Hedge Funds Remain Valuable Pension Tool Despite Fees

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By David B. Brandolph

Aug. 26 — Lower returns and high fees are making pension plans rethink their hedge fund investments. However, plans can still benefit from the reduced volatility that such funds offer, some investment professionals say.

“Fees are becoming a more important issue to pension plans and therefore many pension plans are demanding lower fees from their hedge fund investments, reducing the plan’s exposure to them or eliminating them all together,” David Blanchett, head of retirement research for Morningstar Investment Management in Chicago, told Bloomberg BNA Aug. 25.

Jim McDonald, chief investment strategist with Northern Trust Co. in Chicago, agreed that fees have become a bigger concern because of lower hedge fund returns. However, hedge funds remain valuable tools for plans to reduce investment volatility, he told Bloomberg BNA Aug. 26.

All investors pulled a net $25.2 billion out of hedge funds in July, pushing the total 2016 outflow to $55.9 billion, according to a report by eVestment. That means hedge funds might be facing their first year of net annual outflow since 2009, the report said.

These hedge fund outflows come from major public pension plans in some cases.

The New Jersey Investment Council, which invests the state’s public employee pension plan assets, voted Aug. 3 to slash its target asset allocation to hedge funds by 52 percent. This came four months after New York City’s pension for civil employees voted to eliminate its $1.5 billion hedge fund portfolio.

In 2014, the nation’s largest pension plan, the California Public Employees’ Retirement System, decided to drop its $4 billion hedge fund program.

Value Proposition

Much of this outflow can be attributed to high hedge fund fees, Blanchett said. For pension plan sponsors, investing in hedge funds is a “value issue,” he said. Hedge funds tend to have relatively high expenses in addition to the extra monitoring costs when compared with more plain vanilla investments, such as stocks and bonds, he said.

Though hedge fund costs have been coming down recently, sponsors are questioning whether it makes sense to allocate to investments that commonly charge 2 percent in fees in addition to 20 percent of the fund’s gains, often making them the most expensive investment in a plan’s portfolio.

Hedge funds have been sold based on past performance and diversification, but many sponsors “haven’t seen the performance,” Blanchett said. “If you’re going to pay fees in excess of 2 percent, you want a high degree of certainty of outperformance, and unfortunately many hedge fund investors haven’t experienced that,” he said.

Through July, the average return of hedge funds this year as measured by the Barclay Hedge Fund Index was 2.73 percent. The S&P 500 Index, which measures the 500 largest U.S. stocks by capitalization, returned 6.34 percent during that period.

Place for Hedge Funds

There is a place for hedge funds in pension plan portfolios, McDonald said.

“People have been disappointed by hedge fund performance as the funds failed to meet investors’ expectations, he said. At the same time, “some investors have had misplaced expectations as to the performance of these funds,” he said.

“People don’t invest in hedge funds to beat the S&P 500 stock market index,” and hedge fund returns shouldn’t be compared to that benchmark, McDonald said.

Instead, hedge funds take less risk and pension plans can appropriately use them to reduce the plan’s overall portfolio volatility, he said.

In addition, in the current low-interest-rate environment, plans can protect against interest rate increases by moving a portion of their fixed income investments to-hedge fund fixed-income-oriented investments, he said.

Fixed-income investments generally decline when interest rates rise.

Merit of Careful Selection

Northern Trust projects that, on average, hedge funds will return 3.5 percent annually over the next five years, McDonald said. By comparison, the company projects a 5 percent annual return for world stock markets.

Hedge funds are expected to have a lower return because they are taking less risk, McDonald said. In addition, he said the lower expected returns are due to the higher fees they assess.

Plans can get higher returns with careful selection of hedge fund managers, he said.

It’s hard to pick hedge fund managers that add value over time, Blanchett said. While some hedge fund managers have shown consistent above-market performance, “it’s difficult to know who is going to outperform ahead of time,” he said.

In addition, hedge funds self-report their investment returns, which may, in some cases, be unreliable, Blanchett said. The ability to confirm such returns has been improving but hasn’t reached nearly the level of return confidence that mutual fund investors enjoy, he said.

The ingredients for selecting high-quality managers are a combination of consistent over performance, stability in the management team and a determination that the managers are committed to continue working as hard as in the past, McDonald said.

To contact the reporter on this story: David B. Brandolph in Washington at dbrandol@bna.com

To contact the editor responsible for this story: Jo-el J. Meyer at jmeyer@bna.com

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