After a series of posts that were rather critical of the media, it seems only fair to praise an article that makes its points succinctly. This week’s Buttonwood column in the Economist discusses hedge funds and pension deficits in the context of the decision of CalPERS to abandon hedge fund investment. It makes for rather depressing, but also very interesting reading.
The most provocative part of the article is the assertion that pension funds allocate assets to hedge funds as part of a “Hail Mary” bet, i.e., a desperate attempt to improve performance to justify their often unreasonable return assumptions. As an example, CalPERS return target is 7.5 per cent, which seems rather ambitious in the current environment. It is indeed rather unlikely that a traditional 50/50 or 60/40 portfolio of equities and bonds will offer more than, say, four to five per cent per annum in USD terms over the coming years. Additional return sources would need to be identified to meet their higher target. But active long only strategies are unlikely to make up the difference.
This is where the attraction of opaque private market investments and hedge funds comes in. Hedge funds, private equity, infrastructure and even insurance linked strategies are rather less well understood than traditional investments; it is often not very clear how their returns are generated. The ignorance about their true characteristics encourages some investors to overestimate their performance potential, which leads to unreasonably high return forecasts. But there are no miracles either in private market assets or in hedge funds; only a minority of them will provide positive added value. Winners always need losers. But maintaining the illusion of vastly superior return potential allows politicians to delay the day of reckoning for public pension funds at least past the next election.
Some people will praise CalPERS for their “courage” to abandon hedge fund investments. But they continue their “Hail Mary” bets with substantial positions in private markets. If one applies reasonable return assumptions, CalPERS’ actuarial position is desperate. Pity the poor tax payers in California. They are not alone but that is never a great consolation (I know, I live in Geneva).