Hedge Funds’ High Cost and Correlations Can be Problematic

You get what you pay for, right? While this adage rings true in the retail world, it does not apply to hedge funds. In fact, California Public Employees’ Retirement System (CalPERS), the largest pension fund in the U.S., recently announced that, due to the high cost, it is pulling all $4 billion out of its hedge fund investment program of 24 hedge funds and six hedge fund-of-funds.

How expensive are hedge funds? They generally charge fees of 2 percent of assets and 20 percent of returns. CalPERS reports that it paid $135 million in fees in the fiscal year that ended June 30 for hedge fund investments that earned 7.1 percent, contributing 0.4 percent to its total return. An investment in the MSCI All World Equal Weight stock index would have earned 21.7 percent during that same period and cost a lot less!

In a press release addressing the change, Ted Eliopoulos, interim Chief Investment Officer at CalPERS commented, “One of our fundamental investment principles is that cost matters.” He also noted that hedge funds are “an expensive investment vehicle, especially at our scale.”

Given that CalPERS was one of the first pension funds to invest in hedge funds in 2002, and is viewed as a leader in the pension fund industry, their divestiture is significant. Yet, the decision does not mean the demise of the hedge fund industry. In fact, nearly $57 billion flowed into hedge funds in the first two quarters of this year, illustrating that many investors still believe in hedge fund strategies. In spite of their steep cost, hedge funds hold a record $2.8 trillion in assets and McKinsey & Co. estimates that assets in alternatives, including real estate and private equity, could reach $14.7 trillion by 2020.

While Eliopoulos stressed CalPERS’ decision was unrelated to performance, the pension plan’s investments failed to outperform the HFRI, a benchmark hedge fund index which returned 9% in 2013, well short of the S&P 500’s 30%. Hedge fund supporters will, of course, be quick to point out that hedge funds are not built to outperform in an up market. Rather, they are designed to provide protection in a downturn. Yet, in the downturn of 2008 when the S&P 500 fell over 30%, the HFRI also declined, losing almost 20%. In fact, in several years since 1994, hedge funds have been fairly well correlated to equity markets. (See Figure 1.)

Figure 1: HFRI versus S&P 500: January 1994 through August 2014

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Source: Hedge Fund Research, Standard and Poor’s

In my view, the biggest misconception about hedge funds is that smart managers are worth the high fees because they can outperform the markets by exploiting market anomalies such as mispricing between similar securities. Of course, we know attempts to time the market are a waste of time and money. In fact, research shows that each year approximately 80% of active fund managers underperform their respective benchmarks, proving that market prices reflect most of the available information and that no investor, not even highly paid hedge fund managers, can hope to know more than the total market knows.

Yet, even as the financial industry moves toward greater transparency and a focus on cost efficiency, hedge funds remain cloaked in secrecy, demanding high fees and professing their superiority.

Rather than tout an ability to forecast the future and pick better stocks, we employ Evidence Based Investing which is grounded in decades of solid academic research. And we invest in passive funds offered by Dimensional Fund Advisors (DFA) where University of Chicago’s Nobel Laureate Eugene Fama and Yale’s Roger Ibbotson are board members, and Dartmouth’s Ken French serves as the firm’s head of investment policy. You can read more about DFA in “Why Our Firm Uses DFA Funds” authored by Dougal Williams, CFA.

Dimensional’s investment philosophy is particularly important to remember given the growth of a new industry of “liquid alternatives.” These funds mimic a range of hedge fund strategies, but are more liquid and lower cost. Because liquid alternatives don’t have the high minimum investments of hedge funds, a much wider range of investors can access hedge fund strategies from equity long short value investing to merger and convertible arbitrage. That’s especially dangerous if investors do not fully understand the risks involved in these liquid alternatives.

In sum, our investment approach is based on decades of academic research, focused on education, and intentionally designed to create and maintain real wealth. This stands in stark contrast to the confusing and sometimes expensive world of hedge funds. In fact, it may be just a matter of time before more pension plans wisely follow CalPERS’ lead and divest from their hedge funds and revert back to the disciplined methods which continue to create the greatest wealth in the history of the free capital markets.

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