CalPERS: A 7% Return? You’re Fired.

A headline this week that is getting no small amount of attention is that CalPERS—one of the largest pension funds in the world—is “exiting hedge funds.” More specifically, CalPERS is eliminating their $4 billion of exposure to hedge funds and “funds-of-funds,” citing high fees (in conjunction with mediocre performance) as their primary reasoning.

CalPERS currently holds more than $300 billion in its fund, so a $4 billion allocation is literally a good (or bad) day in the markets. It’s less than 1.5% of the fund’s assets—a virtually meaningless allocation. That being said, it’s the language in their explanation that I find interesting. After five years of double-digit annualized returns for the S&P 500, it appears CalPERS no longer sees value in paying for these non-correlated (low or negative beta), risk-managed returns.

Could this be exactly the wrong time to be making such a decision?

CalPERS reports that it spent $135 million in hedge fund fees in the year ended June 30th—which amounts to more than 3% annually—during which this allocation produced a net return of about 7%. Now, that’s not too impressive if you’re benchmarked to the S&P 500, which did better than 20% over that period. And it’s even less impressive when you consider the 0.09% annual expense ratio to own the Vanguard S&P 500 Index ETF (VOO). But the whole point of allocating to hedge funds is exactly what it sounds like—to hedge your funds against the broader market (i.e. S&P 500).

At least, that was the original intent. It’s tough to prove you are adding value by reducing volatility in a bull market.

Nonetheless, this call by CalPERS reeks of market timing to me. Anyone who has been a professional allocator of assets for the past several years knows the danger of trimming, or eliminating, exposure to last year’s laggards in the hopes of improving this year’s returns. It is the exact opposite of the “Dogs of the Dow” theory, an investment philosophy coined by Michael B. O’Higgins in 1991.

O’Higgins put together a study that essentially validates the practice of not just steering clear of last year’s winners, but specifically allocating funds to last year’s losers. Now, he wasn’t looking for his losers among a list of penny stocks on the verge of insolvency. The Dogs of the Dow theory operates strictly from the 30 companies making up the Dow Jones Industrial Average—picking the 10 with the highest dividend yield at the end of the year (often this is the result of poor share performance, whereby the company’s dividend has become disproportionately hefty).

“Greed is good. Greed is right. Greed works.”
Gordon Gekko, ‘Wall Street’

Is CalPERS getting greedy?

With every year that goes by, 2008-09 becomes a more and more distant memory. A fund manager who earned a 7% total return in 2008 would almost certainly have been dealing with record fund inflows for the next few years. But 7% can get you fired in 2014….

Below is a chart of the S&P 500 over the past ten years. Without doing any calculations, today is the single worst day—over the last ten years, or any other trailing period—to increase your portfolio’s correlation to the market.

The ideal time to buy insurance is when you don’t need it—it’s cheaper that way. The same goes for portfolio protection, whether in the form of buying put options or non-correlated assets. To be clear, CalPERS has given no indication they will be plowing this $4 billion into the S&P 500 Index. They may very well be adding to one of their other non-equity asset classes (the fund’s current allocation can be found here). However, given their 64% allocation to “growth”—54% public equities, 10% private equity—it does seem like CalPERS may be giving up on an asset class at precisely the wrong time.

If you have questions or feel we might be able to help you, please give us a call….

Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on can be found here.

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