Max Whittaker / Reuters /Landov

Stop risking public pensions on hedge funds

CalPERS made a wise call that other states should follow

September 25, 2014 6:00AM ET

Managers of the nation’s largest public-employee pension fund, the California Public Employees’ Retirement System (CalPERS), are closing out their investments with hedge funds. Taxpayers everywhere should applaud the move — and then ask their state and local politicians when they will do the same as CalPERS.

The hedge fund industry has shrugged, noting that it manages more than $2.3 trillion in assets while the CalPERS hedge fund investments amounted to about $4 billion. But that reaction misses the point entirely. The move is really about public workers and taxpayers, not the industry.

The reason to applaud the CalPERS withdrawal is not that all hedge funds are bad investments, though they can be. Overall, the roughly 5,000 hedge funds have underperformed the market in the last decade while charging very high fees; the base charge can be 40 times the cost of index fund management, whose aim is to earn the average market return.

Rather it’s because hedge funds are not suited to the risk-averse investing that public workers and taxpayers should expect.

Risky investing

In finance the term “hedge” means to reduce risk, generally by acquiring an opposing position to one’s investments in advance in case the market goes in the opposite direction. Hedges are often created using derivative bets called puts and calls that reduce the risk of catastrophe but also eat into gains.

Hedge funds operate in many different styles. Some engage in high frequency trading, buying and selling stocks in much less than the blink of an eye to capture little anomalies in securities prices that only computer software can detect. Others buy commodities such as aluminum and oil and hold them until prices rise.

However, no formal legal definition exists of the term “hedge fund,” which today often means risky investing. And these investment pools operate largely outside the regulatory framework of mutual funds.

Most people invest their own money, but hedge funds juice their returns by borrowing. Mortgages typically require 20 percent down, creating an initial leverage of $4 of debt to $1 of equity. The hedge fund industry likes to talk about a ratio of $30 borrowed for each dollar of cash equity, which represents a lot of risk, but the ratios can go a lot higher. Records in the 2003 federal trial over taxes in the Long Term Capital Management case, which I covered, showed that firm partners borrowed part of their stakes, leveraging their positions at up to $300 to $1. The firm did spectacularly well, thanks to board members Myron Scholes and Robert C. Merton — Nobel laureates for their research on derivatives — until the 1997 Asian financial crisis and problems with Russia forced the Federal Reserve and 16 major banks to put up $3.6 billion to bail out the fund. 

For a decade, hedge funds overall have underperformed the market even though they charge hefty fees and add significant risk to the securities markets, as some hedge fund operators have publicly acknowledged.

In our era of proliferating high-risk investment pools that call themselves hedge funds, combined with high-frequency trading and near zero-interest loans to banks, a lot of money has been allocated to underperforming investments. Some top-flight investors have decided to pull out.

The combination of high speed trading and a “dash for trash puts to shame even the speculative excesses of the dot-com era,” Andrew Cunagin wrote in a letter telling investors he was closing the hedge fund Rhinehart Capital Partners. “This is a circus market rigged by HFT [high frequency trading] and other algorithmic traders who prey on the rational behavior of warm-blooded investors. They only serve to further undermine the integrity of public markets.”

He was writing not about investing as done by Warren Buffett and others with long-term strategies but about the instantaneous, speculative buying and selling of stocks on the basis of mathematical formulas, those algorithms he referred to.

The money of vulnerable people must be invested with exceptional care to safeguard from loss.

Hedge funds charge hefty fees. Many hedge funds charge what is known in the trade as 2 and 20. That is for a 2 percent annual management fee, or $20,000 per $1 million, and 20 percent of all gains. Julian Simon’s Renaissance Technologies charges a 5 percent base and 44 percent of gains. From 1982 through 2009, when it averaged extraordinary 35 percent annual returns after expenses, that was a great deal, but since then, Simon has underperformed the market.

Compare these numbers with the very well-managed ExxonMobil pension fund, which its latest disclosure reports show has overhead charges of less than $1,200 per $1 million. Vanguard 500 investors pay as little as $500 annually to manage $1 million.

To get a better sense of the numbers, consider a year when the market return is 5 percent and a hedge fund earns that. On a $1 million investment, after a 2 percent management fee and a 20 percent profit performance fee, the hedge fund investor will be ahead by $19,200, or less than 2 percent; the Vanguard investor will be ahead by $49,950, or almost 5 percent.

Not worth the cost

Hedge funds earning market returns, therefore, are not worth the added cost. But bigger returns mean bigger risks, including the risk that the hedge fund managers are not as shrewd as Simons’ team and could lose all the money.

What’s more, hedge funds often have in their contract disclosures that not all investors may be treated alike. So one investor pays 2 and 20, while another pays 1.5 and 25 or some other arrangement. Pension funds, by contrast, have a fiduciary duty, a duty of loyalty, that should include always getting the best pricing offered to any fellow investor of similar or smaller size in any specific fund.

The first reason, then, to applaud what CalPERS did is to recognize that it is acknowledging a costly mistake. Hedge funds simply are not appropriate for taxpayers and public-sector workers. They are, rather, for wealthy speculators willing to take big risks in the hopes of earning big rewards while being able to tolerate the chance that an investment will shrivel or even be wiped out.

Pension money should be invested prudently. “Prudent” comes from the word “provident,” meaning to prepare for the future. And while its origins are in religious concepts, failing to prudently handle earthly money can turn the end of life into hell. Given survivor benefits in pension plans, these pools of money should be treated as widows-and-orphans money. Under ancient and well-tested principles, the money of such vulnerable people must be invested with exceptional care to safeguard from loss. That means investment-grade bonds (more on that below) and either blue chip stocks or broad indexes.

Only with the rise in the last six decades of modern portfolio theory — investing in many different arenas to spread risk — have we gotten away from the idea that for widows, orphans and pensioners, only high-grade corporate bonds and a few blue chip stocks paying big dividends are appropriate investments.

Prudence may require that public-sector workers divert more of their cash wages into pension plans, which they probably will not welcome. But taxpayers can reasonably insist on this, because if large sums are lost in speculative investments, taxpayers may take a hit to make up for those losses or to provide welfare to impoverished government retirees.

Public sector workers should support prudence over speculation and stand behind making sure the proper amount is set aside each year. Otherwise they run the risk that a federal bankruptcy judge might cut their benefits, as happened in Detroit, or politicians will renege on their old-age annuities, as Gov. Chris Christie of New Jersey has proposed for state workers.

Let’s leave the hedge funds to the speculators.

David Cay Johnston, an investigative reporter who won a Pulitzer Prize while at The New York Times, teaches business, tax and property law of the ancient world at the Syracuse University College of Law. He is the best-selling author of “Perfectly Legal,” “Free Lunch” and “The Fine Print” and the editor of the new anthology “Divided: The Perils of Our Growing Inequality.”

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera America's editorial policy.

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