CalPERS Scales Back Private Equity

Over the summer, the California Public Employees Retirement System (CalPERS) announced that it was eliminating its exposure to hedge funds.

CalPERs is making headlines again by saying that they are going to substantially cut their exposure to private equity, the other major strategy that falls under the ‘alternative investment’ umbrella.

I’ve made the case for a decade that we can do almost anything a very large institution can do on our clients’ behalf, although there were three exceptions: hedge funds, private equity and direct commercial real estate.

While I wanted to do anything that the big guys can, Acropolis as a firm realized that we don’t necessarily want to use these strategies because they are illiquid, high cost and tax-inefficient. We also weren’t convinced that these strategies enjoyed better long-term performance.

You also have to remember that large institutions are different – and not just in their asset size and sophistication. Importantly, they don’t have to worry about taxes and their time horizon is infinite. Those facts don’t apply to our clients.

What’s interesting about this news from CalPERS is that the world’s largest institutional investor is leaving private equity and hedge funds because the fees are too high and the products and strategies are too complex. Sound familiar?

And, while CalPERs isn’t saying it directly, the performance hasn’t been very good either – hedge funds have performed poorly and private equity hasn’t done much better than public equity (the stock market).

Hedge funds and private equity became extremely popular in the industry thanks to the tremendous success of the Yale endowment and their extraordinary chief investment officer, David Swenson.

Under Swenson and prior to the 2008 financial crisis, Yale enjoyed returns in the high teens, well above the stock market. Because the portfolio is made up of highly illiquid investments that don’t receive market prices, the volatility looked extremely low.

The 2008 financial crisis was a wakeup call for institutional investors pursuing this approach because these strategies lost as much as the public markets, but nothing could be sold, which put a pinch on the institutions that rely on annual endowment harvests to fund operations.

Since then a lot of investors have criticized the Yale Model, which they defend in their 2013 annual report. I happen to agree with Yale – the model is not broken, although it may make sense to keep more of the portfolio liquid.

My conclusion was that the model was fine, but the strategy didn’t make sense for us – our clients have to deal with taxes and have finite time horizons.

What is interesting about the CalPERs decisions is that they are taking it a step further and saying that the strategies don’t even make sense for the largest institutional investor in the world, one that dedicates millions of dollars and man-hours to investing every year.

If it doesn’t even make sense for CalPERs, can it make sense for the little guy? We answered this question several years ago, but the CalPERs decision lends credence to our stance in my view.