A Concurring Opinion on Rhode Island’s Hedge Fund Foray
The business section of the Sunday New York Times carried Gretchen Morgenson’s critique of the Rhode Island Retirement System’s foray into hedge funds. Although I concur with the conclusions of “How to Pay Millions and Lag Behind the Market,” I think the analysis misses the mark. Ms. Morgenson relies, in part, on a forensic accounting study conducted by Edward A. H. Siedle, the president of Benchmark Financial Services. This spring I wrote about Rhode Island’s foray into alternatives and Mr. Siedle’s attempts to dig out information on their allocations (“Rhode Island is Following South Carolina into Alternative Investment Abyss [April 26, 2013]).
Ms. Morgenson makes the case against Rhode Island’s hedge exposure based upon short-term performance results and the lack of transparency afforded by the state’s managers. Looking at Rhode Island’s performance, Ms. Morgenson writes:
Unfortunately, the hedge funds held by the state have underperformed the overall stock market so far this year. As of Aug. 31, the most recent data available, the Rhode Island State Investment Commission said its 10 hedge funds investing in stocks returned an average of 8.73 percent, while nine so-called real-return hedge funds generated 3.61 percent. Neither matched the 16.15 percent gains in the Standard & Poor’s 500-stock index during the period. [Emphasis added]
Year-to-date investment performance is hardly an appropriate way to measure the efficacy of an investment strategy. Rhode Island’s hedge funds could just have well outperformed the S&P 500, and it would not mean that the hedge fund strategy was warranted or successful. Moreover, the S&P 500 is hardly a valid point of comparison given the very different risks associated with hedge funds. In terms of drawing conclusions from investment returns, we might have a tentative idea about the success or failure of Rhode Island’s hedge fund investments in three year’s time.
Ms. Morgenson also cites Mr. Seidel’s findings that:
found it troubling that state officials won’t require the hedge fund managers they have hired to disclose how they are investing the pension’s money. He also noted conflicts of interest common at hedge funds that may put the Rhode Island pension at a disadvantage to insiders or favored investors.
These aren’t criticisms unique to hedge funds and don’t bear directly on the argument that Rhode Island’s hedge funds aren’t likely to perform well. While complete disclosure would be helpful, it isn’t likely to improve the prospects of Rhode Island’s hedge fund exposure. Many endowments and foundations have achieved reasonable returns from hedge funds without position-by-position transparency. Ms. Morgenson notes that some hedge fund investors may have negotiated preferential rights vis-à-vis Rhode Island on fees, transparency, or other terms. Hedge funds and other private pools of capital are governed by privately negotiated agreements. While Rhode Island might be disadvantaged because they didn’t receive the best terms from its hedge fund managers, there’s no actual evidence for this point.
The real problem with Rhode Island’s hedge fund strategy is that the pension plan has joined the wave of large institutional investors seeking to earn exceptional returns from niche strategies. Unfortunately, the niches disappear when billions of dollars chase limited opportunities. Furthermore, rising interest rates, the very factor public pension plans are attempting to ameliorate, will also weigh on hedge fund returns. Many hedge funds amplify their returns through leverage. The cost of borrowing is likely to rise.
In the end, I doubt that hedge funds will help Rhode Island generate better returns. However, the plan’s short-term investment performance and contractual terms will have little to do with its long-term prospects.