AQR’s Asness: Hedge Funds Aren’t as Bad as You Think

Hedge funds have been getting a bad reputation recently but not all criticisms may be deserved, according to AQR Co-founder Cliff Asness.

“One accusation the critics make is ‘just look at 2013’ when hedge funds, mistakenly often assumed to be very aggressive investments, failed miserably to keep up with the S&P 500,” Asness wrote in his most recent article “Hedge Funds: The (Somewhat Tepid) Defense.”

Hedge funds underperforming the roaring stock market in 2013—an overall return of 9.4% versus 32.4% for the S&P 500—is consistent with their low beta and low correlation with equities. Asness said despite critics’ claims, it was only a “mildly disappointing” year for hedge funds.

“Hedge funds are not meant to keep up with the S&P 500 one-for-one, certainly not when it soars,” he said. “Of course some stars will keep up, either by luck or skill, but as a broad category it’s never been the case at such a time.”

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asness hedge fund 1 (Source: AQR)

2008 was also not as bad a year for hedge funds as it looked, Asness argued, as the group is only partially hedged to equity market returns.

Furthermore, when looking at hedge funds’ compound return—annualized over the 1994 to 2014 period—the asset class “looked OK”. It only trailed the 60/40 portfolio by 0.5 percentage points, according to AQR’s calculations.

However, Asness’ defense for hedge funds ends there.

Observing hedge fund beta and correlation to the S&P 500 for a rolling 36-month period, Asness concluded hedge funds have been delivering the “same expensive stock market beta but less of the uncorrelated stuff”—things for which investors pay high fees.

“The ‘uncorrelated stuff’ I refer to may in fact be true manager alpha, but is also composed of many known strategies that, even if they survive hedge funds’ very high fees, should be available to investors at more reasonable fees,” he wrote.

Cumulative alpha from 1994 to 2013 also revealed it had essentially flattened since the financial crisis, supporting Asness’ assertion that hedge funds should be offered at a better price.

asness hedge fund 2 (Source: AQR)

12_Profile_Ted Eliopoulos_final.jpg Ted Eliopoulos, CalPERS CIOScalability drove the decision by the California Public Employees’ Retirement System (CalPERS) to unwind its hedge fund program, above issues of cost and complexity, the pension’s CIO has said.

Ted Eliopoulos—who was appointed permanent CIO in September a day after the $300 billion pension announced its decision to scrap its $4 billion Absolute Return Strategies program— said in an online video interview that scale was “the main driver” of the decision.

“One of our prime considerations in reviewing the program is whether we believe we could scale the program to a much more significant part of the overall portfolio,” he said. “Our analysis, after very careful review, was that mainly because of the complexity of the hedge fund portfolio and the cost we weren’t comfortable scaling the program to a much greater size than it currently held.”

Instead, over the course of the next few months the allocation is to be sold and redistributed to other parts of the portfolio, with the staff responsible for the investments also being reassigned within CalPERS.

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When asked about how the hedge fund decision relates to other investment decision made by the pension, Eliopoulos said the “number one yardstick” was the board’s “investment beliefs”, which were published for the first time last year.

Among the 10 investment beliefs, the pension states it will “take risk only where we have a strong belief we will be rewarded for it”, and “costs matter and need to be effectively managed”.

Eliopoulos said: “Those beliefs give the framework to weigh investment decisions, and they include considerations such as cost and complexity.

“We look at returns, both looking backwards at programs and how they have performed, and we look to the future—how will these programs perform or return going forward?

“In addition to that… we assess not just the volatility of our program but a whole array of risk factors in making investment decisions.”

Eliopoulos also spoke of CalPERS’ engagement with companies, governments, and fellow investors concerning climate change and tax policy.

In the US, the Treasury Department last month began to crack down on “inversions”, whereby a US-based company either sets up an overseas office or acquires a foreign company in order to redomicile itself for tax purposes.

Eliopoulos emphasised that, in general, tax was something to be addressed by relevant governments as a policy issue, but expressed concern about corporate inversions.

“We think the best approach is for the US government to address this type of a loophole in the context of overall corporate tax reform, and we’ve urged the government to get at it,” he said.

On climate change, Eliopoulos cited CalPERS’ recent appearance at the UN’s global summit in September as an example of the pension’s engagement with this issue.

“Our main response to climate change is engagement,” he said. “We like to engage with our companies and understand and disclose what the issues are within our portfolio, rather than take divestment actions.”

Eliopoulos was #12 in CIO‘s 2014 Power 100 list.