In a report this week on New York’s state retirement fund investments in hedge funds, the state’s top financial watchdog used botched numbers to reach incomplete conclusions for purposes that remain murky.
Taking aim at the office that runs the state’s employee retirement system, the Department of Financial Services declared that pension allocations to hedge funds had lost $3.8 billion over the last eight years, due to a both high fees and poor performance. “Hedge fund managers continue to reap hundreds of millions of dollars in fees, regardless of their performance, which is a rip-off at the expense of pensioners,” DFS Superintendent Maria T. Vullo said in a statement.
The timing of the report was odd, given the fact that State Comptroller Thomas DiNapoli has already decreased the state’s allocation to hedge funds and suggested retreating even farther from high-fee investments. It’s been more than a year since the state has invested in a hedge fund, DiNapoli’s office claimed. Still, Vullo suggested that the state should consider “taking away the checkbook” from DiNapoli, who oversees the pension fund.
But it’s not just the motivation behind the report that’s befuddling. The numbers it cites appear to be faulty, clashing with the figures reported by the state retirement fund in the crucial post-crisis years of 2009 and 2010.
The reach its headline $3.8 billion figures, the DFS report compares returns from the fund’s investments in hedge funds to those in domestic and international stocks. In a side-by-side comparison, equities have indeed done better in most years. Over the last decade, according to the retirement fund’s most recent annual report, equities have returned 5.4 percent, compared to 3.2 percent for hedge funds.
If the state had kept its hedge fund money in stocks over the last eight years, it would have saved around $1 billion in fees and enjoyed another $2.8 billion increased in returns, the report concludes.
But the analysis is marred by the fact that the DFS goofed up its accounting of the fund’s equity returns. In the fiscal year ending March 31, 2009, the fund reported that its domestic equities portfolio lost 37.9 percent of its value, while international stocks tanked 45.6 percent. Weighted together, equities sank by 40 percent. Yet the DFS report shows equities losing a relatively mild 7.12 percent that year. In terms of absolute numbers, the DFS report implies that equities lost $5 billion in 2009, compared to the actual loss of $24 billion for the fiscal year -- a $19 billion error.
The next year, when markets sharply rebounded, the DFS report errs in the other direction, claiming equities gained 26.6 percent, compared with actual returns of 53.2 percent.
Where the state’s top financial cop got those numbers is a mystery. “The figures used in the chart are baffling and seem at odds with the known facts, like much of the report," a spokesman with the state comptroller’s office said. The DFS did not respond to requests for comment.
The fact that the DFS whiffed in fiscal year 2009 is consequential. Like most pension funds, the New York state retirement system justifies its pricey alternative investments on the logic that hedge funds happen to hedge. From the 2016 annual report: “The investment goals for the absolute return strategies program [hedge funds] are to provide diversified superior risk-adjusted returns with low correlation to other asset classes.”
In other words, when the stock market zigs, hedge funds zag. Or at least they zig a little less.
That exactly what happened during the financial crisis. While the fund’s equities sank by 40 percent, its hedge fund portfolio lost half that amount. If the state had kept its hedge fund investments in index funds instead during that time -- as the DFS report implies it should have -- the retirement fund would have been some $800 million poorer in 2009 that it was.
What’s more, the report conveniently leaves out the fiscal year 2008, the start of the downturn, during which the retirement fund’s hedge funds outperformed equities by 6.4 percent. If the retirement fund had kept all its hedge fund investments in the stock market instead, it would have ended 2008 with roughly $330 million less than it did.
The DFS report doesn’t explain why it ignores the comptroller’s stated rationale for putting aside two percent of the state’s retirement assets in hedge funds -- that is to minimize risk during a market correction -- nor does it justify its arbitrary eight-year time frame.
This isn’t to say that we should just take the comptroller’s word that the cushion hedge funds provide during market crashes really justifies their massive fees and lower performance. And that cushion itself might be oversold, given that the hedge fund industry has grown increasingly correlated with the S&P 500 in the last few years. "Hedge funds in aggregate are essentially long the S&P 500,” a Morgan Stanley analyst wrote in 2014. So much for hedging.
It’s no mystery that hedge fund fees have been too high, and returns too low in recent years. And given the ample opportunities for venality and corruption by state retirement fund managers -- an experience New York knows well -- it’s worth scrutinizing the investments that pension fund custodians make. But slipshod hackwork doesn’t do much to advance accountability.