Swedroe: Hedge Funds A Bad Buy

As the following research shows, state and local pension funds invest more than $2 trillion on behalf of beneficiaries. The stock market crash of 2008, the steep decline in interest rates, and the growing problem of unfunded pension liabilities led many pension plans to attempt to outperform public stock and bond benchmarks.

Jeff Hooke and Ken Yook, authors of the study “The Grand Experiment: The State and Municipal Pension Fund Diversification into Alternative Assets,” published in the Fall 2018 issue of the Journal of Investing, found that over the 20-year period 1996 to 2016, pension plan allocations to hedge funds increased from 0% to 6%, and their allocations to private equity increased from just 3% to 11%. The authors also noted that these increases mostly came at the expense of allocations to fixed income, which fell from 43% to 26%.

Benchmarking Pension Plans

While investments in passively managed public equity and public debt funds (such as index funds) come with low expense ratios, investments in private equity and hedge funds come with much higher expenses—with fees typically in the range of 1.5-2.0% plus a performance fee (typically 20%).

Hooke and Yook noted that these fees now exceed $15 billion a year. They studied the performance of state pension plans from 1997 through 2016 to determine if the fees were justified by superior performance.

They created three benchmarks against which pension plan performance could be measured:

• Benchmark 1: 60% U.S. stocks, 40% global fixed income
• Benchmark 2: 40% U.S. stocks, 20% non-U.S. stocks, 40% global fixed income
• Benchmark 3: Match average asset allocation by public pension plans each year; for hedge fund allocations, the benchmark

The benchmarks for allocations were as follows:

• U.S. Stocks: Wilshire 5000 Total Market Index
• Non-U.S. Stocks: Morningstar non-U.S. stocks
• Global Fixed Income: Bank of America Merrill Lynch Global Fixed Income Market Index
• U.S. Fixed Income: U.S. Fixed Income Index
• Non-U.S. Fixed Income: Bank of America Merrill Lynch Global Fixed Income Market Except U.S. Index
• Private REITs: S&P U.S. REIT Index
• Cash: Bloomberg Barclays 1-3 Year U.S. Treasury Bond Index
• Hedge Funds: 60% U.S. equity and 40% U.S. fixed income
• Private Equity: Wilshire U.S. Micro-Cap Index

Following is a summary of Hooke and Yook’s findings:

• Benchmarks 1, 2 and 3 provided returns of 7.72%, 8.11% and 8.05%, respectively. Note that benchmarks have no costs. Thus, we should subtract an estimated cost of index fund implementation. The net return of the pension plans was 6.83%—0.87%, 1.28% and 1.22% below that of the three benchmarks. Since index funds have low costs, the underperformance far exceeded what the net returns to the benchmarks would have been.
• The volatility of the returns of pension plans were similar to that of the benchmarks. Pension plan volatility was 11.6% versus 11.7%, 13.6% and 12.3%, respectively, for the three benchmarks. However, since the volatility of illiquid private equity and hedge funds is greater than published, the actual volatility of pension plan returns is understated.
• The Sharpe ratio of pension plans was 0.67 compared with 0.69, 0.65 and 0.73, respectively, for the three benchmarks. Again, note that, since the volatility of hedge funds and private equity is understated, the Sharpe ratio of pension plans is overstated.
• The results were similar over three subperiods examined—net returns of public pension plans are lower than benchmark returns—including the post-financial crisis period 2009 through 2016. Over this period, pension plan net returns were 8.74% versus 10.33%, 9.48% and 10.10%, respectively, for the three benchmarks.

The authors concluded: “Public pension plans, in the aggregate, had lower returns and similar volatility when evaluated against several public-security-oriented index portfolios.”

Loser’s Game

The bottom line is that it’s clear that public pension plans would have been far better off simply investing in low cost, passively managed, publicly available mutual funds and/or ETFs instead of allocating assets to active mutual fund/separate account managers, private equity and hedge funds. They earned lower returns without any significant improvement in volatility.

Making matters worse is that the study doesn’t include the fees paid to all the consultants that pension plans hire to help them determine which active managers, private equity and hedge funds are most likely to deliver the higher returns they are seeking.

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