The price of skill
Investment in alternatives is not always straightforward for pension funds given the governance challenges they frequently face, the perception that their interests are not always aligned with those of managers, and that returns will be eroded by high fees.
The recent decision by CalPERS to boost direct private equity is a case in point. Public discourse favours transparency and dislikes remunerating well-paid service providers. Boosting internal capabilities seems like a better bet than paying high fees to general partners.
CaLPERS, along with a few other large pension funds, exited hedge funds several years ago. Yet institutional demand for hedge funds remains healthy, according to various measures. Will this demand persist?
One recent assessment, carried out by Toronto-based CEM Benchmarking, which specialises in measurement of pension fund portfolios, finds that hedge funds underperform a simple equity/bond blended benchmark by a considerable margin over a long time horizon. Measuring portfolios of 27 leading funds and proprietary data from 382 other funds against self-reported benchmarks finds net value added of a flat -0.09% over the 17 years to end-2016. Against a simple and investable blended equity/bond benchmark specifically designed to have a high correlation with hedge fund returns, average net value added was -1.27%.
Benchmarking hedge funds is indeed tricky, as much art as science. Peer group benchmarks are biased towards survivors; risk-free benchmarks set the bar too low. CEM finds serious flaws with the LIBOR-plus benchmarks used by 29% of its study sample, in that “cash-based benchmarks only serve to generate random noise about performance while serving to perpetuate the myth that hedge fund portfolios are uncorrelated and have no simple market beta”.
“There is clearly alpha for those with the wherewithal to find it, which speaks for the benefits of economies of scale”
Of course, it is possible to take issue with the composition of CEM’s chosen benchmarks, yet hedge funds are still seen as a repository of manager skill in an era of portfolio commoditisation. Given that 36% of funds did outperform CEM’s chosen benchmark, there is clearly alpha for those with the wherewithal to find it, which speaks for the benefits of economies of scale in pension funds. When it comes to hedge funds, which sit alongside a wide range of commoditised and diverse strategies, such as factor ETFs, larger institutions are likely to drive future demand for more sophisticated strategies.
Ten years on from the financial crisis, public discourse is now more focused on the perceived misdoings of tech giants and data protection, while criticism of banks and hedge funds has diminished. It remains to be seen whether pension funds, large public ones in particular, regain their appetite for higher-fee alternative strategies that have fallen out of favour in recent years and, if they do so, whether the services of demonstrably talented alternatives managers will be bid up in a sellers’ market.
Liam Kennedy, Editor