Swedroe: Pension Funds Turn In Vain To Hedge Funds

Hit by a “perfect storm” that combined a decade (2000-2009) in which the S&P 500 lost about 1% a year with a rising tide of pension obligations, public workers’ pension funds across the country increasingly began turning to riskier alternative investments (such as hedge funds) in an effort to boost returns and close the gaps in their underfunded plans.

Unfortunately, taking greater risk with such investments hasn’t produced the hoped-for results. In fact, it seems these efforts have only worsened the situation for beneficiaries. The big winners have been the purveyors of such investments, who earn much higher fees than those charged for passively managed funds—such as index mutual funds and ETFs—that invest in publicly available securities.

Shortchanged Students
The latest evidence of bad outcomes is from a March 2016 paper, “Missing the Mark: How Hedge Fund Investments at the University of California Shortchange Students, Staff and California Taxpayers.” The study, by the UC system’s largest employee union, AFSCME Local 3299, found that the University of California’s 12-year experiment with hedge fund investments, with more than $6 billion currently invested in them, had failed to deliver on their twin promises of downside protection and superior returns. Among the study’s key findings were:

• UC paid hedge fund managers $1 in fees for every $2 generated in net returns. The UC system could have saved $950 million in fees and generated the superior returns it sought by investing in low-cost, traditional asset classes.
• Because of the extraction of large management and performance fees from gross returns, the UC system’s hedge fund holdings have routinely underperformed its overall pension and endowment funds, costing more than $783 million in investment returns over 12 years.
• Despite the claims that hedge funds invest in uncorrelated assets, there was a strong positive correlation (0.87) between UC’s hedge funds and the market. In bear and bull markets alike, UC paid upward of $1 billion in fees for returns that largely mirrored the trends in the stock market.
• Despite their claim to provide “absolute returns,” hedge fund investments produced negative returns in two of the 10 years prior to the study, including a loss of 13% in 2008 (when the UC system’s bond portfolio returned 6%). In 2011, when the S&P 500 returned 5.5% and the Barclays Aggregate Bond Index returned 7.5%, investments in hedge funds lost 2%.
• Over 12 years, the University of California’s absolute-return hedge fund program yielded a cumulative 112% in net returns. Excluding hedge fund investments, the returns were 168%.

Long-Term Underperformance

None of these results should be surprising to investors who have been following the industry. For example, 2015 was the seventh-straight year that the HFRX Global Hedge Fund Index underperformed the S&P 500 Index. For the 10-year period 2006 through 2015, the HFRX Global Hedge Fund Index returned just 0.1% per year and underperformed every single major equity and bond asset class. The table below shows the returns of the various indexes:

Sadly, the University of California’s experience is all too common. Consider the fate of 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 roughly 60%, the fund made the decision to seek the “promise” of higher returns through 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 only about 10% larger.

In 2014, John Murphy, a former executive director of NYCERS, pointed out that the fund had lost money in just five years out of the prior 30, all in the 2000s, after the system adopted its private equities program. He reported that when he calculated what the returns might have been had NYCERS 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.

As another example, The New York Times reported in April 2012 that the $26.3 billion Pennsylvania State Employees’ Retirement System at the time was holding more than 46% of its assets in riskier alternatives. The system had paid $1.35 billion in management fees during the prior five years and reported a five-year annualized return of 3.6%, well below the 4.9% median return among public pension systems. Georgia’s $14.4 billion retirement system, which was prohibited by state law from investing in alternative investments, earned 5.3% annually over the same time frame and paid only about $54 million total in fees.

And as yet another example, the article observed that fees for the then $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% of its total in 2010, up from 16% in 2006. Yet CalPERS had earned just 3.4% annually over the five years prior to the 2012 article.

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

Funds Make Changes

It does seem that at least some public pension plans are reacting to the poor results. For instance, CalPERS announced in 2014 that it would eliminate all of its hedge fund investments over concerns that they were too complex and expensive. Eliminating its hedge fund program helped CalPERS, which now oversees about $300 billion, save $217 million last fiscal year.

Officials overseeing pensions for Los Angeles’s fire and police employees chose in 2013 to get out of hedge funds altogether after an investment of $500 million produced a return of less than 2% over seven years.

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

The good news for taxpayers and pension plan 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%.

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