Hedge Funds’ Performance? Volenti non fit injuria

Date: Thursday, August 30, 2012
Author: Theodore Brailey, Hedge Fund Insight

(Latin: "to a willing person, injury is not done")

Many years ago, when I was but a hedge fund neophyte in short trousers (for it was Summer), I attended a weekend conference at Oxford University. I retain two memories from that weekend; the first was my introduction to Fannie Mae and Freddie Mac (even then everyone knew the implicit guarantee would have to be made explicit), and the second was a comment by a maths professor who ran a hedge fund on the side, which was, “Never has so much be made by so many from so few”. Apart from being surprised that an educated man would think it humorous to rehash Churchill, I was taken aback by the unabashed greed, but then I have never worked on the sell-side.

The rules on investor eligibility mean hedge fund investing “is not by any enterprised nor taken in hand unadvisedly or lightly; but reverently, discreetly, advisedly, soberly and in the fear of God, duly considering the causes for which alternatives are ordained”. The hedge fund industry has no case to answer against the recurring charges of non-performance and self-enrichment at the expense of clients. Those who invest in hedge funds willingly undertake the investment and operational risks implicit in the niche money-making schemes of the stinking rich. All of the usual criticisms, e.g. the fees, the hidden beta, the lock-ups, the illiquid holdings and the spraying of chic joints’ walls with Tattinger, are all disclosed in the offering documents and/or are writ large in the industry’s track record, which is getting on for thirty years as an investment style. Whatever gripes the poachers-turned-gamekeepers have, and they are all valid, it remains the case that “He who lies down with a dog will rise with fleas”.

The performance scandal is in the developed world’s pension fund industry. Data from the OECD[1] show that for the decade ended 31^st December 2010 the real return for the national pension fund for the UK was 0%, the United States’ real return was -1.8% and Switzerland’s 1.2%. The pension funds in these countries are significant industries, as their size as a percentage of GDP indicate. The accompanying chart shows the real return over the decade ended December 2010, for a selected list of OECD countries against the size of the pension fund as a percentage of GDP (all data in US dollars and garnered from the OECD website)

Unlike hedge funds, which are sold to a minority of investors who self-certify themselves as sophisticated (volenti non fit injuria), pension funds hold the savings of those trusting souls without pretensions to knowledge of finance and who take advice given to them by professionals. So if the real return was zero in the UK, where did 10 years of monthly national contributions go? Well, there’s inflation – that’s the government’s take. And of course there are fees for advice, portfolio management, stock research (alpha anyone?) and the service providers who administer pension funds. An industry that absorbs all profits and provides a nil value service to its customers is not a industry with growth prospects. The pensions industry is going to have to lower its fees and produce as required, or investors are going to start managing their own retirement.

The potential for an even greater disaster is implicit in the yields available on sovereign debt for supposedly risk-free investment. Of course, the geniuses who coined the term “risk-free” for Western sovereign debt were trained to be blind to inflation as a means of liability repudiation. This willful ignorance of inflation as a wealth expropriation mechanism allows savers to have their retirement accounts raided unseen by their governments. The high priest of inflation, J.M. Keynes, acknowledged as much when he said,

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.”

Of course there is nothing arbitrary about the confiscation through inflation, and Keynes knew it, but since he was a happy beneficiary of it he kept mum. With G7 10 year yields at 1.5% or less, how can any pensioner, or anyone without at least two decades ahead of him (one decade isn’t enough, see above) invest safely for their retirement? Few private sector workers have a sufficient pension fund to live on an income of 1.5% from it. The data on central banks’ balance sheet expansion are  staggering, if translated into implicit price rises. Should yields rise, bonds will suffer substantial capital losses. The best retirees can hope for is that the Great Recession continues for another 10 or 20 years, so that like the Japanese they see nominal prices fall. Of course, that implies a debt deflation and constantly rising unemployment. But without economic growth the massive unacknowledged liabilities of the public sector will overwhelm the productive capacity of the country to support them – a process which started with the PIGS but will arrive on Britain’s shores in the next 10 years.

Hedge funds’ returns are a mote in the investing eye, but the beam that the pension fund industry lobbyist considerest not is the abysmal performance of 90% of global retirement savings because of all participants’ cupidity. Pension managers and service providers must re-orient themselves to retirees before their customers walk away.