- This forum contribution tries to make some connections between the state of the industry work and culture issues that we are discussing at present. In the State Paper we have some scenarios in Part III that have suggested the possibility of more internalised management and adjustments to hedge fund allocations reflecting the difficult to scale/over-expensive/ difficult to align to overall strategy issues that some asset owners are articulating.
- PFZW/ PGGM recently announced their decision to drop hedge funds out of their strategy, following the CalPERS decision that was widely discussed in late 2014. Scale, governance cost, complexity and controllability are the major factors behind the decision of both funds to drop hedge funds. This is what PGGM says:
“In our new investment policy, we agreed that greater emphasis should be placed on controllability and intelligibility. That’s why a complex investment category like hedge funds, which encompasses such diverse strategies, no longer sits well with PFZW”.
Also “PFZW believes that the implementation of its investment policy can be controlled most effectively if such control is not exercised too remotely.”
CalPERS comments were “Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost and the lack of ability to scale at CalPERS’ size, the hedge fund program is no longer warranted.” - ‘Control’ here is the ability of the AO organisation – Board and Executive – to influence its results from internal factors and ultimately its success in meeting its mission (and not relying on external factors with a heavy chance component, like positive markets, positive results from delegation and financial help from the sponsor where control at best is weak control. Control is increased by
- Organisational skill and not being too susceptible to chance ‘noise’ factors
- Internal management and not over-delegating
- Time horizon and not having outcomes too reliant on short-term market volatility
- Matching liabilities/goals and not unduly relying on risk-taking
- Levels of control are not high for the AO’s, because of the high noise industry we inhabit. For example on my modelling (trust me) a highly skilled AO would do well to control 25% of the average one year outcome, and 33% of the three year outcome. So I see this struggle for control being influential in hedge fund allocations.
- Through this lens one of the factors in these CalPERS and PGGM decisions becomes clearer, that control comes from maximising the reach of internal AO skill and at least part of that skill is in the use of risk factors and diversifying factors. The skill of many hedge fund managers is in these areas but using delegation versus direct investing reduces AO control. Indeed because these positions may duplicate what the AO already holds there is potentially a bigger drag on control from this delegation (to contrast with an active equity manager where the factor exposures are clearer and the AO can maintain factor control). So Cliff Asness saying the hedge fund industry needs to ‘reinvent itself’ may be a coherent view.
- One of the interesting vignettes of this industry which captures the zeitgeist of identity crisis comes from Warren Buffett’s wager for charity against the hedge funds which was made in 2008. Buffett pitched an S+P 500 Index fund against a hedge fund of funds model that Protégé Partners manage, with winner take all (well give to charity) after ten years. After seven years the figures are +7.3% pa for the S+P and +2.6% pa for hedge funds. Betting with Buffett: Seven Lean Years Later. The commentary by Ted Seides of Protege is an excellent example of giving rich context to the results. http://cfainstitute.tumblr.com/post/110804139197/betting-with-buffett-seven-lean-years-later
He explains in measured terms some of the circumstances that have led to these results with the US equity market getting the benefit of unique monetary conditions and the hedge fund opportunity set in contrast being well below par. He argues for this period being very unusual and unsupportive to hedge funds, but expresses considerable optimism for the last leg of the wager in the next three years. - Fees are ‘just over half of the underperformance’ – there is a 2.7% pa hedge fund fee taken from the gross return. For another day let’s debate how skilful we need the hedge funds to be to support this amount of extracted return.
- In the TAI culture paper I explain the merits of organisations producing fair context to their performance while recognising the difficulty in producing detailed and unbiased accounts. I commend the style of performance reporting by Seides. This is conceptually central to the delivery of ‘meaningful measurement’ that is needed for internal and external accountability with obvious elements of customisation needed in the two different reports. It seems to me that what is often missing is more work to attribute performance to good and bad skill and to hook up measurement with accountability; and in this process we have to understand the limits of controllability in outcomes and performance.
- I advocate a triage to address the performance attribution of every investment portfolio by isolating and attributing the various investment convictions in a portfolio, differentiating between:
- good results reflecting outcomes in-synch with the investor conviction – skilful
- bad results reflecting outcomes out-of-synch with the conviction – unskilful
- good and bad results reflecting outcomes outside the conviction – lucky and unlucky
So I have some sympathy with the Seides narrative and its contextual excuses. That said you would wish to have performance reported through a reasonably unbiased – dare I say – independent account. I advocate having an independent risk and performance function carrying out this role in both asset owners and asset managers.
- Returning to hedge funds, the core thesis of the fund of hedge funds proposition is having strategies that are adaptable to all conditions. The performance narrative for the last seven years can be presented as ‘bad luck’ but I’d pitch for ‘not skilful enough’.
- So what are the implications of this learning on hedge funds up close? There are two really big trends – explored in the TAI State of the Industry paper
- the sophisticated AO’s internalising and doing some hedge fund strategies for themselves, like factor investing and smart betas
- AO’s looking right through their portfolio in a multi-asset framework with an integrated factor based return driver model and index / benchmark structure
Have asset owners gone far with this agenda? Not even close I’d say. But they are working on it with some assiduousness, and I think it will materialise.