ANALYSIS

CalPERS to senate: hedgies with US assets should register with SEC

Joe DearIn his testimony to the US Senate on the regulation of hedge fund and private equity managers, Joe Dear, CIO of CalPERS, said that all managers of US assets should be subject to SEC oversight, and that alternatives should not bear the brunt of blame for the crash, as regulatory shortcomings are now also evident.

Testifying to the US Senate last week about the regulation of hedge fund and private equity managers, Joe Dear, chief investment officer of the $180 billion CalPERS, recommended that hedge fund managers raising capital in the US be forced to register with the market regulator and for all sell-side agents to adopt fiduciary responsibilities.

Speaking to the US Senate banking subcommittee on securities, insurance and investment, Dear echoed the controversial European Union directive to force all alternatives managers aiming to raise assets within the region to register in that market. He recommended that investment managers raising funds in the US be forced to register with the Securities and Exchange Commission (SEC) and be subject to its oversight.

The statement was an endorsement of a proposal put forward by the Investors Working Group (IWG), of which Dear is a member, in a separate report on US financial regulatory reform (see related story).

Dear also recommended another IWG view: to force managers to regularly disclose their activities to regulators on a real-time basis, and to investors and the market at later dates.

In addition, managers and other sell-side agents should adopt fiduciary rules of conduct, he said.

“Investment advisers and brokers who provide investment advice to customers should adhere to fiduciary standards of care and loyalty. Their compensation practices should be reformed, and their disclosures should be improved,” Dear said.

In his speech, Dear emphasised the US pension giant’s support for high-quality private equity and hedge fund managers, and said that alternatives managers should not bear more than their fair share of blame for the precipitous build-up of leverage in the financial system and consequent crash.

He said the inadequacy of quantitative risk management tools was one of the “powerful lessons” of the financial crisis, and that regulators should reflect on their own failures in identifying the risks existing beyond public markets.

“One of the powerful lessons of the crash for us was the limited value of many quantitative risk management tools. So an obvious imperative for us is to improve our quantitative and qualitative comprehension of the risks in our portfolio,” Dear said.

Institutional investors should also “improve the depth and detail of their due diligence, adhere scrupulously to best practices in decision making, and make timely disclosures of their investment policies, holdings and performance”.

He said regulators would need “new tools and authority” to remedy the gaps exposed by the crash, but also addressed the regulator’s failings.

“Not all of the regulatory shortcomings we see so clearly now are the product of gaps and omissions. Regulators also failed to use the authority they possessed to protect investors and assure the integrity of markets, exchanges and investment providers,” he said.

“Enforcement is not the only tool of effective regulatory systems, but its absence can dangerously weaken the credibility of those systems.”

Due to their privacy, hedge fund and private equity vehicles were able to generate large risks to the financial system.

“When these entities operate in the shadows of the financial system, regulatory authorities lack basic information about exposures, leverage ratios, counterparty risks and other information necessary to assure that overall risk levels in the financial system are reasonable.

“Clearly, the build-up of massively leveraged positions was enabled by the absence of any effective regulatory oversight. Combined with misaligned compensation practices that, among other things, encouraged excessive risk taking by rewarding short-term success without penalty for subsequent losses, the result was an unprecedented degree of risk in the system.”

CalPERS, a seasoned investor in alternatives, holds about $20 billion in private equity and $6 billion in hedge fund assets. These allocations account for 14 per cent of its total portfolio.

Its hedge fund program, begun in 2002, has generated an annualised return of 3.89 per cent against the 1.32 per cent from its global equity managers in the same timeframe – after expenses.

At March 31, 2009, its private equity portfolio outperformed the S&P500 by more than 1000 basis points over a 10-year period.

“Can these performance benefits be delivered through other investment products? No,” Dear said.

“Sure, investors can boost returns from investing in publicly listed equities by borrowing to enhance returns, but that does not necessarily bring with it the long term focus of a partnership with an expected duration of 10 to 12 years.”

The benefits of original private equity and hedge fund strategies could not be achieved through systematic replication, or so-called ‘alternative beta’.

“Some hedge fund returns can be duplicated with lower cost replication strategies, but, by definition, they only work for existing strategies, not the innovations that competitive markets constantly call forth,” he said.

Dear said that risk was a crucial element in any successful investment and couldn’t be eliminated. But it must be assiduously monitored, in all its forms.

“Policy makers, investors, regulators and the public need to accept that risk is inevitable and necessary; return without risk is like love without heartache – they go together. If risk cannot be avoided then it has to be managed,” he said.