Hedge funds have enjoyed quite a run – until, perhaps, recently. The decision in mid-September by CalPERS to exit hedge fund investments could mean that hedge funds may have hit their high-water mark – and could signal that real estate and other more conventional investments may gain increased attention.
Private investment vehicles available to wealthy investors have long existed, but “hedge” funds became increasingly prevalent during the last generation. These funds were originally carefully designed to carefully manage changes in the financial markets; they would often “hedge” their bets with options or other risk measurement control techniques.
During the 1990s, hedge funds began to really multiply, funded with wealth created during the bull market of that time. Into the 2000s, hedge fund became increasingly popular, and their strategies expanded to include credit arbitrage, massive mathematical and statistical processing, and leverage and active trading in equities, bonds, foreign exchange, futures, swaps, and other derivatives.
U.S. institutional investors, such as pension and endowment funds, began allocating greater portions of their portfolios to hedge funds. Those funds had an aura of exoticism and mysticism about them, especially when ‘90s-era instances of international financial turmoil seemed to involve several larger hedge funds — even though studies have shown that they were not the causative factors in those crises. With this “mystique” came pricing power – and many hedge funds were not cheap. Scores of hedge fund manager billionaires have been minted over the last few decades.
Those costs, and a general inability to maintain the better-than-expected returns that hedge funds had led wealthy or institutional investors to believe would be worth the price of admission, were cited in CalPERS’ decision. On September 15, it announced that it would terminate its $4.5 billion hedge fund portfolio to “reduce complexity and costs.” “Costs matter and need to be effectively managed,” CalPERS’ website states, and a CalPERS spokesman told the New York Times that the returns the hedge fund was generating just didn’t justify the high costs. The CalPERS decision was followed quickly by an announcement that the Teacher Retirement System of Texas, the sixth-largest U.S. public pension, would reduce its own hedge fund allocation.
Well… what is going to be done with those investable assets? In CalPERS’ case, it appears that it has increased its allocation to a number of commercial real estate investments. $400 million is going to be added to an existing partnership with Invesco Real Estate, and $200 million to an existing partnership with Pacific Urban Residential. Another $600 million is going to a real estate partnership with Bentall Kennedy and yet another $700 million to two real estate partnerships with GI Partners.
Somewhat interesting, if the trend were limited to that fund; but some international pension funds have followed the same course. Pensioenfonds Metaal en Techniek, the Dutch metal workers and mechanical engineers’ pension, is divesting itself completely from hedge funds and will reallocate those assets into local residential mortgages. The €55 billion ($71 billion) pension had earlier allocated €1 billion ($1.3 billion) to hedge funds. The pension fund said that its management cost of the hedge fund portfolio was no less than 32% of its entire asset management cost – but involved only 0.54% of assets.
Is it commercial real estate’s turn? Commercial real estate valuations are strong; the properties generally feature current cash flow; and those income streams can help to temper the volatility of the investment. For many institutional investors, real estate may be a good fit with their investment horizons; institutional liabilities are better suited for longer-term assets than those of shorter durations. Real estate is an “alternative” asset that doesn’t fall in the same category as daily traded assets, and there is some evidence that real estate provides an inflation hedge. Properly purchased, it can give access to well-insulated investments that protect against rising interest rates.
CalPERS is likely moving to reduce volatility, and a move into real estate would provide them with stability and a more stable income stream. In any event, it’s hard to ignore that CalPERS just voted with their feet. “We’re willing to take risk,” said Mr. De Anda, “but with hedge funds, we just couldn’t get there.” The move into commercial real estate has been made more viable because of the general recovery in the sector. More risky speculative development investments seem to be less of a focus for larger funds like CalPERS – which perhaps is why they’ve begun to steer clear from hedge funds and, it appears, into commercial real estate.