It’s the waiting part that’s hard

CalPERS, the highly influential California public employee pension agency, announced in September that it would no longer invest its dollars via hedge funds. That decision is not altogether surprising in that the annualized rate of return of the hedge funds in the CalPERS portfolio over the past decade was only 4.8 percent. The behemoth pension plan sponsor was careful to note that not all hedge funds are bad, but that “at the end of the day, judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size,” the hedge fund investment program “is no longer warranted.”

In essence, CalPERS recognized and acted upon what should be apparent to everyone: hedge fund returns have simply not lived up to their hype. As Victor Fleischer famously put it, “hedge funds are a compensation scheme masquerading as an asset class.” A recent study by Vanguard confirmed that a standard portfolio with an asset allocation of 60 percent stocks and 40 percent bonds outperformed almost all hedge funds during the past decade. Moreover, the annualized returns of the HFRX Global Hedge Fund Index (which attempts to reflect the opportunities in the hedge fund industry) underperformed every major stock asset class, and even three Treasury indexes, for the last 10 calendar years (through 2013). This year has been dreadful too (see below left). As a consequence, a recent survey of institutional investors overseeing a collective $1.9 trillion worldwide found that only 39 percent of them were satisfied with the performance of their hedge fund managers and only a quarter of respondents said they expected a “satisfying level of performance” in the following 12-24 months.

When analyzed on an asset-weighted basis, hedge fund returns are even worse. As Simon Lack documented in his book, The Hedge Fund Mirage, if all the money that has ever been invested in hedge funds had been invested in U.S. Treasury bills instead, the overall results would have been twice as good. That failure – and it is a monumental failure – is largely on account of outsized fees. The notorious “two and 20” (a two percent fee plus 20 percent of earnings) makes realizing the outsized gains hedge fund investors expect essentially impossible to obtain in the aggregate, despite a handful of prominent success stories.

Hedge fund apologists will no doubt retort that hedge funds are, naturally enough, designed to be a hedge rather than to outperform traditional investments generically (see below).

They're telling you that the Filet tastes meatier than Salmon. The Salmon is half the calories & half the fat content http://t.co/dGdUTKkGCu

— Attain Capital (@AttainCapital) December 11, 2014

And at least initially hedge funds were indeed designed to perform differently than the overall market. The sociologist and diplomat Alfred W. Jones coined the phrase “hedged fund” and is generally credited with creating the first hedge fund structure in 1949. Jones referred to his fund as being “hedged” in that his portfolio included both long and short positions designed to limit overall market risk.

The idea wasn’t superior returns nominally, but rather superior risk-adjusted returns. “Any idiot can make a big return by taking a big risk. You just buy the S&P, you lever up — there’s nothing clever about that,” said Sebastian Mallaby, the author of More Money Than God: Hedge Funds and the Making of a New Elite. “What’s clever is to have a return that’s risk-adjusted.” Even more fundamentally, the objective was non-correlated returns — positive returns in difficult and bad markets.

But hedge funds haven’t delivered on that promise either, especially lately, since big chunks of money have begun flowing into them. During the tech bubble at the turn of the century, hedge funds often did what they were supposed to do. For example, the Yale Endowment – heavily invested in some of the world’s great hedge funds – performed exceedingly well during that period. From July 2000 through June 2003, while the S&P 500 fell 33 percent, Yale’s endowment actually gained 20 percent. Yale’s portfolio continued to perform well until 2008.

However, things didn’t go so well for Yale and for hedge funds generally during the financial crisis beginning in 2008.Yale lost 24.6 percent in its fiscal year 2009 (compared to an S&P 500 loss of roughly 26 percent over that time). Perhaps worse, hedge fund investments were highly and surprisingly correlated with traditional equities during the financial crisis. What was supposed to be an important hedge didn’t do its job.

Over the next several years, Yale and other similarly managed endowments, with large hedge fund allocations, continued to underperform. State pension fund trustees relying upon hedge funds obtained similarly poor results.* Over the most recent ten-year period ending December 31, 2013, trailing returns for 835 endowments across the United States, heavily reliant upon hedge funds (53 percent of their assets were allocated to “alternative strategies, largely via hedge funds), averaged 7.1 percent while the S&P 500 Index over the same period returned 8.78 percent per year.

It is of course unreasonable to expect a hedge to perform well when traditional markets rally (as during much of the last five years), but the underperformance and correlation during the financial crisis coupled with the extent of the more recent underperformance is troubling indeed. CalPERS also highlighted the high costs of evaluating, monitoring and managing hedge-fund investments, even after the exceedingly high fees.

In a Bloomberg View column, Barry Ritholtz of Ritholtz Wealth Management asked a primary but often overlooked question: Why hedge? As Ritholtz persuasively argues, people and entities with sufficiently long investment horizons simply don’t need a near-term hedge. Thus CalPERS, with its very long-term outlook and consistent cash inflows from current workers, doesn’t need to hedge. In essence, lower returns – even with lower volatility – simply don’t make a lot of sense. At the retail level, it seems that investors are more interested in feeling rich and having access to offerings they perceive as exclusive than in owning a quality investment.

With that (lengthy) introduction, the latest news about hedge funds seems — at first glance at least — more than a bit surprising. Chief Investment Officer reported last week on a study of major plan sponsors and found that these investors were remarkably bullish about hedge funds and other alternative investments (see below).

Source: Quinnipiac University and the Connecticut Hedge Fund Association

Indeed, plan sponsors reported, despite abysmal overall performance by hedge funds and commodities, that they actually planned to increase their allocations to such alternative investments over the next 12 months (see below).

Source: Quinnipiac University and the Connecticut Hedge Fund Association

What should we make of this counterintuitive news? Since hedge funds are not an asset class, it can’t be a mean reversion play.

A (only partially) tongue-in-cheek piece entitled 17 Signs You Were a CIO in 2014, also in CIO, offers a good starting point.

5. As soon as CalPERS announced it was killing its hedge fund program, you began mentally preparing to defend yours to your board — and then actually had to do so at your next meeting. The tactful CIOs among you rehearsed delicate ways to differentiate your portfolio from the Sacramento giant’s. The cynical mumbled the word “politics,” and the shy emailed their consultant to prep a PowerPoint.

….

13.  Your spouse is so tired of hearing you rant about that one board member. “Yes, dear, I know he’s very frustrating and refuses to understand what basis points are/how risk parity works/why shifting to an all-passive allocation is a bad idea at this point in the cycle. No, dear, I’m sure he’s not doing that intentionally to make you want to stab yourself in the eye with a pen. And, sweetheart, I think you’ve had enough Scotch for one night.”

Facing individual challenges from skeptical board members, plan professionals are not likely to admit having been in error. They hope, with varying degrees of confidence, that their chosen vehicles will in fact do what they want when the market (inevitably) turns…whenever that turns out to be. I suspect that the conversations go something like this…

Do our hedge fund positions make sense anymore? Our performance relative to the standard indices has been really poor.

You’re asking the wrong question. Our return expectation for our hedge fund positions is much lower than it used to be. The old days of always thinking about double-digit returns are gone, probably forever. We’re much more focused today on downside protection. Thus we are pretty happy overall with the past five years even though our hedge funds didn’t come close to outperforming the S&P. Upside is pretty easy to get, generally, but we are in need of downside protection to offset our beta risk. We use a return assumption of roughly 5-6 percent for our diversified portfolio of hedge funds and have hit those numbers which compares very favorably to core fixed income, where the expected return is only 2.5-3 percent. As long as the expected return is higher for hedge funds than fixed income, we will continue go there. You’ll note that our performance stacks up quite well to our peers.

But they have lots of hedge fund exposure too.

Smart investors recognize that to compound your returns, you have to implement a strategy where one might get a fraction of the S&P returns but have downside protection. But we’ve done more. We have constantly and consistently measured and monitored the performance of our outside managers and have demanded much more in the way of transparency and much less co-mingling of accounts. We now have SMAs that allow us to see if these guys are doing what they say they are going to do.

What do you mean?

We now have the ability to run better risk scenarios and perform factor analysis on hedge fund positions side-by-side with our broader set of portfolio holdings. That allows us to assess sources of beta and alpha universally. This has facilitated our risk-aligned portfolio model, so hedge fund allocations have made sense in recent quarters despite disappointing performance. Hedge funds (and we) screwed up pretty badly in 2008, but we have much better controls in place now.

So bad performance isn’t really bad?

We now look at the marginal contributions of our hedge fund allocations to risk and return. We look at the exposure overlaps as well as the position overlaps. We look at each manager’s return stream and determine how differentiated those return streams are. We want to be sure our hedge fund managers are doing what we pay them to do, which doesn’t mean beating the S&P 500. It means correlating with the things they’re supposed to correlate with, not correlating with the things they’re not supposed to correlate with, and enhancing our overall portfolio in ways we can’t easily do on our own. Diversification is painful because some parts of a diversified portfolio will seem to be doing poorly even when they’re doing exactly what we want them to.

But don’t they cost too much?

You get what you pay for.

So you’ll be sticking with them?

We will actually increase our hedge fund allocations some because things are working so well. By their nature, hedges will underperform in a rally and the traditional markets have gone mostly straight up since the financial crisis. You’ll see the benefit of our approach when the market turns – as it inevitably will.

But according to some analysis from David Swensen and Yale, an “average endowment” — whose asset allocation surely looks a lot like ours — runs a 28 percent chance of losing half of its assets (in real terms) over the next 50 years and a 35 percent chance risk of a “spending disruption” over the next five years. Doesn’t that worry you?

Nobody’s perfect, but our risk control mechanisms have been really beefed up.

So in essence we’ll be doubling-down on hedge funds and hoping for the best?

Yes.

Do you think we’re at greater risk of a weak market now than we have been?

It’s hard to predict the future, but, as I said, the market always turns.

When it does, would we be better off in cash than in the hedge funds?

Well, that’s a good question. Probably, perhaps even substantially better off, but cash has a negative real return right now, so it doesn’t make any sense to take a radical step like that.

If we did, though, and the market goes down, wouldn’t we be able to pick up some bargains with our cash?

Theoretically, yes.

Could we sell our hedge funds and do the same?

Not really. We can only get our money out at certain times, and usually not all at once. But we would expect our hedge fund managers to pick up some of those bargains on our behalf.

Have they been good at doing that in the past? Is that what happened in 2008 and 2009?

We think we have a stable of managers that will do that for us, yes.

But, I’m confused, will they be increasing their risk then? If we expect them to have a reduced risk profile in our scheme of things, are they going to abandon that then? If they don’t, who will pick up the slack – and pick up the bargains? What’s the use of a weak market if we don’t have any money to put to work when it shows up? Like I said, I’m confused.

That’s understandable. It’s all quite complex, but you can rest assured that our risk management system helps us maintain an optimal portfolio no matter what. You might not see the need for the hedge funds, but they make sense. Everything we know about markets indicates that they will prove their worth some day.

It’s the waiting part that’s hard.

_______________

* The outperformance by the big endowments in the 1990s was driven largely by investments in older, more established venture capital firms which were frequently difficult to get into and size-constrained but which offered great results. For example, Yale made “home run” early investments in Compaq, Oracle, Genentech, Dell Computer, Amgen, Amazon, Yahoo, Cisco Systems, Red Hat, Juniper Networks, Google, Facebook, LinkedIn, Twitter, and Zynga. By 1999-2006, the performance advantages of these types of funds had largely dissipated. A major academic survey found that “an influx of capital into private equity is associated with lower subsequent returns.” In other words, the trade had gotten increasingly crowded. For further support of this idea, Cambridge Associates estimates that 3 percent of venture capital firms generate 95 percent of the industry’s returns and adds that there is little change in the composition of those 3 percent of firms over time (more here). Newer and smaller players (“not Yale”) don’t have that level of access. According Yale itself, “nearly 80 percent of Yale’s outperformance relative to the average Cambridge Associates endowment was attributable to the value added by Yale’s active managers, while only 20 percent was the result of Yale’s asset allocation.” But, obviously, not everyone can get access to what and who Yale does. Because the difference between good and not-so-good is particularly acute in this space, lesser endowments get disappointing leftovers. Moreover, since even Yale has now significantly reduced its private equity exposure, if you don’t have Yale’s access and expertise, you might well decide to limit AI exposure to that needed for reasonable diversification. And you might not even play at all.

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