According to Elizabeth Parisian and Saqib Bhatti of the Roosevelt Institute, the decision by pension funds to invest in hedge funds some years ago has had disastrous consequences, ultimately resulting in subpar returns for the pension funds and paying billions in undeserved fees to hedge fund managers.
The new report from the Roosevelt Institute is titled “All That Glitters Is Not Gold”, and takes a closer look at whether hedge funds have provided U.S. pension funds better and less correlated returns as promised, and also tackling the question are hedge fund fees adequately disclosed and as high as many critics suggest.
Methodology of the study
Parisian and Bhatti analyzed 11 U.S. public pension funds investments in hedge funds. With publicly available data and data given by the pension funds, the authors undertook a year-by-year comparison of hedge fund net returns and total fund net returns for each pension fund. The study also compared the hedge fund rates of return to fixed income net returns for each pension fund to figure out whether hedge funds actually came through on their promise of uncorrelated returns and if less expensive fixed income strategies actually offer better net returns.
Hedge fund fees are not completely reported or fully accounted for, so Parisian and Bhatti used industry standard fee structures such as management and incentive fees then projected actual fees charged by hedge fund managers based on earlier statements of net return to investors. These figures are not exact because of lack of transparency with hedge fund fees, but are certainly close enough to come to a conclusion regarding the hedge fund investments by pension funds.
Key findings regarding pension fund investments with hedge funds
The results of this study show that hedge fund investments failed to deliver any significant benefits to the group of 11 pension funds studied. In specific:
- Hedge fund net return rates were less than the total fund returns for close to 75% of the total years reviewed, leading to an estimated $8 billion in lost investment revenue by the 11 pension funds. Moreover, hedge fund managers charged an estimated $7.1 billion in fees to the pension funds over the period reviewed. The data showed that on average, the pension funds were paying a staggering 57 cents in fees to hedge fund managers for every dollar of net return to the pension fund.
- Although hedge fund managers tout both uncorrelated returns and downside protection, it turned out that 10 of the 11 funds reviewed in the study saw significant correlation between hedge fund and total fund performance.
Recommended next steps for pension funds
Parisian and Bhatti suggest that every pension fund involved with hedge funds undertake a thorough asset allocation review to consider less expensive and more effective methods of diversification. The asset allocation review must include a full analysis of past performance of their hedge fund investments, as well as a wide-ranging comparison to lower-fee alternatives.
It is also important for pension funds to require full fee disclosures from hedge fund managers and consultants, including complete disclosure of historical investment management and incentive (carry or profit sharing) fees charged by hedge funds.
Finally, the report highlights that pension funds should also work toward instituting legislative policies that mandate full fee disclosure by hedge funds.
See full report below.