Hedge-Fund Mediocrity Is the Best Magic Trick
Never have so many investors paid so much for such uninspiring returns.
Bloomberg, February 15, 2018
Hedge funds have accumulated $3 trillion, with a substantial portion of it coming from public pensions. That these funds don’t deliver outperformance is almost beside the point. What they are selling is an inflated estimate of expected returns. This serves a crucial purpose for elected officials, letting them lower the annual contributions states and municipalities must make to the pension plans for government employees.
It is a dodge that everyone goes along with. When the bill comes due in a few decades, this will cost taxpayers a bundle.
It really is one of the more astounding market inefficiencies that so much money has been allocated to hedge funds by pension plans, not to mention university endowments and other institutions. I have no issue with those funds that have consistently beaten a simple investment mix of 60 percent broad equity indexes and 40 percent in bond funds. It’s the rest of group that is so problematic. In much the same way that the world’s worst index fund manages to stay in business, it is a challenge to explain why so much money has found its way to so much mediocre performance. Behavioral explanations can only go so far.
A recent Bloomberg Businessweek column looked at this issue. The conclusion: The investment managers often share their lofty fees (traditionally 2 percent of assets under management plus 20 percent of any gains) with placement agents who hawk the hedge funds, especially to pension funds. Some states have banned their pension plans from using the agents, but not enough of them have done so.
But this only explains why some people are motivated to go out and sell an underperforming investment product. It doesn’t answer the core question of why so many investors buy them.
As the Businessweek article noted: “Hedge funds that invest in stocks returned 7.2 percent annually from 2009 to 2017, which was less than half the S&P 500’s return, according to data from Hedge Fund Research.” Even if you don’t like the Standard & Poor’s 500 Index as the benchmark, it’s worth noting that hedge funds have also underperformed pretty much every other benchmark out there.
If this were small change we were talking about, it wouldn’t be such a big deal and I’d have an easier time keeping my outrage in check. But the scale of the assets allocated to hedge funds is large, and getting larger. According to Fortune, “Since 2005, state and local pension plans have sharply increased their exposure to alternative investments, including private equity, real estate and hedge funds, from 9% of portfolios, on average, to 24%.” Other estimates put the figure even higher: According to Leland Faust, founder of CSI Capital Management, “More than half of the $3 trillion held in hedge funds nationwide is pension fund and retirement plan investments.”
Whether it’s trillions of dollars or merely hundreds of billions of dollars, it is still a lot of money not being put to the best use. This only exacerbates the underfunding crisis facing U.S. pension plans. The Economist magazine noted that the average U.S. public-sector pension was only 68 percent funded, according data compiled by the Center for Retirement Research at Boston College.
The continuing puzzle is why hedge funds continue to be so successful in selling their underperforming products, especially to public-pension plans. We have looked at the issue before, and have considered the principal-agent problem — in other words, those with no skin in the game make the investing decisions for those who do. Pondering that puzzle has led to a few surprising conclusions.
The best explanation I can find is this: Those who manage pension plans and pools of assets put money into hedge funds based on expected returns, not actual performance. The likely expected rates of return for hedge funds have proven to be works of fiction, fantasies made up out of whole cloth. There simply is no rational basis for making the claim that hedge funds will deliver an expected return higher than equities.
Future expected returns should be estimated by looking at historical returns of an asset class, then applying a probable estimate of outcomes. 1 This is done for stocks, bonds, cash, real estate and so on. Hedge funds, however, are not a discrete asset class. Calculating expected returns doesn’t generate a reliable or real number. Instead, it is an exercise in making assumptions — about the skill of the manager, the process employed to make decisions and how replicable past above-market returns might be.
It is at best a guessing game.
This is the heart of the problem. Pension-plan managers aren’t dumb; but as I noted at the start, there is an obvious reason they intentionally buy a false promise of higher returns.
In the end, taxpayers lose in three different ways: First, they pay much higher investment fees than they would via other available options — and those fees act as a drag on returns. Second, there’s the outright underperformance mentioned above. And third, the public is on the hook for making up the unfulfilled promises made to state employees, including teachers, firefighters, police and other government workers.
The result is a ticking time bomb that will go off at some point and that can only be dealt with through either unimaginable tax increases or stiffing government employees who worked hard in the expectation they would have enough money for a secure retirement.
In the past, I’ve summed up the bargain that hedge funds offer investors thusly: Come for the high fees, stay for the underperformance. It is funny because it was true, though I’d add one other element: Taxpayers and pension funds get duped in the process. There is no other explanation for why there is so much money parked in so many expensive funds with subpar returns.
1. This can be calculated by multiplying potential outcomes by the chances of them occurring.
Originally: Hedge-Fund Mediocrity Is the Best Magic Trick