Hedge funds are back. Worries about European debt crisis, war in the Middle East and the potential for rating agencies to downgrade America’s treasuries have rattled shareholders. But those fears haven’t held back investors from pouring record amounts of capital into the cowboy country of largely unregulated, nontransparent funds.
Hedge funds were tarnished by Bernie Madoff and drained of cash when investors raced to pull money off the table at the start of the financial crisis in 2008. But pension funds and individual investors, hoping to recover from cataclysmic losses during the meltdown, are doubling down on the alternative investments. Institutions and rich individuals injected $102 billion into accounts in the first quarter of 2011, causing the industry’s assets to swell past $2 trillion, the highest level in history, according to Hedge Fund Research Inc. Analysts say investors are flocking to the funds because they offer the potential of higher-than-average returns during a time of economic uncertainty. “People are expecting a lot of volatility in the market going forward, and used properly, hedge funds can help even out those bumps,” says Jason Bell, a senior investment manager at Wells Fargo Private Bank in Roseville.
Critics say Madoff was an example of the risk posed by an industry shrouded in secrecy. “A hedge fund manager can legally go out and use your money to buy lotto tickets if he thinks that’s a good idea,” says Jack Ablin, chief investment officer of Harris Private Bank, which services high-net-worth individuals. “And there is not really any legal recourse because you gave him that authority.”
Hedge funds have a reputation as a risky and exotic tool of the rich. But it’s not just the corporate types that have jolted the industry back to life: It’s state employees, like bus drivers and sanitation workers.
Pension funds, which invest the retirement savings of government workers, have helped hedge funds regain their swagger, says Vincent Deluard, executive vice president of TrimTabs Investment Research. “Pension funds are the elephants,” he says. “They move very slowly. But when they do move they go all at once in a herd.”
Pension funds around the country lost billions when the stock market plunged in 2007 and are in danger of not being able to meet their obligations as baby boomers reach retirement. Deluard says pension investment managers are now doubling down on hedge funds with hopes the alternative investments can make up for losses from the crisis. But the worker funds may not have the skill and experience to play watchdog to the loosely regulated industry. “My fear is that many pension funds are not that sophisticated. They are firefighters and teachers,” Deluard says.
The California Public Employees’ Retirement System plummeted more than 25 percent, from $260 billion in October 2007 to $160 billion in March 2009, according to Clark McKinley, a spokesperson for the fund. As of March 2011, CalPERS was still down 10 percent from precrisis levels.
CalPERS was among the first pension funds to start investing in hedge funds in 2002. The fund has $5.5 billion of total assets, or 2.3 percent of total assets in the funds. CalPERS is authorized to invest up to 8 percent of its total assets in hedge funds. “The idea of the [hedge fund] program is to give equity-like return with bond-like risk,” McKinley says.
While all of the CalPERS investments lost $100 billion between October 2007 and March of 2009, its hedge bets only lost 13 percent, McKinley says. “We are very confident in our hedge fund program because we haven’t been burned,” McKinley says.
While McKinley says CalPERS has no intention of dramatically increasing its stake in hedge funds, other pension managers around the country are doing just that. In a Deutsche Bank survey released in March, 72 percent of pension fund executives said they plan to increase the size of their hedge fund team in 2011. Overall, 82 percent of investment consultants say they expect their institutional clients to increase hedge fund allocations in the coming year. Public pension investors across the country have nearly doubled the percentage of their portfolios allocated to hedge funds from 3.6 percent in 2007 to 6.5 percent in 2010, according to Preqin, an investment research company.
“Pension funds are the elephants. They move very slowly. But when they do move they go all at once in a herd.”
Vincent Deluard, executive vice president, TrimTabs Investment Research
Ohio Public Employee Retirement System is preparing to invest $1.2 billion in its first direct stake into individual hedge funds, Pensions & Investments reported on June 24. Until now the fund had only invested in “funds-of-funds” or hedge funds that invest in other funds. Last summer, trustees in Ohio increased the group’s overall allocation in hedge funds to 3 percent, or about $2 billion, from just $100 million.
New Jersey’s public workers funds are upping their hedge fund bet by nearly 25 percent, FINalternatives reported in March. The new investments, approved by the New Jersey Investment Council in March, will bring the state’s hedge fund portfolio to $3.6 billion, or 5 percent of its total investments.
“Pension funds took a huge hit during the crisis, and they are going to have a very tough time paying out,” says Bud Haslett, head of risk management at CFA Institute. “Hedge funds offer the potential of outsized risk-adjusted returns.” And with treasury bills offering the lowest returns since the Eisenhower administration, the potential of those big gains are tempting for pension investors still wounded from the crisis, Haslett says.
But Haslett says the push for retirement funds to buy into alternative investments smacks of herd mentality, posing a risk to pensioners. ”If everyone is doing it, it must be alright. That’s the attitude,” Haslett says. Pension fund managers are often evaluated based on the performance of peer funds, so one group’s successful use of hedge funds can pressure others. “The bosses see another [pension fund] is doing well with a hedge fund, and they say, ‘Why aren’t we in this fund? We need to get better returns.’ There is this peer pressure.”
In recent months reported hedge fund returns have been unimpressive. “The industry got hit hard in 2008, but what’s really shocking is how quickly they’ve come back,” Deluard says. “Frankly, they haven’t been doing much to deserve it.” While old-fashioned mutual funds gained 8 percent this year through May as the stock market rallied, hedge funds increased only 2 percent and could dip into the red after losses in June are counted, Deluard says. “The hedge funds caught a lot of the downside when the market went down but missed most of the upside when it came back up.”
And even these lukewarm numbers could be exaggerating the success of funds. The only public data on the return of hedge funds comes from voluntary self-reporting by managers. “Let’s say a manager has a really bad month. Maybe he figures ‘I am not going to report anymore’,” says Sol Waksman, president of BarclayHedge, the maker of Barclay Hedge Fund Indices. “Maybe he’ll come back when that damage is repaired.” So are the numbers for hedge funds better than they would be if managers always reported losses? “The answer to that is, certainly.” In fact, Waksman says there is no reliable estimate on the indices’ level of accuracy.
Hedge funds have almost no requirements to reveal holdings to the public. The secrecy of their strategy is what allows managers to sometimes beat the gains of mutual funds, Haslett says. But it also means that if a fund has a bad year, managers can simply shut their doors, return the remaining capital and open up again under a new shingle, making the performance of the industry nearly impossible to judge.
And with more capital flooding into niche funds, Haslett says their advantage over standard stock investments could be eroding. “If you have an opportunity, and more and more groups pour money into it, you lose the alpha,” Haslett says.
J. Carlo Cannell, founder of San Francisco-based Cannell Capital LLC, says that as funds take on more investment, they often lose focus and provide less value to shareholders. It was the fear of dulling that edge that led him to return half of his fund’s $1 billion to investors in late 2007. The fund specialized in picking out and investing in companies overlooked by big investors. Cannell compares the strategy to going to a flea market for deals (“I am basically a trash collector,” he says.) But as the fund approached $1 billion, it became harder to find enough gems-in-the-rough in which to invest. “Having that much capital was straining our style,” he says.
Cannell’s lesson may prove a cautionary tale to investors as hedge fund managers prepare to grapple with an estimated $2.25 trillion in assets by the end of the year. “Assets in a hedge fund are an impediment,” Cannell says. “Do you want to be managing a portfolio of 800 companies? Or would you do better with a more concentrated portfolio? You basically succeed yourself out of the best opportunities.”
When it comes to the California public pension system, one thing is crystal clear: it absolutely must and will change. The question is when and how. Practically every expert who has analyzed the state’s pension figures uses the word “unsustainable” to describe the system.