Why Public Pension Giants and Hedge Funds Don’t Mix

FEG’s Nolan Bean explains why a large retirement system like CalPERS is unlikely to gain alpha from hedge funds.

Terminating its hedge fund portfolio was the “best decision” the California Public Employees’ Retirement System (CalPERS) could have made, argued Fund Evaluation Group’s (FEG) Head of Institutional Investments Nolan Bean.

At FEG’s annual investment forum, Bean claimed that a $291 billon public fund like CalPERS has little chance of squeezing alpha from hedge funds. The number of managers necessary to justify a hedge fund allocation at a fund of CalPERS’ size can lead to a portfolio that’s over-correlated to equities, while disclosure requirements make it difficult to invest with the top managers.

“They’re subject to FOIA [Freedom of Information Act] requests,” Bean said. “Hedge funds don’t want to be subject to FOIA requests. The best hedge funds won’t take money from them.”

“As you have more managers, you basically become the market.”And having access to the best managers is especially important when it comes to hedge funds, which Bean argued have the highest performance dispersion of any other class of manager.

“The reward is greater when you get it right, but the pain is also greater when you get it wrong,” he said.

Out of every 10 hedge funds, Bean estimated that at least six or seven weren’t worth investing in—meaning CalPERS’ program, which included 24 hedge funds and six funds-of-funds, had the odds stacked against it.

“As you have more managers, you basically become the market,” Bean said.

But just because CalPERS was right to dump its hedge funds doesn’t mean everyone should, he noted. With management fees dropping—the average is now 1.5%—investors are able to get a better deal than ever. For smaller, more private funds such as endowments and foundations, there is plenty to be gained, Bean said.

Not only are these asset owners more attractive to hedge funds seeking to avoid public scrutiny, they are small enough to invest with smaller managers—which Bean argued are usually the best performing.

“Attractive opportunities exist,” he said. “But manager selection is critical.”

Related: Blackstone: CalPERS is Right to Dump Hedge Funds