Reuters/ Max Whittaker

The hedge fund industry today is buzzing about the nation’s largest public pension fund’s decision to ditch all of its hedge fund investments.

On Monday, the California Public Employees’ Retirement System (CalPERS) said it’s dumping all of its hedge fund investments because of fees and complexity.

“Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size, the ARS program is no longer warranted,” Ted Eliopoulos, CalPERS Interim Chief Investment Officer said in a statement.

We’ve spoken to a few managers who run money for institutions like CalPERS. The sentiment from them is that hedge funds as an asset class aren’t the problem. Instead, it’s the particular hedge funds CalPERS chose to invest. Investments were made largely based on the fee structure of the fund, not on the potential alpha the fund could deliver. Those funds which reduced their fees for CalPERS won the allocations.  

“I think CalPERS is not a particularly good hedge fund investor,” one prominent hedge fund manager told Business Insider. He cited the pension fund’s lackluster annualized rate of return of 4.8% over the last ten years. “I would redeem too.” 

He continued: “I think it’s not hedge funds as an asset class. It’s the ones they invest in.”  

Another prominent hedge fund manager echoed that same sentiment. 

“They got what they paid for since they only invested in managers who would cut fees. So the best funds wouldn’t do that, so they had a mediocre portfolio.”

In 2013, CalPERS spent $ 135 million on fees for a 7.1 percent return, according to Bloomberg News. 

In general, there has been a backlash against fees hedge funds charge their investors. 

Fund managers are paid through a compensation structure commonly known as the “2 and 20,” which stands for a 2 percent management fee and a 20 percent performance fee charge. More specifically, “2 and 20″ means a hedge fund manager would charge investors 2 percent of total assets under management and 20 percent of any profits.

Here is how the fee structure would be at a hedge fund with this structure that manages $ 100 million: If this fund earned 20 percent in a year, the fund would earn approximately $ 2.4 million in management fees (2 percent of $ 120 million is $ 2.4 million). They would also earn $ 4 million in incentive fees (20 percent of $ 20 million). Combining those two revenues, they would earn a total of $ 6.4 million on the $ 20 million made leaving the investor a net of $ 13.6 million.

This was a simple example as there can be lots of variations on these fees depending on the fund.

Given the struggles of major macro hedge funds of last five years and the strong performance of passive investments, it has become harder for many hedge funds to justify the fees. 

“Most hedge funds offer a questionable value proposition, but everybody invests in the HOPE that they will get an upper quartile manager who is worth the fees.  But by definition, at least half, probably ¾ of hedge funds don’t offer value after fees,” another hedge fund manager told us.

“[There] is a general backlash against hedge fund fees, again this is down to the optics of equity performance currently versus hedge funds. In bad times they will see, if they chose their managers carefully who do not just mirror the S&P 500, that they will over perform across the general cycle,” a macro fund manager told us.

Others think CalPERS move is symbolic of a market place that is confusing the role of a hedge fund compared with that of a long-only mutual fund.

“This is more to do with CalPERS inability to meet its own performance targets and thus reduce their deficit. They are actually taking more risk and not less risk by lowering the diversification hedge funds can offer in bad times,” the macro fund manager told us.

“That being said, hedge funds themselves are tending to mirror the stock market because they are under pressure by their investors (the same pension funds) to produce equity like returns. These things tend to happen when volatility in equities is low so people confuse the actual risk in owning them.”

Folks in the hedge fund space are certainly wondering if other pension funds will follow suit. While CalPERS is the largest U.S. pension fund, they only invested in 24 hedge funds and six fund-of-funds with a total investment of $ 4 billion.

“They were tiny. 1.5% of the portfolio? They were clearly never believers.” 

Business Insider » Finance

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