With the recent decision by the California Public Employees' Retirement System (CalPERS) to divest their entire $4 billion investment in hedge funds saying they're "too expensive and complex," should Rhode Island consider doing the same?

Rhode Island General Treasurer and Democratic gubernatorial candidate Gina Raimondo's office has defended the State Investment Committee's strategy.

"We will continue to learn from best practices around the country and will look closely at the CalPERS decision. Rhode Island’s pension fund is less than 3% the size of CalPERS, and has very different funding and cash-flow needs," said Andrew Roos, Chief of Staff in the General Treasurer's Office.  "Given our fund’s different characteristics, we will continue to pursue strategies that pursue the best outcomes for Rhode Island pension participants.

However, Forbes columnist and Raimondo critic Edward Siedle pointed to what he saw as the real reason for CALPERS' move -- and why other states might be following suit. 

"Ironically, [CalPERS] said it wasn't performance at all, but that it had to do with fees and complexity.  Those were known all along, the only variable was how they would perform," said Siedle of the move.  "There have been serious red flags related to [hedge fund] investments related to illegal acts.  What CalPERS is saying as their reason makes no sense.  I would say they're doing it in anticipation of future disturbing revelations."

Strategy in Question

Roos defended the state's investment commissions decision to diversify its investments into hedge funds.  

"Every action the State Investment Commission has taken during this administration has been to promote retirement security and ensure funds will be available to pay pension checks to our retirees," said Roos.  "After the financial collapse of 2008-2009 when the fund lost over two billion dollars, the SIC reviewed its policies and unanimously adopted a plan to reduce volatility while continuing to pursue strong long-term returns."

"This strategy is working," said Roos.  "Over the last three years we have reduced the volatility of this portfolio by 50% and achieved strong returns (1 year: 15.12%; 3 year: 9.05% as of June 30th 2014.)"

Siedle, however, took a different vantage point following the state's annual investment report was made public this summer.  

"The market was up 25% over the period.  The state's pension fund underperformed the market by 10% -- on $8 billion, that's $800 million," said Siedle in July.  "Why did Rhode Island do so badly this year?  Hedge funds and private equity.  If you look at the SIC report, private equity underperformed the market by 30%, and hedge funds did less than half of what the market did, at 12%."

"Raimondo's disclosing here $26 million in direct billing fees, but what about fund-to-fund fees?  In the past, she's disclosed fees of $70 million.  What we need to know are the total fees, direct and indirect, billed or not billed," added Siedle at the time. 

Last October, Siedle had hit out at Rhode Island's hedge fund fees -- and lack of transparency -- in his investigative report, License to Steal, and called for the Securities and Exchange Commission (SEC) to "investigate ERSRI’s failure to disclose skyrocketing investment expenses, questions surrounding ERSRI’s Point Judith venture investment, and ERSRI investment consultant conflicts (and) payments from money managers."

"My report was these [hedge] funds were stealing money, and that's the thing the SEC could not fail to follow up on," said Siedle on Tuesday.  

Experts on Issue

"I have examined funds across the nation that have much too big of an exposure to high cost VC funds, private equity funds, as well as hedge funds. CalPERS even had "funds of hedge  funds" in its portfolio which is multiple layers of fees and complexity that's rarely appropriate for a fiduciary," said financial analyst and GoLocal MINDSETTER Michael Riley.  "The key is to replace complex, opaque, high cost hedge funds  with sensible conservative vehicles that outperform an index fund like the Vanguard S&P 500 at significantly lower risk."

Riley noted that future accounting changes could have an impact.  

"When GASB 68 is recognized by audited reports later this year there will be an avalanche of reform and investment reallocation in municipal and state plans," said Riley. "The focus will be on risk management, low costs, transparent and liquid solutions."

The Maryland Public Policy Institute, which has been highly critical of Wall Street hedge fund fees relative to net assets, reported in 2013 that there was "substantial evidence that Wall Street managers are unable to beat passive equity index funds that cost much less in fees."

"It's funny, we're such a small policy shop, but we were really the first ones digging and looking into fees, and now it's becoming a big deal.  Our research has been injected into at least two political races (Rhode Island and North Carolina)," said MPPI President Christopher Summers.

"I think states are seeing the impact of fees -- states like Maryland are spending hundreds of millions annually -- and are looking at their impact on state budgets.  People are becoming much more aware of the seriousness of the problem, in light of unfunded pension liabilities," said Summers.  "And it's not just states.  We did a report looking here in Maryland at counties and school boards. "

"The CalPERS decision shows that there is major concern about the transparency -- or lack of it -- in hedge fund fees," said Summers.  

Candidates Weigh In

The candidates for General Treasurer -- Democrat Seth Magaziner and Independent Ernie Almonte -- offered their opinions. 

Almonte was bullish on reducing -- and eliminating -- the state's utilization of hedge funds.   

"I believe our investments should be both low in cost and transparent. As Treasurer, I commit to reducing, and will work towards eliminating investments in hedge funds - keeping in mind exit fees in our existing contracts," said Almonte.  "It is not right to gamble with peoples' pensions, and that is exactly what we are doing by investing in high-risk areas like hedge funds.  As Treasurer, I will reduce fees and risk by diversifying our pension portfolio, and will evaluate all alternative investments based on return rates, transparency, and costs." 

Magaziner said he wants a review before making any decisions.  

"As Treasurer, I will review all of the state's investments one by one to identify ways to improve returns and reduce risk. I have significant concerns about the high fees and lack of transparency with hedge funds, but I will leave all options open until the review is completed," said Magaziner.  "As the Vice President of a billion dollar investment firm that produced strong returns for our clients, I am eager to get to work improving investment returns for the people of Rhode Island."

Siedle noted that the State Employee Association of North Carolina (SEANC), for whom he is working, is planning on urging the North Carolina Treasurer to divest from hedge funds.   

"I would urge all my clients to get their money out now.  CalPERS is the bellwether for all state pension funds," said Siedle.  "They're aware there are things going on in this sector that are unsavory.  I believe they're doing this because the conducted their own internal review.  They paid $11M to a firm to look into pay-for-play allegations, and a former board member is going to prison."

Siedle warned that if a critical mass of states decided to divest from hedge funds, there could be "run on the banks."

"Rhode Island might not be able to get their money out if they're last in line," said Siedle.  "You don't know who's wearing shorts until the tide goes out -- as demands for this money goes, only then do you find out what is really there.  Remember, these hedge funds have disclosures saying the investments are illiquid, and you might not be able to get your money out."