Dan Och, chairman and CEO of hedge fund firm Och-Ziff Capital Management, earned $400 million in 2013 — more than 10,000 times the pension payout for the average California public retiree. With public pensions across America underfunded, beneficiaries facing the prospect of cuts and pension reform playing a major role in many U.S. elections, plans’ investment practices face growing scrutiny. Much of that attention is falling on hedge funds.
The reason is simple: money. The S&P 500 index returned 32.36 percent last year, but the average hedge fund was up just 9.13 percent, according to the HFRI Fund Weighted Composite Index. Yet due to lucrative fee structures, the managers of the very largest hedge fund firms, those that typically attract institutional money, are earning millions — and in some cases billions — in management and performance fees.
So last month, when the $296 billion California Public Employees’ Retirement System announced that it will terminate its $4 billion Absolute Return Strategies portfolio, it looked like the writing was on the wall for hedge funds and U.S. public pensions. After all, the 2001 decision by America’s biggest pension plan to get into hedge funds kicked off its peers’ movement toward absolute-return investments.
In a statement then–interim CIO Ted Eliopoulos cited fees and complexity for CalPERS’s decision to redeem from 24 hedge funds and six funds-of-hedge-funds. “Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost and the lack of ability to scale at CalPERS’s size, the ARS program is no longer warranted,” he said. Two days later the $126 billion Teacher Retirement System of Texas announced that it was cutting its hedge fund allocation from 9 percent to 8 percent.
CalPERS’s hedge fund allocation wasn’t big enough to make a meaningful difference to the return on its overall portfolio. In the 2013 fiscal year alone, though, the pension plan spent $60.7 million on hedge fund management fees and $55 million on performance fees. But the one-, three- and five-year returns for the ARS portfolio were only 7.4 percent, 3.8 percent and 1.4 percent, respectively, compared with 22.1 percent, 11.3 percent and 3.5 percent for domestic equities. As of January, CalPERS had $700 million in New York–based Och-Ziff’s OZ Eureka Fund and $21 million in OZ Domestic Partners II. Eureka returned 18.46 percent for CalPERS in 2013; Domestic Partners, only 5.33 percent.
CalPERS’s circumstances are unique, giving managers some reassurance that not every public fund is running for the exit. First, there’s the California fund’s internal politics. CalPERS was slow to build its hedge fund book, but by 2008 it had a total of $7 billion with 27 firms. After that year’s market collapse, it retooled ARS. The restructuring was complicated by an investigation into CalPERS’s relationship with two hedge fund advisers and the 2011 departure of Kurt Silberstein, the investment officer running the portfolio.
CIO Joe Dear supported the hedge fund program, hiring industry veteran Ed Robertiello to replace Silberstein and restating CalPERS’s commitment to “this important investment strategy.” In June 2013, however, Dear was diagnosed with cancer; he passed away this February. Eliopoulos, senior investment officer for real estate, took over as interim CIO. Eliopoulos was perceived as being less supportive of hedge funds than Dear. On September 17, two days after CalPERS announced that it was eliminating its hedge fund program, the board named Eliopoulos CIO.
CalPERS’s size and funding status further distinguish it from most of its peers. It’s one third larger than the No. 2 U.S. pension plan, the $188 billion California State Teachers’ Retirement System, and dwarfs most other public funds. CalPERS’s funding ratio is also relatively healthy for a public plan, so it can be more illiquid and long-term in its investment approach. And because it has more internal resources than many U.S. institutions, it can manage complex strategies in-house.
The fund’s size, resources and liquidity profile align it more closely with other huge pension plans in countries such as Canada, New Zealand and Norway, which tend to have little or no hedge fund exposure. These institutions are paying more attention to less liquid areas, where they can put large amounts of capital to work, such as infrastructure, private equity and real assets.
By contrast, CalPERS’s U.S. counterparts remain broadly in favor of hedge funds. At a mid-September meeting of the University of California Board of Regents, the 28-person committee that oversees the state university system, UC CIO Jagdeep Bachher expressed confidence in the university’s absolute-return allocation. As for his CalPERS colleagues who might now find themselves out in the cold, Bachher joked that “we’re hiring, and we’re always looking for good people” at the $90 billion UC pension and endowment. For hedge funds, parting ways with CalPERS is the end of the beginning, not the beginning of the end.
Follow Imogen Rose-Smith on Twitter at @imogennyc.
