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Large pension funds have been taking the Serenity Prayer to heart:
God, grant me the serenity to accept the things I cannot change,
And wisdom to know the difference.
Courage to change the things I can,
We cannot control the market. We cannot control the performance of a stock. And we certainly cannot control the performance of a hedge fund. We can, however, control our costs.
As Reuters recently reported, pension funds have been pulling out of expensive hedge funds. The New York City Employees Retirement System (NYCERS) is a case in point. The pension with $51.2 billion in assets as of January 31 pulled its investment from several hedge funds because of poor performance.
This shift away from expensive investment alternatives offers several important lessons to individual investors.
First, fees matter. A lot. Hedge funds are notoriously expensive. A typical fee structure includes a management fee of 1% to 2% of assets under management and a performance fee equal to at least 20% of the fund's annual gains. In other words, the fund wins even if it loses money in any given year, and it wins big if the fund goes up in value.
John Bogle described the effect of costs on investment returns in The Arithmetic of “All-In” Investment Expenses. The conclusion was sobering. The impact of sales loads, transaction costs, excessive cash and expense ratios can reduce an investor's return by more than 2%. And his analysis did not factor in the performance fees typical of hedge funds.
To put these fees in perspective, I ran a hypothetical portfolio through Personal Capital's 401k fee analyzer. Assuming an investment horizon of just 15 years and a relatively small portfolio, a fee of just 0.30% can cost the equivalent of an entire year of spending in retirement.
In the face of high fees, many will argue that what matters most is the after-fee returns. High fees are just fine, they argue, so long as the returns justify the expense. That brings us to the second lesson for investors.
In the world of investing, you get what you don't pay for. While counter-intuitive, the more expensive an investment the more likely it is to underperform the market. According to a 2010
According to Morningstar:
If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.
There are several reasons for this outcome. With high costs, a fund must significantly outperform the market just to break even on an after-fee basis. In addition, expensive funds with active managers often make excessive trades. These trades generate additional costs and, in taxable accounts, can result in capital gains taxes. These headwinds make beating the market over the long term virtually impossible.
Third, some argue that hedge funds are an important part of a diverse portfolio because they mitigate risk through diversification. Diversification, however, is not by itself a justification to make an investment. An investment should be able to stand on its own merits first, and only then be assessed in terms of an overall portfolio. Further, some studies show that hedge funds do not provide the diversification or downside protection some claim.
The siren song of diversification has been sung to steer many to non-traded REITs, variable annuities, commodities, and hedge funds. While these asset classes may serve a roll in some unique situations, the vast majority of investors have no need for these expensive and often illiquid investments.
Finally, one does wonder if the exit from hedge funds is another example of chasing performance. Hedge funds have performed poorly over the last several years relative to the market. Patience runs thin when you combine poor performance with high fees. History tells us, however, that hedge funds will have their day again, even if just for a moment. Will pension funds hire yet another consultant, receive a different opinion, and jump back into hedge funds then? Probably.
