale as views on the most likely path begin to crystallize. Technologies for producing and storing electrical energy from renewable fuel sources, for energy-efficient housing and offices, and for reducing or capturing and disposing of greenhouse gas emissions from industrial processes are moving along rapidly. In important areas, costs are falling quickly. Given appropriate and moderate policy nudges and continuing economic and social stability, it is overwhelmingly likely that the global economy will substantially decarbonize during this century.

If…an emissions peak in the 2020s becomes a plausible prospect, investment values for fossil fuels, electrical utilities, and renewable energy (among others) will react strongly. The value of many fossil fuel investment projects will turn negative as assets lose their economic value and become stranded; companies and countries will face significant write-downs, with clear consequences for financial asset prices.

As the authors note, we don’t know exactly how the earth will eventually react to greenhouse gasses. Different responses will have different implications for the global economy. From the paper:

If we are unlucky, and the climate’s response comes out at the upper end of the range while emissions go on climbing, the likelihood of the global economy’s potentially heading toward rolling collapse will significantly increase. A run of extreme weather events in the 2020s, particularly events that lead to sharp increases in prices for staple crops or inundate prominent cities, might then focus the attention of the capital markets on the consequences. A broad adjustment of asset values might then follow as investors try to assess in detail the likely winners and losers from the prospect of an increasingly turbulent global social, economic, and political future.

We are not suggesting that this kind of outcome is unavoidable, or even that it is the most likely. We are merely noting that the chance of events’ unfolding in this way over the next 10 to 15 years is significant, that it will rise sharply in the absence of a robust climate deal next year, and that long-term investors need to factor this into their investment analysis and strategy.

If these scenarios correctly capture the likely outcomes, then we have reached a turning point for the global economy. For the past 150 years, the exploitation of fossil fuels has generated enormous value for investors, both directly and by enabling global industrialization and growth; but it is now rational to anticipate that continued and increasing emissions from fossil fuel use might, over several decades, lead to the destruction of investment value on a global scale. Moreover, capital markets may adjust to this possibility on a relatively short time scale.

So how should institutional investors respond?

Broadly speaking, there are three main ways that investors can help. The first is to raise the cost of capital for companies or projects that will increase greenhouse emissions. The second is to lower the cost of capital for companies or projects that will reduce greenhouse emissions. The third is to use their influence to encourage legislators and regulators to take action to accelerate the transition from a high- to a low-emissions economy.

Formally adopting a policy of divesting from the fossil fuel sector can be helpful with the first of these, provided that the reasons for doing so are made public, so that other investors are encouraged to consider their own positions. Alternatively, active investors might take significant shareholdings in fossil fuel companies, so as to exert a material strategic influence to prevent investments that encourage long-term value destruction.

Supporting investments in renewable energy sources and related sectors is particularly effective where the potential exists to disrupt traditional industries. Tesla Motors is a case in point, since the potential for rapid growth of electric vehicles could transform the auto industry. Through the related development of high-performance, low-cost battery packs, it may also transform both the domestic use of solar power and the electrical utility business.

There is little time left for legislators to agree on the terms for orderly cooperative action to reduce emissions. Investors concerned about long-term value should act now to encourage the adoption of mechanisms to ensure an early peak and rapid decline in greenhouse missions. By the end of 2015, the chance for this kind of action will have largely passed.

The above excerpts represent only a portion of the insights the paper has to offer. The rest of the article can be read here [subscription required].

Photo by Penagate via Flickr CC

Video: Hedge Fund Manager On “Tweaking” Fee Structure

The video above features John Paulson, founder of $22 billion hedge-fund firm Paulson & Co., talking about the fee structure of hedge funds and whether he feels “pressure” to change that structure to appease fee-averse investors.

“Institutions are becoming a little more demanding…they are putting pressure on the management fee and the incentive fee,” Paulson says during the video.

The footage was taken during a panel discussion at New York University’s Stern School of Business.

Video courtesy of the Wall Street Journal.

CalPERS To Measure, Disclose Carbon Footprint of Portfolio

CalPERS and several other institutional investors signed the Montreal Carbon Pledge yesterday. The pledge mandates that the investors measure and publicly report the carbon footprint of their entire investment portfolio.

Public Pension Funds Drive Venture Capital Boom, But Performance Is An Issue

The venture capital industry is becoming a major force again, and pension funds are the major driver of the resurgence. From Businessweek:

Public pension funds—the state-run investment pools responsible for the retirement benefits of nearly 20 million Americans—have quietly been funding the recent boom in venture capital. The investment pools are made up of tax dollars and contributions from state employees. For the last few years, they have made up the biggest single source of funds flowing to venture capital, according to the most recent Dow Jones Private Equity Analyst Sources of Capital survey. In 2014, they contributed 20 percent of the sector’s overall haul, down slightly from a 25 percent contribution in 2013.

Indiana’s Public Retirement System allocates (PDF) 1.6 percent ($363 million) to venture capital, which is on the higher end as a percentage of assets; the California Public Employees’ Retirement System (CalPERS) allocates a more typical half percent of assets, although the fund is so big that this meager fraction totaled $1.8 billion in 2013. The amounts are small enough that if pension funds’ entire venture capital investments were to evaporate, pensioners would still be all right. In most states, pension obligations are guaranteed by state constitutions. If the investments—in venture capital or anything else—don’t pay off, taxpayers are on the hook for the shortfall.

But there’s a problem: some of the best venture capital funds don’t want to do business with public pension funds. From Businessweek:

Because public pensions must be transparent about their investments, which are subject to the Freedom of Information Act, many top-performing venture capital funds won’t accept pension money; they don’t want to publicly disclose their portfolios. This makes public pensions pick from other—often lesser-performing—funds.

Like hedge funds and other kinds of private equity, venture capital funds charge an annual management fee of 2 percent, plus 20 percent of profits. Performance is an open question. Many funds fail to perform (PDF) as well as an Standard & Poor’s 500-stock index fund. Diane Mulcahy,senior fellow at the Kaufmann Foundation, has observed that many venture capital funds aren’t profitable and that steady fee income diminishes the funds’ incentive to find profitable investments.

Other institutional investors are funding the VC resurgence, as well. Endowment funds provided the VC industry with 17 percent of its capital in 2014, according to the Dow Jones survey. Corporate pension funds accounted for 7 percent, while union pension funds accounted for 2 percent.

Photo by c_ambler via Flickr CC License

Professor: Pension Funds Need To Rethink Manager Selection

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.

CalPERS, Harvard Money Linked To Caribbean Pay Day Loan Venture

A unique series of events exposed this week a controversial investment made by a handful of institutional investors.

Institutional investors such as Harvard and CalPERS invested a combined $1.2 billion with a private equity fund, Vector Capital IV LP. But Vector soon tried investors’ patience, as it was slow to invest that money.

Eventually, some investors threatened to pull out altogether—which led Vector to make the quick decision to invest in Cane Bay Partners VI LLLP, a company that ran numerous pay day loan sites in the Caribbean and charged up to 600 percent interest for a loan. From Bloomberg:

By 2012, investors including Harvard University were upset that about half the money [invested with Vector] hadn’t been used, according to three people with direct knowledge of the situation.

Three Americans on the Caribbean island of St. Croix presented a solution. They had built a network of payday lending websites, using corporations set up in Belize and the Virgin Islands that obscured their involvement and circumvented U.S. usury laws, according to four former employees of their company, Cane Bay Partners VI. The sites Cane Bay runs make millions of dollars a month in small loans to desperate people, charging more than 600% interest a year, said the ex-employees, who asked not to be identified for fear of retaliation.

Mr. Slusky’s fund, Vector Capital IV, bought into Cane Bay a year and a half ago, according to three people who used to work at Vector Capital and the former Cane Bay employees. One ex-Vector employee said the private equity firm didn’t tell investors the company is in the payday lending business, for which borrowers repay loans out of their next paychecks.

Pay day loans are controversial because they charge high interest rates on loans given to people who are usually in a financial bind to begin with.

Many states in the US have banned the practice, which has forced the businesses to go online.

For now, Cane Bay Partners claims it is only a “management-consulting and analytics company”.

Photo by www.panamacity-hotels.travel

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