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Hedge Clipping

The “smart money” has been using for hedge funds for decades. But, how smart are hedge fund as investments?

Earlier this week, the giant California public pension fund Calpers, announced it would no longer invest in hedge funds. Many in the financial media wondered why, while the better question is “what took them so long?”

Problem One

Hedge funds are expensive! They charge between  2% and 3% per year plus take 20% to 30% of profits in those years they make money. 

Those higher costs require that they dramatically outperform the market, consistently. To do so requires extraordinary luck or a bit of cheating (maybe both). To beat the return of the S&P 500 over the past ten years would have required pre-fee average annual returns of between 12% and 14%. Yet, over the past decade, most hedge funds have failed to match even the S&P 500. The Calpers hedge fund portfolio posted a decade-long average annual return of less than 5%. 

Calpers paid over 3% in fees on its hedge fund investments last year or $135 million. Had that money been in a globally diversified portfolio of 50% stocks and 50% bonds through DFA and Vanguard, that amount would have been closer to $10 million. Plus, instead of making less than 5% over the past ten years, they could have made more than 8% with lower fees and less risk!

Problem Two

Part of the perceived value of hedge funds is stated in the first part of their name. They were initially designed to hedge against the inevitable falling market by using complex alternative investments and strategies. We have since learned that these magical derivatives and systems are poorly understood, even by those who created them, and very expensive. Occasionally, they even blew up in the faces of their creators (Lehman, for instance).

In addition to being difficult to accomplish and expensive, hedging investments makes NO long-term sense. If we agree that the only sensible way to invest is by putting money in the steadily and, so far, consistently growing global economy, then hedging is betting against the house. That is the definition of gambling. A hedge can only outperform when the market is falling. Rising economies must result in rising values for their constituent pieces, businesses (stocks).

The BIG Problem

There is something inherently wrong with a product that does so little for clients and so much for managers. Some of the highest paid people on the planet are hedge fund managers. They are paid truly obscene amounts for doing very little. For example, the best perfuming hedge fund in 2013 was Appaloosa Management. For outperforming the S&P 500 by about nine points, manager, David Tapper collected about $3 billion. This from a fund with assets on only $14 billion. A fund that invests in very dangerous securities, like garbage (worse than junk) bonds, and was accused of profiting from illegally obtained information.

Hedge funds are incredibly complex, often dangerous, occasionally illegal. and ultra-opaque wealth shifting vehicles that shouldn’t be on any investor’s list of portfolio possibilities. They certainly should never be used in any retirement product. Those who advise and manage pension funds have a fiduciary responsibility to make scientifically sound and appropriately priced investment decisions. Those who use hedge funds are playing awfully close to the edge of irresponsibility. Yet, we may be seeing signs of them taking those responsibilities more seriously.

The BIG Solution

If pension trustees want to act in the best interests of their clients, the plan members, maybe they should go even father. Here's a bold idea: Create a simple, well-diversified portfolio of global equities and conservative bonds using low-cost institutional funds from firms like Dimensional and Vanguard and rebalance regularly. The pension plans could save even more using this strategy because they could fire all of their overpaid analysts and managers. Why, that looks a lot like a winning scenario for the pension beneficiaries, doesn't it?

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