In 2014 the California Public Employees' Retirement System (CalPERS) announced that it was exiting all of its hedge fund and fund-of-fund investments — a surprising move since CalPERS had been a leader in the adoption of hedge funds among major institutional investors only 15 years earlier.
Since the $280 billion CalPERS is considered a leader in the investing world, their shift caused many other pensions and endowments to follow suit and take a fresh look at their asset allocation, revisiting hedge funds and their place in portfolios.
Just last week, the $55 billion New York City Public Pension voted to pull all of its investments from hedge funds, making this exodus a coast-to-coast phenomenon.
Having reviewed the press surrounding these debates and decisions, the reasons for the abandonment of hedge funds comes down to three basic arguments: hedge funds are expensive, hedge fund strategies are often complex, opaque and risky, and the stock markets have outperformed hedge funds by a wide margin since 2009.
Some of this is politically driven, some results driven. A look into what's really going on here may provide individual hedge fund investors some insight into whether they too should be reconsidering whether they really need hedge funds in their portfolio.
Starting with the argument that hedge funds charge high fees, it's important to understand who is making the argument. In the case of the New York City Public Pension, much of the opposition to hedge fund allocations came from a group of what the Wall Street Journal calls “liberal advocates and labor unions,” whose main argument was based on the fact that the hedge fund managers were making enormous fees at a time that pensioners' assets were not growing. The optics of investment managers driving Ferraris and hosting lavish parties at a time that pensioners are struggling are quite disturbing to this group.
As I have addressed at length in previous columns, the question of fees cannot be divorced from the elements of volatility and returns. Thus the question shouldn't be simply “How much am I paying” but rather “Are my risk-adjusted returns high enough to justify the fees I am paying”
In other words, the issue should be about rather than .
To be fair, not all who voted out hedge funds in New York were focused only on cost. A statement from Mayor de Blasio, for example, touched on the question of value: “Analysis shows that our pension funds have not seen better risk-adjusted returns despite the high cost of management fees in portfolios that include hedge funds.”
The second arrow in the quiver of anti-hedge fund advocates is that hedge funds are opaque, complex and risky.
As one of the trustees of the New York pension fund summed up: “Hedge funds are charging exorbitant fees for high-risk and opaque investments. As financial stewards of public employees' money, we must invest in responsible and secure assets.”
It is true that many hedge funds are often complex in nature, and can appear opaque to outside investors. This requires more of a leap of faith than investing in traditional long-only investments, where what is owned is easily understood.
But to say this complexity and opacity necessarily leads to higher risk is simply untrue. Many hedge funds use the tools at their disposal — including leverage, shorting and derivatives — as risk management tools rather than return-enhancement tools.
As a result, these “true” hedge funds are complex rather than risky because they are complex. The fact that a trustee of a pension fund is not sophisticated enough to understand the difference is not an excuse to ignore hedge funds — their job must be to educate themselves regarding the risks and rewards of the entire investment universe rather than simply favouring those that they already understand.
The final argument — that hedge funds have underperformed the stock markets over the last six or seven years — is a false argument. It is a classic “apples to oranges” comparison that simply picks the best-performing asset class over a time period and pits it against the one under review.
Proponents of the “haven't kept up to the S&P 500” argument seem to forget that the S&P 500 lost about 50 per cent of its value over a seven month period between September 2008 and March 2009.
I'm quite confident that, at the time, these individuals weren't complaining about their hedge fund fees as those funds lost relatively little compared to the broader markets or even gained value over the same period of time.
So what does all of this mean to individuals deciding whether to add, keep, or remove hedge funds from their own portfolios
First, investors should tackle the threshold issue of what “hedge fund” even means. If they are able to focus on funds that actually hedge risk at the expense of giving up outsized returns rather than those that are referred to as hedge funds simply because their fee structures are high, they will have a better chance of choosing managers who will actually assist them in achieving their objectives, rather than simply providing levered exposure to stocks and bonds.
Once the calculus of what funds ought to be considered is done, then all investment managers and funds under consideration should be judged on a net-of-fee risk-adjusted returns basis.
The management fees are worth whatever they are if they lead to risk-adjusted returns that are both expected and sufficient. This is both an absolute and relative exercise; the question should be “What is the cheapest way to achieve my objectives within the risk paradigm I am comfortable with” rather than “Is there some other investment that has done really well in recent times that is cheaper”
The complexity and opacity must be addressed to the point of satisfaction that the moving parts are designed to manage risk rather than enhance returns. If you can't get comfortable with this answer because the answers are unclear or you (or your advisor) don't have the training to understand them, don't invest.
Finally, a word about size. Because the pension funds discussed here are enormous, their smallest investments are in the tens of millions of dollars. This requires that they invest in very large hedge funds with very long track records.
While there are indeed large hedge funds that have 15-25 year track records of net-of-fee excellence, many of the best performing funds are capacity constrained and therefore manage smaller amounts between $50-250 million.
Although far too small for institutional investors to consider, these funds should absolutely be in the universe of funds individuals should look at during their search, since the size of these funds is large enough to accommodate their relatively small allocations.