2015 saw hedge funds post the worst returns in the industry’s history since the 2008 financial crisis. Wrong-way bets in the high yield credit, emerging markets and other volatile assets, amidst tightening liquidity conditions and deterioration in global economic growth, led to the death knell of such heavyweights like Bain Capital’s Absolute Return Fund ($2.2 billion AUM), Fortress Macro Funds ($2.3 billion AUM) and BlueCrest Capital Management ($7 billion AUM). Moreover, even the once-infallible Pershing Square has suffered staggering losses owing to its sizable stake in controversial pharmaceutical firm Valeant Pharmaceuticals Intl Inc. (VRX).
The lackluster results of the hedge fund industry as a whole have led to many financial heavyweights, notably Warren Buffett, to publicly decry the 2-and-20 fee structure charged by active money managers for their services. Buffett’s sentiment seems to have been shared by even the most ardent active-oriented investors, as the first quarter 2016 saw fund redemptions at a level not seen since the 2008 financial crisis. With such a high degree of risk for so little reward, it begs the question as to why pension funds--arguably some of the safest and most risk-adverse financial institutions along with insurance providers--are still investing in the volatile hedge fund space.
The Case for Hedge Funds
The motivating factor behind the decision of some pension funds to stick it out with active money managers can be attributed to the low interest rate environment and the increasing life expectancy of the average person. As reported by the New York Times, pension funds are forced into seeking increasingly aggressive return strategies, as loose monetary policies have reduced the rates at which funds discount their liabilities. Moreover, these payout increases are coupled with falling pension funding levels and rising life expectancies; the NYT cites Moody’s estimates of an 8 percent drop in pension funding for 2014, while the average American male can now be expected to live until for 86.6 years, up 2 years from a previous figure. Lower interest rates have also weighed negatively on the returns of passive indices, such as an investment grade credit index, as sub-zero yielding bonds have exploded in volume across the global fixed income space. Real estate returns also have not fared much better: returns on prime office space in commercial hubs like Hong Kong, New York and London have dwindled to 4 percent, down from 6 percent in 2008.
Therefore, it would appear that the partnership between pension and hedge funds has been borne out of necessity due to the current macro-economic situation.
The Bottom Line
The last few quarters have been a tumultuous time for hedge funds. Increasing volatility across the global capital markets have led to industry-wide redemptions, not seen since the financial crisis. Yet despite these risks, pension funds continue to support active managers to meet aggressive growth mandates in the face of falling yields and the increasing life expectancies of pensioners.