NEW YORK (TheStreet) -- The decision by the California Public Employee's Retirement System, known as Calpers, to dump its $4 billion in hedge fund holdings reflects the abysmal returns hedge funds have posted this year. The question isn't why Calpers elected to get rid of its hedge fund holdings, it's what took them so long.
Calpers and other institutional investors such as pensions, endowments, and sovereign wealth funds have long been ignoring all sorts of data showing that their manager selection criteria is flawed. Hedge Fund Intelligence estimates that on average hedge funds have returned 3.7% to date. Yet, the S&P 500 (SPY) has returned over 8% over that period. And all those funds had to pay high fees to have the "smartest guys in the room manage their manage."
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Obviously, most of these guys aren't so smart, they just wear expensive suits.
Most institutions and their consultants implicitly or explicitly limit their manager selection criteria to hedge funds with a multi-year track record, three years or more, and assets under management in excess of $250 million. Most manage well over $1 billion in total assets. Unfortunately, all the evidence shows that choosing hedge funds with long track records and large holdings is exactly the way to be rewarded sub-par returns.
A recent study by eVestment found that the best absolute and risk adjusted returns came from young, 10 months to 23 months of performance, and small, AUM less than $250 million, hedge funds. My anecdotal evidence is consistent with this fact, my young and small fund, Oxriver Captial, organized under the new JOBS Act regulations, is outperforming the bigger more established funds.
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This is not the only study showing that young managers outperform old ones. (Young managers refer to young hedge fund management companies not the age of the human manager.) One study eventually published in the Journal of Financial Economics found that for every year a hedge fund is open, its performance declines by 0.42%. The implication is that hedge fund investors should be gravitating to the new managers if they want high returns.
Yet, another study by Prequin found that even when established managers launch new funds those funds under-perform launches by new managers. The Prequin study found that managers with three years or less of track record outperformed older managers in all but one of seven strategy categories. The median strategy had the new managers beating the older ones by 1.92% per year. Yet, that same study found that almost half of institutional investors would not consider investing in a manager with less than three years of returns.