What Took So Long?

I hope that you had a wonderful Thanksgiving holiday despite the many impediments that we are facing this year. It is still my favorite holiday, and I might actually be hungry by Friday!

I came across a comment in a ValueWalk.com article that mentioned that pension plan allocations to hedge funds were down in Q3’20. I’m not shocked: just dismayed. What took so long? A quick comparison of hedge fund returns through September 30, 2020, for a variety of time frames reveals consistent underperformance for hedge funds relative to equities (S&P 500), but more shockingly, to bonds as measured by the Bloomberg Barclays Aggregate index. In fact, there is not a single period (1-year, 3-, 5-, 7-, 10- or 20-years) in which the HFRI Hedge Fund Composite tops the BB Aggregate. The 10-year time period reveals that the two indexes actually produced the same result at 3.6% annualized.

Now, I don’t expect HFs to keep pace with equities longer-term, but we’ve gone through a number of difficult markets during the last 20 years, so the fact that HFs (and all of their fees) trailed the S&P 500 by 1.6% per year is troubling. Worse, HFs underperformed the bond market by 0.2% per year for 20-years. A plan sponsor and their consultant(s) may not think that 20 bps per year is much, but bonds haven’t only outperformed HFs, they’ve also been a terrific source of income to meet the promised benefits (and expenses), while being the only asset class that adequately hedges the plan’s liabilities.

As a reminder, defined benefit plans have a relative liability objective (asset growth versus liability growth) that are bond-like in nature and the present value of that liability rises and falls with changes in interest rates (discount rates). An allocation to hedge funds creates a mismatch between the plan’s assets and liabilities. E&Fs and HNW individuals that have an absolute return objective (positive spending each year) should have a greater interest in HFs that also have an absolute return objective. Hedge funds may be much more sexier than bonds, but they certainly aren’t helping the average DB plan given their poor returns and outrageous fees.

Oh, and the extra 20 bps per year that were generated by bonds relative to HFs for 20-years ending 9/30/2020 produces an additional $9.93 million ($100 million starting account) in additional assets that can be used to fund promised benefits. That’s not chump change for most of us.

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