The Future of Hedge Funds

in Institutional Portfolios

Rachel Koh, Nicholas Aveni, Patrick Dennehy, Karan Seth, Ryan Sullivan and Joseph Bartlett

University of Massachusetts­ Amherst

Project Sponsor: Ben Happ

December 1, 2014

Introduction

The goal of our project is to study the evolution of the hedge fund portfolios of institutional investors over the last several years and to make educated guesses about possible changes in their allocation in the next several years. Institutional investors have been important clients for hedge funds, and we are particularly interested in public pension funds and endowment funds. On average, at stake for hedge funds is billions of dollars in investments made by public pension funds on behalf of public­sector employees . Over the past decade, 1

pensions and endowments have increasingly moved away from stocks and bonds and put money into investments such as hedge funds, real estate and private equity as alternatives to stocks and bonds, because of the asset allocation benefits that alternative asset classes offer.

Hedge funds are private investment partnerships in which the general partners make a substantial personal investment. They often take large risks on non­traditional speculative strategies with illiquid assets. That can amplify their gains and their losses through leverage as well. Unlike mutual funds, hedge funds are not required to register with the SEC and disclose their asset holdings, largely because hedge funds are either limited partnerships with no more than 500 investors or offshore investment vehicles. This limited regulation gives hedge fund managers large flexibility in making their investment decisions. However, they are not allowed to advertise to the public, and the minimum investment requirement is very high. Hedge funds also charge higher fees than other money managers, usually 2% of assets under management and 20% of profits. Hedge funds performed better than many investments during the 2008 financial crisis, falling on average by less than 20%, compared with the 37% drop in the S&P 500, according to HFR, a hedge­fund research firm. This helped attract even more pension money. But they have struggled overall to repeat that success in recent years . 2

In our research, we gather various types of sources that are publicly available, such as public pension funds database compiled by Boston College, aggregate endowment funds data provided by NACUBO, and news articles. Also, we resort to surveys for actual opinions of real professionals in the field and current news articles. This is important because to make projections into the future, current sentiments of investors is one of our main keys for interpretation, given the limited data.

1 http://online.wsj.com/articles/pension-funds-eye-reducing-hedge-fund-investments-1413762698 2 http://online.wsj.com/articles/pension-funds-eye-reducing-hedge-fund-investments-1413762698

Data

As briefly mentioned above, our data are the following:

1. Public pension funds database (PPD, henceforth) : 150 state and local public pension 3

plans and annual data for 2001­2012. 2. NACUBO public aggregate data of endowment funds 4

3. News articles Center for Retirement Research at Boston College utilized the annual financial reports of

individual funds to compile PPD. When they did, they used the label used in the report and did not make any modification to the asset class labels. For instance, the hedge fund allocation and absolute return allocation were treated as different variables in PPD, so we had to merge the two variables. Also, in case that the asset allocations did not add up to 1, we had to go back and double­check on those funds’ reports.

NACUBO stands for National Association of College and University Business Officers (NACUBO), a membership organization representing more than 2500 universities across the country and around the world. Its mission is to advance the economic and financial practices of universities so that it ultimately benefits the academic objectives. The NACUBO aggregate data on 700­800 US colleges were reported on annual basis. First, we compiled all the annual data from 2004­2013 into one data set to perform analysis of data over time. Unfortunately, the individual funds data were by paid subscription only, but we were able to look up most annual reports of the top 20 endowment funds in the rankings, such as Harvard, Yale, and University of Texas system . However, we mainly use aggregate data for our analysis because each 5

endowment fund had different ways of classifying asset classes when they reported portfolio allocation, so lack of standardized reports of individual funds motivated us to rely mostly on aggregate data.

Endowment Funds

The average annual returns of endowment funds are given in the Table 1 below. It shows that in 2008 and 2009, endowments suffered loss, especially a big loss of ­17% on average in 2009. However, compared to the market performance (S&P 500 returned ­26.2% in 2009 and ­13.1% in 2008), endowment funds fared better. We used the public data provided by NACUBO

3 Public Plans Database. 2001­2010. Center for Retirement Research at Boston College and Center for State and Local Government Excellence. 4 http://www.nacubo.org/Research/NACUBO-Commonfund_Study_of_Endowments/Public_NCSE_Tables.html 5 http://www.bc.edu/offices/endowment/top50endowments.html

to analyze the endowment funds’ asset allocation to alternative asset classes over time. We acknowledge that aggregate data may not be fully reflective of the individual endowment funds, but our purpose is to study the general trend on average rather than focusing on individual funds.

From 2004­2008, the data on the asset allocations specifically to hedge funds are available, although from 2009, NACUBO only provided the allocations to a general group of alternative strategies that encompass private equity, venture capital, and natural resources in addition to hedge funds. The data clearly shows the increase in the funds’ allocation to alternative strategies over time. In Table 2, from 2004 to 2013, over a 10­year period, the portion allocated to alternative strategies doubled. Also, larger funds tend to allocate more to alternative strategies than smaller funds. The largest group of funds seems to allocate to alternatives approximately at least as much as 6 times the amount that the smallest group of funds allocates. Quite interestingly, the size and allocation to alternative strategies seem to be

closely related, in a monotonic relationship.

There is no evidence that the funds reduced their allocation to alternatives during the financial crisis of 2007­2009. Because the endowment funds were hit especially badly in 2008­2009, we treat only those two years as the crisis period. We can find some ominous sign for the alternative investment vehicles in this table. From 2010 to 2013, there is no more upward trend in the allocation. Although a dramatic increase from 2004 until 2009, ever since then, endowment funds have stayed at 30%. This signals that the upward trend and popularity in alternatives by the endowment funds have essentially ended. At this point, and without the data for 2014, we do not know what will be happening in the future. We have to wait and see, or make use of some other sources or opinions of experts to make educated guesses about the actions of the endowment investments.

In Table 3, allocations to only hedge funds from 2005 to 2009 show that the hedge fund investment was in an upward trend, gaining popularity. Also, larger funds seem to allocate much more heavily to hedge funds, than smaller funds. The difference is huge—as much as 10 times

fold. Larger funds seem to have gained access to hedge funds much earlier than smaller funds.

Table 4 shows the proportion allocated to hedge funds only within the alternative category. This shows something contrasting to what we saw before in regard to the relationship between the fund size and the asset allocation. As opposed to our previous finding that the fund size is closely positively related to the allocation to alternatives, now we find that relationship is no longer existent between the fund size and the proportion allocated to hedge funds within the alternatives group. This suggests that the endowment funds were increasing allocations to other alternative strategies such as private equity and natural resources when they were increasing allocations to hedge funds. There does not seem to be a positive relationship between performance and asset allocation to alternatives on average, however. The worst year for endowment funds was 2009, but the asset allocation to alternatives was at the peak in 2009. The best year for endowment funds was 2007 and 2004, when the asset allocation to alternatives or to

hedge funds was still in its rise.

Studying the annual reports of the top 20 major endowment funds, we found that the majority of them (meaning all funds that publicly reported hedge fund allocations) increased their hedge fund holdings over the last 5­10 years. There is no clear sign of reduction in hedge fund holdings during the crisis, consistent with the aggregate data. Although we do start to observe at most 1% reduction in the hedge fund allocation for the most recent year 2014 for some funds, we do not know whether this is the start of downward trending.

Pension Funds

After filtering out funds with no reported hedge fund allocation, we end up with 52 funds. Table 5 reports the average allocation to hedge funds and average 1­year return of the 52 funds. These funds, like endowment funds, incurred huge loss (­7% in 2008 and ­15% in 2009) compared to other years, in the year 2008 and 2009. In the figure corresponding to Table 5, the hedge fund allocation shows an upward trend from 2003 until 2012, no sign of reduction in hedge fund holdings during the crisis. Just like the endowment funds, the hedge fund investment was getting more and more popular in the public pension funds, regardless of the loss during the crisis.

We further analyze the fund size and divide the 52 funds into two groups, one with investment pool greater than the fund average (“big” funds) and another with investment pool smaller than the average (“small” funds). Table 6 reports the results after dividing the funds into two groups each year. In the graph corresponding to Table 6, we observe no considerable difference in hedge fund allocation between the big and small funds; both seem to have been increasing hedge fund investments over time. But in fact, small fund group allocated 0.6% more on average from 2005 to 2012. In the year 2008­2009, both big and small funds incurred large losses, with small funds losing more in 2008 and big funds losing more in 2009. Overall, large funds performed 1.5% better than small funds on average, which is reasonable since large funds do have better managers and resources. We detect something interesting in the year 2008 and 2009 in the relationship between allocation to hedge funds and annual return. Going from 2008 to 2009, big funds slightly decreased the hedge fund allocation while small funds increased allocation by 1%. Then, in 2009, the worst year for institutional investors, the small funds that increased the hedge fund holdings incurred a smaller loss (6.3% smaller) than the big funds. Although more analysis is necessary, of course, we carefully conjecture that hedge funds may indeed possess some hedging skills in the down market, as found by other researches.

CalPERS and the Future of Hedge Funds 6

The future of the hedge fund industry is in question with some recent news coming out of California. The enormous California state pension plan known as Calpers ($300 billion in assets) announced it would eliminate its investing program in hedge funds. The critics of hedge funds were in joyful bliss as they hoped this would cause a mass exodus in the hedge fund space from pension funds, endowments, and others. Many called hedge funds “a doomed asset class helmed by greedy billionaires who overcharge for a too­complex asset” (NY Times Dealbook). However, is this actually the case? We examined this possibility and the likelihood it would come to fruition.

In the case of Calpers (California Public Employees’ Retirement System), their withdrawal from the hedge fund space opened up the floodgates for people to voice their personal, and often unwarranted, views on hedge funds. Calpers’s chief investment officer Ted Eliopoulos explained his move in a statement. “When judged against their complexity, cost and the lack of ability to scale at Calpers’s size,” he said, “hedge fund investment by the pension fund doesn’t merit a continued role.” We can break down his statement and begin to analyze if Calpers was right to withdraw from hedge funds and if it is going to start a trend with other funds retreating.

First, we can address the issue of complexity. Are hedge funds really that complicated? There are a variety of different strategies out there, ranging from simple long­short funds to more complex strategies that use derivatives and computer programs to calculate algorithms. While many may seem complex on the surface, some are simple and easy to understand how they invest. And in Calpers case, they have two professional advisors whose sole job is to help with hedge fund investing: UBS and Pacific Alternative Asset Management Company (Paamco). It is hard to understand why these advisors could not help Calpers navigate the hedge funds’ complexity.

The next issue is about fees. As we understand, hedge funds typically charge 2% management fees and 20% incentive fees. In the previous fiscal year, Calpers accumulated $135 million in fee expenses from its hedge fund investments. But lets compare those fees to that of private equity. Private Equity, or PE, usually charges the same fees as hedge funds, 2 and 20. Calpers is still fully committed to investing in private equity, with 15% of its capital in the space for a total of $31.6 billion as of the previous fiscal year. Calpers has proven that it is willing to pay high fees as long as the returns are there.

Neither high fees nor complexity seem to make too much sense. The actual reason is much more simple. The hedge fund space is not working for Calpers because of its strategy. Paying over $135 million in fees earned Calpers a paltry 7.1% return. The pension fund itself earned 18.4% over the fiscal year. This is not new news for Calpers. They only average 4.8% annually over the last 10 years from hedge fund investments. Only 1.5% or $4 billion of Calpers assets are dedicated to the hedge fund space. Hedge funds were designed to hedge returns (hence

6 http://dealbook.nytimes.com/2014/09/15/nations-biggest-pension-fund-to-end-hedge-fund-investments/ http://dealbook.nytimes.com/2014/09/23/hedge-funds-are-still-finding-love-just-not-at-calpers/

the name). When the stock market performs poorly, hedge funds are intended to perform better. So with Calpers investing so little of their assets in the hedge fund space, they could not take advantage of the hedging aspect of hedge funds. In order to fully capitalize on the hedge fund space, Calpers would need to be investing in the tens of millions of dollars. Not only that, but their overall investment strategy was flawed. The pension fund had very diversified hedge fund strategies, ranging from long­short, multistrategy, event­driven, international, fund of funds, etc. Overall, they had over 40 different hedge funds and too little money to invest properly in each. They were too big and would have needed to invest an enormous amount into hedge funds to make it worth their investment. There aren’t 40 great hedge funds that can take in $1 Billion. They had a hard time separating the winners from the losers. They also avoided the major funds, such as Bridgewater, who earn outsize returns each year and instead invested in relatively unknown hedge funds. CalPERS did not intentionally avoid funds such as Bridgewater, but instead had too many parameters for investing in theses funds. They wanted transparency and full disclosure on investments made by the hedge funds, which many top funds denied. These funds would rather not disclose everything to CalPERS than take their substantial investment. The top performing hedge fund in Asia denied them for just this reason. This is not consistent with other pension funds.

So did Calpers make the right choice? We believe so. Their decision to exit the hedge fund space was very rational. $135 million in fees for a 7.1% return is not worth it at all. If the returns were higher, the fees would have been justified. But the bigger question is what does this mean for the future of hedge funds and if pension funds will continue to invest in them. In our opinion, hedge funds are not going anywhere anytime soon. First of all, other pension funds that can choose the right hedge funds and search for higher yields will stay fully invested. Texas’ teachers fund and the Massachusetts’s pension fund are examples of funds that are thriving in this space. The Massachusetts’s hedge fund invests about 9% of its assets into hedge funds and has no plan to exit that space. However, we do believe these pension funds will reassess how they are and should be invested in the hedge fund space based on CalPERS decision. The outcome of this reassessment should conclude that hedge funds are solid and they should remain fully invested. Many of the pension funds are underfunded as well and are seeking higher than normal returns to compensate for this. Hedge funds can provide this upside for them in the future. The second reason hedge funds are here to stay is because of volatile markets. Investors need a place to put capital and limit market exposure in volatile markets. There are other ways to hedge your investments in the stock market, but hedge funds are the most efficient resource for these large pension funds and endowments, with the added bonus of potentially large returns. Calpers was unwilling to adjust its hedge fund strategy at all. They did not right the train called activist investing like everyone else did. The other pension funds on this train are seeing the rewards of their choice.

For us, the future of the hedge fund space is clear. It is not going anywhere, and will soon see a surge of investments back into the space. In times of steady climbs in the market, hedge fund returns look average or even below average. However, in times of market volatility or decline, hedge fund performance soars. Investors would like to be a part of that and will be a part of that. So while Calpers may not be on board anymore, that doesn’t appear to be consistent with other funds. This situation should be treated as an isolated incident, and not the start of a trend out of hedge funds. The idea that hedge funds are “doomed” is blown out of proportion and

honestly a bit naïve.

Impact of Volcker Rule on Hedge Fund Investments 7

Another big story out of the hedge fund industry came straight from Wall Street. Goldman Sachs is preparing to sell $285 million of their hedge fund holdings in the third quarter of this year, continuing their massive sell­off this year. The reason behind this move is because of the creation of the Dodd­Frank act in 2010 following the financial crisis. Inside of this act is a part called the Volcker Rule. The Volcker Rule bars banks from numerous types of investing and trading with their own money, which has historically yielded tremendous returns for firms like Goldman Sachs. The deadline to divest in these funds is July 2015.

Along with divesting in hedge funds, Goldman and other major banks began closing their proprietary trading desks, which were part of the problem in the 2008 financial crisis. These prop trading desks were involved in investing in hedge funds using the bank’s money, some of which were operated by the bank themselves such as Goldman’s hedge funds. Now, the Volcker Rule prohibits banks from supplying more than 3 percent of the money for its own hedge funds.

So far this year, Goldman Sachs has sold $2.55 billion it had in hedge funds and has plans to get rid of $375 million more in the coming months. In total, Goldman has about $11.4 billion in funds that are subject to the Volcker Rule, with some of the remaining funds relatively illiquid and hard to unload. This means banks may face major losses on illiquid investments in funds subject to the Volcker Rule as they are hard to sell and may require them to be sold for under fair market value.

As the Volcker Rule applies to all major banks and investment firms, we may see a major pullback in hedge fund investments over the next year. Other banks like JPMorgan Chase, Credit Suisse, Citi Group, Morgan Stanley, Bank of America Merrill Lynch, and others are in a similar position as Goldman Sachs. While these banks will be able to retain a large amount of their hedge fund investments, the minor pullback across the entire industry may stunt the growth of the hedge fund industry as a whole. Many of these investments are illiquid and difficult to sell, so both the banks and hedge funds could see losses. But what does this do to the long­term success of the hedge fund industry.

After analyzing what the result of banks divesting some of their hedge fund holdings would be, it seems apparent that hedge funds will need to source new investors to survive. The large Wall Street investment banks are major clients for hedge funds, and while not all of their investments need to be sold off, there is a significant amount of investments up for grabs. Hedge funds, along with help from the banks who are selling, need to find new investors to pick up the slack. This may be a major benefit to the hedge funds if they are able to further diversify their

7 http://dealbook.nytimes.com/2014/11/05/goldman-sachs-sells-285-million-in-hedge-fund-holdings/

investor pool, and limit the amount of holdings big banks have. However, it will not be that easy to find buyers for some of these illiquid assets.

Hedge Fund Outlook

Although there are concerns from investors investing in hedge funds, the vast majority of investors plan to maintain or increase their hedge fund allocations. Among these issues are performance, concern for fees, transparency and regulation. 89% of investors are planning to maintain or increase their allocations to hedge funds despite these concerns. This suggests that there should be a net increase in hedge fund allocations over the coming year. Public pension funds and private wealth firms are currently the most significant allocators to hedge funds.

Key Stats:

∙ 72% of investors believe that hedge fund returns met or exceeded expectations over the past 12 months

∙ 47% of investors believe that additional regulations are positive for the hedge fund industry

∙ 29% of investors stated that strategy is the most important factor when selecting a hedge fund manager

∙ 41% of investors believe that North America is currently presenting good hedge fund investment opportunities

∙ 53% of investors in liquid alternatives stated additional liquidity as a key reason for investing in these funds

8

Conclusion

After our research we have found a steady investment in alternative strategies post­2008. There have been slight fluctuations in the direct investment in hedge funds, but generally, there have not been significant changes in the past few years. The fairly recent announcement of the California Public Employees’ Retirement System (CalPERS) to cut $4 billion of its hedge fund holdings comes as a slight surprise. Hedge funds provide a set of strategies that can reduce the portfolio correlation with the market while on average, also providing positive returns. CalPERS complains that their hedge fund allocation has not been providing the average annual return that

8 Preqin Investor Outlook: Alternative Assets H2 2014

they have set. The fund points to over complexity, a steep fee structure and an inability to scale to CalPERS size as reasons for its withdrawal. For CalPERS management team it may have seemed like a viable option to dismiss its hedge fund holdings. They were not receiving the desired returns, which they pointed to fee structure as one reason for. The $4 billion that they had invested does not necessarily hold enough value to put enough pressure on the overall portfolio correlation when the AUM sits around $300 billion. However, this does not set the standard for other pension and endowment funds. Diversification benefits that hedge funds provide, along with better returns in a poor market provide ample reasoning to stay invested in alternative investments and hedge funds. The market is relatively up right now, and with uncertainty pertaining to the future post QE, it makes more sense to invest sooner rather than later in alternative investments. CalPERS lost about a third of its value when the financial crisis occurred, but who is to say they will not lose more if another crisis occurred? We do not see other public funds exiting their hedge fund allocations any time soon, especially with uncertainty in the markets future.