Hedge Funds and Alternative Investments

Recently the Wall Street Journal[1] reported that the largest public pension fund in America, “California Public Employees Retirement System” (known as Calpers), is reducing its exposure to hedge funds by an estimated 40%. When interviewed, a spokesman indicated Calpers has decided to take a “back to basics approach” with regard to investing and portfolio construction.  The article goes on to cite other large public pension funds taking a similar approach, and also provides a brief history of hedge fund investing by large pension funds, beginning with this explanation:

“Public pensions began wading into hedge funds roughly a decade ago, as they sought to boost long-term returns and close the gap between assets and future obligations to retirees.”

The fees are also mentioned, which are typically 2% of assets under management and 20% of profits. In comparison, Sigma’s fees begin at 1% and step down from there as the account increases in value.

As with any type of investment like this, the early adopters accrue the largest benefits. Recently, I attended a conference where the speaker likened alternatives and hedge funds, or new investment ideas, to a buffet table: The first person in line gets the prime rib, lobster tails, salad and side dishes, while the last people in the line (or those that stay too long) are left with ground chuck. The speaker also pointed out that when an asset class becomes easy enough for everyone to own, the behavior of that asset class and other publically traded asset classes tends to converge.  In other words, the behaviors of the asset classes become much more closely correlated and the intended diversification benefit is lost. Yet, hedge funds and other high-fee alternative investments have become “all the rage” for many of our industry peers, with diversification as the explanation for adding this high-fee investment to the portfolio.

As investment advisors and fiduciaries for our clients, we must give due consideration and analysis to such investments. Over the years we have had various conversations about investing in hedge funds and alternatives. At Sigma, we have never found the publically traded hedge fund arena, or related alternative asset classes, to be of appeal for several reasons. First and foremost is the idea of the “back to basics” tactic. Sigma has always maintained a disciplined and “basic” approach to portfolio construction and management. While we have considered and invested in some publically traded alternative investments, such as gold or real estate for example, we have never understood the appeal of the hedge fund world for individual investors. Unless one jumps in early, (which requires private market illiquid investments), the cost is prohibitive. The below cited Wall Street Journal article provides the example of the “LA Fire and Police Pension”, where the hedge fund investment was just 4% of the pension’s total portfolio. Yet the fees that went to hedge fund managers represented 17%, or $15 million, of all fees paid by the fund. (And it got poor returns to boot!) It is likely that a portion of the hedge fund investments were in private investments.  If they had been completely in publically traded hedge fund vehicles, the fees would have been even higher.

In addition, the trading strategies used by hedge funds are merely an amalgamation of strategies that can be employed in basic portfolio construction. To charge a fee of 100% greater than a traditional money manager, PLUS a percentage of the profits for such strategies, has never made sense to us.

There are many ways to make money in the investment world, and there is a time and place for legitimate investment opportunities of all kinds. However, not all investments are for everyone. At Sigma, we remain committed to the basics, and are pleased to see that Calpers now seems to find our style of “Back to Basics” portfolio management an investment approach of interest.

All comments and questions are welcomed.

Denise Farkas, CFA®