Hedge Funds Lose Calpers, and More

Assets at hedge funds, once a niche investment vehicle for ultra-wealthy investors, hit a record $2.8 trillion this year. There are now more than 10,000 hedge funds and counting. Their steep fees have minted scores of billionaire managers and spawned not a few criminals in what has turned into a gold rush of the 21st century.

Their high-water mark may turn out to be Sept. 15, 2014.

That’s the day Calpers, the California Public Employees’ Retirement System, announced that it was terminating its $4.5 billion hedge fund portfolio to “reduce complexity and costs.”

As the biggest public pension to publicly turn its back on hedge funds — Calpers had over $300 billion in total assets at the end of its most recent fiscal year — “this is a watershed moment,” said Timothy Keating, president of Keating Investments in Greenwood Village, Colo., an investment adviser and author of several studies on asset class performance.

The decision startled the investment world, but it was hardly spur of the moment. Under the direction of Ted Eliopoulos, who was confirmed as Calpers’s chief investment officer last week, the pension fund has been examining hedge funds since February, when it revised its broad asset allocations and demoted hedge funds to a “program” rather than a separate asset class with a specified allocation target. Since hedge funds cover a wide swath of investment strategies, be it investing in and betting against stocks or fixed income and arbitrage strategies, they were hard for the fund to classify. Once the official reassessment was underway, some troubling conclusions emerged.

Foremost were fees. It’s no secret that hedge funds rank among the most expensive investment vehicles. They typically collect a performance fee, frequently 20 percent, and also take a percentage of assets under management, often 2 percent but sometimes more, even if their investments lose money. Calpers said it spent $135 million in hedge fund fees in its last fiscal year and $115 million the year before.

That’s actually a bargain by hedge fund standards, since it’s less than 4 percent of the total amount Calpers invested in hedge funds. But compared with low-cost index funds, it’s exorbitant. Vanguard, the biggest mutual fund company that pioneered low-cost index funds, said the average expense ratio for its funds is just 0.19 percent.

One of Calpers’s “core beliefs,” listed on its website, is, “Costs matter and need to be effectively managed.” Mr. Eliopoulos was at pains to say that weak performance by the hedge funds wasn’t the issue, perhaps to avoid the anger of the hedge fund industry and its bevy of consultants. But clearly, costs and performance are related.

Joe DeAnda, a Calpers spokesman, told me this week that the returns the hedge fund program generated — last fiscal year it was 7.1 percent, far below the 24.8 percent return on global equities — didn’t justify the high costs. He said Calpers had been trying to better understand the relationship between costs and performance, and evidence had been mounting that high costs correlated negatively with high returns.

While hedge funds aren’t expected to outperform stock indexes in good years, their allure is their claim to protect investors in down markets, and over time will produce higher risk-adjusted returns. But because hedge funds were only 1.5 percent of Calpers’s total portfolio, their performance had little impact on the fund’s total returns, good or bad. “It really didn’t move the needle one way or the other,” Mr. DeAnda said. To have an impact, the hedge fund program would have to be scaled up to the $30 billion to $40 billion range, he said.

At $40 billion, the fees Calpers paid would have soared to $1.35 billion, assuming it paid the same percentage, and Calpers’s investment committee balked at the prospect. While Mr. DeAnda said it wasn’t a determining factor, widely publicized tales of hedge fund managers’ excess, like the $147 million Hamptons estate of Barry Rosenstein of Jana Partners or Daniel Loeb’s $46 million Rothko painting, don’t exactly resonate with Calpers members, who are retired civil servants.

“The fees are obscene,” Mr. Keating said. “The conclusion that there’s a high correlation between high costs and poor performance is unassailable over longer periods.”

With total assets now approaching $3 trillion, the sheer size of hedge funds is also likely to lower returns. “I have long argued that the industry is overcapitalized. It seems so obvious from the data,” Simon Lack, author of “The Hedge Fund Mirage,” told me this week.

As the industry has grown, so has the number of hedge fund managers, which makes choosing the successful ones more difficult than ever. Even a pension fund as large as Calpers had only mixed success. Over the last three fiscal years, its best-performing hedge fund was Deephaven Global Multi-Strategy Fund, with an annualized return of 31 percent. (Last year, it had stellar returns of 136 percent.) But its worst fund, SuttonBrook Eureka Fund, had annualized losses of 36 percent, and last year, it returned a dismal negative 67 percent. Over periods longer than three years, Calpers’s set of hedge funds failed to meet Calpers’s target rate of return.

Calpers had stakes in over 20 individual funds, which in Mr. Lack’s view, is too many. “You have to have incredible skill at manager selection,” he said. “Not everyone can pick hedge funds, but if you have that skill, you don’t want too many. The more funds you have, the closer you’ll be to the average return, which is terrible.”

Mr. DeAnda of Calpers agreed. “It’s been a constant struggle to identify and select the right managers, which is another reason the committee decided not to ramp up the program.”

Ultimately, he said, “We’re willing to take risk when we have a strong belief we’ll be rewarded. With hedge funds, we couldn’t get there. They’re expensive and they weren’t materially impacting the portfolio.”

Mr. DeAnda said about two-thirds of Calpers’s equity portfolio would now be passively managed in low-cost index funds, and “most of what we have will be passively managed.”

Other huge investors may or may not follow Calpers’s decision to go cold turkey. But Calpers is closely watched if for no other reason than its huge size.

“It may take years of mediocre returns delivered at great expense to persuade investors to reconsider hedge funds,” Mr. Lack said. “Calpers merely seems to have arrived there earlier than others, perhaps because they began earlier than many public pension funds.”

Mr. Keating said it will be hard for pension funds and endowments to ignore that “Calpers just voted with their feet.” Big investors, he said, are “going to have to ask some very uncomfortable questions: How do returns on a simple 60-40 stock and bond allocation, using low-cost index funds, compare to what they’re doing now?” The answer, he said, “is not going to be pretty.”