When CALPERS, the country’s largest pension plan, decided to liquidate its hedge fund portfolio in 2014, there was an outpouring of predictions of a mass exodus of pension plans’ investments in hedge funds. The mass exit never occurred. In fact, pension plans continued to throw money at hedge funds at an increasing rate. As a result, most observers predict a continued growth of pension fund investments in hedge funds.
However, this may be an overly sanguine view which fails to take into account the slow decision making process of institutional investors in general and pension plans in particular. It took CalPERS over a year of intensive analysis to come to its decision, which it attributed to administrative cost and marginal contribution of hedge funds to their overall portfolio rather than lack of performance.
What may be more significant in determining the future of pension fund investment in hedge funds are the recent studies by pension plans that have caused to withdraw their assets from hedge funds. A short list of these plans include American Federation of Teachers, the UK Rail Plan, PFZW, Europe’s second largest pension plan, and New York City among others.
While it seems that these studies are like shouting into the wind when faced with the tsunami of literature propagated by the hedge fund industry and its dependents, the size and prominence of the pension plans guarantee they will have a hearing and most likely inspire additional studies and decisions to exit or reduce their hedge fund investments. The fact that these plans are conducting their own studies, rather than relying on their investment consulting “gatekeepers” is also highly significant.
American Federation of Teachers, “All that Glitters is not Gold”
A recent study by the American Federation of Teachers entitled “All that Glitters is not Gold,” based on a study of 11 union pension plans, asks the straightforward question: “Would public pension funds have fared better if they had never invested in hedge funds at all?” The phrasing of this question is unique as it bypasses some of the controversies of how one measures hedge fund performance and which benchmark to use to determine whether hedge funds add value.
The study found that over a 13-year period, as was succinctly summarized by its co-author, Elizabeth Parisian, in a hearing of the Illinois House Revenue and Finance Committee:
“Our analysis suggested that hedge funds failed to provide the eleven pension funds we studied with superior returns as promised. At the same time, hedge funds collected fees that are in no way justified by performance.”
The analysis was very simple: for each year, the net return of the hedge funds of each pension plan was compared to the plan’s overall portfolio return. The results were extremely discouraging for hedge funds. Among the studies’ conclusions:
Comptroller of the City of New York
- Hedge fund return lagged the overall portfolio’s return in 75% of the years in the study
- Over the entire period, the funds lost $8 billion by investing in hedge funds rather than the plan’s portfolio
- Yet, the hedge funds took home $7.1 billion in management and incentive fees, representing 57% of the gross revenues generated by the hedge funds
- In 10 of the 11 plans, hedge fund investments showed a “significant correlation” with the plans’ overall portfolios
In another example, the Comptroller of the City of New York conducted a study of the City’s five public employee pension funds experience with hedge funds over the past 10 years and found that the hedge funds’ above market returns of $2.5 billion was almost entirely given to managers in terms of management fees leaving a paltry $40 million for the pension funds.
Europe’s second largest pension plan, the 156 billion Euro Dutch healthcare workers’ fund, Pensioenfonds Zorg en Walzijn (PFZW), recently “all but eradicated” its hedge fund holdings because of poor performance, cost and complexity.
Pension plans currently account for over one-third of the assets invested in hedge funds globally. They are under extreme pressure to make up for a widening shortfall in meeting their members’ future claims. Where once hedge funds were seen as an important part of the solution, their weak performance over the past several years have tried the patience of a growing number of pension plans and we can expect increasing criticism over time.