Business Day

A Hedge Fund Sales Pitch Casts a Spell on Public Pensions

NOV. 6, 2015

It has been just over a year since the California Public Employees’ Retirement System said it would wind down its $4 billion portfolio of hedge fund holdings. High costs and complexity made the vehicles “no longer warranted,” Calpers said at the time.

Given Calpers’s leadership in the public pension arena, some thought other pension managers and institutional investors would follow suit. But that does not appear to be happening, even during this, a trying year for hedge fund performance. The question is, why not?

Christopher B. Tobe, a pension consultant and former trustee for the Kentucky Retirement Systems, said most public pension funds seemed to be sticking with hedge funds, known as alternative investments, in spite of mediocre returns. “I’m seeing huge increases in alternatives among public pension funds,” he said in an interview. “Nobody seems to care about performance.”

For the first nine months of this year, that performance has underwhelmed; hedge funds, which hold $324 billion in public pension money, eked out a net 0.18 percent gain, according to Preqin, a data analysis firm. That’s certainly better than the 2.6 percent loss recorded during the period by the Standard & Poor’s 500-stock index, but meager hedge fund returns like these are nobody’s idea of great.

Besides contending that hedge funds provide outsize returns, their supporters say the funds have another big selling point: Their returns are not correlated to the stock market. That means they move independently of the market when it goes up and down.

But research shows that hedge funds are becoming more and more correlated to the overall stock market. They are less likely, it turns out, to perform as a hedge against a balanced portfolio’s other holdings.

One reason pensions turn to hedge fund managers is to try to close the expansive gap between what the pensions owe their beneficiaries and the amount of funds that they have to meet those obligations. According to a report by the Pew Charitable Trusts, that gap was around $1 trillion in 2013, the most recent year available.

Whether hedge funds can actually help fill pensions’ coffers is the question responsible trustees must try to answer. Few are financial wizards, so it’s hard for them to truth-squad the sophisticated sales pitch.

Some data is emerging, though, that raises serious doubts about the benefit of hedge funds for big investors with a long-term perspective. Utah, for example, increased its holdings in hedge funds and private equity in recent years. By 2013, those allocations at the Utah Retirement Systems had reached 40 percent of assets under management, up from 16 percent in 2005.

Have its hedge funds helped the Utah pension’s investment performance? A May 2015 report to the Utah Legislature suggests not. Prepared by the Office of the Legislative Auditor General, the report concluded that if the state’s retirement system had maintained its 2004 allocation with fewer alternative assets and no hedge funds, the pension fund would have gained $1.35 billion in additional assets by 2013.

A new report, “All That Glitters Is Not Gold,” draws a similar conclusion. Conducted by researchers for the American Federation of Teachers, the report examined the hedge fund performance of 11 large public pensions and found that these investments exacted a high cost, had laggard returns and generally moved in tandem with the overall stock market.

“The report was really intended to give information to pension trustees so they could ask the tough questions and fulfill their fiduciary duties to the funds and their participants,” said Randi Weingarten, president of the teachers’ union.

The pension funds scrutinized in the report have $638 billion in assets under management, $43 billion of which was in hedge funds as of the most recent fiscal year. The 11 funds had varied experiences with hedge fund allocations, so the report studied only those years that a fund owned the vehicles.

That meant some of the analyzed returns stretched over longer periods than others. The Teacher Retirement System of Texas has been investing in hedge funds since 2002, for example, while the Employees’ Retirement System of Rhode Island has invested since 2012.

Over a total of 88 fiscal years studied, the report concluded that the pensions’ hedge fund stakes generally trailed those of each overall fund. For every pension fund reviewed, the total fund portfolio outperformed the hedge fund piece over the period in which hedge funds were in the mix.

In slightly more than one-quarter of the years analyzed, the hedge funds outperformed a same-size total fund’s returns, but that failed to make up for lower returns in other years. This lackluster performance translated to $8 billion in lost investment revenue at these funds, the report said.

Hedge fund managers, meanwhile, collected an estimated $7.1 billion in fees from the pensions, it said. That averages out to 57 cents of every dollar in net returns earned by the funds.

The report’s authors, Elizabeth Parisian of the A.F.T. and Saqib Bhatti of the Roosevelt Institute, could only estimate hedge fund costs because many appear in confidential contracts. They took a conservative approach, assigning a 1.8 percent management fee and an 18 percent cut of gains.

Fee secrecy is a major problem with hedge funds and private equity investments, according to Edward Siedle, a forensic pension investigator at Benchmark Financial Services in Ocean Ridge, Fla., and a former Securities and Exchange Commission enforcement lawyer.

“When I started with the S.E.C. 30 years ago, there were two things that the regulators and the regulated agreed on: Money management fees would come down over time and transparency would increase,” Mr. Siedle said in an interview. “But just the opposite has happened. Fees are at a historic high and transparency at a historic low.”

Finally, the teachers’ union report turned up compelling data on how closely hedge funds’ performance mimics that of the overall market. Ten of the 11 pension funds reviewed in the report demonstrated “significant correlation” between the performance of the hedge funds they invested in and the performance of the overall fund. The similar returns occurred even during the 2008 crisis, the study found.

Fixed-income portfolios among the nine pensions providing information about these accounts showed less correlation, the report said, at a much lower cost.

Howard Crane, a former trustee of the Colorado Public Employees’ Retirement Association, said in an interview that hedge funds, as currently constructed, pose real problems for public pension funds.

“The manager is being paid upfront 2 percent with certainty, and the client is given 80 percent of the net return, after the fact, with uncertainty,” he said. “I think it’s unconscionable in the context of taxpayers who get to foot the bill if something goes wrong.”

A version of this article appears in print on November 8, 2015, on page BU1 of the New York edition with the headline: A Sales Pitch Casts a Spell on Pensions.

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