Thursday, January 12, 2012

Are Hedge Funds the Solution to the Public Pension Crisis?

The investment landscape has been frustrating everyone over the past few years,  particularly for those tasked with coming up with investment strategies for public pension plans.

Bloomberg reports this morning, for example, that the pension actuary for New York City will be recommending that the City reduce its assumed pension return assumption from 8% to 7%.  While this might seem logical - the plan has earned less than 4% per annum for the past decade, after all - it does have significant financial consequences:

New York's chief actuary is recommending that the city’s $115.2 billion pension plans lower their assumed annual rate of return on assets to 7 percent from 8 percent, which would open a funding gap of at least $2 billion next year, according to two people familiar with the proposal. 

The article goes on to note how much pension costs have grown in the past decade:

New York's pension costs have increased to $8.5 billion this year -- including the reserve -- from $1.5 billion in 2002, when Mayor Michael Bloomberg first took office, representing almost 13 percent of the $66 billion budget for fiscal 2012.

One major problem, of course, is the relatively meager return from stocks over the past few years.  Bonds have been a big winner for the past decade, but with interest rates now at 60-year lows it is difficult to make the case that bonds will provide attractive total returns in the next few years.

So alternative assets classes have jumped to the attention of nearly every plan sponsor. But do the alternatives to stocks and bonds actually deliver the goods?

In short:  mostly no.

Take hedge funds, for example. There have been numerous articles and books written recently that fund managers have done a relatively poor job at delivering the returns that the sector once promised.

Writing in Monday's Financial Times, columnist Jonathan Davis cites a new book about hedge funds that has just been published.

Named The Hedge Fund Mirage, author Simon Lack uses his many years of working with hedge funds at JP Morgan to uncover the basic truths about the sector.

According to Mr. Davis, here's the basic thrust to Lack's book:

In fact, concludes Mr. Lack, while many hedge fund managers have prospered from hefty fees, the bulk of their investment gains have not been shared with clients.  On an asset-weighted basis, measuring cash invested to cash returned, hedge fund investors in aggregate, while narrowly beating the average return from equities, would have made more money over the past decade from investing in government bonds, and even from Treasury bills.

There are lots of reasons for the disappointing returns from hedge funds, but one of the biggest reasons is the size of the industry.

When the hedge fund industry was just starting, potential returns could be startling, simply because there was so little competition. Now, with nearly $2 trillion in the hedge fund sector, managers not only are struggling for good ideas, but the shear size of the funds they manage forces them into making large "macro" economic bets which have unfortunately mostly not proven to be successful.

And so the search for investment solutions continues.