The biggest pension fund in the U.S., the California Public Employees Retirement System (CalPERS), will sell its entire book of hedge funds, including 24 direct interests and another six hedge-fund-of-fund stakes. CalPERS apparently intends to redeploy this capital to internal investment strategies.
Some people — mostly hedge fund employees — are trying to blow this off as the irrelevant and irrational action of an unsophisticated investor. Not so fast, bros. As someone who spends his life watching public pension fund behavior, I can tell you unequivocally: This. Is. Big.
In the same way Stanford’s tiny divestment from coal sparked a massive re-evaluation by institutional investors around the world — not only of coal assets but also of all carbon assets — so too will this divestment catalyze a similar reevaluation of hedge funds. In fact, Ted Eliopoulos, CalPERS’s new Chief Investment Officer — yes, he was just named permanent CIO — tipped his hat to this: “We certainly had a very thoughtful and deep conversation with our peers in the institutional investor network, as well as a wide variety of talented active external managers and so we considered those opinions in forming our own conclusion.” Translation: Giants are going to take another look at their hedge funds. Simple.
Now, if you’ve read some of my other columns — both short and long form — you’d be forgiven for assuming that I’m universally against hedge funds. (I received a lot of e-mails congratulating me on some sort of moral victory with the CalPERS divestment.) But my views on hedge funds — and on asset managers in general — are more nuanced than simply “being against hedge funds.” Fine: I admit to cracking a wide smile when I heard about the divestment. But I believe, sincerely, that some hedge funds can and will play important roles in our economy. In fact, my own thinking has evolved on the value that a properly structured and aligned hedge fund industry can play in capitalism. I’ll discuss this in more detail below.
What I am against, however, is greed, rent seeking and general market inefficiencies. And it just so happens that hedge fund managers are some of the greediest white guys out there. Note 1: Yes, you read that right — 97 percent of hedge funds are majority owned by Caucasian men. Note 2: And don’t get me started on the cliché hedge-fund-white-guy-turned philanthropist. There are doctoral theses to be written on the negative externalities these guys create through rent extraction as hedge fund managers and then noncommercial donations as philanthropists.
Anyway, I’m not alone thinking that hedge funds have jumped the shark; take it from a certain famous hedge fund manager: “More often than not, [hedge funds] charge too much for these straightforward, nonmagic strategies and package them, again, with too much net long exposure...We are not surprised that some have found that the broad universe of hedge funds, and thus likely any very large diversified portfolio of them, is not an attractive enough proposition.”
Last year on average, hedge funds returned 9 percent, which was 23.4 percentage points less than public market returns. The global HFRX (global hedge fund index) underperformed every major equity index between 2004 and 2013. And while a 2011 paper by Roger Ibbotson, Peng Chen and Kevin Zhu showed that hedge funds did produce alpha on average — at least for some period of time — a follow-up paper by Jakub Jurek and Erik Stafford showed that the alpha disappears when hedge fund strategies are adjusted to include tail risk and cost of capital.
At the same time as so little value has been created, hedge funds have been very well compensated. I’d wager that there are more hedge fund firm CEOs that earn $500 million per year than there are pension fund CEOs in the U.S. that make more than $500,000. Yes, I’ve said it before: that’s a multiple of 1,000. And these compensation differentials create profound distortions in labor markets, as hedge funds wind up dragging people away from other industries that actually add value and, instead, put them to work in a black-box business of rent seeking. And yet the mandates to these funds continue to grow! There’s now $3 trillion invested in these funds, which is triple the amount these funds had a decade ago. Some $57 billion of additional capital went into hedge funds in the last two quarters alone.
All that, I believe, may be changing soon. Hedge funds have a serious lemons problem that threatens the entire industry if not resolved. As you’ve just seen with CalPERS, if you allow enough bad actors to survive then you actually threaten the entire industry. Better to allow the bad actors to simply die and bolster the good actors. As such, I think it would be awesome if the big pension funds mount a legitimate review of their hedge fund programs. We need Darwin to wave his wand over the entire sector. We need the Giants to ask themselves if they are benefiting from hedge funds or if these vehicles are good for capitalism. Because long-term investors have a vested interest in the health of capitalism, answering the latter question actually does matter. Why shouldn’t the Giants use the CalPERS divestment as a reason to ask some of these questions again — or, sigh — for the first time?
Having said all that, I also want to stress that I’m not pressing for a massive divestment. I’m not usually a fan of binary outcomes like this. The world is too messy and gray for these sorts of policies to make much sense. Even a guy like me — someone who has been a vocal detractor of hedge funds — can see roles for hedge funds that are socially valuable. It may require some suspension of disbelief, however. Indeed, as I alluded to above, I’ve actually been reading about and noodling on the positive roles for hedge funds in financial markets. And there are some. In describing my thoughts below, I’m going to build on the thinking of Robin Greenwood and David Scharfstein and their seminal paper from the Journal of Economic Perspectives. Here goes:
• Creative Destruction: Just as venture capitalists work hard to build companies and create value, it seems to me that hedge funds often play the opposite role. They are increasingly the wrecking ball of the inefficient or unattractive parts of our industrial geography. Picture Bill Ackman’s teary-eyed war against Herbalife or Starboard’s attack on Olive Garden; whether these specific bets are right or wrong, I’m with Schumpeter in believing there is value to be had in creative destruction. Note: My only wish is that some hedge funds would look to generate creative destruction among their own ranks! I’m personally quite interested in the role hedge funds can play in this regard; the anti-venture capital firms, if you will.
• Uncorrelated Returns: Hedge funds can provide diversified and uncorrelated returns to investors that need them, smoothing out highly volatile market returns. This could be particularly valuable now, especially given that we are likely heading into a low-return environment. It’s perhaps for this reason that so many people have been scratching their heads about CalPERS’s timing. You wouldn’t necessarily want to sell hedge funds at the top of a bull market; you’d sell them at the bottom of a bear market. That said, the last time markets crashed, so too did hedge fund returns. So much for uncorrelated returns then. Notwithstanding, a renewed hedge fund industry would be well advised to refocus on this valuable aspect and stop hugging benchmarks. Uncorrelated investments turns will have broad social value.
• Market Efficiency: In theory, active managers can lower the cost of capital for corporations by rendering the pricing function of financial markets more accurate. And when there’s a more efficient pricing system, companies are more likely to get what they are worth and in turn, are more likely to raise capital to finance growth. That’s the theory at least. Sadly research shows that active management does not necessarily result in more efficient pricing. As evidence, hedge funds were around and investing for both the Internet boom in 2000 and the mortgage-backed boom in 2007. Granted, hedge fund lobbyists will tell you, as they’ve told me, that hedge fund managers spotted these bubbles and began to short the sectors. Kudos, dude. But I’m less interested in you helping to pop massive asset bubbles than to help prevent massive bubbles from forming. Whatever the case, market efficiency is a very good thing. Think of hedge funds as being highly skilled specialist doctors; they focus on the efficiency of a tiny component of an organism and have the ability to intervene to bring that component back into balance and health.
• Risk Allocation: The financial system is adept at moving risk around and allocating it to the parties that are best suited to manage it. There are a lot of risks that hedge funds could be focused on that could have positive impacts on both returns and capitalism. For example, hedge funds could be liquidity providers in crises, which could prevent needless destruction of value. They could help late-stage venture companies provide liquidity to early-stage investors, which could, in turn, allow those early stage investors to recycle capital. And there’s a handful more ideas for risk-transfers that could offer social value.
In short, hedge funds can create real and enduring value for the economy. But I think for this to happen, the Giants will have to exercise far more discipline over these intermediaries than they have thus far. And it will start with a rigorous assessment of what it is we want these hedge funds to be doing ... and how much we should pay them for it. I’m enthusiastic about hedge funds having to defend the role they are playing in institutional portfolios. We need some evolution in the pensions world.
