Much has been made about the California Public Employees’ Retirement System’s (CalPERS’) plan to eliminate all its hedge fund investments over the coming year. Ironically, I typically advise clients not to focus on what trend setters – especially billionaires (more on that trap in another article) – do with their money, as they are playing in literally a different league than most individual investors.
However, this decision by a key trend setter, the nation’s largest pension fund, provides an excellent entrée for holding productive discussions with your wealth manager.
There are three main questions this move should prompt regarding your position in hedge funds:
- What is the goal of including alternative investments in my portfolio?
- How do you evaluate which products you’ll be using?
- Am I getting a good value for the fee I’m being charged?
Let’s go through each of these step-by-step:
Goal and Role of Alternative Investments
As a rule, you need to consider your portfolio from a holistic point of view – whether the parts are together creating the balance you seek. There’s a belief that what could be deemed underperformance in certain categories may be acceptable – and even possibly desired – when you’re gaining an important benefit, say, flexibility or ready access to cash.
CalPERS initially started looking at hedge funds because they weren’t contributing to the overarching goal of meeting their combined investment targets over the long term. In CalPERS’ case, the goal is to earn an average of 7-8% a year. Note: On a pure numbers basis, the asset class has produced 7.1% for the most recent fiscal year. However, the annualized rate of return on its hedge fund investments over the last 10 years was 4.8%, well short of the target (Source: BusinessWeek). CalPERS apparently concluded that the reduced volatility these investments added wasn’t worth the additional complexity and costs.
Furthermore, CalPERS made their decision by weighting the importance of other goals, chiefly simplifying assets and reducing costs.
Discussion points: What exactly are you seeking to “hedge”? Once you determine that, you and your advisor can assess the available options out there and then establish whether or not you’re paying the right amount – or too much.
Evaluation Process of Alternative Investment Products
When you look at alternative investments, what are you really seeking? Many think it’s about access to smart people. However, I would ask: Do you really need a specific person or simply access to the beta of the strategy (for example, merger arbitrage, managed futures, reinsurance, etc.)?
CalPERS calculated that they had 24 hedge funds and six hedge funds-of-funds, which earned 7.1%. Given that the pension has a total $300 billion in investments, this meant that the combined hedge funds were contributing 0.4% to their total return. CalPERS had determined in step one that a hedge fund investment might be useful to their portfolio, but in practice the added complexity of the process did not deliver on the promise. They decided to stop looking for the really “smart people” and focus on investments that more simply provide exposure to different markets.
Discussion points: What are the overarching goals of your portfolio? While diversity is a good thing, has your portfolio grown more complicated than you’re comfortable with? What are you paying to maintain certain investments? Is it more important to you to have a less volatile portfolio or potentially higher returns?
Be on the Lookout for Fees That Diminish Your Investments
Hedge funds famously charge “2 and 20,” which means it could cost investors up to 2% of their total investment and20% of any profit just to maintain a position. Of course, we can assume that the larger the investment, the more “wiggle room” there is in negotiating fees.
Still, no matter what “bargain” you’re getting to gain entrance to an investment vehicle, you can never lose sight of the end-goals: Is the asset providing true value in the context of your overall portfolio and your combined goals (whether they be cash flow, risk tolerance, tax concerns, or other items specific to you)?
Discussion points: If you decide that alternatives are necessary to help you achieve your goals, search for the least expensive version of a product. There are many hedge funds that offer similar products for wildly different fees. Find out what fees you’re paying for different investments, and dig deeply to find if those fees deliver value. Based on CalPERS’ annual statement, they paid approximately $600 million in investment management and consulting fees last year (overall). Like CalPERS, you may arrive at the conclusion that the money you spend on fees is better spent elsewhere.
As with all investments, you should thoroughly discuss the decision to purchase alternative investments with a financial professional. They are not suitable for all investors. Alternatives may reduce returns, but they also may offer a valuable benefit to a common stock/bond portfolio. In my experience, the single benefit worth paying extra for is almost always reduced volatility. But every case is unique, which is why I’d advise discussing your situation with a trusted financial advisor.
