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.” 

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The Consequences of Crowding

It is axiomatic in the investment world that as an approach, sector or asset class becomes more popular, it suffers from both falling expected returns and rising correlations.  In other words, good trades get crowded and their advantages tend to disappear.  This crowding happens because success begets copycats as investors chase what has been hot.  Our behavioral biases all but demand it. 

Those of us who have been around long enough have seen this ongoing give-and-take happen time and time again.  Whether we’re talking about large-cap Dow stocks in the 60s (the “Nifty Fifty”), gold during the 70s, Japanese stocks in the 80s, U.S. stocks (especially techs) in the 90s, or more recently (for example), gold, commodities, bonds, China, private equity and Apple, to name but a few, the trend is your friend right up and until it isn’t anymore. Let’s take a quick look at one of these examples, currently in the news, and examine the consequences of failing to recognize the crowding phenomenon and to adapt to the consequences thereof in a very specific context.