How Will Hedge Funds Be Affected by NYCERS’ and CalPERS’ Exit?

After the 2007-08 financial crisis, many large institutional investors turned to hedge funds for diversified asset management. These hedge funds promised a package that hit home: high equity-like returns without the volatility of the market.

Investments skyrocketed. By 2014, public pensions had increased their hedge fund holdings to 5.2 percent of total assets, compared to just 1 percent a decade earlier. Hedge funds now manage six times as much as they did at the turn of the century, flaunting a $3 trillion dollar industry that drew as many critics along the way as it did billionaire elites.

Though hedge funds have consistently underperformed the S&P 500 since the financial crisis, managers continue to benefit from management fees, making larger institutional investors weary.

Source: Bianco Research

These investors are finally taking action. CalPERS (California Public Employees’ Retirement System) announced in fall 2014 that it would eliminate its $4 billion hedge fund program. The American International Group promised to halve its $11 billion investment by the end of 2017, followed by MetLife announcing a two-thirds reduction of its $1.8 billion exposure. This April, NYCERS (New York City Employee Retirement System) voted to liquidate its $1.45 billion hedge fund holdings.

These investors are cornerstones because they leave their money longer than family offices. Pension and insurance company capital stabilize hedge funds—drawing even more investments. This so-called ‘mass exodus’ has shaken industry players, but their concerns are premature and shortsighted.

The Leak is Small to Nonexistent

The media is in a frenzy over the huge sums rushing out of hedge funds—last fall, HFR Inc.published the first net quarterly withdrawal in four years. J.P. Morgan analysts predict that a total of $25 billion will exit by the end of this year.

Despite the big name departures, invested capital has shrunk by a surprisingly small percentage. Furthermore, hedge funds aren’t actually losing their institutional investors. This year, more institutions have poured upwards of $1 billion into them than ever before. Institutions that were already invested also increased allocations. Even though the $1 billion club consists of only 5 percent of all investors, they now hold a quarter of total hedge fund investments. It’s no surprise these high-profile exits are drawing headlines, but large institutional investors aren’t going anywhere. Their (growing) big-ticket sizes will keep them influential in the industry for some time.

Still, smaller investors control the majority of industry investments. Are they the next to go? Contrary to popular belief, it’s a matter of scale rather than performance. CalPERS calculated that in order to make hedge funds worthwhile, it would need between 5-10% exposure, a near impossible feat given the limited quality supply within the industry. CalPERS’ ex-hedge fund program only held 1.4% of total assets under management—a 10% exposure would have represented 1% of all investments in the industry. Smaller investors have a much easier time hitting these efficient allocation marks, and thus have infinitely less reason to cut the cord.

Effects of the Political Spotlight

This year’s elections ushered in a widespread distrust of Wall Street and its elitism. After the Institutional Investor magazine announced the world’s top 25 hedge fund managers earned $13 billion last year, the industry’s “two and twenty” fees became the symbol of excessive personal wealth.

The season fueled a growing anti-hedge-fund movement, led by a protest group called Hedge Clippers that lobbied pensions to divest from the funds. They spotlighted NYCERS hedge funds’ investments in Puerto Rican debt, accusing them of spiraling the island deeper into economic depression. These reports heightened tensions as NYCERS serves a significant number of Puerto Rican retirees.

NYCERS divested within a week of the presidential primaries. There’s no doubt the political unrest was the tipping point for many institutional investors. Democratic presidential candidate Hillary Clinton criticized the industry’s tax loopholes and Warren Buffett warned of high fees for low returns. Even the popular TV series “Billions” layered the industry’s risky investing and lavish spending into the storyline.

Tish James, A NYCERS trustee, has admitted that the Hedge Clippers contributed to their decision to divest. The recent exits are no different from corporations cutting sponsorships to athletes undergoing drug inspections. The movement is far from a mass exodus, but individual cases of preserving reputation.

Natural Selection Within the Hedge Fund Industry

The widespread disappointment with mediocre returns and expensive fees isn’t unjustified. The industry, once only an option for rich families, lost quality control as accessibility increased. Daniel Loeb of Third Point describes that “we are in the first innings of a washout in hedge funds and certain strategies.” This thinning of the herd is past overdue—Don Steinbrugge of Agecroft Partners also emphasizes “too many players,” with “85 to 90% of fund managers not worth the fees they’re paid.”

The industry is responding. Hedge funds that offered higher-cost duplicates of “liquid alternatives” or “multi-asset” options are retreating. Other managers are lowering their fees and require higher payment only after hitting certain performance targets.

The cut also treats overcrowding symptoms. Thousands of hedge funds currently compete for a small number of attractive trades. Consequently, funds are packing in the same few positions as exemplified by recent events with Valeant Pharmaceuticals. As Douglas Dachille, A.I.G.’s chief investment officer put it, “[It] looked good until the trade turned against them. Then the exit door turned out to be very small. The result was a lot of bad performance.” Underperformers are filing out in a Darwinian manner, and most are optimistic about the funds that remain.

Managing Expectations Alongside Investments

Pensions poured into hedge funds after the crisis due to their impressive record during the turmoil. Marenda, managing director of Cambridge Associates, describes how the investors were unfortunately “chasing what had worked in the last cycle, but were actually in a different cycle.”

Frustrated managers rebutted investor complaints about underperformance, reiterating their role in protecting down years rather than outperforming good years. Despite advertising strong returns, the crux of the industry lay in preserving capital and delivering superior risk-adjusted returns in the long run.

Since bull and bear markets cycle, it makes even less sense for investors to be opting out at the recent equity market push. MPI research shows that whenever significant market turbulence is taken into consideration, hefty hedge fund allocations are worthwhile. It can take a long time for equities to bounce back from downturns. A quarter of a century later, the Nikkei still sits at below half its peak of 39,000 in 1989. The US stock market took over a decade to recover from the Great Depression.

The vast majority of pensions and insurance companies understand this. A 2014 Preqin reportshowed that institutional investors’ most important factor for investing in hedge funds was uncorrelated movement with the stock market. A mere 7 percent of these giants claimed high returns to be an objective. CalPERS and NYCERS are no different—thus, more reason why their exits should be treated on a case-by-case basis.

Alternative investments are designed to be kept in portfolios despite market swings. Performance proxies reveal valuable diversification benefits of hedge funds, even during periods of extended equity bull markets. It’s time the industry stopped to take a breath. There is no mass exodus, only individual decisions based on a variety of contributing factors. At most, this is a trimming of hedges—cutting away the twigs and shaping the industry back into its most efficient form.

—

DarcMatter (“DM”) is a global fintech platform that streamlines the capital raising process for asset managers and provides investors with transparent and direct access to funds in the asset management industry.

DM’s mission is to enhance capital flow through fintech to create transparency and efficiency by providing direct access to funds in the Asset Management industry for Accredited Investors, Advisors, and Asset Managers.