Hedge-fund mediocrity still hasn’t fazed many
Hedge funds have accumulated $3 trillion, with a substantial portion of it coming from public pensions. That these funds don’t deliver outperformance is almost beside the point. What they sell is an inflated estimate of expected returns. This serves a key purpose for elected officials, letting them lower the annual contributions states and municipalities must make to the pension plans for government employees.
It is a dodge that everyone goes along with. When the bill comes due in a few decades, this will cost taxpayers a bundle.
It really is one of the more astounding market inefficiencies that so much money has been allocated to hedge funds. I have no issue with those funds that have consistently beaten a simple investment mix of 60 percent broad equity indexes and 40 percent in bond funds. It’s the rest of group that is so problematic. In much the same way that the world’s worst index fund manages to stay in business, it is a challenge to explain why so much money has found its way to so much mediocre performance. Behavioral explanations can go only so far.
A recent Bloomberg Businessweek story concluded investment managers often share their lofty fees (traditionally 2 percent of assets under management plus 20 percent of any gains) with placement agents who hawk the hedge funds, especially to pension funds. Some states have banned their pension plans from using the agents, but not enough of them have done so.
But this only explains why some people are motivated to go out and sell an underperforming investment product. It doesn’t answer the core question of why so many investors buy them.
As the Businessweek article noted: “Hedge funds that invest in stocks returned 7.2 percent annually from 2009 to 2017, which was less than half the S&P 500’s return, according to data from Hedge Fund Research.” Even if you don’t like the Standard & Poor’s 500 Index as the benchmark, it’s worth noting hedge funds have also underperformed pretty much every other benchmark out there.
If this were small change we were talking about, it wouldn’t be such a big deal. But the scale of the assets allocated to hedge funds is large and getting larger. According to Leland Faust, founder of CSI Capital Management, “More than half of the $3 trillion held in hedge funds nationwide is pension fund and retirement plan investments.”
Whether trillions of dollars or merely hundreds of billions, it is still a lot of money not being put to best use. This only exacerbates the underfunding crisis facing U.S. pension plans. The Economist magazine noted the average U.S. public-sector pension was just 68 percent funded, according to data compiled by the Center for Retirement Research at Boston College.
The continuing puzzle is why hedge funds continue to be so successful in selling their underperforming products, especially to public-pension plans. We have looked at the issue before and have considered the principal-agent problem — in other words, those with no skin in the game make the investing decisions for those who do. Pondering that puzzle has led to a few surprising conclusions.
The best explanation I can find is this: Those who manage pension plans and pools of assets put money in hedge funds based on expected returns, not actual performance. The likely expected rates of return for hedge funds have proved to be works of fiction, fantasies. There simply is no rational basis for making the claim that hedge funds will deliver an expected return higher than equities.
Avocados might be the key ingredient in one of America’s favorite snacks, but here in this rural region of Michoacan, the fruit serves a greater purpose than making guacamole. Avocados help keep a town safe from the violence that is plaguing so much of Mexico.
The financial rewards that have come from producing 80 percent of the avocados imported to the U.S. have led to a citizen council and police force made up mostly of avocado farmers taking back the town of Tancitaro from violent criminals over the past four years.
It’s simple, said Jose Antonio Flores Quezada, 29, a farmer turned policeman: “The more Americans eat guacamole, the better off we are. Avocados are our livelihood.”
Aguacate Sur is a small village within Tancitaro, which spends an estimated $1.2 million annually to fund a quasi-police force known as CUSEPT, a Spanish acronym for Public Security Corps. About half of the council’s funding comes from powerful avocado producers in Tancitaro.
Before the citizens council and CUSEPT existed, ruthless organizations such as Jalisco Generation, New Cartel, Knights Templar and La Familia kidnapped, extorted and killed locals, using profits from avocado farmers to finance their criminal enterprises.
The criminal groups had an “intelligence system” that targeted wealthy avocado farmers, according to an investigation by the newspaper Reforma and Insight Crime, a nonprofit journalistic investigation organization. The criminals used information from Mexico’s now-defunct agriculture secretariat to identify targets to extort.
“These criminals ruled through fear,” explained Jose Hugo Sanchez Mendoza, the head of CUSEPT. “If they wanted to scare people, they’d kill and say this is what happens if you don’t obey. We were a town at the whim of those with guns and without mercy.”
More than 29,000 homicides were recorded last year throughout Mexico, according to preliminary data from Mexico’s Interior Ministry. That’s the country’s highest total since the government began compiling official statistics in 1997. Many towns in a state that’s on the State Department’s highest travel advisory warning have their own civilian self-defense groups. Tancitaro has its own special police force.
Tancitaro’s unusual experiment, which began nearly four years ago, offers a lesson for other regions across the country that are battling crime and violence, said Mayor Arturo Olivera Gutierrez.
“We can’t do this alone,” said Olivera. “I don’t think there’s any place in Mexico that’s safe without civic participation.”
The citizens council’s role has raised fears among some that authoritarian rule is replacing democratic institutions. Not much is known publicly about the council. When in Tancitaro, members were not immediately available for comment. Contacted by phone, a spokesman refused to answer questions, explaining that sharing information over cellphone networks posed security risks. Olivera dismisses those concerns.
“You cannot have security if there is not a culture of citizen participation,” he said, explaining that police enforce state laws. “We also cannot do this in an arbitrary or authoritarian manner. We must work hand-in-hand with the institutions, the laws on the books, whether state or federal, but our citizens must be at the forefront.”
Most Tancitaro residents are connected to the avocado business. In the two months before the Super Bowl, a peak time for guacamole consumption, production at Frutas Finas, one of the biggest manufacturers, soared by 50 percent, said plant manager Hugo Naranjo.
“This is our moment,” Naranjo said. “We’re sending only the best avocados.”