Should Public Pension Funds Reduce their Hedge Fund Allocations?

(HedgeCo.Net) CalPERS was the first high profile public pension to pull out of hedge funds, and was followed a year and a half later by one of the New York City retirement plans. Recently, the number of public pension funds exiting or reducing their hedge fund exposure has accelerated. We believe this trend will increase over the next 12 months due to growing political pressure on investment staffs of public pension funds from the media, union employees, and politicians. The pressure is being driven by unrelenting negative articles about the industry focused on the recent poor performance of various hedge fund indices and high fees.

This trend comes at a time when the average public pension fund is only approximately 74% funded based on an average actuarial rate of return of 7.5% according to a research report from Wilshire Consulting’s Investment Research Group. Many professionals believe that this expected return is unachievable in today’s low interest rate environment. If the actuarial rate of return was lowered to approximately 4.5%, which is what corporate pension funds are required to use, the unfunded liabilities of public pensions would skyrocket.

Many critics cite the underperformance of hedge fund indices, as compared to equity benchmarks since the 2008 market crash, as the basis for exiting hedge funds in favor of an increased allocation to stocks. This strategy strains limits of portfolio diversification as many pension funds already have equity allocations near all-time highs. Notwithstanding the diversification issue, does it really make sense to increase equity allocations after a 6 year period where the market has gone almost straight up, and current valuations are well above their historical averages?

It is important to review why pension funds significantly increased their allocations to hedge funds and re-examine these reasons in the current environment. The catalyst for this growth was the market sell-off of 2008 during which time most public pension funds sustained large losses across their portfolios. Public pensions increased their allocation to hedge funds in order to enhance returns, increase diversification, and reduce downside volatility.

Can hedge funds increase the forward-looking returns of pension funds?

Pension funds must prudently invest the assets of plan beneficiaries. Most pension fund managers apply modern portfolio theory to construct diversified portfolios across multiple asset classes on the “Efficient Frontier” seeking to maximize risk-adjusted returns. For each component of their asset allocation, this requires a forward looking forecast for expected return, volatility, and correlation to other components of the portfolio. These assumptions are based on a combination of long-term historical returns for an asset class, current valuation levels, and economic forecasts. Together, these variables are applied to optimization models to help determine the asset allocation with the highest expected return for a given level of volatility.

As of the end of the 3rd quarter of 2016, the Barclays Aggregate bond index was yielding approximately 2%. This would result in most pensions using a forward looking return assumption of approximately 2.5% for core fixed income. Many public pension funds have significant portfolio allocations to core fixed income which often comprise largely investment grade bond holdings. To enhance pension fund returns, hedge funds do not need to outperform equities. They only need to provide returns uncorrelated to equities that will outperform fixed income.

Do hedge funds add diversification and help reduce tail risk for a pension fund’s portfolio?

One practical shortcoming of applying modern portfolio theory when diversifying allocations across multiple asset classes, is that these models have proven to break down during severe market sell-offs. This was a painful lesson learned by pension funds in 2008 when almost all segments of their portfolio declined simultaneously. The reason these models break down is because two of the inputs are dynamic. When markets sell off, correlations among both long only investment managers and asset classes tend to rise significantly. When combined with a spike in volatility, this creates much more tail risk than originally perceived. In contrast, many hedge fund strategies have correlations that are very low relative to the capital markets benchmarks and some have the potential to become negatively correlated during a market sell-off. This was seen in 2008 when a few hedge fund strategies posted positive returns.

Many pension funds were fortunate that a relatively quick recovery of the capital markets was precipitated by quantitative easing. However, equities can sustain significant declines for long periods of time. For example, the US stock market declined over 80% during the great depression and took 23 years to recover. The Japanese Nikkei index hit an all-time high of approximately 39,000 in 1989, and more than 25 years later is still below half its peak. Since most public pension funds are heavily under-funded, a prolonged sell-off in the capital markets would leave many pension plans unable to pay benefits without increased funding at a time when state and local governments can least afford to make additional contributions to these plans.

Three keys to investing in hedge funds to help improve the probability of success.

1. Understand that hedge funds are not an asset class but a fund structure consisting of numerous investment strategies. The performance of hedge fund strategies and their correlations relative to long only benchmarks varies greatly. In a diversified hedge fund portfolio, choosing the right strategy is more important than manager selection. Successful investing in hedge funds requires choosing strategies that will enhance a portfolio in the context of an investor’s objectives. Some examples include:
· Reduce the volatility and tail risk in the portfolio.

· Outperform the risk-free rate by 4% annually.

· Build a portfolio of fixed income oriented strategies that will enhance the risk adjusted return of the fixed income portion of the portfolio.

· Outperform the equity markets with less risk.

Each of these objectives requires a very different composition of hedge fund strategies and benchmarks.

2. Selecting managers who are likely to outperform is critical. With low barriers to entry and over 15,000 hedge funds in the industry, we believe only 10% of managers deliver on their value proposition and justify their fees. This is why hedge fund indices, which track performance across the industry, perform poorly.
Hedge fund managers should be evaluated across multiple factors including: organization, investment team, investment philosophy and process, performance, risk controls, and service providers. The managers who have the highest probability of outperforming are those who rank well across each of these factors, have identified (and can clearly articulate) an inefficiency in the market, and have a differential advantage in capturing that inefficiency.
The biggest mistake many investors make is only investing in the largest managers with the strongest brands. Unfortunately, many of these managers have allowed their assets to swell well above their optimal capacity which causes returns to be diluted. Often the best performing managers are small and midsized managers with nimble investment portfolios.

3. Fees matter. Despite many articles to the contrary, the traditional hedge fund fee structure of a 1.5% to 2.0% management fee and a 20% performance fee, is not dead. This is what most investors continue to pay unless they are investing in emerging managers that are offering founder’s share discounts or 40 ACT funds. However, many hedge funds have begun to scale or negotiate their fees schedule, providing meaningful discounts for larger allocations. Large pension funds should not be paying traditional hedge fund fees to most managers.
In summary, though hedge funds can help enhance returns, reduce volatility, and help reduce tail risk, we expect to see more pension funds exiting or reducing their allocation to hedge funds due to mounting political pressure. Some pension funds will reduce their allocation methodically by focusing on those strategies that best meet their objectives. Others will do so haphazardly, unfortunately to the detriment of their plan beneficiaries.

Donald A. Steinbrugge, CFA
Managing Partner
Agecroft Partners, LLC
103 Canterbury RD
Richmond, VA 23221

This entry was posted in HedgeCo Networks Press Releases, HedgeCo News, HedgeCoVest News. Bookmark the permalink.

Leave a Reply