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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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Sensing a favorable environment for hedge funds among US institutional investors, a number of UK-based hedge funds are setting up operations in the US to grab a slice of the growing institutional money moving into hedge funds. Well known UK funds such as Winton Capital, Odey Asset Management and Cheyne Capital are among a large number of London-based hedge fund groups that are either starting afresh or boosting existing operations in the US to get exposure to big institutional investors such as pension funds that are increasing allocation through a shift from fixed income to hedge funds.

HF Regulation in Europe Becoming More Stringent

Raising capital in Europe has become difficult following a directive from the regulators to subject alternate investment managers, such as hedge funds, to a host of new requirements including new reporting and disclosure requirements. The directive more commonly known as the Alternative Investment Fund Managers Directive aims to subject hedge funds and private equity funds to the same rules as mutual funds in the hope that such a rigid approach to hedge fund regulation will curb excessive risk taking and prevent the severity of an unforeseen financial crisis.

Commenting on the regulation, Troy Gayeski , senior portfolio manager at SkyBridge, a New York-based fund of hedge funds says, “Europe is going out of its way to make it difficult for investors to invest in hedge funds. The US is still the largest market with the deepest pools of capital and [UK hedge funds] would be crazy to not at least try to expand”.

UK Hedge Funds Flock To US

As the pool of assets available in Europe stagnates, UK hedge funds are flocking in large numbers to the US  to take advantage of the growing number of institutional investors warming up to hedge funds.

Winton Capital, which has $25 billion in assets, last month set up its first US office in New York with six employees. It plans to add to its sales team this year. Another UK hedge fund Odey Asset Management, with $10 billion in assets under management, set up its first US office in New York late last year while a third fund, Cheyne Capital, with $6.5 billion in assets, opened a New York sales office early this year and plans additional hiring. Another London-based fund Cube Capital made its first foray into the US last month when it named Stephen Petretto as the US Director of Marketing. The $1 billion fund plans to set up an office in New York or Boston in 2015.

Some European funds that already have a foothold in the US are planning to boost their teams to seize the positive industry momentum. Such funds include the $14B hedge fund group CQS and the $12B fund Polygon – both of which have offices in New York, but plan to expand their US teams.

US Institutional Investors Also Ramp Up HF Exposure

Unlike its European counterparts, US hedge funds are witnessing strong interest from institutional investors such as insurance companies and pension funds. A recent survey by Deutsche Bank found that 57 percent of institutional investors plan to increase allocations to hedge funds this year. Institutional investors now contribute to two thirds of the overall US hedge fund assets compared to only one third of the assets prior to the 2008 financial crisis. Many large institutional firms which once stayed clear of hedge funds are now including hedge fund investments as part of their portfolio.

Relevance To Job Market

The European rush to tap US institutional money that is moving to hedge funds highlights the positive perception of hedge funds by US institutional investors. It is somewhat ironic that hedge funds are witnessing a favorable fund raising environment at a time when the industry’s returns are consistently and notably falling short of major US financial averages. Hedge funds are viewed as a good investment option especially at a time of uncertainty. With the stock markets stubbornly holding on to historic high levels with questionable improvement in the economy, many large investors are comfortable hedging their position with hedge funds even if the returns are underwhelming. This general positive undertone will likely have a positive impact on the hedge fund job market.

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