• Home
• About Us
• Services
• Bio
• Ramble
• Contact

HEDGING ON HEDGE FUNDS

Rick Roeder       October 2014

After 2001’s dot com bust, a lot of systems, close to or exceeding a funded ratio of 100%, faced a new dilemma. The unprecedented bull market of 1983–2000 had two principal impacts: steadily reduced contribution rates which, in turn, created considerable momentum for benefit formula increases.

The bear market, starting in 2001, created much more pain for retirement systems than the turbulence created by high inflation and skyrocketing energy prices in the 1970’s for a simple mathematical reason. The funded ratios were much lower in the 1970s. Thus, the actuarial losses were limited by asset sizes that did not yet reflect mature funds. Also, the 1970’s had lower assumed actuarial assumptions than those employed at the start of the new millennium.

Like a drug, plan sponsors had become addicted to lower contribution rates in the years leading up to the dot com bust. Strong resistance to increased sponsor contributions was in place. Accordingly, some plan sponsors looked to ways in which actuarial losses could be recouped and high assumed investment returns could continue to be justified. Enter the concept of hedge funds. Initially, the concept of hedge funds was pretty simple: to go “short” in some way, shape or form to mitigate risk to a degree against a portfolio’s long position. However, hedge funds morphed into a vast array of products.

While it would be slightly unfair to generalize to generalize in all cases, hedge funds did have a general sales pitch of “We will be nimble and spot market inefficiencies and invest accordingly.” Or “We will find new investment arenas for you such as timber, currency or art.” Leverage may be involved. Regardless of the wide arena of new investments, hedge funds touted higher potential yields than those available in “brick and mortar” stock and bond portfolios. Many systems bought the pitch and signed up for various hedge products.

With such touted sophistication, came management fees that proved to be much higher than for other asset classes. Fees for hedge funds often run around 2% of assets under management plus a healthy kicker, often 20% of profits, for actual fund performance. For all the slickness of the marketing of hedge funds, “exploiting market inefficiencies” sounds suspiciously like a fundamental no–no in investment philosophy: market timing.

For some large systems, the high management fees have not been worth the actual returns. CalPERS has announced its decision to divest itself of an element of its $4 billion in hedge funds as part of its desire to simplify its investments and better control plan expense. CalPERS reported an outstanding return of 18.4% for its fiscal year end June 30, 2014. Not only did CalPERS’ hedge fund performance of 7.1% lag, but the payment of $135 million in hedge fund fees added insult to injury.

Last year, the Los Angeles Safety system also bailed out of hedge funds. Their 4% asset allocation to the class accounted for 17% of their overall fees.

Hedge funds offer one other issue for systems. Systems go to great lengths and expense to determine its asset allocation among various investment classes. One of the issues with hedge funds, with significant investment latitude, is that such latitude can compromise a disciplined approach to asset allocation.

After the CalPERS announcement, CalSTRS announced its intention to retain their hedge funds.

Hedge fund supporters still exist in other large systems, as well. Kevin SigRist, chief investment officer of North Carolina’s $90 billion, said the state is generally pleased with their hedge fund performance. In the Tar Heel state, hedge fund performance has been produced yields of 6.86% and 7.59%, respectively over the three–year and five–year periods ending on June 30, 2013. In the midst of a strong bull market, these numbers do not seem so strong. SigRist’s support is in stark contrast to the position of the State Employees Association of North Carolina, who have been calling for an exit from the asset class.

Will hedge funds be heading off into the sunset? Stay tuned.

Guest authors are welcome to submit articles and their thoughts to the ROEDER RAMBLE for potential viewing on this site.