Hedge funds sound great. Indeed, in a market like the current one, they almost sound downright phenomenal. After all, stocks have been on such a great run for over five years, everyone is seemingly waiting for a big fall, and you can’t find any positive news about bonds to make you comfortable. So where do you go? Hedge funds? They are supposed to help in situations just like this.
According to California Public Employee’s Retirement System (CalPERS), the nation’s largest pension fund, hedge funds are not the answer. With $237 billion of assets to steer for over 1.5 million people, CalPERS recently announced that enough is enough and was moving the entire $4.5 billion position out of hedge funds to “reduce complexity and costs.” After all, last year alone they spent over $135 million just in hedge fund fees. If this had been invested in Vanguard, for instance, with an average expense ratio of 0.19% on their funds, there would have been a savings about $126 million off the bat.
This amount doesn’t even account for the fact that the hedge funds underperformed as well. According to CalPERS, their hedge funds returned 7.1% the previous year compared to a fantastic 24.8% realized in their global equities. If that $4.5 billion had been invested in stocks instead of hedge funds, another almost $800 million could have been earned.
This is where the rubber meets the road. Hedge funds sound great in theory– you get returns that act differently than both stocks and bonds and that are after “absolute return,” or a fancy way of saying they don’t want to lose money. No one wants to lose money. But countless studies, books (including Simon Lack’s The Hedge Fund Mirage), and now actions by funds like CalPERS show that while the idea seems to make a ton of sense, reality is different. After accounting for the enormous fees, let alone the tax drag if you’re a taxable investor, unlike CalPERS, the normal investor is left with a seemingly overpriced repackaging of securities.
Even so, hedge funds and other alternatives alike are improving. As the market catches on and assets shift around, fees are coming down. Reporting is also getting better, or in general, being able to know what the fund owns and how it is performing. Access to funds is improving also. All of these factors may spell a brighter future for hedge funds than has been seen the last 6-7 years, but time will tell. In the meantime, the best solution for investors is to focus on keeping costs low, remaining diversified, and not losing sight of the power of the traditional stock/bond mix in controlling risk.