CalPERS: Why All the Fuss?

September 28, 2014

Much has been made of California Public Employees’ Retirement System’s (CalPERS) decision to redeem some $4 billion of its assets from hedge fund investments. However, less is made of the fact that CalPERS manages some $300 billion in funds. This means that CalPERS had slightly more than 1% of its assets under management invested in hedge funds, so the real question is … why did they bother?

Perception is Everything

Is the redemption of $4 billion in a $3.1 trillion hedge fund industry truly that consequential? After all, hedge funds attracted more than three times that amount in new money just in the month of August. Massachusetts has $5.6 billion invested in hedge funds, a much larger investment than CalPERS. Yet California has attracted all the press because of its decision to pull out.

While the CalPERS’ redemption will be largely without consequence to any hedge fund’s bottom line, the perception that hedge funds are in any way failing their clients, could have serious consequences. This perception, however false it may ultimately prove to be, is why hedge funds need to be concerned about the CalPERS decision. To quote the Chief Investment Officer of CalSTRS (California State Teacher’s Retirement System, Christopher Ailman, “that industry definitely has a perception problem” Worth noting – CalSTRS has no current plans to redeem its hedge fund investments. 

The CalPERS determination has attracted attention because it was among the first pension fund to test the hedge fund waters and like many other California icons, it has a disproportionate influence among its peers.

Hedge Funds Need to Respond

CalPERS’ prominence as a pioneer in hedge fund investment places it in a unique position to undermine the hedge fund industry’s preeminent role among institutional investors. No doubt, this is the principal driver for those hedge fund managers who have, albeit anonymously, spoken out.

There have been two primary rebuttals. The first purports that CalPERS chose the wrong hedge funds. Therefore, the redemption reflects on the selected hedge funds rather than the industry as a whole. While this argument makes a good sound bite, it falls short of the quantitative argument necessary to keep other institutional investors in the fold.

The second argument, marginally compelling, defines the thirty or so hedge funds employed by CalPERS as poor performers and, by extension, poor choices. The unnamed source forthrightly acknowledged that CalPERS was underserved relative to equity market returns. This source goes on to suggest that hedge funds may need to bring fee structures in line with results.

A Third View

Hedge funds, by definition, are designed to function as preservers of wealth, while taking full advantage of investment opportunities that do not subvert that objective. The hedge fund industry would be better served by emphasizing the tremendous success it has enjoyed in this traditional role.

Hedge funds cannot, nor should they attempt to, be all things to all clients. Concerns regarding fee structure, complexity, and scalability need to be addressed with potential clients up front. Net performance is, and will continue to be, the best measure of hedge fund success.

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Even ardent defenders of hedge fund fee structures must acknowledge the impact a marketplace open to retail investors may have on the status quo. Is the hedge fund 2 and 20 rule going the way of the banking industry’s 3-6-3 rule?

Disruption

It is no revelation that 2 and 20 has been under assault for some time. Average management fees have plummeted 25 percent and the average take on profits has dropped 10 percent, making the two and twenty rule a misnomer. More accurately, it has become the 1.5 and 18 rule.

The erosion of the hedge fund’s traditional fee structure is certainly a response to the lackluster performance of hedge funds relative to benchmark indices, specifically the S&P 500. While arguments can be made that using the S&P 500 as a performance benchmark is a questionable practice, the fact remains that hedge funds, particularly long-short hedge funds, have under-performed the S&P 500 consistently since December, 2010.

Understandably, investors of all stripes have rebelled against a hedge fund fee structure that does not reflect its underwhelming performance.

A Time for Every Purpose

Enter Convoy Investments, LLC, co-founded by Howard Wang and Robert Wu, formerly of Bridgewater Associates, LP.

Convoy has responded to investor concerns over the merits of the 2 and 20 fee structure by eliminating the 20 percent performance fee altogether and reducing the management fee to  1.25 percent. Additionally, the firm has reduced its minimum investment to $500,000 in sharp contrast to the standard required minimum of $1 million.

This will be attractive to a subset of disgruntled institutional investors and well-received by retail investors sitting on the sidelines because of the hefty fees typically associated with a hedge fund investment. Wu and Wang have introduced this novel fee structure at the confluence of an investor rebellion against 2 and 20 conventions, and the rise of the retail investor, easily put-off by what are perceived to be extraordinary fees for otherwise ordinary returns.

Is This the Trend?

Only time will tell if Convoy’s fee structure will divert assets from hedge funds operating on a more traditional fee structure. Like any hedge fund, Convoy’s track record will be the principal driver for investment. There is no fee low enough to attract an investor to an under-performing hedge fund. Convoy has yet to establish a track record but, Howard Wang and Robert Wu have earned their bona fides by virtue of their Bridgewater experience. Time will tell how much they learned from that experience and if it can be translated into returns that will grow the firm’s assets under management.

There are a number of ways hedge funds can differentiate themselves from one another and the fee structure may be the least significant methodology. Performance will always be the principal driver and experienced investors are keenly aware that there is no free lunch. Performance fees are a powerful incentive and the absence of such a fee may, at first blush, seem attractive, it may also be a harbinger of lackluster gains. How Convoy’s fee structure is received and, how it performs relative to its peers, will be an interesting story to watch unfold.

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