California’s public pension fund, Calpers, is pulling some of its money out of hedge funds. It’s one of several pension funds worried about the high price and low returns of those investments, as the Wall Street Journal reports :
Its hedge-fund investment is expected to drop this year by 40%, to $3 billion, amid a review of that part of the portfolio, said a person familiar with the changes. A spokesman declined to comment on the size of the reduction but said the fund is taking more of a “back-to-basics approach” with its holdings.The retreat comes after many pension funds poured money into hedge funds in recent years in hopes of making up huge shortfalls.The officials overseeing pensions for Los Angeles’s fire and police employees decided last year to get out of hedge funds altogether after an investment of $500 million produced a return of less than 2% over seven years, according to Los Angeles Fire and Police Pensions General Manager Ray Ciranna. The hedge-fund investment was just 4% of the pension’s total portfolio and yet $15 million a year in fees went to hedge-fund managers, 17% of all fees paid by the fund.
This only looks like good news on the surface. We’ve criticized public pension funds for lunging into complicated and expensive vehicles that the boards of these funds (often appointed by politicians and in some cases in cahoots with politicians and union management) don’t always understand. Now, however, they are taking another look at the high fees and the relatively poor performance of many hedge funds, and some are pulling back.
That’s fair enough, and Warren Buffet’s advice to shift to inexpensive index funds makes sense. But the context suggests that denial is still a major factor in the public pension business. What these funds really need to do is to adopt more realistic and less aggressive targets for income. Then cities, states, and towns have two options: either ratchet down future promised benefits to the levels that the funds will actually be able to pay for, or ensure that workers and taxpayers put enough money into the pension funds so that they can fulfill all their promises even if the fund managers don’t strike portfolio gold year after year.
The shift toward realistic goals would allow funds to switch to much more conservative and less aggressive investment strategies, which is what pension funds should have been doing all along.
What’s actually happening is different. After the financial crisis and the recession, and thanks to ultra-low interest rates at the world’s central banks, stocks and other investment assets have risen in price at breakneck speeds. This is an engineered bubble, and regardless of what happens next, it is not a good indicator for the long-term pace of stock market increases (alas). But pension fund managers are looking at hefty increases in their portfolios (more than 10 percent for stocks per year, for example) and thinking that they can have their cake and eat it too—move away from expensive and risky hedge fund assets and get go-go returns from investing in ordinary common stocks.
If only life worked that way. Unions and the politicians who collaborate with them are still in denial about the serious pension problems that American public employees face. Prudent pension fund managers would use recent big gains to reduce the long-term deficits of the funds and reduce their targets for future returns. But prudent management is what America’s public employees don’t have.
Though some of the individual money managers may be prudent and intelligent, the system’s incentives turn the industry into something like a compulsive gambler in a casino. Having lost a few hands at blackjack, and having had a run of luck at the slots, the industry has decided to stay away from the blackjack table and put all its money into the slot machines.
Here’s the problem: Like compulsive gamblers, the fund managers don’t want to quit gambling when they are winning because luck is on their side, and they don’t want to quit when they are losing because they believe that the tide has to turn.