Patience is wearing thin among some large public pension funds with regard to their hedge fund investment returns. Years of weak returns combined with high investment fees have forced a few prominent pension funds to consider reducing allocation to hedge funds. Among the pension funds planning cuts in hedge fund allocation include the largest US public pension fund, the California Public Employees’ Retirement System or Calpers, the School Employees Retirement System of Ohio and New Jersey’s State Investment Council. In addition, another pension fund that sought the advice of Warren Buffett on allocating large capital to hedge funds was told in no uncertain terms to choose index funds over hedge funds.

Calpers Mulling 40 Percent Cut

Calpers is a widely followed pension fund as it is the largest pension fund in the US. It had assets of approximately $301 billion at the end of its fiscal year ending June 30. Its return from hedge fund portfolio during the fiscal year was the lowest among all of its asset classes at 7.1 percent, well below the 25 percent return on its public equity investments.

As of June 30, Calpers had $4.5 billion representing 1.5 percent of its portfolio invested in hedge funds. Compared to a few other pension funds, this proportion of hedge fund allocation is quite small. Pension funds such as the School Employees Retirement System of Ohio and New Jersey’s State Investment Council have a much larger proportion of their assets invested in hedge funds. But smaller than anticipated returns on hedge fund investments over the last 10 years is prompting Calpers to consider cutting its hedge fund allocation by 40 percent. Calpers says it will make a formal recommendation to its Board in the fall.

Other pension funds cutting hedge fund allocation are the School Employees Retirement System of Ohio, which will reduce hedge fund investments to 10 percent of its assets in 2015 from its current 15 percent and New Jersey’s State Investment Council which is lowering its hedge fund investment limit to 12 percent from 12.25 percent of its overall portfolio.

Last year, the Los Angeles Fire and Police Pensions fund got out of hedge funds entirely after an annual investment return of only 2 percent over seven years. The fund had approximately 4 percent of its assets, amounting to $500 million, invested in hedge funds but fees paid to hedge fund managers accounted for 17 percent of its total fees.

Buffett Advises Against HF Investments

Another pension fund, the $20 billion San Francisco City & County Employees’ Retirement System is currently debating whether to allocate any capital to hedge funds. Its chief investment officer is making a pitch to allocate as much as 15 percent of the pension fund’s assets to hedge funds. One of the pension fund’s board members had his reservations about the significant hedge fund allocation plan and sought to get the advice of Warren Buffett on the matter. Buffett responded with a hand written note that read, “I would not go with hedge funds — would prefer index funds.”

David Kotok, the chief investment officer at Cumberland Advisors has deep expertise on advising public pension funds on their investments. He says that many pension funds that pump a large portion of their assets to hedge funds are underfunded and are on shaky financial footing.  Kotok adds that such funds are taking on more risks to improve their returns.

Relevance to Job Market

During the recent financial crisis in 2008, many hedge funds reported smaller losses than the overall market and some funds such as Pershing Square Capital Management and Paulson & Co even reported big gains. Such an outperformance during a time of market weakness prompted many pension funds to up their allocation to hedge funds.

But since 2009, hedge funds have consistently, and by a large margin, underperformed the market. As a result, it is not a complete surprise to see some pension funds lowering their hedge fund allocation. Verne Sedlacek, CEO of Commonfund which manages money for pension funds and endowments, says “We are seeing a little moving away from hedge funds, but so far it’s just on the margin.”

Recent data from BarclayHedge and TrimTabs Investment Research shows that hedge funds attracted approximately $83 billion in new capital during the first half of this year, the most since 2007. This suggests that despite concerns from certain investor classes, there is still interest among the broader investor community for hedge funds. And as such this planned pullback by a few pension funds likely will not negatively impact the job market.

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The extraordinary influence hedge funds can sometimes have on markets was on full display recently when a small number of hedge funds and some individual investors together forced the sovereign South American country Argentina, with a population of almost 42 million people, to default on its debt commitments. The group led by US hedge fund Elliott Capital Management stood firm on its demand for full payment on its loans to the sovereign nation and won backing from the top US court after a series of lawsuits forced the Argentinian government to either pay the group in full or face default.

Origins of the Dispute

Argentina’s current crisis with debt has its roots in 2001 when the country defaulted on more than $80 billion of debt. The country, however, managed to persuade a vast majority of its bondholders to take a cut of approximately 70 percent on the amount they were owed and restructured its loans. Those investors who agreed to the cut and exchanged their original bond agreements for the new ones are commonly referred to as exchange bondholders.

However, a small group of investors which included NML Capital, a subsidiary of the New York based Elliott Capital Management, and a smaller hedge fund named Aurelius Capital Management, as well as some private individual investors refused the amended terms and took Argentina to court. This group of investors is referred to as holdouts, and as per the court ruling Argentina currently owes the group over $1.5 billion in principal and interest.

Hedge Funds Force Second Default

The holdout group was led by billionaire hedge fund manager Paul Singer whose relentless pursuit to demand full payment put the sovereign nation on the spot. Singer, age 69, is driven by his worldview in his crusade against Argentina. He is a Republican donor but has strong libertarian leanings.

Widely followed fellow hedge fund manager Daniel S. Loeb, who himself has launched several high profile campaigns to impose his view on companies, is all praise for Singer. “He doesn’t get into fights for the sake of fighting. He believes deeply in the rule of law and that free markets and free societies depend on enforcing it,” says Loeb of Singer.

Singer’s Elliot Capital now manages over $23 billion and has returned an average of 14 percent a year since its founding in 1977. The fund has in the past won similar cases against other sovereign nations and managed to obtain payments through court orders from countries such as Peru and Congo-Brazzaville. People familiar with the fund say that its bets on suing governments make only a small proportion of its portfolio.

The US court ruling has virtually brought the case to a stalemate. The ruling prevents Argentina from making interest payments totaling $539 million to exchange bondholders who agreed to restructured loans of approximately $23 billion without first paying in full the approximately $1.5 billion owed to the holdout group. The court ruled that such payments will be deemed illegal.

Difficulties in Paying the Holdout Hedge Fund Group

At first the outstanding loan amount of $1.5 billion owed to the holdout group may seem insignificant, given that Argentina has foreign exchange reserves of approximately $30 billion. But paying the holdout group would lead to a larger problem as a clause in its restructured debt agreement prohibits the country from offering anyone a better deal than what the restructured creditors received, unless they also get the same deal.

As a result, paying the holdout group its full due of $1.5 billion would force the country to extend the same deal to the remaining 93 percent of investors who participated in its debt restructuring. This would in turn would trigger claims of more than $120 billion – which the country does not have.

However, this prohibiting clause is set to expire at the end of this year and according to Lutz Roehmeyer, a fund manager at LBB Invest in Berlin, a solution to the holdout group is likely only after this clause expires.

Relevance to Job Market

This case of hedge funds taking on a large sovereign nation is an exception, but it brings to the fore the active aggressive investment style of a typical hedge fund, characterized by calculated risk taking following rigorous due diligence. On the contrary, most mutual funds are passive investors and spread their investments across a large number of companies to minimize volatility. Most hedge fund managers have significant portion of their personal wealth invested in the fund which provides the drive to come up with creative ways to generate big profits.

Commenting on the legal wrangle, Columbia University professor and economist Joseph E. Stiglitz warns that the issue is not just about Argentina. He says Singer and Elliott have already done a lot of damage and adds that their tough posture will extend the economic misery of other over-indebted countries. This extraordinary ability of hedge funds to influence financial markets and other outside forces is often a factor that attracts top talents to this profession.

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