By Michael Oliver Weinberg
Recently there has been a great deal of press critiquing at least one state pension plan's hedge fund investments because of the fees it is paying on them. The populist sentiment is that high fees enrich hedge funds and diminish returns. That conclusion is flawed. The treasurers and chief investment officers who invest in hedge funds are fulfilling their fiduciary obligations and enabling pension plans to better meet their funding goals.
Hedge fund fees are not low on an absolute basis or compared with traditional passive investing, but on a risk-adjusted basis over a market cycle, we do not believe they are unwarranted, and would rather pay higher fees for higher net returns than lower fees for lower net returns.
Hedge fund critics will assert that hedge funds have, on average, underperformed the long-only indices this year and in the four years following the end of the last bear market. What the critics are missing is that it is not at all surprising that hedge funds would underperform long-only indices in a bull market. Hedge funds, by definition, are hedged. In a bull market, a short component is an inherent drag on performance, but it will result in outperformance during market corrections and bear markets, and result in outperformance over a market cycle.
You might question the sanity of paying higher fees for underperformance during a bull market, but one must consider the importance of capital preservation in bear markets and the simple mathematics of compounding. In 2008, the S&P 500 (including dividends) lost 37%. The Credit Suisse Broad Hedge Fund Index was down 19%. An investment in the S&P required a near-60% gain to recover, while the hedge fund index required only 25% gain to recover. And while many hedge fund managers were collecting management fees following losses, they were not collecting incentive fees until they re-attained their high-water marks, aligning their incentives with their investors'.
When I was investing in hedge funds, one of the most important risk rules I followed was to almost entirely take risk off the table when approaching a loss of 20%. The rationale was that if one is down 20%, achieving a 25% return to break-even is challenging but viable in a reasonable period of time, say 11% per annum for two years. However if one is down 37% and needs a 60% return to break even that would take roughly 4.5 years at 11%.
Those who are opposed to pensions investing in hedge funds due to their higher fees presumably prefer traditional investing, either active, with its higher fees (though lower than hedge fund fees), or more likely passive investing, with the lowest fees. I'm not averse to traditional investing, either active or passive. Each has its advantages and disadvantages. However, the primary flaw with relying on traditional investing is that one is entirely reliant on markets going up, or positive market beta, to achieve returns.
In the past decade, I've spent a great deal of time investing in alternatives for global pension plans, including Japanese pensions. The Japanese market peaked nearly a quarter of a century ago and has since declined about 65%. At 10% per annum, one would need nearly 11 years to break even. Japanese hedge fund indices started tracking performance too late for me to make a valid comparison for that full period, but the Eurekahedge Hedge Fund Japan Index was up about 130% from 2000 through mid-2013. In that same period, the Dow Jones Japan, a traditional index, was down about 10%.
This is one of the flaws with traditional investing, particularly passive investing: it is entirely reliant on positive market beta. Over long periods markets may achieve no returns or negative returns, so though one may have successfully minimized fees through traditional passive investing, one has actually lost money (or made very little) over a long period. Due to their short exposure, hedge funds have the ability to earn a profit during market corrections and prolonged bear markets. Consequently, my Japanese pension clients who had the courage and foresight to invest in alternatives achieved substantial positive returns while traditional low-fee passive investors lost money. Paying lower fees would have been a Pyrrhic victory.
If hedge funds achieve the same return as the market but with slightly less risk, from a modern portfolio theory perspective that implies that one can favorably shift one's efficient frontier and achieve the proverbial free lunch, the same return with less risk. Or if hedge fund achieve higher returns with less risk or the same risk, this too implies that through the addition of hedge funds, one can again achieve a higher return with the same (or less) risk.
To cherry-pick a year or even a multiyear bull market and state that over such periods hedge funds have underperformed the indices, and charged higher fees, is neither surprising nor disappointing. It's to be expected and doesn't invalidate the investment premise or advantage of adding hedge funds to a traditional portfolio. Hedge funds differentiate themselves from traditional long-only indices over a market cycle, which by definition includes a bear market. As evidenced by the aforementioned Japanese example, hedge funds particularly differentiate themselves over prolonged bear markets. Over market cycles is when the relative capital preservation, ability to achieve positive returns irrespective of a declining market, and simple rules of compounding result in higher rates of return, or even positive rates of return while indices may achieve negative rates of return.
Given the choice between investing a pension in lower fee traditional investments or a blend including higher fee hedge funds, based on two decades of investment experience in both traditional investing and alternatives, and through multiple bull and bear markets, I would choose the portfolio with the hedge funds. Populist anti-hedge fund sentiment is detrimental to pension returns.
Michael Oliver Weinberg is an adjunct associate professor of finance and economics at Columbia Business School and the chief investment officer of MOW & AYW, a family office. He was formerly global head of equity and event allocations at FRM, the multistrategy fund of hedge funds, where he was also on the investment and management committees.
See also: Why equity long/short investing is not dead and never will be