News

By Chris Larson

California Public Employees’ Retirement System’s (CalPERS’) move to no longer invest in hedge funds, or in funds of hedge funds, is unlikely to spark a trend of investors fleeing the asset class, say experts, but they do expect continued pressure on hedge funds to lower their fees and be more transparent.

“It’s definitely the big topic of discussion” with investors and service providers, says Carl Lingenfelter, chief administration officer at Northern Trust’s hedge fund services division. “Still, the content and the questions people are asking are really just a continuation of the discussions that people been having around performance and fees and fund structures for quite some time,” he says.

The CalPERS decision is actually positive, says Damien Loveday, global head of hedge fund research at Towers Watson. “The first reaction may be ‘Oh, this is terrible news.’ But no, this is great,” he says. “This is right in line with everything we’ve been talking about for the last 10 years, about how investors need to be better aligned with their investment managers, particularly with respect to fees.”

Ted Eliopoulos, CIO at the $300 billion CalPERS, revealed the decision to pull out of hedge funds last week, saying that he and the board had decided hedge funds aren’t worth the “complexity, cost and the lack of ability to scale at CalPERS’ size.” He did not blame underperformance for the decision.

Experts say Eliopoulos brought up a good point: hedge funds can be quite challenging for investors, no matter how large or small. For instance, “The lack of transparency has been an issue for years,” says one wealth management investment official, who previously oversaw investments at a public pension fund and requested anonymity. “This is certainly improving, but it’s still a struggle.”

Other issues that trouble institutional investors about hedge funds include a lack of liquidity, the potential for fraud and, of course, fees, says Ron Oldenkamp, president of third-party marketer Genesis Marketing Group. “The 2-and-20 [fee] model is under a lot of pressure,” he says. “I think for hedge funds to really continue to prosper going forward, they need to address the fees and other issues.”

Whether the CalPERS decision inspires other pensions to pull out of hedge funds remains to be seen. “I don’t think there will be widespread cuts, but there will definitely be more thinking about alignment and governance, and some investors may decide to cut,” Loveday says.

“There will likely be some institutions that follow CalPERS’ move,” says David Frank, CEO and managing partner at Stonehaven, a third-party marketing firm. “But the attention caused by their move is likely to result in more discussion about how groups should allocate to hedge funds … not if they should be invested in hedge funds.”

Indeed, Northern Trusts’s Lingenfelter thinks institutions will continue to invest in hedge funds, though they will likely slow down the pace for the time being, or even put such investments on hold temporarily. “There will certainly be a pause in many investors’ discussions around their investments, or potential investments, in the hedge fund sector, particularly in the U.S. public fund space,” he says.

He’s optimistic in the longer term. “I think we will ultimately look back at this as a turning point in the maturity of the hedge fund sector as it becomes a truly institutional asset class, as people finally realize that it’s not a

one-size-fits-all investment and look instead at how hedge funds complement their other strategies and asset classes,” Lingenfelter says.

Hedge funds themselves do not seem excessively worried that public pensions will abandon the strategies en masse. A senior marketing executive at a multi-billion-dollar manager, who asked for anonymity, notes that while state and local pensions still receive some criticism from the public for investing in hedge funds at all, “the institutional marketplace will continue to be a target for hedge funds.”

The marketing executive says that, after discussions with peers in the wake of the CalPERS announcement, he sees no signs of panic among other large hedge funds. He adds that the pension’s $4 billion hedge fund portfolio, while large in absolute terms, is a small fraction of the overall $3 trillion hedge fund industry.

In fact, says marketer and media strategist Mark Macias of Macias PR, start-ups and smaller hedge funds could turn the CalPERS situation to their advantage, if they offer clients and prospects greater flexibility on fees and transparency. “I think the bigger managers should be a little worried,” he says. “It’s the start-ups, the hungry managers, who can change the fee structure,” which should allow them to attract more assets, assuming the performance numbers are there as well, he says.

The same goes for transparency. “I’m telling my clients they need to be very clear with transparency” regarding fees and investment processes, Macias says. “People don’t like hedge funds if they see them as a black hole.”

The CalPERS move should not have much long-term impact on high-net-worth and retail investors looking at hedge funds either, Lingenfelter says. “There will probably be a little more skepticism in the retail market, especially around fees,” he says. “But as funds are able to generate a track record of performance net of fees, we will continue to see retail and traditional wealth management … increase their alts exposure.”

Towers Watson will still pressure managers to lower fees and otherwise be better aligned with investors, says Loveday. For those that do so, there’s no cause for alarm, he says: “If you’re a good manager, with fees that are aligned with investors, you have nothing to worry about.”

Copyright 2014, Money-Media Inc. All rights reserved. Redistributed with permission. Unauthorized copying or redistribution prohibited by law.