Calpers, the influential California public employee pension agency, announced in September that it would no longer invest its dollars via hedge funds. That decision is not altogether surprising in that the annualized rate of return of the hedge funds in the Calpers portfolio over the past decade was only 4.8%. The behemoth pension fund was careful to note that not all hedge funds are bad, but that “at the end of the day, judged against their complexity, cost, and the lack of ability to scale at Calpers’ size,” the hedge fund investment program “is no longer warranted.”
In essence, Calpers recognized and acted upon what should be apparent to everyone: Hedge fund returns have simply not lived up to their hype. A recent study by Vanguard confirmed that a standard portfolio with an asset allocation of 60% stocks and 40% bonds outperformed almost all hedge funds during the past decade. Moreover, the annualized returns of the HFRX Global Hedge Fund Index (which attempts to reflect the opportunities in the hedge fund industry) underperformed every major stock asset class, and even three Treasury indexes, for the last 10 calendar years (through 2013).
When analyzed on an asset-weighted basis, hedge fund returns are even worse. As Simon Lack documented in his book “The Hedge Fund Mirage,” if all the money that has ever been invested in hedge funds had been invested in U.S. Treasury bills instead, the overall results would have been twice as good. That failure—and it is a monumental failure—is largely on account of outsized fees. The notorious “two and 20” (a 2% fee plus 20% of earnings) makes realizing the outsized gains hedge fund investors expect essentially impossible to obtain in the aggregate, despite a handful of prominent success stories.
Hedge fund apologists will no doubt retort that hedge funds are, naturally enough, designed to be a hedge rather than to outperform traditional investments generically. And at least initially hedge funds were indeed designed to perform differently than the overall market. The sociologist and diplomat Alfred W. Jones coined the phrase “hedged fund” and is generally credited with creating the first hedge fund structure in 1949. Jones referred to his fund as being “hedged” in that his portfolio included both long and short positions designed to limit overall market risk.
The idea wasn’t superior returns nominally, but rather superior risk-adjusted returns. “Any idiot can make a big return by taking a big risk. You just buy the S&P, you lever up—there’s nothing clever about that,” said Sebastian Mallaby, the author of “More Money Than God: Hedge Funds and the Making of a New Elite.” “What’s clever is to have a return that’s risk-adjusted.” Even more fundamentally, the objective was non-correlated returns, positive returns in difficult and bad markets.
But hedge funds haven’t delivered on that promise either, especially lately, since big chunks of money have been flowing into hedge funds. During the tech bubble at the turn of the century, hedge funds often did what they were supposed to do. For example, the Yale Endowment—heavily invested in some of the world’s great hedge funds—performed exceedingly well during that period. From July 2000 through June 2003, while the S&P 500 fell 33%, Yale’s endowment actually gained 20%. Yale’s portfolio continued to perform well until 2008.
However, things didn’t go so well for Yale and for hedge funds generally during the financial crisis beginning in 2008. Yale lost 24.6% in its fiscal year 2009 (compared to an S&P 500 loss of roughly 26% over that time). Perhaps worse, hedge fund investments were highly and surprisingly correlated with traditional equities during the financial crisis. What was supposed to be an important hedge didn’t do its job.