Bonfire of the Hedge Funds
Hedge funds have been in the news recently, and in movies and TV series, but palm branches are no longer being tossed in the path of their managers. In Michael Lewis’ The Big Short, the riveting book and movie about the collapse of Wall Street, the protagonists of the story include two unknown hedge fund managers who shorted the shadowy sub-prime mortgage mess and housing bubble. It’s a bit comedic at first but the story line takes a dramatic turn with the failure of two Bear Stearns hedge funds that bet the wrong way on housing.
The goal of most hedge funds is to reduce volatility and risk while preserving capital and delivering positive returns under all market conditions. When used properly, hedging as a market buffer is prudent.
You can’t follow hedge funds these days, however, without noticing a lot of horror stories. It’s like the Bonfire of the Vanities all over again, except that the 21st Century “Masters of the Universe” greatly overshadowed the 1980s Wall Street bond traders and investment bankers portrayed in the Tom Wolfe novel. Yet, the new Masters have watched in disbelief as some of their heirloom, bespoked firms provided the fuel for 2010s bonfires:
In October, hedge funds suffered their worst monthly loss since the 2008 crisis. Several well-known funds closed their doors in 2015 as big bets on oil went bust and returns sank. Fund managers suffered an estimated $24 billion in asset liquidation.
CalPERS and the Dutch pension fund PFZW decided to divest their $4 billion and $5 billion hedge portfolios, respectively, in 2014. In the case of CalPERS, the reasons for this divestment were primarily centered on high fees and the fund’s desire to reduce risk and complexity in its investment portfolio. Other institutional investors followed suit.
Former 32-year-old hedge fund manager Martin Shkreli, later arrested by federal authorities for securities fraud, was roundly lambasted for raising the price of Daraprim, an essential cancer drug, from $13.50 to $750 — per pill.
Hedge fund managers have been blamed for holding up an orderly bankruptcy process for Puerto Rico and for buying a large part of the distressed mortgage markets, capitalizing on the foreclosure crisis to become the nation’s largest absentee landlord. Really?
As we explain in our forthcoming Responsible Investor Guidebook, co-authored with Annie Malhotra, savvy investors have raised serious doubts over the prudence of extraordinarily large fees and investment opacity that exist among some alternative investment managers and vehicles, especially hedge funds. As the Wall Street Journal pointed out, “Investors, who have long suspected that this arrangement enriches managers faster than their clients, are belatedly fighting back. Sovereign-wealth funds, for example, some of which have begun conducting their own buy-outs in-house, simply will not pay ‘2 and 20.’”
As explained by the US Department of Labor (DOL), fees are just one of several factors investment fiduciaries need to consider when selecting service providers and plan investments. While the law does not specify a permissible level of fees, it does require that fees charged to a plan be “reasonable.” When fees for services are paid out of plan assets, fiduciaries will want to understand the fees and expenses charged and the services provided. They will want to monitor the plan's fees and expenses to ensure that they continue to be reasonable. In recent years, pension funds have become more diligent in enforcing the fair costs rule.
But, in the 2000s, led by CIO Peter Gilbert, the Pennsylvania State Employees' Retirement System (SERS) joined a number of state pension funds betting big on hedge funds. An exposé in the New York Times warned that had invested an astounding $10+ billion, or almost a third of its $33 billion portfolio, in a broad hedge strategy.
I was writing, at the time, Up from Wall Street, a book about alternative pension investments, and I knew that most institutional investors rarely allocated more that 5% to hedge funds, one of the alternative investment choices to diversify the overall portfolio. So I wanted to know why the managers had over-invested, in my view, in hedges. A colleague from the state’s SEC was asking similar questions.
In early June of 2007, the SERS interim managers—Gilbert was long-gone----agreed to meet with a couple of policy colleagues and myself. The managers invited their astute, serious staff analysts to the meeting. The SERS team explained that their hedge strategy would not result in the kind of disaster experienced by Long-Term Capital, which nearly paralyzed the financial system in 1998, causing Alan Greenspan to round up Wall Street’s leading investment houses to back an orderly wind-down (nor, I’m assuming, the 2006 $6 billion Amaranth Fund wipeout, the largest in history to that point).
The analysts explained that:
SERS had constructed a portable alpha strategy, which had been overlaid with credit default swap insurance contracts to regain the beta, as they said. Furthermore,
SERS was betting on hundreds of hedge funds in domestic and international stocks, private equity, venture capital; in all 7 strategies and 21 sub-strategies, across all asset classes.
The SERS officers asserted that the Fund deployed several in-house managers and a number of large hedge funds of funds to keep reins over a tight ship. And it had worked for many years, yielding an annualized alpha of 4.5% above the S&P return net of costs, over $1.3 billion in extra profits for the fund. Their presentation sounded so logical, a thing of beauty. I asked a few more questions but, to be honest, it was a complicated system, difficult to understand. As I would soon learn, though, gravity trumps beauty.
At the time, the hedge market was still going strong. But there were many economy watchers, such as Warren Buffett, who complained loudly about that 2 and 20 fee structure. He also worried about the systemic risk that hedge managers brought to the market. Hedge managers were skewered by novelist Wolfe in a piece about the new “Masters of the Universe,” neuvo-patricians often residing in Westchester, Connecticut, who had acquired so much wealth that instead of waiting to be admitted to the ritziest private clubs, they simply opened their own. To become it, they bought it. They made the so-called old Masters and the “Barbarians at the Gate,” the junk bond kings of the 1980s, look tame.
Just days later after my meeting in Harrisburg, those two Bear Stearns hedge funds sunk due to entanglements in the sub-prime mortgage market. It was the beginning of a long, cascading down slope. By September 2008, Wall Street plunged precipitously after the Lehman Brothers bankruptcy. Lehman was the counter-party to a boatload of credit swaps, which evaporated overnight – wiping out many hedges, and blowing a hole in the hull of the economy.
Given its massive leveraging, hedges then provided some of the black powder for the avalanche. The regulators of the Street, famously, temporarily banned short-selling. Institutional and wealthy investors alike redeemed tens of billions out of hedge market, and it was predicted that half that market could fail.
As a Wall Street Journal article later explained, in December, 2008, PA SERS suffered total losses that momentous 3rd quarter amounting to $4.2 billion-- before hedge fund losses. Hedge losses may have added another $2.5 billion or so of red ink.
Here's the money quote: "Use of the aggressive strategy, called 'portable alpha,' has been cut in half, with officials of the SERS acknowledging that the pension fund's exposure was 'too large.’” The Pennsylvania trust, and those of Massachusetts and New Jersey, were hit harder that other public funds that got hit solely with the sledgehammer of the financial markets meltdown. Taxpayers were then asked to make up the difference, but the bad allocation decisions more than likely also led to so-called “pension reform” measures meant to gut the defined benefit programs of those states.
In November of 2008, I tried to warn incoming Pennsylvania Treasurer Rob McCord, a Democrat and former VC director from Philadelphia, that he needed to dig into the hedge fund fiasco, as I had a sense of impending doom after Lehman. I also strongly suggested that he, as a trustee and leader of three of the Commonwealth’s pension funds, needed to shepherd a responsible investment policy for the funds.
Mr. McCord blew me off, following his own greed agenda, and he was later convicted of federal extortion charges. Today, SERS, one of the nation’s oldest and largest retirement plans for public employees, has nearly 230,000 members. Its asset market value has grown back to only $26.5 billion. Sadly, the Pennsylvania funds have still not joined the rest of the modern responsible investment world.
Recall that in the SEC settlement with Goldman Sachs, pension funds were invested in the wrong side of the Goldman Collateralized Debt Obligation (CDO) scheme. The “Abacus” fund involved an investment in a bad pool of cloned mortgage-backed securities. It was one of many that criminally sucked in the retirement funds of teachers, factory and construction workers; the endowments of foundations and churches; the assets of municipalities. Betting against the clients of Abacus and other Goldman funds was John Paulson and his Paulson and Company hedge fund (also smack in the middle of the Puerto Rico bankruptcy story).
The New Masters
It’s been said that the reason that the regulators and courts can’t seem to find the perpetrators of the massive frauds and outright thefts because the deals were so complex. After all, the Abacus deal involved something called “synthetic CDOs.” In Big Short, it took a skit starring Selena Gomez and Richard Thaler playing Blackjack to explain synthetic CDOs (along with gags and cartoons to explain other investment circus oddities).
But the more honest explanation is that, unlike earlier financial scandals in our history, the regulatory cops in Washington, DC didn’t go after the financial crooks because they were too conflicted. The revolving door between Wall Street and the White House was swinging widely in both the Bush and Obama Administrations. So, as recounted in The Big Short, none of the large bank principals were held accountable, forced to pay back the money or went to jail.
These new “Masters” hurt millions of American citizens and families and sent our nation and the whole world into a near-depression. For decades, they have, essentially, “red-lined” large parts of our real economy. Since many of the bad apples are still at it, we should call them what they have become: shadow bank robbers.
As fiduciaries of workers’ capital, trustees have the power to question the elephant in the room. Trustees should negotiate lower fees or say no if a candidate’s fee structure is outrageous. Trustees may also seek responsible fund managers whose fee models are more reasonable.
But beyond the fee discussion, people in positions of investment trust must do what is responsible and right. As we mention in the Guidebook, pension fund investment involves fiduciary care. The idea of fiduciary duty is ancient, emerging in Europe during feudalism. The word “prudence” derives from the Latin term for “foresight” and means “acting with or showing care and thought for the future.” Pension fund investors need to align their investments with the beneficiaries of those funds. Or, you could say, they need to be paying it forward, not having it stolen from underneath.
It comes down to common sense investment. In 2014, Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board, said this at a conference in London about the markets: “Financial capitalism is not an end in itself, but a means to promote investment, innovation, growth and prosperity.”
For a really good, on-going review of hedge actors, check out this website partly sponsored by the AFT: http://hedgeclippers.org
Mark Carney. (2014, May 27). Inclusive Capitalism: Creating a sense of the systemic. Conference on Inclusive Capitalism.
David Dayen. (2015). How Hedge Funds Deepen Puerto Rico’s Debt Crisis. The American Prospect.
Peter Dreier & Aditi Sen. (2015). Hedge Funds: The Ultimate Absentee Landlords. (How Wall Street capitalized on the foreclosure crisis to become the nation's largest owner of single-family homes. The American Prospect.
Economist. (2014, February 8). Fees for hedge funds and private equity: Down to 1.4 and 17. The Economist. Retrieved from http://www.economist.com/news/finance-and-economics/21595942-cost-investing-alternative-assets-fallingslowly-down-14-and-17.
Michael Marois. (2014, September 15). Calpers to Exit Hedge Funds, Divest $4 billion Stake. Bloomberg.
Renae Merle and Carolyn Y. Johnson. (2015, December 17).Martin Shkreli, face of a new economy, charged with an old-school crime. Washington Post.
Gretchen Morgenson. (2015, November 6). A Hedge Fund Sales Pitch Casts a Spell on Public Pensions. New York Times.
Elizabeth Parisian, AFT and Saqib Bhatti. (2015).All That Glitters Is Not GoldRoosevelt Institute.
SEC. (2010). SEC Charges Goldman Sachs with Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages. US SEC.