Hedge Funds Cost Pensions $15 Billion in Lost Opportunities

A new report poses an interesting question: “Would public pension funds have fared better if they had never invested in hedge funds at all?”

This is a subject we have investigated numerous times. The conclusion of the report confirms our earlier commentary: a small number of elite funds generate alpha (market-beating returns) after fees for their clients while the vast majority underperform yet still manage to overcharge for their services.

One wouldn’t imagine that a market pitch built around “Come for the poor performance; stay for the excessive fees” would work. And yet the industry continues to attract assets. This year, gross hedge fund assets under management crossed the $3 trillion mark.

The subject of high fees for weak performance is one we have addressed many times (see this, this, this, this, this, this, this, this,this, this, and this).

The most recent report gives us an opportunity to examine the latest data and see if our narrative holds up.

The report was prepared by theRoosevelt Institute on behalf of the American Federation of Teachers, based on a mix of publicly available data as well as information provided directly by the pension funds.

Don’t dismiss the report as the work of two left-of-center organizations. It is an objective analysis designed to aid pension managers looking to control costs and improve performance.

The data back up the concerns about both. The study looked at 11 of the country’s largest pension funds and their hedge-fund investments. The researchers found that hedge funds “lagged behind the total fund for nearly three quarters of the total years reviewed, costing the group of pension funds an estimated $8 billion in lost investment revenue.” Although the hedge funds underperformed compared with the rest of these pension funds’ investments, the managers charged a collective $7.1 billion in fees. In total, that’s a $15 billion swing.

Not only did the higher returns that hedge funds promised not exist, but the downside protection was nowhere to be found. In 10 of the 11 pension funds reviewed, there was a very significant correlation between the hedge fund and overall pension-fund performance. The hedge funds invested primarily in similar assets as the pension funds; there was little or no diversification benefit.

Perhaps the most astonishing data point in the entire report is this: Managers of these hedge funds on average received 57 cents in fees for every dollar of net return to the pension fund.

Despite all of this, there is a fascinating and counterintuitive spin on all of this: “Nobody seems to care about performance”, as pension consultant Christopher B. Tobe told Gretchen Morgenson of the New York Times.

That’s not precisely true. People do care about performance, as well as fees. It is just that in the hierarchy of public-pension fund needs, both take a back seat to expected returns. This is because the higher the expected return, the lower the capital contributions required of some obligated public entity.

Here is the punchline: Those expected returns are a myth. They don’t exist, except for the most elite funds, which are a tiny percentage of the industry. A few can generate alpha; most of the rest are mere wealth-transfer machines. As the chart below shows, none of the major classes of hedge funds beats the market.

In other words, hedge funds aren’t used to generate higher returns; they simply make it possible for some public entity to reduce contributions to the underlying pension. This is the primary driving force in the rise of hedge funds for public pensions.

This fiction has been perpetuated by consultants and others with a vested interest. The myth has been swallowed whole by politicians, who can make the finances of the local and state governments they oversee appear better than they really are.

I have yet to find the source of the idea that hedge funds outperform the market. It was created out of whole cloth as a sales pitch. There is no basis in accepted academic theory or actual practice to expect the hedge-fund industry to deliver returns above beta (market-matching returns). But the huge gap between pension-fund obligations and their actual assets has encouraged fund managers to invest more in hedge funds because of these inflated return expectations.

This misrepresentation is creating an even bigger shortfall in the future for pension funds. The sooner they figure this out, the better off they will be.

(Corrects sixth paragraph to indicate that the study was designed to aid pension managers, and wasn’t conducted by the managers.)

originally published here: The Reason Pension Plans Stick With Hedge Funds