Learn from the Plight of the Rhode Island Pension System

Hedge funds should be a tough sell for most investors.

By SHARE
Daniel Solin
Daniel Solin

The New York Times' Gretchen Morgenson recently discussed the plight of the Rhode Island pension system, and noted the troubling trend of public pension systems increasing the percentage of their assets allocated to "alternative investments" like hedge funds and private equity. Such investments now account for almost a quarter of the $2.6 trillion in public pension assets nationwide.

As Dr. Phil would say: How is this working?

So far, seeking higher returns than those offered by stocks and bonds is not a winning strategy for Rhode Island's plan. The hedge funds it selected significantly underperformed the Standard & Poor's 500 index from this year through August 31. In sharp contrast, the managers of these funds had a banner year. They earned $70 million in fees.

Here's a more compelling issue: Why is this news? My colleague Larry Swedroe looked at the performance of hedge funds generally for the period 2003 through 2012 and from January-June 2013. He used the HFRX Global Hedge Fund Index as a measure of hedge fund performance. This index provides returns that reflect the global hedge fund universe.

For the period from 2003-2012, the HFRX Global Hedge Fund Index had annualized returns of a paltry 1.6 percent compared with annualized returns of 7.1 percent for the S&P 500. For the period January-June 2013, the HFRX Global Hedge Fund Index had a total return of 3.2 percent compared with a total return of 13.8 percent for the S&P 500 index.

The word "Pension" being washed away on a beach.

(iStockPhoto)

A 2011 study of hedge funds by Roger Ibbotson, Peng Chen and Kevin Zhu reviewed data from approximately 8,400 hedge funds from January 1995 to December 2009. Its findings were startling:

  • More than 60 percent of the returns of hedge funds came from stock market returns. Hedge funds did not diversify risk from stock market returns.
  • Fees charged by hedge funds were far higher than those of other investment vehicles.
  • While hedge funds in the aggregate produced an "alpha" (increase in return over a benchmark) of 3 percent on average, it would have been exceedingly difficult for investors in those funds to capture that return. More than 60 percent of the funds in the database failed.
  • The higher returns generated by hedge funds did not cover the additional fees they charged.
  • Given these findings, it is difficult to understand the love affair between pension fund administrators and alternative investments. Just because pension plan administrators are engaged in collective cognitive dissonance about hedge funds doesn't mean you have to follow suit. You should not be surprised to learn the Hedge Fund Association applauds the Securities and Exchange Commission for lifting the ban on general solicitation and allowing hedge funds to advertise their offerings to qualified individual investors. You can be assured they will not be advertising their obscenely high fees and their dismal past performance.

    You can learn from the plight of the Rhode Island pension system. Don't succumb to the allure of hedge funds, even if you qualify to do so.

    Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You'll Ever Read, will be published March 3, 2014.

    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.