The Dangerous World of Hedge Funds Part II

Yesterday I discussed the Wild West culture of hedge funds, and how it makes fund managers rich while often not doing nearly so well for clients.  Of course, conventional wisdom depicts a financial world divided into two cultures with different paces and investment channels – one staid, conservative and security-oriented; the other a frenetic, testosterone-filled “I win, you lose” free-for-all.  Money stays put and grows modestly and safely in the first culture.  But in the second, our cash exits our pockets much more rapidly.

My mother-in-law was clearly at home in the first culture.  A dedicated elementary school teacher, she took a dim view of her daughter’s entrepreneurial efforts.  “Stay an employee at one job for your entire career and collect your pension,” was her fervent advice each time my wife started a new business. It’s fair to say she, like most workers of that era, regarded a pension as hard-earned security to which they were entitled after a lifetime of service.

In the second culture, you have hedge funds – gargantuan pools of investment capital that rapidly multiply and then quickly disappear.  But contrary to what you might assume, and maybe the laws of good sense (if they haven’t been repealed) these two money cultures have not been separate and discreet.  In fact, they’ve been joined at the hip for fifteen years.

In 2001, the California Employees’ Retirement System (CALPERS) began forking over its participants’ nest-egg cash, by the billion, to various hedge funds.  Come on, you didn’t really think hedge fund players can build their multi-billion-dollar empire the old-fashioned way, with ten or twelve fast-talking salesmen dialing one middle-income investor at a time? That’s no way for a millennial hedge-fund employee to become obscenely rich, is it?

Wake up and smell the coffee! According to reporters at Bloomberg, who have repeatedly investigated the issue, in 2015 gross hedge fund assets under management exceeded three trillion dollars. Hedge funds are regularly loading their coffers from, among other opulent sources, the proceeds of public employee pensions.

Thankfully, two large pension funds, CALPERS, and the New York City Employees Retirement City System (NYCERS), have become disenchanted with their respective hedge-fund investments. They’ve felt cheated because of the fees fund managers have charged them, and with those same funds’ gross underperformance in the marketplace.

In her talk to NYCERS board members, New York City’s Public Advocate Letitia James acidly said, “Let them sell their summer homes and jets, and return those fees to their investors.”  Interim Chief Investment Officer of CALPERS Ted Eliopoulos also objected to hedge funds’ exorbitant fees.  In 2014, he commented, “One of our fundamental investment principles is that cost matters,” adding that hedge funds are “an expensive investment vehicle, especially at our scale.”

Public employees are too conservative a group to be playing a wild and crazy game with their retirement accounts. Hedge funds practice sophisticated financial techniques like shorting the market (speculating on the downside of stocks) which unsophisticated investors don’t understand.  The irony is most hedge funds require that individual investors be accredited, which, as outlined by Investopedia, means they:

1) earn an individual income of more than $200,000 per year, or a joint income of $300,000, in each of the last two years and expect to reasonably maintain the same level of income.

2) have a net worth exceeding $1 million, either individually or jointly with his or her spouse.

3) be a general partner, executive officer, director or a related combination thereof for the issuer of a security being offered.

So if you’re a wealthy, sophisticated investor you know what you’re getting into with a hedge fund.  But if you’re a schoolteacher or a firefighter, you could have money you can’t afford to lose handed over to the caprices and thrill-seeking of hedge-fund-land – without your even realizing it.

In fact, the Bloomberg report is less optimistic that any hedge-fund client fully understands what he’s gotten himself into:  “One wouldn’t imagine that a market pitch built around ‘Come for the poor performance; stay for the excessive fees’ would work. And yet the industry continues to attract assets.”

Unfortunately, many of those assets will continue to come from pension funds. According to the hedge-fund consultant, Agecroft Partners, LLC, “[P]ension plans will significantly increase their exposure to mid-sized hedge funds over the next 10 years.” We can only guess if pension funds continue to make this mistake, it’s because of the funds’ management’s disappointment in market returns in general, and are either desperately hoping for a magic pill or gullibly buying the hype.

Do you see why I continue to suggest you not depend on your pension fund or some market-dependent portfolio to protect your nest egg?  A retirement account that gives you as much protection as you choose from tangible assets like physical gold will give you a degree of independence from Wall St. daredevils.  At least you’ll know when you do, all that glitters is what you originally paid for, and you’ll always have that tangible asset to protect your paper assets.