Goodbye (and Good Riddance) to Kentucky’s Hedge Fund Investments

The Kentucky Retirement System’s (KRS) investment committee recently announced plans to remove hedge funds from the pension system’s portfolio. If successful, this would completely eliminate hedge funds—currently about 10% of KRS’s portfolio—from the retirement system’s investment mix by 2019. Taxpayers should be breathing a sigh of relief.

As of June 30, 2016, KRS and Kentucky’s Teachers’ Retirement System (TRS) each reported annual losses 0.5% and 1%, respectively. These numbers are disconcerting given both plans have a long-term assumed average annual return of 7.5%. The return rates are even more concerning in light of the fact that the benchmarks for KRS and TRS were negative 0.2% and positive 1.5%, respectively, so despite a very low bar, the systems still failed to hit their targets.

The returns for KRS and TRS are a weighted average for returns across several asset classes. For example, on a positive note KRS’s investments in real estate had a positive return of 9.2% as of June 30, 2016. At the same time, TRS’s investments in domestic equities lost 1.8% during the past fiscal year. So in any given year different asset classes will be winners or losers for the pension system’s portfolio, with a total return reflecting the efficacy of a plan’s investment strategy.

Unfortunately, hedge fund investments have consistently been in the loser category for KRS.

Earlier this year, state legislators have roundly criticized one fund, Prisma Capital Partners’ Daniel Boone Fund, which lost KRS 8% of its investment during the 2014-15 fiscal year. And despite this performance — one of the lowest-performing assets in KRS’s portfolio —the KRS board of trustees voted to allocate 5% of assets to the fund earlier this year, up from 3.3% last year.

It’s no mystery why KRS has been investing in hedge funds and other exotic assets over traditional assets like bonds and domestic equity. KRS currently assumes a 7.5% rate of return, an unrealistic assumption for any portfolio made up of safer assets. To (attempt to) meet these assumptions, fund managers opt to invest in assets like hedge funds that offer higher returns, but at substantially higher risk.

In 2010, less than 1% of the KRS portfolio was invested in the hedge fund sector. That has grown to a total of 10% in hedge funds and 10% total in private equity in 2016. Yet between the fiscal years ending 2011 and 2016, the cumulative returns from hedge funds for KRS has been 3.93%.

The Issue is Transparency

However, this is not to say that privately developed investment strategies are inherently problematic. The hedge fund industry has obviously had its share of wild success, as some hedge funds are able to “beat” the market by leaps and bounds. In 2015, the top performing hedge fund, Perceptive Life Sciences, netted a 51.8% return. Other top hedge funds saw returns above 20%.

And having hedge fund managers invest pension assets has worked out for other plans. Since 2010, 50 more state plans have added hedge funds to their portfolio, increasing the total to 282. The average hedge fund allocation has also increased during this period, with systems allocating an average of 9.2% of assets, up from 7.5%.

The issue is whether public sector pension plans should be allocating any assets at all to fund managers where there is a lack of complete transparency.

Because Prisma is a hedge fund, it does not need to publish its investment portfolio. This practice is defended as a way to protect their investments from competitors — and understandably so. But that may very well disqualify hedge funds from being part of the investment strategy used on a pool of assets for which taxpayers are the effective backstop for losses. While Prisma does allow “key decision-makers” to request a private briefing, there isn’t the ability for the general public to scrutinize the investment decisions in the same way that is possible with much of the rest of the portfolio.

The Risk of Alternative Investment Strategies May Not Be Worth It

The reality is that though some hedge funds create a splash with their strong returns, the same isn’t always true for the industry as a whole. According to the 2016 Preqin Global Hedge Fund Report, across the board, hedge funds only netted returns of 2.02%, with many reporting substantial losses.

Thus, there is a certain degree of expertise that a public plan needs when assessing how to allocate assets amongst hedge fund managers and strategies. The risks investment managers at KRS might take with pension plan assets may not be inline with the risk tolerance of the taxpayers backing those assets. But without transparency on the overall investment strategy, it is difficult for taxpayers and voters to hold accountable their elected leaders who appoint the investment managers in the first place.

And unfortunately, not every pension plan has the internal expertise needed to do a good job allocating assets to non-transparent investment strategies.

A Cliffwater LLC report found that two thirds of pension systems that invested in alternatives outperformed a simple 65/35 mix of stock and bond index funds. But KRS and other pensions systems were not so lucky. The report accredits this gap to differences in the capability of different pension systems, stating that certain pension systems “just appear more effective in implementing asset allocation compared to others.”

How is such variance possible? To begin, beating the market is difficult. It requires specialized knowledge that can be challenging for fund managers to acquire. A 2009 study found that only those performing above the 90^th percentile of actively managed hedge funds were able to beat the market through skill. The rest, they found, failed to outperform a large number of randomly simulated hedge funds. The authors considered these to be the “lucky” investors.

Additionally, when trying beat the market, hedge funds can find themselves underperforming or even making losses through investments that don’t pan out. Because most investors rely on news sources the public can access (anything else would be insider trading), their only way to beat the market is to act on information more quickly rather than act on “better” information. This is why many investors themselves include low-cost index funds in their own portfolios. Very often, the additional fees that come from active management simply aren’t worth it.

Diversification is For the Private Sector; Low Risk Stability is For the Public

Proponents of investing in hedge funds argue that increased investment in hedge funds is good for institutional investors like pension funds on the grounds that diversification is an important way to hedge against losses. While portfolio diversification is important, diversification for diversification’s sake is not a sound strategy. Called “di-worse-ification” by investors, shifting investments towards riskier asset classes needlessly exposes funds to more risk — and in particular erroneously exposes taxpayers to unaccounted for risk. The prudent strategy would be to diversify within safer asset classes. It’s wiser for public plans to invest in a variety of equities and bonds across different industries to protect against one firm or sector’s sudden downturn rather than risk some of the portfolio on high variance assets.

Unfortunately, many pension funds still feel pressure to make these risky investments to chase unrealistically high assumed returns. Lowering the assumed rate of return means making other tradeoffs to fully fund the pension system. But moving out of risky assets the Commonwealth has a poor history with is a step in the right direction to address the misfortune that KRS currently faces. Revising assumptions so they better reflect a market where low returns are here to stay minimizes the chance investment in volatile assets leaves KRS, and other systems, worse off than before.