Hedge funds are facing a ‘critical period’ in wake of US pension fund’s decision to divest from asset class, writes Christopher O’Dea

The recent decision by US benchmark public-employee pension fund CalPERS to eliminate its entire $4bn (€3.1bn) hedge fund allocation signals the potential review of hedge fund holdings at all pension funds at a time when the vehicles are struggling to improve sluggish returns and reduce volatility that’s unsettling investors looking to them to dampen fluctuations in portfolios.

While hedge funds represent only about 2% of CalPERS’ portfolio, the fund’s investing strategy is a widely watched barometer for how public-employee funds allocate their assets.

“Hedge funds are certainly a viable strategy for some, but, at the end of the day, when judged against their complexity, cost and the lack of ability to scale at CalPERS’ size, the Absolute Return Strategies programme is no longer warranted,” said Ted Eliopoulos, CIO.

CalPERS’ move has been in the making since this spring, when Eliopoulos took over as interim CIO, replacing his predecessor, Joe Dear, who died earlier this year. Eliopoulos, who joined CalPERS in January 2007 as senior investment officer for real assets, was named CIO just days after CalPERS announced it was terminating its hedge fund programme.

The change will result in asset withdrawals from 24 hedge funds and six funds of hedge funds. CalPERS says it will take about a year to exit the funds in a manner that does not result in a negative impact on the value of its holdings.

But CalPERS’ decision has already put a spotlight on the value of hedge funds to pension portfolios, says Frederick Rowe, vice-chairman of the Employees Retirement System of Texas and general partner at Greenbrier Partners, a money management firm in Dallas. 

Rowe believes it’s time for all pension funds to weigh the contribution of alternatives against the cost of holding hedge funds. “I think they should look,” he says.

Meanwhile, Donald Steinbrugge, CFA and managing partner of hedge fund consultancy Agecroft Partners, says investors, as a result of the CalPERS news, can expect continued downward pressure on hedge fund fees for large mandates.

Over the last five years, “there has been a strong trend of hedge funds increasingly offering fee breaks for large pension funds and the clients of institutional consulting firms”, he says.

Managers initially discounted management fees only, but now discount performance fees as well.

“For a typical hedge fund with a 2-and-20 fee structure, the discount is often 25% off standard fees,” he says. But he adds that, on average, pension funds will continue to increase their allocations to hedge funds.

That’s because most institutions currently target an after-fee return assumption of 4-7% for a diversified portfolio of hedge funds – compared with core fixed income at only 2.5-3%.

“As long as the expected return is higher for hedge funds than fixed income,” he says, “we will continue to see money shift from fixed income to hedge funds.”

That’s held true so far. Hedge funds continued to garner assets at a strong pace in August, with more than $12bn flowing into alternatives, pushing total industry AUM to another all-time high of more than $3trn, according to eVestment’s Hedge Fund Asset Flows Report.

With US equities at record highs, “alternative exposures to equity and credit markets make a lot of sense for today’s institutional investors”, says Peter Laurelli, eVestment vice-president of research.

Yet, despite fee discounting, hedge funds just aren’t getting the job done. Hedge fund returns have lagged the S&P 500 by a wide margin over the last one, three and five-year periods ended in June, according to research firm Preqin.

And while institutional investors look to hedge funds to dampen volatility, the sector got off to a rocky start in 2014 – the Preqin All Hedge Fund Benchmark posted a loss in three of the first four months of the year, leaving nearly one-third of respondents in the firm’s second-quarter investor confidence survey dissatisfied with hedge fund performance.

While it may take some time for pension investors to alter their alternative allocations, Rowe says the industry has entered a critical period – and hedge funds face a fundamental challenge.

“When you have a diversified group of managers,” he says, “it’s going to be hard to beat the market after expenses and fees.”

And fee discounting only proves the point. 

“You start out behind, and it’s hard to catch up.”