|Investment||1-Year Return||Value of $1M Investment||10-Year Return||Value of $1M Investment|
|CALPER’s Hedge Fund||7.10%||$1.071M||4.88%||$1.6M|
|MSCI All World Index||21.70%||$1.217M||10.44%||$2.7M|
|Vanguard Total Stock Market ETF||18.30%||$1.183M||9.95%||$2.6M|
|Conservative Index Funds||14.50%||$1.145M||8.60%||$2.3M|
There’s been a lot of news lately that California Public Employees’ Retirement System (Calpers) — the second largest public pension fund in the United States with more than $250 billions in assets — announced on Monday that it is dumping all of its $4 billion in hedge fund investments over the next year.
Here’s some commentary from Market Watch columnist Brett Arends who offers this advice: “Be like Calpers: Dump your hedge funds“:
Hedge funds are a racket. They are great news for the people managing the funds, as they earn big, fat fees. They are usually a poor deal for the investors.
Just take a look at the case of the California Public Employees’ Retirement System (Calpers), which has just announced it is dumping its investments in these funds. Calpers says its hedge fund investments earned 7.1% in the 12 months to June 30. For that performance, it paid $135 million in fees to the managers.
An investment in the MSCI All World Equal Weight stock index would have earned 21.7% over that same period (see table above) — and even someone who picked a random sample of world-wide stocks stood a good chance of beating the hedge whizzes.
Over 10 years, Calpers says, their hedge funds earned a compound return of 4.8% a year. That’s enough to turn a $1 million investment into $1.6 million. But over the same time the MSCI All World Equal Weight portfolio earned 10.44% a year. That’s enough to turn that $1 million into $2.7 million.
In other words, if Calpers had shunned hedge funds completely and randomly picked a big basket of stocks from around the world, chances are that their investment profits would have been nearly three times as great. (The bigger the basket, the more likely it is to approximate the overall return of the market.) Gotta love that hedge fund expertise, don’t you? Wow, those quantitative analysts and their computer models are just so, so amazing.
Some people will argue I’m being unfair. A broad collection of stocks isn’t risk-managed, they’ll say. When you buy all those stocks, many of which are quite small, you’re getting higher returns but you’re taking on more volatility.
OK. Let’s try a different portfolio. Let’s say you wanted a more conservative, risk-managed portfolio. Try this for size:
20% Vanguard Total (U.S.) Stock Market index fund
20% Vanguard Developed (International) Markets index fund
20% iShares MSCI Emerging Markets index exchange-traded fund
20% Vanguard Long-Term Treasury index fund
20% Vanguard Inflation-Protected Securities (TIPS) index funds
It’s hard to get a simpler risk-adjusted portfolio than that. You’ve got 60% of your money in stocks — split equally between the U.S., developed overseas countries, and emerging markets — and the other 40% in bonds, split between long-term Treasurys (in case of deflation or crisis) and TIPS (in case of inflation). This is a common, garden-variety portfolio. There is no hindsight genius involved. The only activity required is rebalancing once a year, on June 30, to restore the equal weights.
How did it do? In the 12 months to June 30, while Calpers’ hedge fund geniuses were eking out 7.1%, this portfolio earned more than twice as much, or 14.5% (see “Conservative Index Funds” in the table above). Over 10 years, while the hedge funds were earning just 4.8% a year, this portfolio earned a healthy 8.6% a year—with minimal risk.
That’s enough to turn $1 million into $2.3 million. In other words, four Vanguard funds and one ETF from iShares, bought online and simply rebalanced once a year, earned twice the profits of whatever geniuses Calpers found.
Note: I added the Vanguard Total Stock Market ETF to the table above for another point of comparison.
Brett Arends comments on hedge funds in general:
Hedge funds typically charge you about 2% of your assets in fees every year, plus 20% of the profits (but not the losses), if any. Those fees eat up huge amounts of any profit. Investors who think they are going to beat these high hurdles are probably living in fantasyland. Since 1928, U.S. stocks have generated compound returns of around 10%, and long-term Treasury bonds around 5%. The typical balanced, 60-40 portfolio of stocks and bonds has therefore earned around 8% a year on average.
But if a hedge fund that invests in these stocks and bonds charges 2% a year in fees plus 20% of profits, then it will need to generate gross returns of 12% a year just to keep up. In other words, your hedge fund manager will have to beat the market by a 50% margin—i.e., earning 12% when the market earns 8% — just to cover his fees. You won’t gain anything extra unless he beats the market by more than 50% each year.
MP: In other words, if you are willing to pay hedge fund managers (or active managers) thousands of dollars so that they can invest your money at lower returns than index funds and basically lose money for you compared to the market, here’s an alternative investment strategy with the same outcome: Invest yourself in a portfolio of low-cost index funds. And then once a year have a big bonfire in your backyard where you burn up as many $100 bills as it takes to represent the money you gained from index investing vs. a hedge fund investment. For Calpers’ $4 billion investment in hedge funds at 7.1% over the last year vs. 14.5% in a conservative index portfolio, the annual loss from the hedge funds would be $296 million — that would have generated 2.96 million $100 bills for the annual Calpers bonfire!
HT: Warren Smith