Life for pension funds is getting tough. The race to the bottom in global interest rates has reduced the rate at which funds discount their future liabilities. Life expectancy continues to surge. Deficits have ballooned.
In response, pension funds are looking to cuts costs, and investment management fees are a relatively simple place to start. This leaves hedge funds - which typically charge an annual fee of 2 percent of assets under management along with 20 percent of performance - high on the kill list. But public relations also appears to be playing a role.
The Dutch pension fund PFZW recent said it was removing hedge funds from their investment portfolios partly because of their “limited concern for society.”
That suggests that politics rather than rational portfolio construction contributed to a series of recent pension fund defections – including the California Public Employees’ Retirement System and Britain’s West Midlands Pension Fund. From a financial perspective, however, divesting from hedge funds looks like a mistake.
There is no denying that pension funds need to take action to trim costs or strengthen returns. The industry’s liabilities have ballooned and asset growth has failed to keep pace. Moody’s estimates that pension funding levels in the United States fell by 8 percentage points, or $201 billion, to 78 percent in 2014. The aggregate pension deficit in Britain doubled. And the continued decline in bond yields in 2015 is likely to make the situation worse.
Even good news is bad news. In the most recent update to United States actuarial tables, it was revealed that the average 65-year-old man can now expect to live to 86.6 years old, a full two years older than in the previous update. This lengthens the period in which pension funds need to make payments. Beyond a certain shortfall, funds will have to start calling their sponsors for more money or they will have to trim payments. The British telecommunications company BT recently announced that it would pour 2 billion pounds into its plan. The governor of Illinois, meanwhile, has proposed capping pension payouts.
On the surface, blaming hedge funds seems to make both financial and political sense. Pension funds can easily find lower-fee investments in equities and bonds, using exchange traded funds, for example. In addition, more ambitious funds could head into equities or other risky assets. For example, Calpers officials announced that they were looking at increasing commercial real-estate investments. That helps explain why pension allocations to hedge funds fell by 25 percent from 2011 to 2014.
There are several potential drawbacks. First, today’s lower interest rate environment does not only increase fund liabilities, it also reduces the prospective returns on passively invested assets. Long-term returns on an investment grade credit index are likely to be less than 3 percent a year in dollar terms, or less than 2 percent a year in euros. Around 16 percent of government bonds already offer a negative yield.
Meanwhile, with equity valuation levels in line with, or even above, long-run averages, the returns on equities are likely to be in the high single digits, at best. In a diverging world, volatility may increase further, too. Real estate is no silver bullet, either. The yield on prime office space in cities like Hong Kong, New York and London has dwindled to below 4 percent, down from around 6 percent in 2008. And increasing risk levels may not be the most responsible use of sponsors assets.
Although they clearly charge higher fees than passive funds, hedge funds have shown that they can deliver positive performance even after taking these challenges into account. A balanced portfolio of hedge fund strategies has delivered an average post-fee performance of 5.3 percent over the last 10 years.
Importantly, some strategies have a relatively low correlation to bonds or equities, too. Macro funds, for example, have seen just a 32 percent correlation to equities over the last 10 years, suggesting that decent returns can be repeated, even in an environment of low returns from mainstream financial assets. And, in any case, hedge funds have delivered higher returns than most pension funds have been able to – an average of 3.6 percent for the three years that ended March 31, according to the investment management firm Wilshire Associates.
High fees and political considerations have made hedge funds unpopular among some pension fund managers. But for pension funds, maintaining returns to meet their needs remains their No. 1 priority. A knee-jerk response to cut out hedge funds could prove costly in the long run.
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