Calpers' Hedge Fund Exit Highlights Limits of Wishful Accounting
The California Public Employees’ Retirement System sent shock waves through the hedge fund world last week when it announced it is abandoning the asset class entirely. A lot of talk has been invested since in debating whether the move by Calpers—whose $298 billion under management makes it the nation’s largest public pension—is the beginning of a trend or a hiccup.
Early evidence is mixed. The Teachers Retirement System of Texas, the sixth-largest U.S. public pension, cut its hedge fund allocation by 1 percentage point three days after Calpers’ announcement. In contrast, Christopher Ailman, longtime chief investment officer of the California State Teachers' Retirement System, told Bloomberg TV that his view of hedge funds is unchanged.
One certainty is that since their inception, hedge funds have been notoriously expensive. If the price difference between two burger shops were as large the one between the typical hedge fund and low-cost index fund, you’d have one restaurant charging $200 for a burger and another next door $5 (hedge funds' standard 2% management fee versus the 0.05% fee for a low-cost institutional index fund). Throw in the fact that the $5 burger has been the demonstrably superior product in recent years (equity index funds have beaten the pants off hedge funds) and you'll get a sense of how the hedge fund vs. index fund dichotomy has played out.
How does the investment world’s equivalent of the $200 burger shop stay in business? BloombergView’s Matt Levine offered an explanation after the Calpers announcement. “Once you have hired people to invest some of your money in hedge funds, they will want to invest more of your money in hedge funds,” he wrote. “Investing in more hedge funds lets them hobnob with (and do favors for) hedge fund and fund-of-fund managers, which has its own advantages. (Not that hedge fund managers are awesome, I mean, but that they might hire them later at higher-than-Calpers salaries.)"
Another view was presented last September at a Cleveland Federal Reserve event, which drew little attention. Based on a wonky paper by three academics, it concluded that public pension officials are favorably inclined toward hedge funds for reasons that go beyond making work and lining up lucrative jobs for themselves.
“The distinct regulatory framework for U.S. public funds gives them strong incentives to shift a larger allocation to risky investments, as this increases the assumed expected rate of return,” the authors wrote. “This in turn helps these pension funds camouflage their degree of underfunding and potentially delay making difficult decisions on contribution levels and pension benefits.”
There’s no question that public pensions have plenty they'd like to cover up. State plans last year had 75% of what they needed to meet retirement obligations, according to Wilshire Consulting. Nationwide, states and localities faced a funding gap of about $1.4 trillion as of March as officials struggle to make up for recession-era investment losses and years of shortchanging their pension plans, Federal Reserve data show.
That might help explain why the authors of the paper presented at the Cleveland Fed event found U.S. public pension plans have, over the last two decades, pumped an ever greater proportion of their assets into hedge funds and other risky investments. Namely, because it has enabled them to claim their future returns will be high, which has a far more pleasant ring than calls for tax hikes or retiree benefit cuts.
Public pension have pushed their claims even as the steady decline in interest rates has prompted those governed by more prudent accounting standards to cut their expected return assumptions. Those cuts in expected returns by investors--other than U.S. pension funds--is something the authors characterize as “consistent with both their regulations and economic theory.”
In contrast, between 1993 and 2010 the authors found U.S. public pensions increased both their exposure to risky assets and their assumed returns. Their results, have not born out their optimism:
“The increased risk-taking is arguably reckless to the extent that it is driven by…a desire to camouflage or make up for underfunding. We find evidence suggesting that the increased risk-taking of U.S. public pension funds has resulted in an underperformance of more than 60 basis points [0.6%] annually” compared with returns for other pension funds, they write. “Our results show that U.S. public pension funds underperform and that this underperformance is greater among more mature U.S. public plans and those with a higher strategic allocation to risky assets.”
Given that assessment, Calpers’ move looks like one small step for the American taxpayer.
Neil Weinberg is a reporter at Bloomberg.
Follow me on Twitter @neilaweinberg
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Photo: Bloomberg
Thanks René. Clearly, HF portfolios are thoroughly disappointing for DB pension plan allocators. High fees, limited upside and some downside deviations may not be the best value proposition when liabilities have shot up and they're sitting on a mountain of bonds. That being said, this may be due to the many restrictions imposed on the industry on how good managers can take risk. Large investments by Plans usually come with many requirements on when to buy, what to buy, how to stay within strict VaR limits,beta, liquidity premiums etc...Post '08 and the excesses of the HF industry, it makes sense. Perhaps the balance between risk management and risk mitigation hasn't been properly found yet.
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10 年I concur with René's insights and would add that we might see liquidity risks and longevity risks come back to the table at the same time whenever pensions start divesting those assets on a large scale.
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10 年If CALPERS was allocating to hedge funds to "outperform" a broad equity benchmark, they were simply doing it for the wrong reason. I would be reviewing my allocation to hedge funds that have outperformed the S&P in recent years for the simple reason that some of them will do much worse than the benchmark on the downside, given the embedded risk calibration and leverage. Of course, there are always very few exceptions to this. I remember media coverage about CALPERS complaining about the fee structure after the 2008 market dislocation. Looks like they are, again, in a career risk-management mode. What worries me going forward is the ever-increasing allocation to illiquid alternatives such as infrastructure and private equity. Marking your portfolio to a model looks like the easy way to reduce portfolio volatility and lowering career risk for both consultants and investment management staff. If all these pensions share similar demographics, a dangerous musical chairs game is set as they start to unwind/reduce these allocations. Rene Lévesque (www.mountjoycapital.com)