Can’t pay, won’t pay
Hiring hedge funds was never going to make pension deficits disappear
The CalPERS press release specifically says that the decision is not based on the performance of the programme. But Ted Eliopoulos, the chief investment officer, said that “when judged against their complexity, cost and the lack of ability to scale at CalPERS’ size”, the allocation to hedge funds was no longer warranted.
It is hard to believe that, if the performance of the programme had been stellar, the pension fund would have axed it. But the reference to scale is also striking. Very small pension funds tend not to have the money or the expertise to invest in hedge funds. Now CalPERS (the sixth-biggest pension fund in the world, according to TowersWatson, an actuarial consultant) is saying that it is too big to be involved. Who does that leave?
Investing in hedge funds requires one to believe in three things. The first, which is plausible, is that there are anomalies in the market which a shrewd fund manager can exploit. One example is momentum, the tendency for assets that have recently risen in price to continue doing so. The second requirement is to identify such outperforming managers in advance. This is much more difficult. It takes time to spot good managers, but the average life of a hedge fund is less than five years, indicating that many managers have to give up for lack of clients or because of poor performance. In addition, half of all current funds are less than five years old.
Even if one can successfully identify smart managers, one must then believe that the excess returns will be sufficient to outweigh their high fees. Not all managers charge the “two-and-twenty” of legend (a 2% annual fee plus 20% of the return over a given benchmark) but enough do to make this a very high hurdle to overcome. And investors who use a consultant (or a fund of funds) to help with the selection process have to pay an extra layer of fees.
The evidence for stellar hedge-fund performance is not convincing. Of the last ten calendar years, only one (2005) has seen the average hedge fund outperform a portfolio of 60% equities (the S&P 500 index) and 40% government bonds. Far from being masters of the universe, the managers have been mastered by the market.
One could argue that hedge funds offer a different type of return—less volatile and thus offering a better trade-off between risk and reward. But the example of 2008, when the average hedge fund made a loss of 23%, makes that a harder case to argue.
Anyway, it seems unlikely that pension funds have been putting money into hedge funds for such a reason. It is more likely that a hedge-fund allocation is part of a “Hail Mary” bet, with pension schemes looking for something, anything, that will pep up returns, and help to reduce yawning deficits. CalPERS highlights the issue with its claim that it has adopted “a new asset-allocation mix that reduces risk to the portfolio, while still being able to achieve its return goal of 7.5%.”
The risk-free rate (the yield on the ten-year Treasury bond) at the moment is around 2.6%. One has to take on a substantial amount of risk to hope for a return five percentage points higher than that. CalPERS points to its 8.4% annual return over the past 20 years, but that is irrelevant: when yields fall to historic lows, as they have over those two decades, investors make a capital gain that boosts returns. One cannot expect such returns to continue without a similar plunge in yields in future, which is almost impossible. And a world in which Treasury bonds yielded even less would probably be characterised by slow growth and deflation—not an environment in which CalPERS’s equity portfolio would thrive.
Even if hedge-fund managers did outperform a market index on a reliable basis, it would not solve the problem of pension funding. The 300 largest pension funds in the world have assets of $15 trillion; total hedge-fund assets are around $2.9 trillion, or a fifth of that. So if pension schemes were the only clients of hedge funds, and if they earned an excess return of two percentage points a year after fees, that would still boost overall pension returns by just 0.4 percentage points a year. No wonder CalPERS thought it wasn’t worth the bother any more.