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  • Writer's pictureEric Hahn

Why Pensions and Hedge Funds Don’t Mix

Year in and year out, public pension managers invest in hedge funds that promise market-beating returns. The stated aim is to narrow the gap between what the pensions have promised future retirees and the money available to meet those obligations. What happens instead is that the pension gaps remain while the hedge funds gorge on fees.

A recent report in The Times by Gretchen Morgenson cited the latest research on pensions and hedge funds. One study, by researchers for the American Federation of Teachers, looked at hedge fund holdings in 11 large public pensions between 2002 and 2015, and found that hedge funds lagged overall plan performance in most years, costing the pensions an estimated $8 billion in lost investment revenue. The hedge funds, meanwhile, collected some $7.1 billion in fees, which averages out to 57 cents for every dollar the pensions kept on their hedge fund investments. In effect, the pensions were looted.

One obvious question is why pension managers keep investing in hedge funds. A common explanation is that pension trustees are naïve and desperate and easily outfoxed by Wall Street salespeople. There are also signs, however, of willful blindness. The new analyses are only the latest to cast doubt on the benefits of hedge funds for big, long-term investors. In addition, the California Public Employees’ Retirement System, or Calpers, a pension industry leader, announced last year that it was winding down its hedge fund holdings because of their complexity and high costs. Other pensions have not taken Calpers’s cue.

There are several reasons why hedge funds do not live up to their hype. One is rapid growth — to $3 trillion recently — which means that one bad year can outweigh the gains in years when the funds were smaller. Another is flattering performance measures that exclude poor performers and emphasize hot newcomers. The biggest hit to returns is layers of fees, typically 2 percent of assets under management, plus 20 percent of any gains — for starters.

Rosy promises about hedge fund returns can hurt pension plans in another important way, by giving politicians cover for not making full and timely contributions to troubled plans. Projections from pension plan managers that high-octane hedge funds can make up for any gaps relieves the pressure on delinquent politicians to make the required deposits.

The end result is poorer pensions and richer hedge funds. The victims are the public employees who are counting on their pensions for a secure old age.

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