While the field of behavioral finance has provided us with many examples of anomalies in investor behavior, the biggest anomaly of them all, in my view, is why investors (and especially the supposedly more sophisticated institutional investors) continue to ignore the evidence and pour money into hedge funds.
Despite their poor performance, assets under management at hedge funds continue to grow, surpassing $2.5 trillion. What’s particularly puzzling is that we don’t see this same trend when we look at the fund flows for actively managed mutual funds, where the relative underperformance is nowhere near as poor as it is with hedge funds.
While, in aggregate, actively managed funds persistently underperform, investors are taking notice and acting. For example, in recent years, while equity index funds and ETFs continue to attract net cash inflows, actively managed funds have suffered outflows.
CalPERS Rethinks Hedge Funds
I thought we were seeing the first signs that the tide was turning—and perhaps even that a tipping point had been reached—when, in mid-September 2014, the California Public Employees’ Retirement System (CalPERS), the largest U.S. public pension fund, announced its decision to completely eliminate its hedge fund investments. (Given the evidence, the only question one might ask is: What took them so long?)
Note that CalPERS wasn’t the first state retirement plan to drop hedge funds, just the largest. In early 2014, PERS of Nevada terminated its hedge fund program. Its exit included redeeming investments totaling $4 billion, out of a total portfolio of roughly $300 billion, from 24 large hedge funds and six funds of hedge funds.
Here’s what Moody’s had to say in its Sept. 22, 2014 Credit Outlook: “Large institutional investors have been the primary drivers of flows into alternatives such as hedge funds and CalPERS was at the forefront of this movement. CalPERS’ action is significant for the industry’s growth outlook given the fact that the flow of funds into alternatives has been dominated by large institutional investors. This is in contrast to the early days of the alternatives industry when high-net-worth individuals accounted for the majority of investments. CalPERS started its hedge fund investment program in April 2002. Since 2008, the primary source of funds going into alternatives has been from institutional investors, namely public and private pension plans, endowments and foundations, and sovereign wealth funds (i.e., large, institutional fiduciaries).”
Moody’s additionally noted that, given the CalPERS decision, it was likely that “more alternatives programs will come under scrutiny since hedge funds as a group have underperformed traditional benchmarks. Alternatives have the highest fees and greatest liquidity costs—attributes that are at odds with secular trends toward transparency, liquidity and lower-cost investing. Furthermore, the signaling effect of CalPERS’ decision to exit completely is entirely different from one of reducing hedge fund exposure. The question of whether to scale-up or completely exit a hedge fund program is likely to face other plans with similar exposures as CalPERS.”
Moody’s last comment seemed prescient when, in January 2015, PFZW (Pensioenfonds Zorg en Welzijn), the €156.3 billion Dutch health care workers’ fund and Europe’s second-biggest pension fund, announced it was stopping all further investments in hedge funds. PFZW was one of the first Dutch pension funds to invest in hedge funds back in 2003, and had close to 3% of its assets in them.
Unfortunately, we don’t see much evidence of a trend to follow CalPERS and PFZW. In a recent interview, Christopher Tobe, a pension consultant and former trustee for the Kentucky Retirement Systems, said that most public pension funds appeared to be sticking with hedge fund investments. “I’m seeing huge increases in alternatives among public pension funds,” he said. “Nobody seems to care about performance.” Does Tobe really believe that no one cares about performance, or was he just being sarcastic?
No ‘Gold’ To Be Found
Perhaps the findings of a 2015 study—“All That Glitters Is Not Gold: An Analysis of US Public Pension Investments in Hedge Funds” by Elizabeth Parisian and Saqib Bhatti—will spur further action. The authors examined whether hedge funds have provided U.S. pension funds better and less-correlated returns, or whether pension funds would have fared better if they had never invested in hedge funds in the first place. The authors analyzed 11 U.S. public pension funds’ experience with investing pensioners’ savings in hedge funds. Following is a summary of their findings:
- Hedge fund net return rates lagged behind total pension fund returns in nearly three quarters of the 88 total fund years reviewed, costing the group of pension funds an estimated $8 billion in lost investment revenue.
- The 11 pension funds paid 7.7 times more in fees to managers for their hedge fund investments than for a same-sized total fund portfolio. Hedge funds collected an estimated $7.1 billion in fees from the same pension funds over the period reviewed. On average, pension funds paid 57 cents in fees to hedge fund managers for every dollar of net return to the pension fund.
- Whereas hedge fund managers promise uncorrelated returns and downside protection, 10 of the 11 pension funds reviewed in the study demonstrated significant correlation between hedge fund and total fund performance. As further evidence, they noted that the Hedge Fund Research Inc. (HFRI) Equity Hedge Index has become increasingly correlated with the S&P 500, especially since the 2008 financial crisis.
- Pension funds’ fixed-income portfolios were less correlated with the total fund than their hedge fund portfolios, suggesting that pension funds buying into hedge funds to diversify their investments or buffer against losses during downturns may have been better off just investing more in fixed income at a fraction of the fees.
- Hedge funds failed to deliver significant benefits to any of the pension funds reviewed.
Parisian and Bhatti noted that some of the most striking disparities in fees and performance between hedge funds and other investments were evident in the pension funds that have been invested in hedge funds for the longest amount of time, including the Teacher Retirement System of Texas and the Ohio Public Employees Retirement System.
They write: “This is significant, as some pension funds experiencing poor hedge fund performance claim that they haven’t been invested in the asset class long enough to see the benefits.”
Parisian and Bhatti reached the following conclusion: “Our analysis suggests that hedge funds as an investment product fall short of both of their major selling points: outsized returns that offset the exorbitant fees and uncorrelated returns that smooth out market volatility and offer investors protection during economic downturns.”
Here’s one more bit of evidence on the poor performance of hedge funds. A May 2015 report prepared by Utah’s Office of the Legislative Auditor General found that if the state’s retirement system had maintained its 2004 allocation with fewer alternative assets and no investments in hedge funds, the pension fund would have gained $1.35 billion in additional assets by 2013.
Given all the evidence on their poor performance, what explains the continued—let alone increasing—allocation to hedge funds by pension plans? It cannot be explained by ignorance of the results, because the pension plans have themselves experienced poor returns.
Can it be that hype, hope, marketing and perhaps some free tickets to sporting events and golf outings have triumphed over wisdom and experience? (Note: That’s a rhetorical question.)
The saddest part is that, ultimately, it’s the taxpayers (in the form of higher taxes) and possibly even the plans’ beneficiaries (in the form of reduced benefits) who will suffer from poor decisions made by pension plan trustees. Maybe it will take a revolt by these constituencies to stop the irresponsible decision-making.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.