Hedge funds losing appeal for big pension funds, says Milliman

Michael Armitage
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(Pictured: Michael Armitage) 

The largest US pension fund, CalPERS, turned its back on hedge funds in a much-publicised decision last year. Michael Armitage, of consulting firm Milliman, considers the implications for Australian investors. He says the decision by the largest US pension fund to scrap its $US4 billion hedge fund program should prompt Australians to review their own alternatives strategies.

Michael Armitage* writes:

Several prominent US public pension funds are reviewing their alternatives strategies given CalPERS’ decision, which was prompted by concerns overly high investment fees, as well as the fact that hedge funds’ often complex and opaque trading strategies. Hedge funds offer excellent portfolio diversification benefits but when a $US298 billion fund exits the sector, it demonstrates just how challenging the hurdles are to surmount. 

Hedge funds did outperform plummeting share markets as the global financial crisis wreaked havoc in 2008 but still lost a hefty 18.8 per cent, according to the CS Tremont Broad HF Index. Meanwhile, hedge fund returns have been in the low single-digits as equity markets have surged in recent years.

Many investors have difficulty explaining whether their hedge fund allocation is aimed at bolstering their portfolio’s diversification or for explicit risk management. For many investors, their hedge fund allocations have simply dragged down total portfolio returns while providing no certain protection against falling markets, prompting questions similar to CalPERS: can I meet my investment objectives with more certainty, less cost and by using less-risky structures?

The hedge fund sector now accounts for $US2.82 trillion in assets under management according to HFR but as more money flows towards specific strategies, so the opportunity set of investment ideas diminishes.

The return expectations of fund-of-hedge-funds shows just how much the opportunity for “alpha” (or outperformance) has compressed. In the early-2000s, return targets were typically 7 per cent above cash while today that target has just about halved to 3-4 per cent.  

It is no simple task to grasp the underlying drivers of a hedge fund’s strategy – the drivers which control the levers to risk and return – but the skill used to generate those returns is also now being increasingly questioned by academics and industry participants. 

For example, research by investment firms Alternative Beta Partners and AQR suggests that hedge fund alpha can be explained by more exotic “beta” (or market-generated returns) from strategies involving carry, momentum, value or illiquidity.

New alternative beta products offering hedge fund-like risk factors, such as volatility-focused exchange-traded funds, are allowing investors to dial up or dial down specific risk factors with better transparency and at lower cost.

Those investors who continue to back hedge funds will need to embrace relatively more complexity coupled with less liquidity if they are to have any hope of generating outsized alpha. With the increased availability of liquid alternative beta and beta management strategies investors are presented with more appealing choices.

It makes CalPERS decision all the more understandable. The fund would have had to allocate a substantial multiple of its 1.5 per cent portfolio allocation to have any chance of it having a meaningful impact – a move which would also take it into investment areas few in-house personnel would understand. 

Another option for investors is to invest in smaller boutique hedge funds, which are not burdened by excessive funds under management. Australia has several excellent hedge fund managers however, given their small size, they tend to never make the approved lists of institutional manager selection teams because they don’t have the same reputation as a big firm and can potentially present greater operational risk.  

As I have watched the industry evolve over the past 25 years, my views have come full circle. I believe that hedge funds are best-suited for high-net worth individuals – the same investors who initially backed the sector. They are the only group that has the ability to consistently support boutique hedge fund managers which manage a limited amount of money (including their own) and so have the greatest potential to deliver results.

As institutional funds continue to flow to the largest international hedge fund managers, their expected investment returns will continue to diminish.  As performance fails to meet expectations in both explicit risk management and returns, we will see more headlines about large institutions leaving the hedge fund sector.


*Michael Armitage is Milliman’s head of fund advisory services. During his career, he has developed a $US300 million option trading program for a US hedge fund, launched his own hedge fund, and assessed hedge funds at a major global consultancy.

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