Update to The Hedge Fund Mirage

One of the chapters in Simon Lack’s Wall Street Potholes is on the dangers of investing the way the New Jersey retirement system is doing it.

Excerpts from that chapter follow:

In January 2012, I published The Hedge Fund Mirage; The Illusion of Big Money and Why It’s Too Good to Be True. Although hedge funds have long been associates with fabulous wealth, a little-appreciated fact was that substantially all the profits generated by hedge funds had been eaten up in fees paid to the hedge fund managers themselves. Funds of hedge funds and consultants had taken the rest, with the result that, while hedge funds had been fantastically profitable investments, those profits had not made their way through to the clients. (page 69)

Today’s hedge fund investors are far more likely to be institutions especially US public pension funds investing the retirement savings of teachers, firefighters and other public sector workers. Wealthy individuals are far less significant investors today. In many cases, they represent the smart money, in that they enjoyed the successes of hedge funds 15 or so years ago. (page 75)

I often smile when I hear that phrase sophisticated institutional investors. It’s usually used by service providers seeking to impose an imprimatur of quality on their own business by virtue of their clientele. Of course, many institutional investors are sophisticated. They have the resources to hire investment professionals to advise them on their portfolios, and many do. But just as not all hedge funds are bad, not all institutional investors are sophisticated. In fact, some of the least sophisticated are the public pension plans plowing their money into hedge funds. (page 75)

Using bond yields as the discount rate to calculate the present value of future pension obligations is a sensible approach, and this is what most pension funds do. However, public pension funds follow a different set of accounting rules, and in an especially bizarre departure from private practice they use their expected return on assets to discount their liabilities….It’s a perverse treatment, because it means that changing the mix of assets alters the present value of their obligations, although their actual obligations haven’t changed. So a more risky mix of assets, through the higher discount rate it produces, lowers what they owe future retirees and therefore improves their funded position. (pages 78-9)

Hedge funds with their 7% return potential can appear very attractive to public pension funds grappling with insufficient assets to meet retiree obligations. They can serve to delay the inevitable day of reckoning with its politically unattractive tax hikes or spending cuts (or both) to make the numbers add up. The problem is, no one is pointing this out. The consultants that advise public pension plans are conflicted because recommending hedge funds pays well, so there’s little incentive to do anything else. Moreover, the consultants themselves rarely demonstrate a track record of profitable recommendations. One study in 2013 found that investment consultants were “worthless” (Sorkin 2013). (pages 79-80)

Most voters will opt for policies that defer topping up pensions. It may be criticized as poor public policy, but it’s the democratic process at work. New Jersey is just one example. In 2014, Governor Chris Christie slashed pension contribution (Magyar 2014) by $2.4 billion to meet a budget shortfall. Unions representing the beneficiaries challenged the move, but Christie evidently calculated that few voters would be that bothered. Short of ironclad legal requirements that such pension obligations be fully funded, political leaders responding to the desires of voters will kick the can down the road. (page 80)

Because of the political process that provides funding for public pension plans and their curious accounting, many people with responsibility for tomorrow’s retirees unquestioningly cling to the fantasy of the kinds of hedge fund returns that we haven’t seen for over 10 years. Those who believe that the growth in hedge fund assets represents vindication for the asset class are not thinking very deeply about the process through which such decisions are made. (page 81)

Recommending a substantial hedge fund allocation today either reflects a profound misunderstanding of how financial markets work, or a cynical appreciation of the quirky way public pension accounting renders hedge funds a plausible solution to a funding shortfall. Either way, we can look back on the consulting advice provided over the past several years to the trustees of billions of dollars of public sector retirees and question whose interests were really being served. Hedge fund research has paid well. (pages 87-8)

It’s just that if you’re looking to commit fraud, a hedge fund is the perfect vehicle. The securities are unregistered and the manager may also not be required to be registered with any state agency or the SEC. Creating a fictitious list of holdings in public companies is less likely to cause suspicion than, for example, claiming to own a building or private company that might not exist. (page 89)

2 responses to this post.

  1. Posted by George on May 29, 2016 at 9:57 pm

    One explanation for exemplary hedge fund is survivor bias. Either hedge funds make a ton of money or they disappear. In this case the relationship to the Clinton family caused this hedge fund to make the news.

    Hillary Clinton Son-In-Law’s Hedge Fund Shuts Down Greek Fund After 90% Loss
    http://www.zerohedge.com/news/2016-05-10/hillary-clinton-son-laws-firm-shuts-down-greek-hedge-fund-after-90-loss

    In other news: March pension assets according to the NEW JERSEY DIVISION OF INVESTMENT.

    2016: $70,873.89
    2015: $77,619.07

    http://www.nj.gov/treasury/doinvest/pdf/DirectorsReport/2016/MarchInvestingReport2016.pdf

    http://www.nj.gov/treasury/doinvest/pdf/DirectorsReport/2015/March2015.pdf

    Reply

  2. Posted by dentss dunnigan on May 30, 2016 at 10:10 am

    With a annual drawdown of 10 billion and growing and with employees contribution of 2 billion coupled with interest rates of record lows of 1% for safe investments …unsustainably quickly comes to mind ……nobody is predicting a 5%+ gain in the stock market YOY going out . The sheer size limits good stock picking .

    Reply

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