The State of New Jersey is paying some $600 million in annual fees to hedge funds and private equity firms to have large portions of their pension system’s funds managed.
The rationale behind pushing into hedge funds in 2010 was that traditional portfolio strategies weren’t going to work anymore and hedge funds would add several percentage points to annual performance.
A 2010 memo by the State Investment Council’s consulting firm said “alternative investments have significantly outperformed public markets on a risk-adjusted basis, and we believe they will continue to do so over the long term.” Grady argued the strategy would “maximize returns while appropriately managing risk.” And Institutional Investor magazine reported that the state’s hedge-fund consultant “predicts that the pension could earn an additional 3 percent return above traditional asset classes from a diversified portfolio of alternatives.”
Of course, in the five years since then, the exact opposite has been true – both stocks and bonds (traditional asset allocation) have ripped the cover off the ball while a plain vanilla 529 Plan has crushed the hedge fund indices.
New Jersey’s new rationale for having a large allocation to hedge funds has changed over the last five years now that the original thesis failed. These days, instead of talking about above-average returns, they’ve shifted to the always convenient “risk management” and “volatility reduction” pitch:
Facing intensifying scrutiny of high fees and weak returns, New Jersey pension officials have defended their push into alternatives by claiming those assets are designed to reduce volatility and hedge against downturns. That rationale, though, is a marked shift: when Christie officials originally began plowing more retirees’ money into Wall Street firms, Christie’s administration and their financial consultants promoted the move as a way to boost returns over and above those that could be gleaned from low-fee stocks and bonds.
It’s clear to me that NJ’s financial consultants do not understand the relationship between risk and return. Hence the mission creep.
Higher returns than the stock and bond markets offer requires greater than average risk. It requires concentrated positions, financial leverage or savvy market timing. Otherwise, it isn’t possible. Lower than average risk means lower returns – but that can be achieved with a much more low-cost set of tools.
So which is it – are you using private equity and hedge funds to beat the market or to lower volatility? Can’t have both at the same time, especially not when you’re paying performance fees on top of (or instead of) the alpha that may or may not be generated.
One can easily use a low-cost diversified portfolio to achieve a lower risk, lower return objective without having money locked up in private investments. It just means the committee meetings will be less interesting and there’ll be significantly less beard stroking.