As the country’s largest pension fund, the California Public Employees Retirement System (CalPERS), announced plans to divest its entire $4 billion position in hedge funds, we feel that it’s worth mentioning our response to the news: It’s about time.
In every-day life, having alternatives seems comforting, implying that you’ve got the freedom to live life on your own terms. Likewise, the phrase “hedging your bets” generally sounds smart. But whether it’s CalPERS’ nearly $300 billion dollar pension plan or your own financial nest egg, the alternative investment known as hedge funds takes on a different meaning, with several “buyer beware” caveats to consider before inviting them into your portfolio.1
A Hedge Fund Introduction
Like mutual funds, hedge funds represent a pooled collection of multiple investors’ assets, each of whom pays to play, hoping to profit from the fund’s savvy investments. And they come in a variety of “flavors,” some more appealing than others.
But hedge funds are different from mutual funds in a number of important ways. To borrow key passages from the U.S. Securities and Exchange Commission’s (SEC’s) hedge fund overview and its larger Hedge Fund Investor Bulletin:
Hedge funds have more ammunition.
“Hedge funds typically have more flexible investment strategies than mutual funds. Many hedge funds seek to profit in all kinds of markets by using leverage (in other words, borrowing to increase investment exposure as well as risk), short-selling and other speculative investment practices that are not often used by mutual funds.”
Hedge funds are more Wild West.
“Unlike mutual funds, hedge funds are not subject to some of the regulations that are designed to protect investors. … Without the disclosure that the securities laws require for most mutual funds, it can be more difficult to fully evaluate the terms of an investment in a hedge fund.”
Hedge fund investors ride alone.
“Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most mutual funds.”
Hedge fund investors are assumed to know their way around.
“[A hedge fund investor] generally must be an accredited investor, which means having a minimum level of income or assets, to invest in hedge funds.”
A Hedge Fund Intervention
Wealthy individual investors are often attracted to hedge funds. Because they are generally restricted to accredited investors, hedge funds enjoy an aura of exclusivity. They tend to appeal in the same way a first class airline ticket does. Fund companies’ marketing initiatives as well as the popular press often further fuel the presumption that individual hedge fund investors can expect to receive premiums normally reserved for institutional-level investing.
But if we translate the SEC’s talking points above into what they mean to you as an investor, there are several take-aways to be aware of before you pay for an alleged hedge fund “upgrade.”
The cost to play is almost always markedly higher.
We’ve said it before and we’ll no doubt say it again: Minimizing the costs of investing is among the most important steps you can take to enhance your net returns – the ones you get to keep at the end. As such, hedge funds often start with a high hurdle, given their “2 and 20” industry standard: 2 percent on your total investment plus 20 percent of any profit. Compare these steep costs to the typical fee in the range of a fraction of a percent for a basic stock index fund.
The rewards may NOT be markedly superior (especially after costs).
Despite the implication that you’ll get more for your higher fees, reality seems otherwise.
- In his article, “Be like Calpers: Dump your hedge funds,” Wall Street Journal columnist Brett Arends commented, “Calpers says its hedge fund investments earned 7.1% in the 12 months to June 30. … An investment in the MSCI All World Equal Weight stock index would have earned 21.7% over that same period.”
- In a separate New York Times article on the CalPERS announcement, the authors observed, “Since about 2009, plain old stocks, as measured by the Standard & Poor’s 500-stock index, have generally performed better than hedge funds, raising the question of what the fees are really buying.”
- In financial author Dan Solin’s post, “Your Lesson from CalPERS’ Dumping of Hedge Funds,” he notes: “The annualized returns of the HFRX Global Hedge Fund Index (which attempts to reflect the opportunities in the hedge fund industry) underperformed every major stock asset class, and even three Treasury indexes, for the 10 calendar years from 2004 through 2013.”
It’s hard to tell either way. Even if you’re aware of potentially excessive costs and disappointing returns, it still may be hard to identify which hedge funds are delivering on their promises. Because the SEC presumes that accredited investors are financially savvy and aware of the risks involved in their ventures, hedge fund managers are not as closely regulated nor as strictly required to publish performance reports. As such, the “privilege” of being an accredited investor may hinder more than help you in conducting a thorough due diligence on a hedge fund offering.
So what should we take from CalPERS’ recent announcement? As summarized in the aforementioned New York Times article, “For the $2.8 trillion hedge fund industry, the size of the Calpers investment is minuscule. But losing it is important because Calpers has long been a trendsetter among public pension plans, and the reasons for its decision resonate with many public workers, retirees and the plans’ trustees: Hedge funds can just seem too complicated and costly.”
In other words, like we said above, it’s about time.
1 According to the CalPERS website, assets totaled $298 billion as of July 31, 2014.
Sage Serendipity: To counteract the complexities of hedge funds and add a dash of style to our blog, here are some simple scarf-tying techniques, for ladies and gentlemen alike.