Ritholtz on Hedge Fund Mediocrity

According to Bloomberg columnist Barry Ritholtz, hedge funds are selling public pension funds “an inflated estimate of expected returns,” adding that “it is a challenge to explain why so much money has found its way to so much mediocre performance.”

He cites findings reported by Bloomberg reflecting how “investment managers often share their lofty fees 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, while this might explain what motivates the sellers, Ritholtz points out that it doesn’t explain the buying.

Ritholtz highlights what he calls the “principal-agent problem—in other words, those with no skin in the game make the investing decisions for those who do.” Specifically, those who manage pension plans, he argues, put money into hedge funds based on expected rather than actual returns. “The likely expected rates of return for hedge funds have proven to be works of fiction, fantasies made up out of whole cloth. There simply is no rational basis for making the claim that hedge funds will deliver an expected return higher than equities.”

In the end, Ritholtz contends, taxpayers are the losers. “The result is a ticking time bomb that will go off at some point and that can only be dealt with through either unimaginable tax increases or stiffing government employees who worked hard in the expectation they would have enough money for a secure retirement.”