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.

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:

  • Companies in the S&P 500 are typically among the largest and strongest companies, while venture capital typically invests in smaller and early-stage companies with far less financial strength.
  • Investors in private equity forgo the benefits of liquidity, transparency, broad diversification, daily pricing and, for individuals, the ability to harvest losses for tax purposes.
  • The median return of private equity is much lower than the mean, or the arithmetic average, return. Their relatively high average return reflects the small possibility of a truly outstanding return, combined with the much larger probability of a more modest or negative return. In effect, private equity investments are like options (or lottery tickets). They provide a small chance of a huge payout, but a much larger chance of a below average return. While CalPERS can diversify this risk—it had almost 400 private equity managers as of September 2013—it’s difficult for individual investors to do the same.
  • The standard deviation of private equity is in excess of 100 percent. Compare that with the standard deviations of about 20 percent for the S&P 500 and about 35 percent for small value stocks.

While private equity or venture capital investing is high in risk and high in expected return, the returns investors have actually realized don’t appear to have compensated them fully for the strategy’s incremental risks.

For example, the returns should reflect, at least to a significant degree, a premium for the extreme illiquidity of private equity investments. Highlighting the lack of liquidity is the finding from one paper—“The Cash Flow, Return and Risk Characteristics of Private Equity”—that the internal rate of return for the average venture capital fund did not turn positive until the eighth year.

Given the above evidence, it seems appropriate that the hurdle for investing in private equity should be a premium that isn’t just above the return of an index such as the S&P 500, but above that of more similarly risky, publicly available small value stocks.

From 1926 through June 2014, the Fama-French index of U.S. small value stocks (excluding utilities) had outperformed the S&P by 3.66 percentage points a year (13.84 percent versus 10.18 percent). And since private equity is clearly riskier than public small value stocks (accounting for the higher standard deviation of returns, the high skewness in returns, and the lack of transparency and liquidity), there should be a significant premium over that of small value stocks.

What’s really unfortunate is that the poor realized performance in nonpublicly traded securities could have been avoided if pension plans had simply reviewed the historical evidence on such investments. The picture, as presented in my book, “The Quest for Alpha,” isn’t a pretty one.

Clearly, the two nonpublicly traded securities discussed here—private equity and hedge funds—merit examination beyond their relation to pension plans.

Later this week, we’ll take a look at some words of wisdom from a cross section of heavyweights in the investing world about hedge funds. Hopefully, what they say will provide some insight for the individual investor.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.



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