CalPERS’ hedge fund decision offers important lessons

By Dan Hallett, CFA, CFP on September 26th, 2014

The California Public Employees’ Retirement System – aka CalPERS – announced plans to liquidate its $4 billion hedge fund portfolio.  It’s big news because CalPERS is considered a well-run pension plan.  It’s huge – at nearly $300 billion USD – and it was one of the first pension plans to invest in hedge funds.  Investors and advisors could learn a thing or two from CalPERS’ latest decision.


CalPERS interim Chief Investment Officer Ted Eliopoulos said in a recent Bloomberg interview that a key factor in its decision was its inability to add enough money to maintain a meaningful hedge fund stake.  For example, in mid-2002 CalPERS’ portfolio was $142 billion – of which $6.6 billion – or 4.6% – was invested in more than 200 hedge funds.

Eliopoulos said that CalPERS’ hedge fund investments make up just over 1% of the plan’s $300 billion.  CalPERS’ hedge fund allocation has been under review for a few years but it makes sense that spreading such a small percentage of the portfolio across hundreds of hedge funds would not have a meaningful impact on the fund’s diversification or returns.  But a dozen years ago the fund had almost $7 billion in hedge funds.  Now it’s $4 billion.  So they’ve already been actively pulling money out of hedge funds.  And the other two reasons given by Eliopoulos – cost and complexity – are likely the bigger factors at play.


CalPERS’ Statement of Investment Policy for Investment Beliefs lists ten ‘beliefs’ that guide the fund’s decisions.  Belief number VIII is:  Costs matter and need to be effectively managed.  During the above interview, Eliopoulos said that CalPERS’ equity management cost them just 1 basis point or 0.01% of equity assets.  Their bonds cost 0.07% annually.  This is a function of CalPERS’ size and cost-sensitivity.

CalPERS was able to negotiate lower-than-usual fees for most hedge funds but fees still amounted to $135 million last year – or about 3% of its $4 billion stake.  And this takes a huge slice out of hedge fund returns.  Yet hedge funds are alluring.

The promise of making money when stocks are down; the notion that it’s how the wealthy invest to get richer; and the indication that in the past stock-like returns were achieved with bond-like risk all make us want to try to capture some of these unique benefits.  But the costs are often higher than most realize.

Percentage fees are levied on gross assets (not net equity).  So using leverage increases total dollars paid in fees.  Borrowing costs incurred in short selling and other operating expenses also drive up costs.  And when expressing total fees and expenses as a percentage of net assets invested, all-in fees commonly fall in the high-single-digit or low-double-digit range.


Retail investors have learned the hard way about the dangers of complexity risk.  You can’t form realistic risk and return expectations if you don’t fully understand the product.  With hedge funds complexity is observed in product structures, strategies employed and the general lack of transparency.  CalPERS’ investment belief number VII reads:  CalPERS will take risk only where we have a strong belief we will be rewarded for it.

Investments involving leverage, high costs and complexity typically involve higher risk – and a lower chance for adequate rewards.  Compounding this challenge is the notion of a crowded trade.  With stock investors having experienced two bear markets in the 2000s, many sought so-called ‘uncorrelated’ strategies to boost risk-adjusted returns.  And with significant inflows that have pushed assets well north of $2 trillion, hedge funds are a crowded field chasing a shrinking amount of excess returns.

One of our firm’s core beliefs – and it is the first on CalPERS’ list – is to construct investment portfolios by matching assets with future spending liabilities.  Tom Bradley wrote in a recent blog post – What’s wrong with vanilla? – that investment portfolios’ core still belongs in traditional stocks and bonds.  And these are the building blocks for achieving this asset-liability match.  Meaningful but limited exposure to alternatives – e.g., real estate – can make sense so long as the fundamentals are well understood.  Otherwise, the bulk of the portfolio should be pretty much plain vanilla.