Why Hedge Funds Are a Risky Bet for Public Pensions…and You

It's been another dismal year for many hedge funds, with the Hedge Fund Research Inc. Fund Weighted Composite Index up just 0.27 percent through Dec. 15, barely beating the S&P 500 stock index's slight loss for the year so far. Some of the industry's stars have struggled mightily, failing to deliver the edge that investors expect, even — or especially — when the broader market is just about flat.

Hedge funds have underperformed the S&P 500 for years: The HFRI Fund Weighted Composite Index returned an annualized 3.2 percent for the five years ended Nov. 30, compared to 12.5 percent for the S&P 500 for the five years through Dec. 22. But, despite some signs that investors are now losing patience with the underperformance, the industry still enjoyed an inflow of $80 billion in the first three quarters of this year, according to research firm Preqin. So far this year, 57 more hedge funds have opened for business than have closed.

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So what gives? Why do investors — including many public pension funds — remain willing to pour their cash into such a lagging investment class?

California Public Employees’ Retirement System headquarters is shown in Sacramento, Calif.
Max Whittaker | Reuters
California Public Employees’ Retirement System headquarters is shown in Sacramento, Calif.

The simplest answer is that many investors are still chasing the outsized returns that top hedge funds provide. Public pensions, which as of last year faced unfunded liabilities of $1.1 trillion, according to the Center for Retirement Research at Boston College, may feel particular pressure to pursue lofty returns.

Many public pension funds are still running on the assumption that they can earn returns of 7 percent to 8 percent a year, even though history has proven otherwise, says Martin Fridson, chief investment officer at money management firm Lehmann, Livian, Fridson Advisors in New York.

"That's not going to happen buying domestic stocks and bonds" at this point, he notes. So the choices are to reduce benefits, which is often opposed by government officials and/or prohibited by state constitutions; to cut government spending; or to invest more aggressively.

"Pension fund managers say to themselves that if we put 10 to 20 percent into alternative investments and earn 20 percent a year or some other unrealistic number, that will help us close the gap," says Fridson, who once managed a high-yield bond hedge fund and also acted as a pension consultant for New York City. "It's not based on sober projections of returns, but just saying that the answer is an [outsized] return, because that's how we reach our assumptions."

Public pension funds are increasingly scaling back their projected returns, or facing questions about whether the sometimes heady gains they assume are realistic. The median state pension plan assumes a rate of return above 7.5 percent, The Wall Street Journal reported earlier this year, citing data from consulting firm Wilshire Associates — an annualized gain more than double what the HFRI index has delivered over the last five years.

To be sure, not all investors are sending good money after bad into hedge funds. The nation's largest pension fund, California Public Employees' Retirement System (Calpers), decided last year to dump its entire $4 billion commitment to hedge funds, saying the investments were too complex and costly.

And, of course, the top hedge funds still perform quite well. "If you can identify superior performance beforehand and get in, that makes sense," Fridson says.

That is possible, says Charles Lee, professor of management at Stanford University's business school and co-founder of hedge fund manager Nipun Capital. "Some people say looking for alpha [or outperformance over benchmarks] is like looking for leprechauns," he says. "I don't subscribe to that. Alpha does exist. The question is are you good at choosing people who can find alpha?"

University endowments constitute some of the top investors around, and many have big hedge fund allocations, Lee notes. "They don't think hedge funds are smoking something." University endowments, of course, don't have the same payout requirements that pensions do.

In any case, hedge funds aren't for everyone. If you don't have the information advantage to choose top hedge fund managers, stick with passive investments, Lee says. "And if you're not sure whether you have an advantage, you should assume that you don't."

Laura Veldkamp, professor of economics at New York University's business school, is skeptical about some of the reputed strengths of hedge funds. "A lot claim that they're hedging something, but that's a difficult claim to validate," she says. "Some claim that they hedge event risk, but it's hard to know, because they don't face those events often."

A hedge fund that performed well during the 2008-09 financial crisis may not fare as well during the next financial shock, let alone during the time in between. "The recipe is I can turn iron into gold," but that's obviously hard to prove, Veldkamp says.