CalPERS Abandons Hedge Funds—For ETFs?

If CalPERS is taking hedgies out, ETFs may be coming back in.

If CalPERS is taking hedgies out, ETFs may be coming back in.

The California Public Employees' Retirement System (CalPERS) is one of the largest pension funds in the world. It manages some $300 billion on behalf of its investors. That's a big pool of money.

By itself, CalPERS is about 1 percent of the $31 trillion global pension market. It's sometimes called "the largest pension," but that's a bit of a misnomer. The Federal Employees Retirement System (FERS) has $861 billion under management at the moment, and the Japanese version of FERS has more than $1.2 trillion.

Regardless, it's big. Perhaps more importantly, it's coherent. While FERS has been stuck in underperforming Treasurys for decades and has been returning less than 5 percent for years, CalPERS is largely viewed by the industry as "smart folk."

Its long-term returns (10 years through 6/3/14) have been a respectable 7.2 percent, although that's a combination of pretty consistent 10-percent-plus returns and a devastating 2008 in which the fund lost 27 percent on its investment portfolio.

The fund is remarkably transparent about how it's managing its money. For example, here's the June portfolio snapshot:

That all looks pretty cool, right?

As you might expect from an investment portfolio that's managed against a very-long-term set of liabilities, it invests in things the rest of us might not; for instance, 10 percent of its money is tied up in actual hard assets like forest land and shopping malls. But it also manages hundreds of billions in the public markets.

CalPERS Investment Pivot

Historically, CalPERS has been a big believer in passive investing, but it's largely done it on its own. In fact, if you look at its external investment manager list for equities, you'll note the shocking absence of BlackRock, State Street or Vanguard—precisely the folks you'd expect to see for a large pension fund.

CalPERS has also traditionally been a big fan of finding sources of return outside the regular markets. It has a huge private equity program that invests in smaller, private companies. For the past 12 years, CalPers has also been a big fan of hedge funds, allocating some $4 billion to the sector.

And again, because of its remarkable transparency, we can see exactly how much was where. Of course, in the closed-loop world of hedge funds, it won't mean much to most CalPERS beneficiaries that $558 million was invested in OZ Eureka Fund, LP.

The news today is that CalPERS is giving up on the hedge fund business, freeing up that $4 billion to invest, presumably, elsewhere. The reasons they cite all boil to one: It cost too much to deliver too little.

ETFs Up Next For CalPERS?

So why not ETFs? After all, the stated goal of its hedge fund program was to earn "one-year Treasury bills + 5 percent, while managing risk and avoiding 'overpaying for beta.'" It would seem like there are a lot of absolute-return strategies that might fit the bill.

(In general, an absolute-return strategy seeks to have consistent, low-volatility returns not correlated to equities, fixed income or ideally, anything.) We track 33 absolute-return ETFs with some $1.7 billion in assets right now, with some significant funds in the mix:

Any one of these funds would be substantially cheaper than the ones they're abandoning. And while none of them has beaten Treasurys by 5 percent over the last five years, the leader from IndexIQ here—the IQ Hedge Multi Strategy Tracker (QAI | B-73), has consistently delivered low-volatility returns since launch, earning it our Analyst Pick nod in the segment.

So should Index IQ expect a flood of money? Unfortunately, I doubt it. Despite a love for passive management, so far CalPERS has shown an extreme reluctance to join the ETF club. Its last 13F filings suggest it has just a handful of positions in ETFs, most of them insignificant.

With the exception of the position in the SPDR S&P Emerging Markets Small Cap ETF (EWX | D-81) these are really and truly just cash management positions, and in total add up to just 0.10 percent of the $300 billion total under management at CalPERS.

Still, I look at that position in EWX, and I think I understand. The reality is that it's big enough that it can effectively manage its own index products, and do it pretty darn cheaply.

It has 2,600 people on staff, and several hundred million dollars in operating budget. That buys you a pretty solid investment management process. But it's worth noting that CalPERS has been on the hunt for a new chief investment officer since midyear.

Maybe when it finds the right person for the job, it'll come in with an understanding of how ETFs can benefit it outside just those hard-to-manage areas like emerging market small-caps.

And heck, I'd be happy to help.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected] (especially if you're with CalPERS), or on Twitter @DaveNadig.