Heading for the entrance – why pension funds are still committed to hedge funds

So, it is no surprise that CalPERS’s decision to redeem its hedge fund holdings has generated headlines and I read with interest the article ‘End of the Road for Hedge Funds’ in the 25^th September 2014 edition of Professional Pensions Magazine. What is seldom reported with the same degree of fanfare is the growth in institutional investment into hedge funds, which has seen consistent inflows over the last twenty years.

On the one hand, one could look at the performance of CalPERS’ hedge fund allocation and conclude that they had not done a particularly good job at manager selection. You could review the performance of any number of pension funds and find better performance than that achieved by CalPERS. On the other hand –CalPERS’ entire hedge fund portfolio was less than 2% of their total portfolio – even if hedge fund performance had been top notch, it simply would not have been enough to move the needle.

In my opinion this is the heart of the problem. CalPERS are simply too big to even be able to allocate a significant portion of their portfolio to hedge funds.

A 15% allocation to hedge funds would have implied a $45 billion investment, which would have made CalPERS one of the largest multi-managers in the world. This would have represented a massive challenge, not only in terms of practical problems and challenges, but also because, in our view, there is only a limited amount of ‘alpha’ available.

Looking at it from this perspective I think the CalPERS decision makes perfect sense.

My firm Aurum has been investing in hedge funds for over twenty years. The challenge we face is capacity, i.e. the ability to invest easily in the truly outstanding managers that are producing alpha not beta. Now more than at any time previously, capacity is limited due to the substantial inflows these managers are experiencing. The bulk of these inflows are from institutional investors; notably pension funds.

The points made about hedge fund and FoHF performance are true if you take average performance based on indices. However, averages are just that and they hide the strong returns of the few exceptional managers. One can also present a very different picture depending on your choice of time horizon.

I also acknowledge that many FoHFs are dominated by equity long-short strategies, which can be accessed more cheaply via other routes. At Aurum we believe that there are many products generating return streams that are essentially ‘beta masquerading as alpha’, or are harvesting other forms of generic risk premia.  We now appear to be approaching the tail-end of a 30 year bull market in fixed income with equities having also enjoyed a stellar run since the financial crisis. In our view there has never been a more important time to have a genuine non-correlated source of return in one’s overall portfolio; and many pension funds the world over recognise this too.

Are pension funds heading for the door? Yes, but for many that door is likely to be an entrance rather than an exit for the foreseeable future.