CalPERS Throws in the Towel on Hedge Funds

In organizing the posts on this blog, I've favored the label "alternative investments," as opposed to, for example, just "hedge funds."  In the past, we've written one of the most widely read posts about the public's "Two Faces on Private Equity." Rereading this, it is ironic that Warren Buffett, a vociferous critic in print at the time, has now thrown in with Brazilian private equity partners 3G on major investments.

The Yale endowment fund, led by Dave Swensen, has been one of the institutional models for successfully using alternative investments, including hedge funds, private equity, and real estate. Harvard's endowment has been in the news recently because of its falling down repeatedly in its once legendary investment management.  This post makes good background reading for today's issues about CalPERS.

CalPERS has assets of $298 billion in its investment portfolio to support 1.6 million members, either currently working or retired,or a stunning $186k per member, most of whom are working so the retirees should be quite comfortable.  The trouble is that for all their shareholder activism, self-promotion, and expensive internal management, CalPERS cannot select, construct and manage an alternative investment portfolio, in this case specifically hedge funds.

According to the Wall Street Journal, the fund's fiscal year-ended June showed its hedge fund portfolio of $4 billion returning 7.1% versus Vanguard's Balanced Index return of 12.5%.  The prior year too showed dramatic under performance at 7.4% versus 10.8% for Vanguard's Balanced Index.

The Journal notes that HFR's index of 2,000 hedge funds has been under performing its benchmark since 2009.  It points out that even in the down year of 2008 hedge funds lost 19%, not much less than traditional equity investors who lost 22.2%.  So, the $24 trillion hedge fund industry doesn't protect the downside in any significant way.

However, just to note that I got an interesting post from AQR's Cliff Asness which raises a very interesting point on which he has hammered for a while. To paraphrase, much of the institutional investor's market-like performance for hedge funds comes from the fact that their positions, whether in outside funds or in funds-of-funds, have too much of a net long position and therefore shouldn't be expected to perform too differently from traditional longs, like balanced funds. CalPERS and Harvard and others suffer from this disease of not being short enough in their hedge funds.

Proponents of hedge funds claim that there are good managers out there who can point to long-term out performance.  Who are they?  What's the basis for this claim?  What are the strategies and processes in this opaque world that can produce this alleged out performance?

Even Morningstar rates hedge funds for individuals.  If CapPERS concludes that hedge funds are too complex to manage, produce little diversification benefit, are too expensive and not scalable at their asset level, how can a small investor ever hope to benefit from these investments.  You can guess my answer.

Alternative Investments and The Individual Investor

My previous post about alternative investments and the Yale experience drew considerable readership and a few questions.  In various talks, Dave Swensen has characterized alternative investments, e.g. real estate, commodities, and private equity, as offering higher returns in order to compensate investors for risk and for their illiquidity.   This makes them perfect vehicles for investors like the Yale Endowment which, as Swensen says, is built to be indefinitely lived and which should not have liquidity needs. 

In the previous post, we noted that the liquid part of the endowment offers a substantial cushion even in the unlikely event that the fund were to have liquidity needs.  So, an investor like the Yale Endowment is perfectly suited to maximize alternative investments in particularly illiquid vehicles like private equity.  To the extent that Yale has a long history with private equity fund managers, who in turn are attracted to Yale's size and appetite, Yale should be able to enjoy a higher return and lower risk profile for its alternative investments than other institutional investors.

Now, take the case of institutional investors like state pension funds.  As we noted before, they neither have the experience, competence or appetite for risk that the Yale Endowment does.  And, most importantly, state retirement funds may very well face liquidity issues in the future.  A significant body of academic research shows that the unfunded pension liability of state funds in Ohio, Illinois and Texas for example, will ultimately require large tax increases to pay for the tails in actuarial lives of current retirees as well as for future retirees.What if the taxpayers revolt?  What if these funds somewhere down the road are restructured into two-part vehicles combining a DB element with a DC element?  I'm not saying that this will happen, simply because of our politics.  However, unlikely doesn't mean improbable. Political forecasters do worse than economic forecasters, after all. As Dana Carvey's George H.W. Bush would say, "Gotta be prudent!" 

State pension funds cannot afford to reach for return in the way the Yale Endowment does.  Finally, the last group which is completely ill-suited for alternative investments is the average individual investor, who could easily be subject to unexpected events like a catastrophic, uninsured illness or unplanned for long-term care.

In what seemed to my readers to be a contradiction, Dave Swensen has advocated portfolio construction for individual investors from traditional asset classes, using low-cost index funds.  Alternative investments are a no-no for these investors, he says.  In fact, it's not a contradiction at all.