Hey Clara, “Where’s The Beef?”

Several large public pension funds have recently implemented a plan to or are in the process of reducing / eliminating their exposure to hedge funds.  Numerous reasons have been cited for this action, including size of the plan’s allocation, complexity, lack of internal resources, but given the less than stellar results achieved from within the hedge fund space, I can’t say that we are shocked by this action despite a good bit of challenge from many within the retirement industry.

As for the performance, for the 10 years ending March 31, 2016 the HFRI Composite Index has a +3.4% annualized return, while the S&P 500 (+7.0%) and the Barclays Aggregate Index (+4.9%) have beaten it handily.  The fact that the 10-year period encompasses all of the Great Financial Crisis (GFC) when hedge funds should have provided significant down-side protection speaks to the failure of many hedge funds to do what was expected of them. Fees of 2% and 20% or more is a hefty price to pay for perceived risk reduction because you are clearly not getting benefit from exposure to HFs on the return side of the equation.

 

For the record, we at KCS have been discussing for some time now the misalignment of plan assets and plan liabilities within DB funds.  Anyone who knows us has heard us speak about the importance of making sure that the correct bogey (plan liabilities and not the ROA) is being used.  DB plans have a relative objective, and not an absolute one.  Endowments and Foundations, as well as HNW individuals, have an absolute objective (positive spending policy), and the use of hedge funds in this space is perfectly reasonable, if you can select those that provide appropriate risk / return characteristics after fees.

Of course there are excellent hedge funds just as there are terrific managers of long-only equities, fixed income, real estate, etc. Unfortunately, our industry has a tendency to overwhelm the better investment firms / products with positive asset flows until the ability to add value has been arbitraged away.

DB plans don’t need expensive hedge funds in order to close their funding gaps.  They need to only outperform liability growth in order to accomplish that objective, and cheap beta strategies are more than capable of providing that excess return.  If we finally begin to see positive economic growth, here and abroad, a bit of inflation, and gradually rising interest rates, we could see asset growth easily exceed liability growth, which might actually be negative in that environment.

The last 15+ years have not been kind to plan sponsors and their DB plans. A return to the basics is what is needed at this time. We need to get refocused before it is too late.  Too many employees, both private and public, are losing the opportunity to participate in a traditional DB plan. The alternatives are just not cutting it, and the social and economic consequences may be grave!

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