In the 10 years since the enactment of the Pension Protection Act (PPA), defined benefit (DB) pension plan sponsors have been motivated to shift portfolio allocations. The most notable change has been a de-risking through scaling back traditional equities, with a corresponding increase to lower-volatility fixed income.
But plans have still needed to maintain their returns, prompting many sponsors to head into alternative assets such as direct real estate, private equity and hedge funds. “With the financial crisis in mind, we think our clients tend to underweight diversity in their portfolios,” says Brad Morrow, head of Americas manager research with consultants Willis Towers Watson in New York City. “We think diversity pays, and these are the asset classes that can provide diversity as well as a bump in return.”
Equities in U.S. defined benefit plan portfolios were pared down to 43% of total assets, on average, from over 60% in the era before the PPA, according to analysts at CEM Benchmarking in Toronto. An insightful June report studied 200 U.S. DB plans, with aggregate assets of over $3 trillion, from 1998 through 2014. “We looked at both costs and returns, to answer the question: ‘Did we get what we paid for?’” notes senior research analyst Alex Beath. In addition to the scaling back of equities, the report chronicles rapid growth in hedge funds and private equity, and a smaller increase in direct real estate (see chart). Over the study period, Beath found that, on average, real estate and private equity both delivered respectable returns—albeit at high volatility—but that hedge funds were a disappointment.
Broad averages of returns on alternatives may not answer many questions, however, as variations in manager skill and resulting performance are much wider than in the public markets. “If you look at the top 5% and bottom 5% of hedge fund managers over the last 10 years, the difference in return is about 10 percentage points—a multiple of two to three times what you have with traditional equity managers,” says Sona Menon, head of North American pensions at consultants Cambridge Associates, in Boston. “The penalty for choosing the wrong managers is substantial—not only due to the wide dispersion but because managers’ fees are so high.” She adds, “That’s probably even more true for private equity and venture capital, where the difference between picking the right [and wrong] manager[s] is not making a lot of money or a little, but making a lot or losing a lot.”
Owing to the high fees they charge and the complexity of their investments, managers of alternatives are constantly under scrutiny from clients and market observers, but the past few years have brought special attention to hedge funds.
CEM Benchmarking Inc. recently published “Hedge Fund Reality Check,” a report focused exclusively on hedge funds that examines 15 years of portfolio returns. It reaches this conclusion: Only 30% of plans’ hedge fund portfolios managed to outperform simple benchmarks composed of equity and debt indexes. Moreover, plans with the best results generally had long histories with hedge funds and tended to invest in the funds directly, rather than through higher-cost fund-of-funds arrangements.
Investors had noticed such performance shortfalls long ago, however, stirring a small-scale revolt among institutions owning hedge funds. It started to gather in September 2014, when the California Public Employees’ Retirement System (CalPERS), the largest public pension fund in the U.S., ended its $4.5 billion, 13-year-old hedge fund program due to disappointing returns (see “CalPERS’ Hedge Fund Exit: Will this be a new trend?
During 2016’s first half, the New Jersey State Investment Council, historically an enthusiastic hedge fund investor, scaled back its target exposure for 2017 from 12.5% of fund assets to 6%. Other prominent investors have also backed away from hedge funds. In February, the Illinois State Board of Investment, which oversees $16 billion, cut its 10% portfolio allocation to hedge funds by 70%, and in April, the New York City Employees’ Retirement System (NYCERS) elected to eliminate its $1.5 billion in hedge fund investments altogether.
All told, institutional investors redeemed $28 billion from hedge funds in the first half of this year, according to the manager return database of eVestment. The net outflow amounts to only about 1% of the industry’s $3 trillion in assets but negated much of the $44 billion inflows in 2015. Still, performance makes a difference: Those funds showing 2015 returns of greater than 5% saw first-half 2016 inflows of $37 billion, while investors withdrew $98 billion from funds with negative returns, an eVestment report said.
“It’s not surprising that a few brave pension funds are revisiting the whole matter of hedge funds,” observes Jeff Hooke, senior lecturer at the Johns Hopkins University Carey School of Business and retired investment banker. “For one thing, CalPERS is a leader, and they’ve sort of admitted they made a mistake. Once that dam breaks, there’ll be a flood. For another, one weakness of the investment business is that even knowledgeable professionals are always chasing performance and looking for the next new idea. With hedge funds showing poor returns for the last five years, maybe it’s time to move on.”
Do Hedge Funds Still Make Sense for DB Plans?
How the strategy measures up against other asset classes. Portfolio allocations to alternative assets and public equities, in Selected U.S. Defined Benefit Plans, 1998 – 2014
Source: CEM Benchmarking, "Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States, 1998-2014"