Last week, California Public Employees' Retirement System (CalPERS), the largest pension fund in the U.S., announced that it would pull all $4 bn from its hedge fund investment program of 24 hedge funds and six hedge fund-of-funds. CalPERS was one of the first pension funds to invest in hedge funds in 2002, and as a leader in the pension fund industry, the move is very symbolic and perhaps symptomatic of a larger trend of a disenchantment with hedge funds, or more specifically their high fees. However, this may be an idiosyncratic decision by a pension fund unsatisfied with below average hedge fund managers, while the hedge fund industry has seen flows of nearly $57 billion into hedge funds in the first two quarters of this year as hedge fund strategies still are viewed by institutional investors as having the ability to reduce risk and provide drawdown protection in investment portfolios.
CalPERS headquarters (photo credit: Getty Images)
Hedge fund fees too high for CalPERS to justify returns
Ted Eliopoulos, interim Chief Investment Officer at CalPERS said, “One of our fundamental investment principles is that cost matters” saying that hedge funds are “an expensive investment vehicle, especially at our scale”. CalPERS expects to report that it paid out $135 million in hedge funds fees during the year ending June 30, 2014, up from $115 million the year.
While Eliopoulos said the decision wasn’t related to the performance of the program, its hedge fund portfolio overall has delivered lackluster returns over the past few years that have failed to outperform the HFRI, a benchmark hedge fund index.
CalPERS direct hedge fund investments (fiscal year period ending June 30, 2014)
Source: Boomberg, CalPERS Absolute Return Strategies
Aggregate hedge fund returns have significantly underperformed the S&P 500
The July 2013 cover article for Bloomberg Businessweek, entitled “Hedge Funds Are For Suckers”, took aim at hedge funds, including their hedge fund fees and their overall returns in recent years which have considerably underperformed the S&P 500 (in 2013 the HFRI, a hedge fund benchmark index, returned just 9% while the S&P 500 returned 30%).
However, this continued underperformance of hedge funds in a continued stock market rally is to be expected. Hedge funds broadly have something close to a 0.40 equity market beta, which means that if the S&P 500 rises by 1%, we should expect the average hedge fund to return 0.4%. What it also means is that in stock market downturns like the global financial crisis of 2008 or the tech bubble burst of 2001, hedge funds returns on average will not fall as far as stocks and can provide downside protection in a portfolio. In addition, hedge funds are traditionally known for having high long-run "risk-adjusted" returns (as measured by Sharpe ratios) rather than high absolute returns. which is a common misconception about hedge funds.
Annual average hedge fund return (HFRI) versus S&P 500 (January 1994 through August 2014)
Source: Hedge Fund Research, Standard and Poor’s
The myth of uncorrelated hedge fund returns
AQR’s Cliff Asness responded to the CalPERS decision, citing some of his research pointing to many of the key concerns hedge fund investors have that have been highlights of his academic research over the past decade. In his seminal 2000 paper “Do Hedge Funds Hedge?” Asness and his co-authors illustrated that hedge funds are too correlated to equity markets. 2008 was indeed further proof of this phenomenon, as the average hedge fund return (as measured by the HFRI) lost almost 20% as the S&P 500 fell over 30%. This does not mean, however, that hedge fund strategies don’t have a role in portfolios. They can still reduce the long-term risk in a portfolio and mitigate the effects of severe drawdowns (hedge funds still outperformed the S&P 500 in 2008, despite negative returns).
Replicating hedge fund returns in aggregate is much cheaper and easier
In essence, hedge fund returns are not as mysterious as led on by hedge fund managers, who notoriously keep their hedge fund trades and ideas very secret. Bloomberg’s Erik Schatzker puts it best that in aggregate “hedge funds are a leveraged bet on the market”. What this means is that hedge fund performance is in many ways closely tied to the performance of the stock market (in a non-linear fashion). A forthcoming paper in The Journal of Finance by Wharton economist Jakub Jurek and Harvard economist Eric Stafford illustrates this further, that an S&P 500 option put-selling strategy can replicate the average across a diversified universe of hedge funds to a very high degree.
Hedge fund replication is nothing new in the hedge fund industry as firms like Goldman Sachs and AQR have offered investment strategies that can replicate hedge fund returns by employing strategies that have high correlation to hedge fund returns like put-selling strategies or engaging in actual popular hedge fund trades themselves. The main catch is that they are lower-cost strategies that mimic the aggregate returns of various hedge fund strategies. Indeed, CalPERS has explored investing in these types of strategies often referred to a “liquid alternative” strategies.
The growth of liquid alternatives
The disenchantment with hedge funds is also being mirrored by the growth of the new industry of liquid alternatives. Liquid alternatives are investment strategies (primarily 1940 Act mutual funds and some ETFs) that mimic hedge fund strategies and returns, but offers it in a liquid (no lockups), more transparent, and cheaper format. Hedge fund strategies now employed in liquid alternatives include strategies such as equity long short value investing, momentum investing, trend following, merger and convertible arbitrage, as well as carry trades.
Previously, the benefits of hedge funds were limited to institutions and high net worth individuals that are able to participate in private placement vehicles. Through the advent of liquid alternative mutual funds, almost any investor can now access hedge fund strategies and hedge fund like returns.
Goldman Sachs predicts that the liquid alternative asset industry will continue to see 15-20% annual growth in assets with market that could reach $2 trillion in assets. It is also the Morningstar category that has seen the highest growth in assets over the past five years with assets having tripled since 2009.
Hedge funds are still here to stay, though fees may have to be reduced (further)
While other pension funds may follow CalPERS and cut or reduce their hedge-fund exposures, it’s unlikely that the $2.8 trillion hedge fund industry (that has tripled in assets since 2004) will witness an exodus among investors. Many state pension funds, like the State Pension Fund of New Jersey, have recently announced that they are expanding the role of hedge funds in their portfolio. However, it has become clear to the investment community that many strategies pursued by hedge funds don’t rely on very obscure skills or strategies, and do not justify a high fee structures like the traditional “two and twenty” fee structure. While some hedge funds may have real skill worthy of very high fees, persistence in high hedge fund returns has become increasingly harder to find, leading many to reallocate their alternatives assets to liquid alternative investments with lower fees, moving away from direct hedge funds and fund-of-funds, much like CalPERS.
Average hedge fund performance fee
Source: Hedge Fund Research, Wall Street Journal
