California Public Pension Cuts Ties with Hedge Funds

Smart-ish move, for once


Last week, the California Public Employees' Retirement System (CalPERS), the largest public pension system in the U.S., announced that it's going to divest its assets from hedge funds. The move to withdraw about $4 billion of CalPERS $299 billion in total funds is the result of years of poor performance from hedge funds that come at a steep cost and with substantial risk. What led so many U.S. pension funds to invest in hedge funds in the first place? The answer is a long history of unrealistic expectations and mismanagement on behalf of the state government.

CalPERS' foray into the world of hedge funds has not only been plagued with scandals, it has been a disappointing investment. In 2013, CalPERS paid $135 million in fees to hedge funds and generated a rate of return of 7.1 percent. Over the last 10 years, the annualized rate of return on its hedge fund investments has been a mere 4.8 percent.  CalPERS turned to hedge funds back in 2002 as the result of the growing cost of public employee retirement benefits and the high assumed rates of return that pension funds are expected to generate on an annual basis. In some states and municipalities, these expected rates of return can be as high as 8 or 9 percent. In California, CalPERS currently assumes and expected rate of return of 7.5 percent, down from an 8.25 percent expected rate of return back in 2003. CalPERS' actual rates of return on total investments since 2003 have failed to meet expectations, averaging 6.68 percent since 2003.    

CalPERS isn't the only pension fund that has been underperforming. Since 2000, the top 100 largest defined benefit public pension funds have assumed an average expected rate of return of about 7.5 percent, but in reality they have only averaged a rate of return of 5.6 percent. Pension investment fund returns follow the markets boom and bust cycle. In good years returns can exceed 20 percent and in bad years returns can be negative 20 percent. Since 2003 though, CalPERS has failed to make up for all its losses in the bad years.  

The private sector is ahead of the curve in realizing the unsustainability of defined benefit pension plans and their overly optimistic assumed rates of return. Defined benefit pension plans are disappearing in the private sector as employers switch over to 401(k)-style defined contribution accounts. From 1980 through 2008, the proportion of private workers participating in defined benefit plans fell from 38 percent to 20 percent. In contrast, the percentage of workers covered by a defined contribution plan during that same time period increased from 8 percent to 31 percent. Some corporations still maintain defined benefit pensions, but many of those, like General Motors (GM), have aggressively lowered their actuarial assumptions. In the 1990's and early 2000's, GM assumed an expected rate of return of 10 percent. GM literally bet the farm trying to meet that rate of return, once investing in a farm raising genetically engineered pigs.The pig farm investment didn't pan out (GM lost $400 million on the investment). Since then, GM has steadily lowered its expected rate of return to where it is now, 5.7 percent for the full-time workers plan.

State and local pension systems should take note and welcome pension reform that comes with lower actuarial assumptions. Opponents of pension reform, like Matt Taibbi from Rolling Stone, say that reformers want to push more money into the hands of Wall Street fat cats, but nothing could be further from the truth if pension reforms come with lower assumed rates of return. The lower the assumed rate of return, the closer to risk-free the investments will be. Moody's Investor Services recently recommended that state plans assume a 4.33 percent rate of return on investments.

Lowering rates of return will likely shift investments to safer assets, like government treasuries or infrastructure projects. Investing in infrastructure is common among the better-funded pension systems of our neighbors to the north in Canada, but it's a relatively recent phenomenon in the U.S. In 2009, the Dallas police and fire pension fund bought a 10 percent stake in an expressway project becoming the first US pension fund to invest directly in the construction of a major infrastructure project. In 2010, CalPERS followed suit and bought a 12.7 percent share of Gatwick Airport in the UK.

Solid infrastructure investments can still generate exceptional rates of return. In the last three years, CalPERS has generated an annualized rate of return of 18.9 percent on infrastructure investments. Still, pension systems should be careful because, as was seen in the 2007-08 real estate crash, a bad investment in an alternative asset like infrastructure can be just as bad or worse than a bad investment in equities.    

So while a shift away from hedge fund investments and other risky alternative assets, precipitated by pension reform lowering assumed rates of return, would be a positive development it's not the best option for reducing or eliminating taxpayer risk. The ideal option would be pension reform that lets public employees manage their own money in defined contribution accounts, as most private companies now do, which eliminates the inherent taxpayer risk of defined benefit pension systems all together.


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  1. One thing not mentioned in the article is why CalPERS consistently assumed those ridiculous rates of return: it allowed the unions, union-friendly pols, and the union-friendly hacks who comprise the CalPERS board to pretend that the funds were on solid financial footing and wouldn’t require massive taxpayer bailouts, to the point that benefits could actually be increased.

    It was all bullshit in the service of feathering the nests of state workers. It’s only recently that taxpayers have gotten wise to the game, to the point that the unions and their catspaws have to grudgingly acquiesce to fiscal reality.

    1. Got to love all the politics involved.

  2. The author seems to characterize “hedge funds” in this piece like an ‘asset class’

    (Asset Classes: ‘growth stocks’, ‘value stocks’, ‘corporate bonds’, ‘treasury bonds’, ‘municipal bonds’, REITs, preferred shares, commodity funds, etc)

    Hedge Funds are not an ‘asset class’, but a type of legal structure for institutional investment firms to collect fees and take higher risks.

    Within that structure you can have a wide variety of investment strategies, from leveraged vanilla-longs, to ‘Total Return’/Target Growth, to Buy-Write, to Short-only-Funds, to Global Multi-Asset-Class Funds, etc etc.

    If hedge fund investments underperformed, its more a question of ‘Who was the manager, and what was the strategy’ than ‘what was the legal structure they were organized under’.

    I think the most important focus of this story is the chronic under-performance of State Pension funds writ-large. To that point: I do not think ‘hedge funds’ could possibly be blamed in any way for this shoddy track record, as even the first paragraph notes that ~1.3% of total funds invested were with these kinds of institutions. In fact, the more you look at the story, it seems sort of silly that ‘Hedge Funds’ should be featured as a key point *at all*.

    If anything, the most egregious type of underlying ‘story’ in public pension-fund mismanagement is Political Meddling: the costs of which far exceed ‘hedge fund’ fees.

    1. the above should probably be better written as

      “Hedge Funds are not an ‘asset class’, but a type of legal structure for institutional investment firms to collect performance-based fees and utilize instruments otherwise proscribed for mutual funds or other investment institutions

      When I said, “higher risk”… this is not always the case. Just that it *can* be.

      The key difference is that hedgies are allowed to use a wider range of *tools*, which can be used for “higher risk” strategies, or “risk reducing” strategies.

      e.g. the most traditional, ‘hedged equity’ strategy would result in below-market returns but with significantly-below market risk. You’d simply own baskets of stocks, and maintain Put-option coverage on them as an ‘insurance expense’.

      by contrast, a ‘highly levered, naked options-based, event-driven (a la arbitrage)’ strategy is effectively ‘Russian Roulette’ with other people’s money.

      A ‘hedge fund’ could be engaged in either type of behavior; but more are of the ‘risk reducing’ variety than otherwise. Characterizing the entire industry as “higher risk” is grossly misleading if not outright ‘wrong’; and i admit, i almost said so myself.

  3. (continued)

    as to that last point –

    I’ve run the numbers a dozen different ways over the last 6 years or so, but if you took a basket of “Sin Stocks” – a la “Alcohol, Gambling, Tobacco, etc”

    …and compared annualized performance (on a risk-adjusted, relative to volatility basis – e.g. Sharpe Ratio)

    …to “Green” or “Socially Responsible Investments”.. (take your pick)

    Sin Wins every time. By every measure. By a factor of at least “twice as good” in terms of ‘risk/return’. If not better.

    Now – I don’t care how @#*)&$@ ostentatiously moral you are… but if you are handing 10-20% of your annual income to a money-manager…(as are California public employees)

    …do you want that ‘Firm’ to be guided by something *other* than getting the best Bang For Your Bucks? Ensuring you have the *largest nest egg possible* when you retire?

    *THAT* is the problem. Not the bloody ‘hedgies’ and their inflated fees. Its the idiots who want to slap ‘investment guidelines’ and oversight on these hundred-billion $ funds and put layers of administration into the process that have *nothing to do with earning the best return*.

    These same stupid motherfuckers who waste billions then tell the public “IT WAS WALL ST THAT TOOK YER MONIES!!! GET EM!!!”

    1. “*THAT* is the problem. Not the bloody ‘hedgies’ and their inflated fees. Its the idiots who want to slap ‘investment guidelines’ and oversight on these hundred-billion $ funds and put layers of administration into the process that have *nothing to do with earning the best return*.”

      That and assuming overly optimistic rates of return so that they can lie about the chronic over promising and under funding.

      And why does CalPERS get to vote the shares held in trust for those who contribute to it? Why does any fund manager get to do that? I think that’s a big problem with corporate governance today. The boards know that they just have to keep the fund managers happy and not the actual shareholders.

      1. “That and assuming overly optimistic rates of return so that they can lie about the chronic over promising and under funding”

        Yes, no doubt.

        It seems the author was really hooked on this one point and has a lot to say about that angle.

        There’s lots about the public pension scumbaggery that’s well over my head (beneath my contempt?) About the RoR accounting… AFAIK its exactly what you say: allowing them to skim from their earmarked money and underfund the plan.

        About the voting: you have a point. But i’m not sure there’s as much State influence there as you’d think; but i don’t know where they try and throw their weight around. AFAIK many defer their votes to the investment managers so the intermediary banks have the combined weight of the pension funds as well as their own public-traded mutual funds/ETFs. I know they DO jerk around say, Utilities? Because they are basically cash machines for the states in many ways.

  4. This article is an illogical mash-up of unrelated points and misinformation.

    To start with a minor one, GM obviously did not lose $400 billion investing in a pig farm. I have never seen a public accounting of the investment, but from the published reports I would guess the loss to the pension fund was about 0.01% of that, $40 million. And there’s nothing wrong with pig farming as a business investment, people have made a lot of money doing it. It’s a moronic point, even if it were true.

    The scandal at CalPERS involves senior people accused forging documents to get an investment manager to pay placement fees to an entity that was not entitled to those fees, and of course that was owned by one of the accused. That has nothing to do with hedge funds, it could have been any investment manager (and happened not to be a hedge fund manager but a private equity manager). If the charges are true, it’s simple fraud.

    The choice between defined contribution and defined benefit has nothing to do with assumed rates of return, or who has the risk for underperformance. A defined contribution plan could be used to purchase defined benefits from an insurance company. The relevant issue is underfunding, not the legal form of the plan.

  5. Expanding on Gilmore’s point, hedge funds or alternative investments are not necessarily riskier, in fact very few institutional alternative investments are as risky as stocks. And even when alternatives are riskier on a stand-alone basis, they can reduce overall portfolio risk via diversification. A portfolio that takes on more diversification in general can be made safer for the same level of expected returns. Getting out of alternatives is not synonymous with taking less risk. For the same reason, lowering the target return should not lead to investing only in treasury bonds, a safer alternative would be a mix of individually risky investments, the same proportionate mix as when the target return was higher, with a larger allocation to cash.

    Specifically, infrastructure is not a safe investment. Quoting a high three year return over a good period for infrastructure (because the stock market soared and infrastructure assets went up in value like all capital assets) is not the way to make long-term asset allocation decisions. Oh, and by the way, infrastructure is an alternative investment.

    1. Getting out of alternatives is not synonymous with taking less risk.

      Generally true, particularly with regard to financial (credit and market) risk. On the other hand, it can add operational risk. Investment funds generally (including PE, venture and hedge funds) can have a lot of moving parts that don’t show up in other asset classes. To be fair, much the same can be said of infrastructure. And the investments necessarily have a higher degree of opacity than traditional buy and hold securities. The only mistake CalPERS made in going into hedge funds was not bothering to understand their investment.

      1. I don’t entirely disagree, there are operational risks specific to alternatives. But there are risks associated with traditional investments that tend to get ignored.

        For example, alternatives often involve greater leverage and use of derivatives than traditional investments. Those can be used badly and increase or disguise risk. But they can be used to reduce risk and make it more transparent. Moreover, the alternative manager has risk management and disclosure. The traditional manager is likely forced to find investments like equities that have the leverage and derivatives embedded, not subject to portfolio level control or disclosure.

        This is like “complex and opaque structured products”. Equity in the simplest public company is far more complex and opaque than the most Byzantine subprime CDO-cubed. The structured product has a defined pool of assets or indices, and written, objective rules about how cash will flow to all investors in all circumstances. Sure the assets and rules are complicated, but the public company doesn’t tell you its assets, only aggregated totals related to historical cost and CPA imaginings, and it can sell them and buy others at any time, even sell its entire business and buy a new one. There are no rules about how cash moves from revenue tendered by a customer to investor payouts. Yet the structured product risk is considered reckless and likely fraudulent because it is unfamiliar, while equity risk is accepted as a natural part of the economy.

  6. A related point is averaging all alternative returns and comparing it to equity returns is silly. Some of those alternatives (e.g. private equity) will go up and down with the stock market. Other alternatives are designed to be market neutral, some are even anticyclical to the stock market. Averaging all that together makes it impossible to tell whether investments realized their goals. And comparing that portfolio to equities isn’t the point. When equities do well, they are likely to outperform everything else. The question is whether the portfolios of equities and alternatives had a better risk-adjusted return than a pure equity portfolio. Generally speaking, institutional investors who make use of alternatives have better long-term results than those that do not. Even if you disagree with that, it’s the relevant criterion, not the stand-alone return on the alternative bucket.

    It’s true that alternative investments tend to have higher fees than traditional, and there are good investment reasons to avoid high fees. But not all alternatives are high fee, and not all traditional investments are low fee. CalPERS may well be wise to try to reduce their management fees paid, but it’s not a no-brainer, they likely lose out on some diversification and alpha by doing so. Anyway, none of that has anything to do with target rates of return.

  7. Mr. Nava, please cite your source that GM lost $400 BILLION on a pig farm investment. I don’t think their whole pension fund is that large.

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