The CalPERS Decision and the Rise of Liquid Alts

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.

CalPERS has stated explicitly that performance was not a reason to abandon its hedge fund program, though performance had indeed disappointed. Still, reading between the lines, it seems that the story is more nuanced. Perhaps it is fairer to say that performance on its own was not a reason to drop the program, but given all of the other meaningful concerns and risks, it was not worth the effort and commitment required to generate the desired performance.

What Does the Future Hold?
Does this mean that hedge funds are going away? Let's not kids ourselves. There will always be ultrawealthy investors willing to endure plenty of risk and uncertainty to get access to the potentially monster returns of John Paulson and his ilk. Foundations and endowments that lack the unusual size and consequent problems of scale that CalPERS encountered will continue to trade on their long time horizons by investing in less liquid or highly leveraged hedge funds. (I am less sanguine about pensions, which I think in many cases were guilty of performance chasing into hedge funds and have found themselves in investments ill-suited to the defined liabilities they face.)

Moreover, as several commentators have pointed out, it's not as though CalPERS has abandoned alternatives altogether. It maintains a healthy weighting in private equity, which has generated high returns but which as an asset class has high correlations to equities, and to activist hedge funds, which CalPERS classifies within Global Equity. In these cases, it appears, CalPERS believes the potential return is worth the costs and complexity.

Liquid alternatives offer individual investors the ability to pursue many of the same objectives CalPERS articulated for its absolute return program--a moderate, steady stream of return with reduced correlation to equities or core fixed income--while avoiding many of the concerns that bedeviled the pension managers. With SEC oversight on '40-Act funds, investors can shed the worries about back-office stability and outright fraud that stress hedge fund due diligence programs. Still, liquid alts are no panacea. While they generally eschew a performance fee structure, their management fees are still high relative to the mutual fund universe, and some managed-futures funds cloak performance fees within total return swaps. The track records for most managers are brief in the mutual fund space, and although investors can increasingly find managers running strategies in identical or very close fashion to their private funds, handling the flows of a retail mutual fund introduces an unstable new X factor.

Investors can consult the list of  Morningstar Medalists from the various alternative mutual fund categories as a starting point to identify funds that have gained our analysts' confidence. We hope to expand this list over time. Hedge funds certainly aren't dying, but they're not a shining picture of health either, and to the extent that other investors share the concerns of CalPERS, hedge funds' future may well lie in the liquid structures of ETFs and mutual funds.