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When Hedge Funds Meet Pension Funds

Are hedge funds dangerous? Depends on who you ask -- and where you look. For most investors, they're no riskier than other assets -- just ask Eastman Kodak shareholders. But this week, the Guardian featured a brief discussion of hedge funds that shines a light on type of investor whose involvement in hedge funds is more questionable: public pension funds seeking higher returns. The first essay -- subtly titled, "Hedge funds: the mysterious power pulling strings on Wall Street" -- provides more heat than light. Author Chris Arnade describes hedge funds as shadowy entities that thrive on secrecy as a means of exaggerating performance in order to earn lavish compensation for fund managers.
The bottom line: investors, sophisticated or not, can't know in detail what many hedge funds are doing. But as long as the mystique exists, perhaps many don’t want to know.
In his response, Timothy Spangler clears away some of Arnade's imaginary fog. As he explains, hedge fund manager compensation isn't all that mysterious.
Hedge fund managers who earn large amounts of money from their clients do so for one simple reason. For every $1 of profit they earn on their client’s account, they get to keep 20 cents. This is called a performance fee. No profits, no performance fees. So the astute manager who turns $100 into $200 gets to keep $20 as compensation. The client gets his or her original $100 back plus the $80 of profit. No profit, no performance fees. Its fairly clear incentive arrangement and aligns interests between manager and client in an unambiguous way.
But Spangler also focuses on a trend that is a problem, one for which investing in hedge funds is merely a symptom.
It turns out that US public pension plans, in an attempt to have the money necessary to pay the gold-plated final-salary retirement benefits to teachers, police, fireman and other government employees have been shoveling as much money into hedge funds and private equity funds as they can. Without these high returns, hundreds of thousands of beneficiaries would not get their checks each month.
Gold-plated retirement packages aside, the reason public pension funds seek such high returns is years of underfunding due to state and local governments paying too little into their pension funds to meet their payout obligations. And they justify this through the use of high discount rates based on overly optimistic investment return projections, usually in the 7 to 8 percent range. That, in turn, encourages pension fund managers to invest in riskier assets in pursuit of higher yields. Yet, while such returns may be achievable on average, they actually need to be achieved year-on-year for the growth of pension fund assets to keep up with that of pension obligations, which grow without interruption. Therefore, given the fixed and certain nature of pension obligations -- that is, they will be paid out regardless no matter what -- pension funds should use a low-risk discount rate, which should be based on investment return projections on low-risk assets, like a 15-year Treasury bond, in the 3 to 4 percent range.