Guest article from Don Steinbrugge of Agecroft Partners

I would like to share some thoughts regarding New York City Employees Retirement System (NYCERS) voting to exit all hedge funds. Pension funds should always be managed in the best interest of the plan’s beneficiaries. I believe this blanket decision to eliminate a full set of investment opportunities may result in doing the exact opposite. In addition, some of the comments by people associated with the pension fund raise concerns.

The first of these is the pension fund’s consultant stating they can reach their targeted investment returns with less risky funds. One of the main benefits hedge funds provide to institutional investors is to reduce the risk in their portfolios. Hedge fund indices historically have had significantly less volatility than the equity markets. In addition, many hedge fund strategies have very low correlation to long-only benchmarks, which helps reduce the overall volatility of a portfolio through diversification.

Most pension funds have an actuarial rate of return assumption of 7% to 8%. This is a very difficult return target to achieve using only traditional fixed income and equity investments. On the fixed income side, the US 10-year treasury is yielding less than 2% and fixed income securities will lose value if interest rates rise. On the equity side, stock valuations are above their historical averages with a back drop of tepid global economic growth and little dry powder left for monetary stimulus by most countries’ monetary authorities.

Many pension funds currently have 60% to 70% of their asset in equities. Is it prudent to increase that allocation? Equities can sustain significant declines for long periods of time. For example, the U.S. stock market declined over 80% during the great depression and took 23 years to recover. The Nikkei hit an all-time high of approximately 39,000 in 1989 and more than 25 years later is still below half its peak.

It is true that the hedge fund indices have performed poorly over the past few years, but that does not mean that all hedge funds are bad. Remember, the vast majority of long-only mutual funds underperform their market benchmarks. The industry has grown to over 15,000 funds, which is too many. The majority of these are not very good, which hurts the performance of the overall industry. However, I believe 10% to 15% of hedge fund managers are very talented and their funds can add significant value to a portfolio. In addition, hedge funds are not an asset class, but a fund structure incorporating many different strategies. Each of these strategies should be viewed independently and evaluated on its merits. It is important that a pension fund’s investment staff be highly qualified to identify strategies and managers that can add value to their portfolio. Many large institutions have built hedge fund portfolios comprising of the largest, most well-known managers, which is probably not the best strategy to maximize risk-adjusted returns.

Just as asset allocation and manager selection decisions should always be made in pursuit of enhancing the risk-adjusted return of the total portfolio, politics and personal prejudices should always be excluded. I find it surprising that comments like, “Let them sell their summer homes and jets, and return those fees to their investors” are coming from people associated with NYCERS. Obviously most hedge fund managers do not have houses in the Hamptons or private jets. They should also remember that New York City benefits significantly from the hedge fund industry. NYC is considered the capital of the hedge fund industry, which is responsible for paying a massive amount of taxes to the city. Additionally, hedge fund managers have been major donors to a broad array of non-profit organizations that support the city.

Finally, a portion of the media is using this story as evidence that institutional investors are giving up on hedge funds. They often mention CALPERS that exited hedge funds around a year-and-a-half ago. What they don’t mention are the many investors who have been increasing their allocation to hedge funds. Just this month, the Financial News reported that U.S. insurers plan to expand investments in hedge funds, the Financial Times reported Finland’s State Pension is increasing their hedge fund investments by $500 million, and Pension and Investments reported that Illinois SURS is investing $495 million in hedge funds.

In summary, NYCERS should terminate all managers they believe will not generate strong risk-adjusted returns after fees, but this should be done on a manager-by-manager basis and not simply by how they are categorized in their portfolio. As mentioned earlier, the hedge fund industry is made up of a broad array of strategies, and many of these can enhance the risk-adjusted return of a pension fund’s portfolio after fees. In this challenging investment environment, on behalf of the NYCERS beneficiaries they serve, the board should consider the full range of opportunities to create the best possible investment portfolios.