Swedroe: Nails In The Hedge Fund Coffin

August 25, 2014

A growing number of U.S. public pension plans are growing skeptical of alternatives, and rightly so.

This blog is the first part of a three-part series this week on problems with hedge funds and private equity—how they’re viewed and how they affect financial markets as a whole.

The combination of the S&P 500 Index losing about 1 percent per year during the decade from 2000-2009 and a rising tide of obligations caused a “perfect storm” for public workers’ pension funds across the country.

These funds increasingly began turning to riskier alternative investments in private equity and hedge funds in an effort to boost returns and close the gaps created by underfunding. Unfortunately, taking more risk with such investments hasn’t generally produced the hoped-for results.

In fact, it seems such efforts have only worsened the situation. The only winners are the purveyors of such alternative investment vehicles, who earn much higher fees than those charged by passively managed funds—for example, index mutual funds and ETFs—invested in publicly available securities.

The latest evidence of bad outcomes resulting from a move toward these alternative investments comes from the New York City Employees’ Retirement System, known as NYCERS.

Faced with a funding ratio that fell from basically fully funded—at least by its own calculations—to only about 60 percent funded, the fund decided to seek the “promise” of higher returns from private equity investments. In 1997, the city’s biggest fund spent $17.3 million in investment fees for a $31.7 billion portfolio. By 2010, it was spending 10 times that amount for a portfolio that was only about 10 percent larger.

John Murphy, a former executive director of NYCERS, recently pointed out that the fund had lost money in just five out of the last 30 years—all in the 2000s, after the system adopted its private equities program. He reported that, when he calculated what returns might have been if NCYERS had continued its strategy of investing solely in publicly traded stocks and high-rated bonds, the fund would have been billions of dollars ahead of where it is today.

Unfortunately, the experience of NYCERS is all too common. In April 2012, The New York Times reported that the $26.3 billion Pennsylvania State Employees’ Retirement System had more than 46 percent of its assets in riskier alternatives.

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