If you work for the city or if you are a city taxpayer, you should be concerned that the ultimate responsibility for the viability of the San Francisco public employees’ pension falls on your shoulders. With that in mind, consider this question: Would you prefer 1,000 additional police officers making our streets safer, or would you rather pay that money to Wall Street hedge fund managers? Do a few rich guys on Wall Street contribute more to our city than 1,000 new city employees?
“…does it make sense to spend 2/3rds of the fire department’s budget on a few Wall Street hedge fund managers? We could hire a thousand more teachers, or a thousand more gardeners, or a thousand more police officers, or doctors and nurses for Laguna Honda Hospital.”
Over the past two years, the Chief Investment Officer for the San Francisco public pension, William Coaker, has advocated allocating 15% of the $20+ billion city pension plan to hedge funds. His rationalization is that hedge funds provide a cushion during a stock market decline and are less risky than stocks.
Opaqueness, Arbitrary Valuations, and Fees, Fees, Fees
What is a hedge fund? Let me provide a hypothetical example: As the theoretical manager of the West Portal Hedge Fund, I will use your public pension plan’s assets to invest $100 million in a package of West Portal businesses including the Empire Theater, Papenhausen Hardware, Barbagelata Real Estate, Trattoria de Vittro, and various others.
There will be many costs that you will incur as the beneficiary of my hedge fund. The first layer of fees will be paid to business brokers, property managers, attorneys, accountants, and of course San Francisco’s pension plan will have to hire more employees specifically to analyze my West Portal Hedge Fund.
The second drag on your pension’s income will be the 2% fee I charge every year on your $100 million investment whether the value of the fund goes up or stays flat. The third layer of fees will be my annual 20% cut on the profits on the West Portal Hedge Fund.
Calculating the value of the West Portal businesses is not a simple matter. If the pension invests in stocks or bonds, we can look at any newspaper and determine its exact value. In contrast, how will we determine the Empire Theater’s profits and its value? The ticket and popcorn sales are easy. But, how do we determine whether the theater building appreciated 5%, 10%, or 15% in value?
First, drop the “we.” As the hedge fund manager, I get to subjectively tell you how much I think the Empire Theater has appreciated. The higher my personal appraisal, the larger the base for my 20% cut.
Mathematically, if the West Portal Hedge Fund earns a 7.5% profit (4% income and 3.5% based on my evaluation), you get to keep $4.5 million and I get to keep $3 million. You risk $100 million, and I get to keep 2/3rds of what you receive without risking a penny.
A hedge fund is not liquid. Unlike a stock or bond, you can’t just sell out of it. And in 20 years, when the West Portal Hedge Fund is liquidated, neither Coaker nor I will be around to answer if the selling price is less than the total of my annual guesses on appreciation.
History of Underperformance:
Mr. Coaker has stated that he will look for the “rock stars” of the hedge fund world that will work for us and continue with a high level of success. This is the same pension plan that recently lost over $60 million ($2,000, per employee), investing in currency hedge funds. Mr. Coaker was asked, in retrospect, which hedge funds he wished he had invested in, but he has remained silent. This makes it hard for us to evaluate how hedge funds can help us. It is easy to predict the past. If a basketball expert cannot tell you he wishes he picked the Warriors last season, how can you trust who he will predict this season?
Both CALPERS, the gigantic California pension plan, and Warren Buffett, the greatest investor of our time, disagree with Coaker’s strategy. CALPERS recently decided to dump their entire hedge fund allocation. Buffett claims that an index fund, running on autopilot, can beat hedge funds because hedge fund fees create too strong a headwind to success. Buffett is so confident in his theory that he has waged a bet that the average hedge fund cannot beat a passive index fund. So far Buffett is winning because over the past five years, the average hedge fund has earned less than a 4% annual return.
We gained more context of hedge funds’ potential with San Francisco’s plan when a union attorney recently published the performance of the “gold standard of institutional investing,” the Yale Endowment Fund. In the union newsletter, the attorney claimed that not using the Yale hedge fund approach caused San Francisco’s pension plan to underperform over the past five years.
Thus, if we substitute the Yale gold standard numbers into San Francisco’s pension, we can compare the Yale performance to Warren Buffett’s simpler advice. While the union’s attorney is correct that Yale outperformed our pension plan, Yale’s high priced Wall Street managers could not beat Buffett’s robot-S&P 500 Index. A passive index fund beat the best minds by an average of 1.5% per year. It’s like Coaker and his proponents are selling us on replacing our reliable car with a Rolls Royce for our two-block commute; and while we are stuck in traffic, we watch our neighbor leisurely walk past us.
If we continue to apply the Yale performances to Coaker’s desired allocation, we can determine how much the Yale style would have cost us in hedge fund fees. For a performance that could not even beat a passive index, we would have paid hedge fund managers $220 million per year. That’s one billion dollars in fees over five years! The entire San Francisco Fire Department’s 2015 budget is $332 million; does it make sense to spend 2/3rds of the fire department’s budget on a few Wall Street hedge fund managers? We could hire a thousand more teachers, or a thousand more gardeners, or a thousand more police officers, or doctors and nurses for Laguna Honda Hospital.
Coaker’s final selling point is that a hedge fund will outperform stocks in a year when the stock market really declines. Remarkably, in the most devastating year during the middle of the Great Recession, the Yale Endowment declined 24.6% while San Francisco only declined 22.26%. San Francisco outperformed Yale in a down year!
Impetus for Hedge Funds:
In fairness to the commissioners on the Retirement Board, they have recently voted to cap hedge funds at 5% of the plan’s assets. And, in fairness to Mr. Coaker, every pension chief investment officer is trying to leverage his performance to obtain a better gig. If you are trying out for a major league baseball team, and you are a small second baseman, you have to swing for the fences to get discovered. Even if you are not a home run hitter, you have to take great risks and to play over your head to get noticed. Steadiness just does not attract attention. Unfortunately, when chief investment officers of pensions swing for the fences, they are playing with other people’s money- ours!!
Lou Barberini is a San Franciscan and a CPA living in West Portal