30 September, 2014
California: After the Gold Rush
Our Resident Professor is back again offering his view on why one of the world's largest pots of money might have decided that hedge funds are NOT the way of the future for them. With relevant industry experience working for both index funds and hedge funds Prof. Rushman certainly has the expertise to be confident his wisdom is worth listening to.
I have just got back from Sacramento, California, where I have been advising the state pension fund, CalPERS, on asset allocation. As pots of money go, they don’t come much bigger than CalPERS. At around $300 billion, it is the biggest single pot of managed money in the US, and one of the biggest in the world.
As far as investment professionalism goes, CalPERS is regarded as a thought leader amongst pension plans. I certainly feel quite privileged to be able to work with committed, able and ethical colleagues there. That degree of professionalism isn’t always present at other large plans or sovereign wealth funds.
CalPERS often makes news headlines, and whilst I was there the big breaking story was its withdrawal of all its hedge fund investments (see for example, this Bloomberg report). Hedge funds are vehicles that allow the fund manager enormous freedom to invest in any way imaginable and they also command very high fees to pay for the supposedly skilled managers who run them. To prop up the fee structure, the hedge fund industry has created an aura of master-of-the-universe-like invincibility, although data suggest that average hedge fund performance is rather less than stellar. The combination of high costs and lacklustre returns has motivated CalPERS to pull out, a decision which will cause many well-paid hedge fund managers to worry that other institutions may follow suit.
There is another, more subtle argument why hedge funds can’t work for large investors. Because of the size of the investment programme, large investors must diversify their investments amongst many hedge funds. Now, hedge funds make returns by positioning their funds boldly in ways that are different from the average. But if you take a diverse set of hedge funds and take the aggregate performance, a lot of these ‘active bets’ cancel out. What you end up with looks a lot like an average performance, except that you are paying extraordinarily high fees. It would be far better to make investments that reliably achieve average performance but at a fraction of the cost. CalPERS is already investing the majority of its money in index tracking funds, and the closure of its hedge fund programme is as much an accolade to index funds as it an indictment of hedge funds.
It is also an investment philosophy we share at Walden Capital.