If you are a giant public-employee pension fund and you are asking yourself, "Should I invest in hedge funds?" the answer is almost certainly "no." My colleagues Barry Ritholtz and Matt Levine have excellent columns written on this, and I command everyone to go read them now. For those who are lazy and disobedient, however, I'll note a few highlights:
Hedge funds are not an asset class, they are a legal structure. That structure may permit the managers to do things that generate higher returns such as selling short and locking up money in longer-term investments. But "may" is not the same as "does," and in general, hedge funds don't make enough return to justify their extremely high fees. Individual managers may generate those kinds of excess returns, but it's hard to distinguish a manager who is generating alpha from a manager who is having a lucky run.
The larger your investment stake, the harder it is to generate excess returns, because your investments start to change the price of the assets you're investing in. A pension fund the size of the California Public Employees' Retirement System (Calpers) is going to converge toward the returns of index funds. At which point, it really doesn't make sense to invest in hedge funds.
These observations are all prompted by Calpers' decision not to invest its money with hedge funds anymore. This is splendid news for all the people of California, though, of course, it will be a bit hard on the hedge fund managers. Notwithstanding the prospect of desperate fund managers having to fly commercial and sell the third home, other states should follow suit.
However, it's worth noting what this means: California has given up on the hope of above-market returns from hedge fund investments. There is a reason that public-sector pensions have been pouring money into hedge funds: It's become clear that they are dramatically underfunded. California, for example, is about 25 percent underfunded, according to its chief actuary, with only a 50 percent chance of meeting its 7.5 percent target for annual investment returns.
A state can deal with a pension shortfall in two ways: It can raise contributions, or it can try to get higher returns out of the assets it already has. As mentioned above, this isn't really a strategy that's open to a fund as large as Calpers, but that hasn't stopped Calpers from trying. After a series of grossly irresponsible pension enhancements at the height of the stock market bubble, Calpers tried to make up for the shortfalls by using accounting gimmicks to lengthen the schedule of top-up contributions and pushing into riskier investments.
Now the riskier investments have failed, and the accounting gimmicks were mostly based on the hope that the higher returns would bail Calpers out at some unspecified later date. That leaves the California taxpayer with higher contributions. This has already become a problem with many state and local governments; expect it to become a problem for many more.
That doesn't mean Calpers is doing the wrong thing by getting out of hedge funds; on the contrary, it's recognizing the inevitable, and it's always better to do that sooner rather than later. But it's going to hurt.
Megan McArdle is a Bloomberg View columnist who writes on economics, business and public policy.
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