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The CalPERS Decision and the Rise of Liquid Alts

There's more than meets the eye to CalPERS' decision to jettison hedge funds.

Josh Charlson, 10/07/2014

Before the news of Bill Gross' sudden departure from PIMCO washed nearly every other piece of fund industry news off the front page, another news item had garnered considerable attention: The announcement by the California Public Employees' Retirement System, or CalPERS, that the huge and influential pension plan was banishing hedge funds from its approximately $300 billion portfolio. In its public statement, CalPERS cited "complexity, cost, and the lack of ability to scale" as the primary factors in its decision.

Immediately, alarmist-sounding questions began to fly around: Will other pensions follow suit from CalPERS' decision? Does this move spell the beginning of the end for hedge funds? Will so-called liquid alternatives (traditionally hedge fund strategies operating within the constraints of 1940-Act mutual funds) now take over as the default choice for investors seeking hedge-fund-like returns? Meanwhile, some in the hedge fund industry were whispering privately that CalPERS had simply done a poor job of picking its hedge funds.

As is usually the case in stories of this nature, there's a kernel of truth to the statements and a fair amount of hyperbole as well. But the CalPERS decision does shed some important light on the growth and potential value of alternative mutual funds, an area in which Morningstar has been expending considerable research effort.

Not Out of the Blue 
It helps to note that although the CalPERS announcement caught some observers by surprise, in fact it's been a long time coming. The CalPERS investment committee was already expressing concern about its hedge fund program (internally called the Absolute Return Strategies program) as far back as 2009, in the wake of its funds' underperformance during the financial crisis. At the time, the pension issued a memorandum outlining concerns and principles for ongoing investments in three broad areas: alignment of interest through more favorable fee structures, higher level of  control over investments (as opposed to be subject to volatile pools of commingled assets), and increased transparency.

In 2011, absolute return strategies were spun out of their previous home within Global Equity to a stand-alone status, and in 2012 CalPERS conducted an internal reassessment of the purpose of the absolute return program, concluding that its primary purpose was to "act as a diversifier to equity growth risk" in the overall portfolio; nevertheless, one detects a constant struggle by CalPERS to justify the role of the investments in the portfolio. (Investment committee documents and presentations can be found on the CalPERS website.) A later analysis by one of the pension's outside consultants found that the absolute return strategy had trailed its internal benchmark by 200 basis points annually.

Clearly, then, the first two factors cited in the recent press release--cost and complexity (read transparency)--have been generating doubts at CalPERS for some time. But CalPERS is hardly at the vanguard in this respect. Investors have been voting with their feet since 2008, as hedge fund assets declined sharply in subsequent years (though they've rebounded slightly more recently). Raising capital for new hedge funds is increasingly difficult for all but the most established managers. Meanwhile, assets have poured into alternative mutual funds, while the vastly increased choice in strategies has prompted Morningstar to create a number of new alternative categories. It is precisely the improved transparency, liquidity, and costs (and transparency of costs) that have prompted investors to make the shift. Advisors and investors can take some comfort in the fact that the largest public pension fund in the country has now validated their rationale. While this growth has been primarily a retail phenomenon, increasingly institutions are dipping their toes in as well.

Tipping the Scale 
While costs and complexity had been on the front burner for a while, it seems that the third issue cited in CalPERS' announcement, "scale," may have been the tipping point. In short, CalPERS had come to believe that its approximately 1.5% allocation to absolute return (out of the entire portfolio) was insufficient to provide the desired level of diversification, which would require a 5% to 10% allocation. Yet with CalPERS' size, management claims that it would be too difficult to make the necessary investments in the hedge fund world. From a due diligence perspective, there was already an enormous burden on CalPERS and its various vendors and consultants, a burden that would only increase if the pension were to seek an increased number of hedge funds in the program.

Investors can glean some useful information here. An allocation to alternatives of less than 5% generally won't be useful. Although it's not an apples-to-apples comparison because of some fundamental differences in time horizon and risk tolerance between an endowment and a pension, it's worth noting that the Yale Endowment--famed for paving the road to heavy institutional use of alternatives under David Swensen's so-called Yale Model--had a 17.8% allocation to absolute return strategies in 2013. Morningstar and Barron's annual survey regarding alternatives usage has found that the majority of advisors allocate between 5% and 20% of client assets to alternatives.

Josh Charlson is a senior fund analyst with Morningstar.

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