Why Public Pension Giants and Hedge Funds Don’t Mix

Terminating its hedge fund portfolio was the “best decision” the California Public Employees’ Retirement System (CalPERS) could have made, argued Fund Evaluation Group’s (FEG) Head of Institutional Investments Nolan Bean.

At FEG’s annual investment forum, Bean claimed that a $291 billon public fund like CalPERS has little chance of squeezing alpha from hedge funds. The number of managers necessary to justify a hedge fund allocation at a fund of CalPERS’ size can lead to a portfolio that’s over-correlated to equities, while disclosure requirements make it difficult to invest with the top managers.

“They’re subject to FOIA [Freedom of Information Act] requests,” Bean said. “Hedge funds don’t want to be subject to FOIA requests. The best hedge funds won’t take money from them.”

“As you have more managers, you basically become the market.”And having access to the best managers is especially important when it comes to hedge funds, which Bean argued have the highest performance dispersion of any other class of manager.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

“The reward is greater when you get it right, but the pain is also greater when you get it wrong,” he said.

Out of every 10 hedge funds, Bean estimated that at least six or seven weren’t worth investing in—meaning CalPERS’ program, which included 24 hedge funds and six funds-of-funds, had the odds stacked against it.

“As you have more managers, you basically become the market,” Bean said.

But just because CalPERS was right to dump its hedge funds doesn’t mean everyone should, he noted. With management fees dropping—the average is now 1.5%—investors are able to get a better deal than ever. For smaller, more private funds such as endowments and foundations, there is plenty to be gained, Bean said.

Not only are these asset owners more attractive to hedge funds seeking to avoid public scrutiny, they are small enough to invest with smaller managers—which Bean argued are usually the best performing.

“Attractive opportunities exist,” he said. “But manager selection is critical.”

Private lending gets a seal of approval, with $523 billion in total assets and 86% of investors stating investments met or exceeded expectations in 2015.

Investors are continuing to pump capital into private debt, pushing total assets under management above half a trillion dollars as of June 2015, according to Preqin.

Total industry assets ($523 billion) grew from $483 billion at the end of 2014. In 2006 there was just $156 billion in the asset class.

The largest proportion of these assets was allocated to distressed debt, Preqin found, totaling $199 billion. Mezzanine and direct lending funds held about $130 billion and $115 billion in assets, respectively.

“Private debt received a resounding mark of approval from the institutional investor community in 2015, and sustained investor confidence testifies that the asset class can provide strong, risk-adjusted returns,” Ryan Flanders, Preqin’s head of private debt products, said.

For more stories like this, sign up for the CIO Alert newsletter. 

Investors showed consistent support for private debt, Preqin found, with 86% of respondents stating their investments either met or exceeded expectations in 2015. Nearly half of surveyed investors said they would commit more capital over the next 12 months.

Furthermore, 54% of investors viewed private debt positively. More than one-quarter of investors said they gained confidence in private debt over the past 12 months, while just 7% expressed reduced confidence.

Fundraising for private debt reached a six-year high of $85.2 billion, a hike from $72.2 billion in 2014, the report said. More than one-third of total fundraising in 2015 was conducted by funds focused on European opportunities, pointing to the rapid growth in the private debt market in the region.

“Europe’s burgeoning direct lending market, especially, should play an increasingly influential role in the development of private debt after its record-breaking year of fundraising,” Flanders continued.

The swelling in fundraising also helped dry powder hit a record high as of March 2016, with $186.5 billion ready to be deployed. North America- and Europe-focused unspent capital represented 96% of the total, “meaning that the two regions will continue to dominate the private debt landscape in the short term,” the report said.

“With private lending providing an alternative fixed income-style product, the industry should continue to feature prominently in investors’ portfolios over the coming years, and allocation increases are expected to bolster fundraising further,” Preqin concluded.

Preqin private debt