Calpers Has Lost Interest in Hedge Funds
Here is a simple model for hedge fund fees:
- There are some people who can reliably generate alpha -- returns in excess of the market return -- but those people are rare.
- It is somewhat difficult to tell who those people are; in particular, at any given time, there are more people who look like they can generate alpha than who actually can. 1
- If you are one of the people who can generate alpha, you should charge a fee for your services that is equal to the alpha that you generate.
- If you are not one of those people, you should charge a fee equal to the alpha that those people generate, because then investors might think that you're one of them.
This is a cynical and stupid model but it makes some interesting factual predictions, including
- that hedge funds won't compete on fees, because charging a high fee is a way to demonstrate that you can generate alpha,
- that the alpha generated by the hedge fund industry as a whole, net of fees, for outside investors, will be negative, 3 and
- that the more hedge funds you invest in, the more closely your return will approach the industry-wide return, that is, negative alpha. 4
How do those predictions hold up? Well, the first one is pretty good; hedge funds charge pretty similar fees across a wide range of sizes and strategies. The second one is harder to measure, though lots of the measurements that are done don't find much industry-wide alpha. 5 If you can find the people who generate alpha, and convince them to give you some of it, then that's great. If not, probably stick to indexing.
The news that the California Public Employees’ Retirement System will stick to indexing is thus pretty fascinating. Calpers, of course, is good at indexing. Indexing is a big thing for Calpers. Which makes sense. Calpers manages $298 billion. If you have $10,000, you can put it all into like Zynga stock and either make a ton of money or go broke. If you have $298 billion, odds are that you're going to end up getting something pretty close to the market return. 6 Calpers is the market. If you're getting something pretty close to the market return anyway, then indexing is going to be cheaper and easier than spending a lot of time and money trying to get a slightly-better-than-market return.
The weird thing is that Calpers seemed to apply a not-dissimilar approach to its $4 billion of hedge fund investments; it apparently had "24 hedge funds and six hedge fund-of-funds" in its portfolio. My first reaction was: Why does Calpers invest in funds-of-funds? You or I or our rich friend might invest in a fund-of-funds because it's the only way for us to get access to good managers, or because we only have a few million dollars and want to diversify among several managers, or perhaps because we lack the expertise to pick really good managers. But Calpers? Calpers is the elephant in the cliché; it can get access to any hedge fund that any fund-of-funds can get access to, and with $4 billion in hedge funds it can self-diversify.
But it ... seems to have really wanted to diversify? Like, if you want to invest in a bunch of hedge fund subclasses, sure, hire funds-of-funds to pick your managers in each subclass, so that all your bases are covered, and you don't have much concentration risk with any manager. But concentration risk is sort of the point of hedge fund investing. Remember, the more hedge funds you invest in, the more closely your return will approach the industry-wide return. Which is not where you want to be.
Particularly if your hedge fund allocation is just $4 billion of a $298 billion portfolio. That's a lot of money -- enough to require splitting among multiple managers -- and yet it's not much of the portfolio. And so some of the generic arguments for hedge funds -- that they diversify your portfolio and shield against adverse market moves -- look a little silly here. Like, sure, Calpers can invest in an equity long/short fund. But almost 40 percent of Calpers -- over $100 billion -- is in U.S. public equities, much of it invested passively. So it's nearly certain that if Calpers is short a stock via the equity long/short portion of its hedge fund allocation, it is also long much more of that stock, because it is long a ton of every stock. You will not find "long a stock, and short the same stock at hedge fund fee rates" on the efficient frontier.
I like to quote the old line that, "Hedge funds are a compensation scheme masquerading as an asset class," but the best way to think about them is as neither. A hedge fund, ideally, is a smart person making smart trades with your money and giving you some of the profits. But once you allocate an absolutely large, yet relatively small, amount of money to hedge funds as one asset class among many, you run into the problem that they're not an asset class. Your hedge funds are investing a little bit of money in the things -- stocks, bonds, etc. -- that you were already investing a lot of money in. 7 They're just charging more for it.
So the Calpers indexy approach to investing doesn't work so well with hedge funds. I suppose it could try the other approach -- concentrate on a few managers who are actually adding value to the portfolio -- but that is not easy. It is hard to pick the good hedge funds. So you need to hire smart people and pay them big salaries to pick your hedge funds for you, just as you'd have to hire smart people and pay them big salaries to pick stocks or bonds or any other investments for you. 8
But once you have hired people to invest some of your money in hedge funds, they will want to invest more of your money in hedge funds. Their job, after all, is to invest your money in hedge funds, and for some reason people invariably want to do more of their jobs, that is like a defining feature of the modern condition. More concretely, expanding their portfolio lets them argue for higher pay and more status and more subordinates and so forth. And investing in more hedge funds lets them hobnob with (and do favors for) hedge fund and fund-of-fund managers, which has its own advantages. (Not that hedge fund managers are awesome, I mean, but that they might hire them later at higher-than-Calpers salaries.)
So a hedge fund allocation will have a natural tendency to grow, stop focusing on good managers, and become more like an index of hedge funds. And that would not be surprising at Calpers, which has a tendency toward indexing anyway. But it's probably a bad tendency, for the hedge funds. The simplest way to stop it is to cut it off at the root, by cutting out the hedge funds entirely. If they weren't really working as an asset class anyway, then Calpers won't miss them when they're gone.
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This is a simple coin-flipping-contest argument. If your test of "can reliably generate alpha" is "generated alpha in each of the last three years," then you will pick up most (all?) of the people who can reliably generate alpha, and also a lot of other people who had a lucky three years.
This argument relies on the scarcity of that skill. It also assumes that that skill is much more valuable than funding -- that is, that the people who can generate alpha need money less than the people who have money need alpha generation. You can quibble with those assumptions, but I think they're plausible.
Take, for instance, our favorite example, briefly mentioned earlier, of people who seem to be able to consistently beat the market: Renaissance Technologies. It's really hard to reconcile their results long-term with market efficiency (and any reasonable equilibrium model). But here's how it's still pretty efficient to us: We're not allowed to invest with them (don't gloat; you're not either). They invest only their own money. In fact, in our years of managing money, it seems like whenever we have found instances of individuals or firms that seem to have something so special (you never really know for sure, of course), the more certain we are that they are on to something, the more likely it is that either they are not taking money or they take out so much in either compensation or fees that investors are left with what seems like a pretty normal expected rate of return. (Any abnormally wonderful rate of return for risk can be rendered normal or worse with a sufficiently high fee.)
That is, successful alpha generators will generate zero alpha, or thereabouts, for outside investors net of fees. Unsuccessful alpha generators will generate negative alpha for outside investors net of fees.
As Dan McCrum puts it:
It also points to the problem of constructing a hedge fund portfolio. The great selling point for hedge funds is the individual genius of hedge fund managers. There are a lot of very smart people out there, and it is easy to laud the small number having a moment in the sun when they have a great year or two, investment performance wise. ...
The more hedge funds that are added to the portfolio, the closer returns will be to that of the average hedge fund, which has failed to beat a simple mixture of stocks and bonds for many years.
Richard Beales and Dan McCrum are among those bringing up the poor performance data today. Here is a Bloomberg Businessweek article noting that the HFRX Global Hedge Fund Index mostly trails the S&P 500 index in recent years, though of course there's no reason to think that the S&P is the right benchmark, or that the HFRX is the right industry measure, or that pure returns are not a good measure of alpha. When I just run the Bloomberg BETA function (comparing HFRXGL <Index> with SPX <Index>, weekly betas, leaving everything as default), I get an alpha of -0.015 for the last year, +0.011 for the last two years, -0.005 for the last five years and +0.003 for the last 10 years. So that's pretty close to zero (net of fees), which is higher than I expected.
Obviously you can object to HFRX as a measure of the hedge fund industry, for a variety of reasons. It probably undercounts both the very good and the very bad, and there are the statistical problems that you'd have in a largely self-reported index.
I'm being super loose here, but you know what I mean. Like if you put $298 billion in U.S. stocks you're gonna get close to the stock market return. If you put $298 billion into global financial assets you're going to get something close to the weighted average of the market returns on the asset classes you invest in, weighted by how much you invest in each asset class. Probably you should spend some time thinking about that allocation.
So take activist hedge funds. Activists are having a good run recently. But for Calpers, putting a billion dollars into a few activist funds and effectively having $100 million or less of exposure to some activist situations -- less than a tenth of 1 percent of its equity portfolio -- doesn't really move the needle. It already has an exposure -- quite possibly a bigger exposure! -- to those situations, just by being long the market.
For Calpers, the way to profit from activists is not by investing with activists and paying their fees. It's by investing alongside activists, passively, by just owning a bunch of stock in a bunch of companies, some of which activists will eventually push to increase shareholder value. And in fact Calpers can even actively free-ride, like by calling up activists and asking them to get involved. Even if it's not paying their fees, activists will want Calpers as an ally, since it tends to have both a large-ish number of votes and an outsize voice in governance. (If you get Calpers to declare its support for your activist effort, you'll probably get more votes than just Calpers's.)
Anthony Scaramucci: "It's an admission by Calpers that they don't have the right staff or the right managers," sure.
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