The New York Pension Plan Folly

US News

The New York City retirement systems are proudly trumpeting the progress they are making toward their goal of a $3.5 billion hedge fund portfolio on behalf of three of their five pension plans. They are abandoning their prior investment of $450 million in commingled hedge "fund of funds" managed by the Permal Group. The pension plans will be redirecting those funds directly into hedge funds.

I have nothing but sympathy for the beneficiaries of these pension plans.

In one study, Burton Malkiel and Atanuy Saha found that "hedge funds are far riskier and provide much lower returns than is commonly supposed." They also concluded that investors in hedge funds "take on a substantial risk of selecting a dismally performing fund or, worse, a failing one."

In a thoughtful article in The New Yorker, John Cassidy referenced a study comparing the fee-adjusted returns of 77 hedge funds between 1990 and 2000 with the returns generated by a simple benchmark of comparable risk. More than 90 percent of the hedge funds studied failed to outperform their benchmarks.

A recent article in The Economist noted that the HFRX, which is widely used as a measure of hedge fund returns, was up only 3 percent as of December 22, 2012 compared with an 18 percent rise in the S&P 500 index. Over the past decade, a portfolio of 60 percent stocks and 40 percent sovereign bonds has returned more than 90 percent, compared to 17 percent (net of fees) for hedge funds.

According to The Financial Times, between 2000 and 2008, U.S. pension plans earned just 1.9 percent a year (net of fees) on average from their investment in hedge funds. They could have earned similar returns with far less risk in Treasury Bills.

In fact, according to Simon Lack, the author of The Hedge Fund Mirage, "If all the money that's ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good."

Once the New York Pension system reaches its dubious goal of $3.5 billion invested in hedge funds, one thing seems certain: The managers of those funds will be the primary beneficiaries. It's likely these funds will underperform. Do you ever feel like the inmates have taken control of the asylum?

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information, and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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