Swedroe: Nails In The Hedge Fund Coffin

August 25, 2014

The system had paid about $1.35 billion in management fees in the prior five years and reported a five-year annualized return of 3.6 percent, well below the 4.9 percent median return among public pension systems. In Georgia, the $14.4 billion retirement system, which is prohibited by state law from investing in alternative investments, earned 5.3 percent annually over the same time frame and paid only about $54 million total in fees.

As another example, fees for the $242 billion in California’s giant state pension system, CalPERS, nearly doubled to more than $1 billion a year after it increased its holdings in private assets and hedge funds to 26 percent of its total in 2010, up from 16 percent in 2006. Yet CalPERS earned just 3.4 percent annually over the five years prior to 2012.

The article also noted that state pension plans with a third to more than half of their money in alternative investments had returns more than 1 percentage point lower than the returns of funds that largely avoided those assets. They also had paid nearly four times as much in fees.

It does seem that at least some of the plans are reacting to the poor results. For example, it was reported last month that a review of its portfolio led CalPERS to consider reducing its commitment to hedge fund investments by about 40 percent, to $3 billion. A spokesperson stated that the fund is thinking about taking more of a “back-to-basics approach” with its holdings. A decision will come in early autumn.

Separately, officials overseeing pensions for Los Angeles’s fire and police employees decided last year to get out of hedge funds altogether after an investment of $500 million produced a return of less than 2 percent over seven years. One can only wonder how CalPERS can continue to justify any investment in such vehicles.

According to a Wilshire review of public pensions with more than $1 billion in assets, the average public-pension gains from hedge funds were just 3.6 percent for the three years ended March 31, 2014. That’s compared with a 10.9 percent return from private-equity investments, a 10.6 percent return from stocks and a 5.7 percent return from bonds.

The good news, at least for taxpayers and pension beneficiaries, is that the evidence appears to be bringing action, at least when it comes to hedge funds. Wilshire reported that hedge fund allocations fell about one-third, from about 1.8 to 1.2 percent. Unfortunately, because there’s no evidence to justify it, the average amount committed to private equity still is climbing. Those investments jumped to a decade-long high of 10.5 percent.

You might ask why the negative comments on private equity when pension plans investments in it returned 10.9 percent versus 10.6 percent for publicly held stocks over the last three years. The reason is quite simple—that’s an apples-to-oranges comparison. Private equity is clearly much riskier than an investment in, say, a publicly traded S&P 500 Index fund. Thus some premium is required:

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