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Research Department

September-23-14

Calpers To Quit Hedge Funds

Last week, CALPERS (California Public Employees' Retirement System) announced that it would liquidate its $4 billion hedge fund portfolio. What does it mean to investors?

What is CALPERS?

CALPERS is the largest pension manager in the U.S., with $300 Billion in assets invested worldwide and serves 3,000 public sector employers in California. It is also known as one of the most sophisticated investment organizations in the world.

What are Hedge Funds?

Hedge funds are better understood when compared to active equity funds. An active equity fund manager selects the stocks he or she believes will outperform the general market index. Active equity fund returns are driven by two factors: first the manager’s stock selection skill and secondly the correlation with the general direction of the market. In any given year, active equity funds tend do well (in absolute return terms) when the market is positive and vice versa, regardless of their managers’ stock selection skill. This is what the pros mean with the expression “a rising tide lifts all boats”. In an active mutual fund, the “correlation” component dominates portfolio returns and the value added by the “skill” factor is much smaller.

Hedge funds are less constrained than mutual funds in how they manage assets: they are typically allowed not only to purchase the stocks they expect to outperform, but also to sell short the stocks they expect to underperform. Due to these short sales, their returns are relatively less driven by the “correlation effect” and more by the “skill effect” compared to active equity funds. Hiring more skill and less correlation is the major reason why institutions hire hedge funds. In a nutshell, hedge funds represent an extreme type of active investing, because skill is what distinguishes “active” or “predictive” investing from “passive” or “market-based” investing.

Why did CALPERS drop hedge funds?

CALPERS cited three reasons to explain its decision:

  1. Reduce complexity: Hedge funds are generally more complex than other asset classes, which is considered a serious drawback.
  2. Reduce costs: Hedge funds’ management fees and transaction costs, which reduce investor returns, are generally very high.
  3. Lack of ability to scale hedge fund strategies: CALPERS’ assets are so large compared to the active profit opportunities in the market that its hedge fund portfolio is unlikely to make enough money to have any material impact on the manager’s return.

Is this a Big Deal?

Yes and no. From CALPERS perspective, their $4 billion investment in hedge funds represents slightly more than 1% of their assets under management, which is relatively small. But it’s a serious signal for other investors. If such a large and resourceful organization decides to walk away from hedge funds because the benefits of skill and low correlation are outweighed by complexity, cost and scale problems, we doubt the equation is any better for other investors.

Our Take Away

In our view, this one more piece of evidence in favor of market-based investing. When an organization such as CALPERS says it’s not worthwhile for them to pursue extreme active management, it sends a powerful message. Yes, there may be some potential profits from active (predictive) investing, but they are not large enough to cover their cost.

By: Raymond Kerzérho | 0 comments