Great Expectations

“Ask no questions, and you’ll be told no lies.” – Charles Dickens, Great Expectations

A typical conversation between a hedge fund allocator and a hedge fund manager…

Hedge fund allocator: “What are your expected returns and volatility over the next few years?”

Hedge fund manager: “15-20% annualized with very low volatility.”

Hedge fund allocator: “Great. That’s exactly what we’re looking for.”

I’m using some hyperbole here, but not as much as you might think. As I outlined in “The Hedge Fund Myth” earlier this year, the lofty expectations among hedge fund allocators borders on absurd. That hedge fund managers promise the world is understandable (they are selling a luxury item in decline); that investors put any weight on said promises boggles the mind.

The $178 billion New York State Pension fund (3rd largest in the U.S.) is a recent example. After undoubtedly having the above conversation years ago, they are not happy with the results (negative returns in their most recent fiscal year).

Their solution: demand a minimum return of 10% per year.


Will that work?

Not unless we are to believe that simply demanding a higher return from an investment manager can effectuate that outcome. Does saying “I want a return of x%” get you that return? No. When it comes to investing, where there’s a will, there isn’t necessarily a way.

Besides, almost all allocators already demand high performance from their hedge funds, selling the poor performers and buying the best performers, over and over again. Hedge fund performance should be exceptional based on this survival of the fittest model, but as we know it has been anything but.

Since 2005, the S&P 500 is up 129% versus a gain of 4.7% for the HFRX Global Hedge Fund Index and a gain of 0.1% for the HFRX Equity Hedge Index. Keep in mind – these are cumulative returns.


With this backdrop, hedge fund investors have every right to scrutinize their holdings. But for New York State to “demand” a net return of 10% per year when hedge funds haven’t delivered that cumulatively over an almost 13-year period seems a bit out of touch with reality. Given the recent losses in their alternatives portfolio, a minimum return of 0% would seem more appropriate.

More appropriate still would be to acknowledge that markets and returns are unpredictable. To say that all we have are a range of probabilities and possibilities; there is never certainty. As such, the entire notion of minimum returns is contrary to investing reality. Did New York State demand a minimum return from their equity funds in 2008? From bond funds in 2013? If so, they would be 100% in cash which is to say that every asset class has drawdowns and periods of poor performance that won’t meet a “minimum” return requirement given enough time.

Even if hedge fund performance improves from here, I would venture to guess that New York State will not benefit. Why? Because they will be constantly chasing the hottest strategies and funds that meet their 10% threshold. In doing so, performance will suffer even more, and they would be better off exiting hedge funds altogether.

But then what would they do every day? Who would buy them fancy dinners? How would they justify their existence? Who would they blame for poor performance?

Ah, yes, therein lies the problem. It’s hard to do nothing all day. It’s hard to do no harm. Believing in myths and fantasies when your livelihood depends on it is the far easier choice.

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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