The hallmark of the unsophisticated, or perhaps more accurately, the undisciplined investor is a tendency to buy high and sell low – in other words, to follow the market herd.
The California Public Employees’ Retirement System, better known as CalPERS, recently announced its decision to liquidate all of its hedge fund investments. The decision itself is not unwise, but its timing is a reminder that big investors can be as undisciplined as anyone else.
CalPERS’ Chief Investment Officer, Ted Eliopoulos, told Bloomberg that the pension’s hedge fund allocation “did not offer [CalPERS] the ability or the promise to effectively diversify or hedge any meaningful portion of [its] total portfolio.” (1) CalPERS’ announcement cited large fund fees and the funds’ complexity in the decision to pull out of the asset class.
The classic hedge fund promise is that it won’t move in lockstep with the stock market, therefore providing a “hedge” against other investment losses. By following any one of many strategies, or a combination of several, the managers of such funds have traditionally sought to make money when the overall stock market falls – or at least to lose less money than other investments do. At the same time, hedge funds promise to at least make some money when the market rises.
So when the financial panic hit the market in 2008-09, and stocks typically lost half their value, investors wanted something more appealing. They looked to hedge funds, saw something that glittered (at least relative to most everything else), and assumed it was gold. A few funds actually made a bundle during the panic by astutely betting on a housing crash or other consequences of the financial panic. Investors crowded into those when they could, and often into other hedge funds when they couldn’t, hoping for similar results.
CalPERS, as the biggest institutional investor around, can typically get into any fund it wants.
But good investing is a pretty boring exercise, at least if you are prepared to hold on to your investments during downturns and wait for an eventual recovery. Recovery has come with a vengeance since 2009, with the S&P 500 index at around triple its early 2009 low. Few hedge funds have kept up. In fairness, many of those funds are not designed to keep up with a rapidly rallying stock market. That is why they are called hedge funds.
In truth, it never made much sense for CalPERS, or other pension funds, to get into hedge funds in the first place. Pension funds are long-term investors by definition; their obligations span decades. Their fundamental problem is not the result of short-term market moves. Their problem is that they are underfunded relative to their long-term obligations.
Some are trying to hide that problem by seeking a magic investment bullet – something that promises to give them better-than-market returns over the long term. Despite some fund managers’ claims, no such magic bullet has been proven to exist. In any given period, some managers will outperform the market, occasionally by impressive margins. But it never lasts. The strategies that work wonderfully in one set of circumstances stop working when circumstances change.
So the real problem isn’t that CalPERS is getting out of hedge funds. The problem is that CalPERS felt the need to get into them in the first place. CalPERS ought to be able to meet its obligations by gathering actuarially reasonable contributions from California state and local government agencies and investing those contributions in a well-diversified mix of stocks and bonds, in an environment that includes sound fiscal policy, a nonrepressive interest rate environment, and a tax and regulatory regime that promotes capital formation and economic growth.
Of course, a lot of those ingredients are absent or diminished in the world we inhabit today. It would be nice if, as it corrects its hedge fund mistake, CalPERS threw its weight behind those other policies as well. But we are, after all, talking about the California public employees’ retirement system, and these prescriptions are not exactly the fashion in the Golden State today.