| Joseph Dear: Paying for beta in a hedge fund is not a smart strategy (Photographs by Lisa Weisman) |
Joseph Dear has one of the highest-profile investing jobs in the world—and one of the hardest. As chief investment officer of the $229.4 billion California Public Employees’ Retirement System, the largest public pension plan in the U.S., Dear manages the retirement savings for 1.6 million of the state’s employees, retirees and their families. He has his work cut out for him: CalPERS needs to achieve an annual return target of 7.5 percent to meet its obligations to current and future retirees. That won’t be easy, given the current economic environment — U.S. Treasury rates are hovering below 2 percent, the European debt crisis is casting a pall over global markets, and equities and other asset classes remain volatile. CalPERS is not alone. Pensions around the U.S. face funding shortfalls, meaning they do not have enough assets to pay health and retirement benefits for the employees they cover. As of June 30, 2011, CalPERS’s assets covered only 74 percent of its liabilities.
One way CalPERS and other pension plans are hoping to overcome these challenges is by investing in hedge funds. CalPERS was a pioneer among public funds for going directly into hedge funds in 2002. At the outset, the pension’s staff, under the direction of then-CIO Mark Anson, decided that the main point of investing in hedge funds would be to reduce volatility in the plan’s overall portfolio, rather than trying to achieve outperformance. Anson wanted to protect the portfolio from market shocks such as the bursting of the dot-com bubble. The program, called Absolute Return Strategies, invested $25 million to $50 million in each of 12 hedge funds during its first year and resided in the pension’s global equity portfolio. By 2004, CalPERS had broadened the portfolio to include additional strategies, ending that year with $900 million invested across 15 managers, though it remained within the global equity allocation. Anson left CalPERS in 2005, and Kurt Silberstein, then the plan’s senior portfolio manager for global equities, took over. The program expanded under Silberstein, but it also experienced its worst year in 2008, losing 19 percent in the wake of the financial crisis.
As a result of the disappointing performance and the pension’s overall unhappiness with how hedge funds handled that year’s liquidity crisis, Silberstein sent a now-famous memo to CalPERS’s hedge fund managers, demanding better investment terms and greater transparency. (By that time the pension had invested directly into 30 hedge funds and was invested with nine funds of funds). Not every manager was willing to comply, and CalPERS ultimately dropped 15 managers from its portfolio. The manifesto still strongly guides the pension’s relationships with its hedge fund managers, according to Dear.
“Everything is negotiable and we intend to negotiate,” Dear said during a panel discussion at the SkyBridge Alternatives conference, or SALT, in Las Vegas in May. “The money we don’t spend on fees goes directly back into the fund.”
Last year CalPERS moved the hedge fund program out of the global equity allocation and made it Dear’s responsibility. (Silberstein left the pension in July 2011.) Dear joined Sacramento-based CalPERS in March 2009 from the Washington State Investment Board, where he had served as executive director. Before that, he had been chief of staff for Washington governor Gary Locke and had also worked in the Clinton administration as assistant secretary of labor for the Occupational Safety and Health Administration.
Dear’s time at Washington State helped prepare him for the pressures of running a high-profile portfolio under scrutiny. “It was good training for managing a lot of assets in a public setting,” he says.
But the experience could not have prepared him for the gravity of CalPERS’s situation. The pension’s assets plummeted from a high of $260 billion in 2007 to $165 billion in March 2009 after hefty losses during the financial crisis. Former CalPERS board member Alfred Villalobos and former CEO Federico Buenrostro were charged in a pay-to-play scheme in 2010. The Securities and Exchange Commission filed a civil suit in April, charging the two with several counts of fraud for sending falsified CalPERS disclosure letters to one of its managers, private equity firm Apollo Global Management, in order to obtain millions of dollars in placement agent fees for Villalobos and his firm, Arvco Capital Research. Villalobos is also facing criminal charges in California.
Amid the scandal, performance problems and ensuing political backlash, Dear buckled down and got to work, exhorting his investment team to take control of their own destiny. The portfolio has bounced back considerably after losing 24.8 percent in the fiscal year ended June 30, 2009. It gained 13.3 percent in fiscal 2010 and 21.7 percent in 2011.
Now Dear is turning his focus to hedge funds, which until now have provided mixed results. While the pension’s overall investment portfolio returned a disappointing 1.1 percent for calendar year 2011, its hedge fund portfolio fared even worse, losing 2.29 percent. In the third quarter of that year, however, hedge funds delivered on their promise, falling just 1.5 percent, compared with an 18 percent loss for Cal-PERS’s global equity portfolio. During the first quarter of 2012, the hedge fund portfolio was once again a laggard, returning approximately 1.5 percent, compared with a 6.7 percent return for the overall portfolio. Dear calls the performance “okay, not great,” and says the program can — and should — do better.
Today, with a decade’s worth of data points and experience to evaluate, Cal-PERS is undergoing a major review of its hedge fund investing program to figure out what role hedge funds should play in its overall portfolio, how their performance should be measured, and whether its funds are doing what they should to bolster returns and protect capital. CalPERS has held discussions with its consultant, Wilshire Associates, as part of that review. The pension is evaluating its current external hedge fund advisers (UBS and Pacific Alternative Asset Management Co.) and searching for a replacement for Silberstein. At the same time, it is considering an increase in how much it invests in hedge funds. Right now the pension allocates about $5.2 billion to hedge funds. While that might sound like a substantial figure, it represents only 2 percent of CalPERS’s overall portfolio.
AR Managing Editor Amanda Cantrell caught up with Dear last month at the SALT conference in Las Vegas to discuss what CalPERS has learned from ten years of hedge fund investing and where its hedge fund portfolio is going.
| Joseph Dear: The focus on better alignment remains to this day |
AR: What is the focus of your review of the hedge fund program, and what prompted it? Dear: It’s a fundamental look at hedge funds at CalPERS. What’s their purpose in the portfolio? How do we measure them in terms of a benchmark? How do we supply the hedge fund program with capital, and then how do we staff it, and what’s the strategy? It’s completely wide open right now.
If you think about the CalPERS hedge fund program over the years, it has gone through three phases. The initial phase was really a kind of equity long-short. The program expanded in about 2005. And then, during and post the global financial crises, there was a review of the portfolio and what we learned from that experience. So this will be the fourth phase. The additional transition element is that we are looking for a head of the program. That person might come from the inside or from the outside. I don’t know right now.
AR: How does the increasing difficulty of meeting return targets affect what you’re trying to do?
Dear: CalPERS’s reputation is as a pioneer and innovator and a producer of good risk-adjusted returns. I want to take us back to that. We’re three years into that work, and we’re making good progress, but there’s a lot left to do: how to allocate assets, how to build the portfolios, how to staff them, who we do business with, what kind of infrastructure we have to support the investment process, how we work with our board. But all those things are getting better. So whenever my time is up, which I hope isn’t soon, I hope that first the board says, “He did a good job. Our beneficiaries don’t worry about us.” And that the staff is proud to be affiliated with CalPERS.
AR: It’s a lot of work to invest in hedge funds, not to mention the potential political backlash that can come from doing so. With only 2 percent of your total assets in hedge funds, is it worth it?
Dear: Well, 2 percent, that’s not that big. But it’s $5.2 billion, which makes it a substantial fund-of-funds business in its own right. So it depends on perspective. The authorized allocation could go to 5 percent under current investment policies, so there’s plenty of flexibility to grow it. But it’s much more important to have this fundamental dialogue with the board and get them comfortable with the program.
I think, in the past, hedge funds that were within the global equity program tended to not get that much attention from the board. It wasn’t separately reported in terms of results. Then with the turnover of the board, the members that were there when the program was initiated and then modified two times, there was not much knowledge about the program. So that’s what the September agenda item was. And then in March we did another program called the Workshops. It was a couple of hours with some outside speakers, getting right to the basics: what is a hedge fund? We got some sense of direction from the board members, and we’re coming back to narrow our options.
AR: In 2009, Kurt Silberstein sent a memo to CalPERS’s hedge fund managers stating what they needed to do to improve corporate governance. How is that progressing?
Dear: That was the program we called Three Pillars. Kurt brought it to me shortly after I joined. It was about better alignment, transparency and liquidity, and we have worked very hard with our partners to get those conditions imposed.
It meant that for some firms, with which we were unable to reach agreement, they’re no longer managing money for us. There were other reasons for portfolio changes in that time because the financial crisis told us pretty definitively who was actually able to hedge and who wasn’t. Now two-thirds of the assets are in direct investments; the remaining third is in various funds-of-funds programs.
The focus on better alignment remains to this day. It’s true across our entire portfolio. The objective is not cost minimization, per se, but is absolutely to get better alignment so that we make money when our investment partners make money. And they’re not rewarded for asset gathering or for being able to persuade investors to pay high management fees. What that has meant in practical terms is clawbacks and extensions of high-water marks, so that when there are short-term gains and then longer-term losses, there’s adjustment in the compensation. I think these are really important steps.
These fees and structures are negotiable. There may be a few people in the market who are so good and so oversubscribed that they can present their terms on a take-it-or-leave-it basis, but not everybody who would like to operate on that basis can. That means investors have to pay attention and negotiate hard. Everybody’s used to that.
AR: Your overall return target is pretty ambitious. Are you looking to use hedge funds to address that?
Dear: That’s the promise, that you can get an equitylike return at some measurably lower level of risk. Now, can you actually build a portfolio that does that? That’s not automatic. And risk mitigation in a portfolio with a lot of growth risk exposure because of a target like ours is important and quite interesting.
AR: How well has the hedge fund portfolio worked, and what could be improved?
Dear: The performance benchmark for the program is T-bills plus 5 percent. We’ve pretty chronically underperformed that. In a really low interest rate environment, that means it’s effectively a 5 percent real return. Against the HFRI Fund of Funds Index, the program’s performed reasonably well. So it’s good, but I have to believe it could be better. That’s what we’re looking at, and that’s what we’re trying to do.
AR: Was 2008 a big part of the problem?
Dear: That year took a lot out, again, because the equity market was down 40 percent, but the hedge fund program was down 20 percent. So the program hedged and it performed, but not like what people thought. That one year has damaged the long-term track record, but I don’t want to sound like all these other managers: “Well, pay no attention to our bad year,” and, “Our results are really good.” Well, no. It’s the cumulative performance.
Last year it did okay. Again, against the HFRI Index it’s a decent performer, so we should feel good about that. I’m just convinced we can do better.
AR: What strategies do you think you should be looking at?
Dear: What’s missing from our book are global macro strategies. That was partly because those funds didn’t do that well in the financial crisis, which is kind of why they were there. The global macro managers were also some of the ones that were harder to negotiate adherence to the three pillars of alignment, transparency and liquidity.
So one of the questions is adding them back, and then it’s fairly balanced among different strategies. And again, if you’re long-term investors, you really don’t want to be making huge tilts from one strategy or another. You’re just trying to be steady and have the book balance out over time.
AR: What are the roles of Wilshire, Paamco and UBS in the process?
Dear: Wilshire’s role is important in that they are the board’s consultant. So their work tends to be more program evaluation and observation of the programs. The direct support for portfolio management, manager selection and analytics are UBS and Paamco. Part of our reliance on them is simply a decision to outsource that work and not try to build the internal staff capability. That’s one of the things we’re reviewing. The main contract is UBS, and we’ll put that up for bid. They’re definitely competitive to retain the business. But I’m very keen to see what other proposals we can get.
Some things have changed a lot in five years, and our board has a good understanding that when we can handle work internally, it’s much more cost-effective. I think there’s an important argument with respect to manager selection, due diligence and oversight, that that’s not something you want to outsource too much. That’s a vital capability that needs to be resident in the organization, in the staff. And that’s true on all the asset classes.
For hedge funds, that means potentially increasing the staff size and providing more internal resources for the program initially. We’ll still have outside advisers. The other thing you need to do is just make the relationship with the partners you have closer and get better knowledge transfer, which is partly a staffing thing. You have to have time to be able to do those kinds of meetings. But that’s another goal that I’m sure we’ll emphasize.
AR: You’ve talked a lot about paying too much for beta, which can be a real problem in hedge funds. How do you get around that?
Dear: That is a huge issue in trying to figure out the appropriate way to compensate the managers. Because paying for beta in a hedge fund is not a smart strategy. It just isn’t. But separating alpha and beta is a nontrivial problem. That’s one of the things that requires work. A lot of people present beta-driven strategies as alpha and want to get paid for it, and some people do!
AR: In the long run, it goes back to figuring out how much you should be paying for what you’re getting. How do you determine that?
Dear: You’ve got some other alternatives now that weren’t available when our program started. There are clearly some opportunities for replication strategies, which are low cost and capture a lot of the beta. So you look at those. You try to get a deeper understanding of what the managers are doing. And every time you sign somebody up or stay with them, it’s a negotiation. I think the investors are getting smarter about how to do that.
AR: Do you think you would ever change the portfolio mix so that hedge funds are on a more equal scale with private equity?
Dear: Private equity is 14 percent of the portfolio. I’ve said publicly I don’t see it growing beyond that. We could shrink the private equity book a bit as we target better managers and higher allocations to give us a portfolio that’s less unwieldy to manage. It’s too soon to say what could happen to hedge funds. We just said that policy allocation is 5 percent, so we could grow currently if we felt comfortable with that. But with this transition, I think we’re asking for a little help to determine that.
You can ask a lot of questions about real assets, infrastructure, commodities, forest land, other physical commodities in hedge funds oriented toward absolute return that could significantly shift the composition of the portfolio. But because of our size, that will evolve very slowly. And I can’t predict where it will end. The shift we’re making is to move the allocation from an asset-class-focused allocation to a risk-focused allocation. If we do that, and it’s effective, I suspect it will have substantial impacts on the composition of the portfolio. But it’s three-, five-, ten-year impacts, not in the next ten seconds.
AR: Can you elaborate on what you mean by risk-focused allocation?
Dear: If you look through assets, you see that they have risk factors and exposures that are common across different assets. For example, public equity in a corporate bond — it’s exposure to a company underneath that, and it has a growth risk component to it. So you evaluate your portfolio in terms of its equity composition; ours is 63 percent. You evaluate it in terms of its growth risk to exposure, and it’s over 90 percent. So it really changes your view. And then if your allocations are based on the amount of active risk that you take in the portfolio, you’re allocating risks. And it collapses distinctions between things like public equity and private equity. So it should have a substantial impact in how you think about a portfolio.
There are a lot of reasons why you want to have a better comprehension of risk in this environment we’re in. That’s another transition. We kind of have our feet in both worlds now — we’re moving to risk factors but still organizing ourselves on an asset class basis.
AR: How did your experience at Washington State inform your views on how CalPERS should invest?
Dear: Washington State is a wonderful organization and much like CalPERS, but on a smaller scale. The common element across my whole career is I’ve worked with organizations that have performance problems, and I’ve come to understand that when you’re trying to improve performance, you focus on what your problems are and you attack them relentlessly. And if you stay at it long enough, you’ll fix it. It’s nothing special about it. It’s all about performance. And my personal experience is that it’s really okay to focus on very short-term projects and improve performance because if you’re relentless about that, over time you’ll produce significant results.
