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If CalPERS is Withdrawing from Hedge Funds – Should You?

January 5, 2015
by Jack Reynolds

There has been a lot of brewhaha in the investment community about California Public Employees Retirement System’s (CalPERS’) decision to withdraw $4 billion from hedge funds (to learn more see “CalPERS Shows Masters of Hedge-Fund Universe Have No Clothes,” WSJ Online, September 16, 2014).  Why does anyone pay attention to the CalPERS action? iStock_hedge fundsPartly because CalPERS is the largest U.S. public pension plan, and it has some of some of the finest advisers. So, if CalPERS is withdrawing from hedge funds, should you?

In a previous article of mine, Why Are Hedge Funds So Popular Despite Recent Disappointing Returns?,  I provided you with a refresher on hedge funds and critical success factors for investing in them. Is that article still relevant today? Yes. However, in today’s article, I evaluate CalPERS’ move, and provide five key points for private investors who are smaller than CalPERS (which is virtually everyone on planet Earth!).

Five Reasons Why CalPERS’ Hedge Fund Exit May Not be Relevant to Private Investors:

  • 1. Hedge funds represented a tiny fraction of CalPERS’ overall portfolio. According to the WSJ article cited above, CalPERS’ decision to exit hedge funds was based less on their returns, and more on the costs associated with managing them. Hedge funds represented less than 2% of CalPERS’ $298 billion portfolio, making their performance – good or bad – insignificant.  In my experience, clients who  allocate 10% – 30% of their portfolios to hedge funds are able to move the needle with their investments, especially in down equity markets.
  • 2. CalPERS’ move is not going to affect the investment market. The hedge funds business is going to be just fine regardless of whether CalPERS is in it or not.  The trick for sophisticated investors is to build a portfolio of hedge fund managers and funds that meet their needs: risk tolerance, return expectations, volatility profile, liquidity and tax sensitivity, which is no small matter.
  • 3. Withdrawing from an underperforming asset to invest in an outperforming asset may not be wise. One might think that withdrawing from an underperforming asset class (e.g., hedge funds) to invest in an outperforming asset class (e.g., U.S. equities) would be the right thing to do, especially since hedge funds have been underperforming for several years. However, investing in an asset class such as U.S. equities, which has recently outperformed its long-term history, may be a mistake.  This is because overall, an asset class’s investment performance tends to revert to its historical, long-term returns (i.e., reversion to the mean).  It follows that investors should harvest the proceeds taken from outperforming asset classes (e.g., U.S. equities) and invest the proceeds in underperforming asset classes (e.g., hedge funds, provided that one continues to have confidence in the managers in question).  In other words, consider pursuing a strategy that is the opposite of CalPERS’.
  • 4. Why not try to replicate hedge fund returns without hiring hedge fund managers? First, hedge fund replication is complex and controversial.  Second, replication eliminates your opportunity to select the hedge funds that are best suited to your needs. In my experience thoughtful private investors need to construct a portfolio of hedge funds that meet their particular needs, which are driven by risk tolerance, return expectations, volatility profile, liquidity and tax sensitivity. Hedge fund replication does not always focus on your specific requirements. While a hedge fund replication strategy might be suitable for a large pension fund, I do not often see hedge fund replication used by private investors.
  • 5. CalPERS’ decision to withdraw from hedge funds may have been motivated in part by internal management considerations. There may have been staffing issues, since the Chief Investment Officer (CIO) who implemented CalPERS’ hedge fund program is no longer in that post.  Perhaps the acting CIO wanted to make his mark and needed to move quickly. Regardless, this ought not to drive a private investor’s fundamental investment strategy.

If you have a comment on this article, please write your comment in the space provided below. Leaving comments allows readers to expand upon the topics I cover in my articles. So please help us all by commenting. If you would care to discuss investing in hedge funds with me personally, please drop me an email, or give me a ring at 617.945.5157.