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Public Pensions and Hedge Funds Don't Mix

Sean McElwee

Many states have underfunded pensions, partially because to the financial crisis of 2007 and partially because of politicians underfunding the pensions. In order to increase returns and close that gap, more pension systems are turning to alternative investments in hedge funds.

The problem is that hedge funds have a nasty habit of not reaping big dividends. The Wall Street Journal reported in August,

It’s been a great year for the stock market. It’s been a tough year for a hedge-fund manager.

A typical hedge fund has risen 4%, on average, this year through Aug. 9, according to an analysis conducted by Goldman Sachs That performance compares to a 20% total return (including dividends) for the S&P 500 over the same time frame, meaning the market has outperformed an average hedge fund by five times this year.


Hedge funds, on average, underperformed the markets last year as well, with an 8% gain, compared to a 16% total return for the S&P 500.

Matt Taibbi notes in a Rolling Stone article the bet Warren Buffett made with the managers of the hedge fund Protege Partners:

Even though hedge funds can and sometimes do post incredible numbers in the short-term – Loeb's Third Point notched a 41 percent gain for Rhode Island in 2010; the following year, it earned -0.54 percent. On Wall Street, people are beginning to clue in to the fact – spikes notwithstanding – that over time, hedge funds basically suck. In 2008, Warren Buffett famously placed a million-dollar bet with the heads of a New York hedge fund called Protégé Partners that the S&P 500 index fund – a neutral bet on the entire stock market, in other words – would outperform a portfolio of five hedge funds hand-picked by the geniuses at Protégé.


Five years later, Buffett's zero-effort, pin-the-tail-on-the-stock-market portfolio is up 8.69 percent total. Protégé's numbers are comical in comparison; all those superminds came up with a 0.13 percent increase over five long years, meaning Buffett is beating the hedgies by nearly nine points without lifting a finger.

That said, Barron’s reports that even though hedge funds are having a bad couple of years, they are still bringing in money, primarily because of institutional investors like pension funds. But the research shows that hedge funds aren’t good investments for pension funds because the huge influx of capital creates a diseconomy of scale. And yet the percentage of pension funds investing in hedge funds has increased from 2.4% in 2000 to 42.7% in 2008.

While not producing gains, hedge funds have a significant drawback: expensive fees. Demos documented the cost of fees for IRAs and 401(k)s in a 2012 report. Taibbi writes of the fees:

In public finance, hedge funds will sometimes give slight discounts, but the numbers are still enormous. In Rhode Island, over the course of 20 years, Siedle projects that the state will pay $2.1 billion in fees to hedge funds, private-equity funds and venture-capital funds. Why is that number interesting? Because it very nearly matches the savings the state will be taking from workers by freezing their Cost of Living Adjustments – $2.3 billion over 20 years.

This is not to say that pension reform is unnecessary. Many states have real shortfalls which will drain public funding for vital services. However, the idea that states can avoid these shortfalls by pouring money to hedge funds will only exacerbate the problem while enriching Wall Street traders.