With the hoards of investment products available, one often gets carried away with the glib talk of top analysts and investment managers. We have seen how wealthy Indian investors have fallen prey to fancy portfolio management schemes and have ended up with losses. Similarly, hedge funds in the US are made available to certain sophisticated or accredited investors having a net worth of over a million. As the name suggests, hedge funds guard against market declines and are to produce consistently positive returns, irrespective of the direction of the overall market. As lucrative as it sounds, hedge funds are riddled with high costs and inconsistent performance.

 

California Public Employees’ Retirement System, or CalPERS, the largest public pension fund in the US, with approximately $300 billion in assets, recently announced that it will exit 24 hedge funds and six hedge fund-of-funds valued at approximately $4 billion. “Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size, the Absolute Return Strategies program (the hedge fund program) is no longer warranted,” said Ted Eliopoulos, CalPERS interim chief investment officer.

 

According to Bloomberg, CalPERS earned only an average 4.8% annually in the last 10 years from hedge fund investments. This return is a full two percentage points below the target return of 7.5% on its investments of public funds. But that was not the main reason; the pension fund paid $135 million in fees for the year ended June 30 for hedge fund investments that earned 7.1%, contributing 0.4% to its total return, mentioned the Bloomberg report.

 

The question arises as to whether hedge funds are able to add value consistently? A study on hedge funds has pointed out that hedge funds are unable to provide persistent performance over long periods. In an investigation of 4,314 hedge funds by Martin Eling, director of the Institute of Insurance Economics at the University of St. Gallen (Switzerland), found that there is short-term persistence in performance of up to six months. The return persistence weakens as the measurement horizon lengthens. The researchers add that even the short-term performance cannot be exploited by investors due to lock-in periods and exit loads.

 

He cites other research with the same findings. Entry and exit into active management involves high costs and learning about manager skill takes time, thus selecting the right manager becomes a very important issue. This is especially so in case of hedge funds as they specify significant lock-in periods. This implies that the investors need to have sufficient information about the performance of hedge funds over a long period before committing their money to hedge funds. Hence, the issue of performance persistence becomes especially important in the case of hedge funds.

 

The period of persistence of a few months is rather short compared to mutual funds, which have averaged about two years in return persistence. This may make it difficult for investors to take advantage of the short-term persistence.

 

CalPERS with its team of investment professionals would have thought they would be able to pick the best hedge funds. However, in over a decade they realised that they were unable to pick the right hedge funds and ended up paying high costs. A lesson to be learnt, don’t chase fancy products, you just need a few products to grow your wealth safely and smartly.