Hedge Fund Exposure Cut at Some Pension Funds

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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