Fees Add Up

By James Kwak

Public pension funds are having a tough time. On the one hand, the average funding ratio (assets as a percentage of the present value of future obligations) is below 80% because of inadequate contributions by sponsors (states and municipalities) and poor investment returns since the collapse of the technology bubble in 2000. On the other hand, because pensions responded to low returns by shifting more of their money into hedge funds and private equity funds, a larger proportion of their assets is siphoned off as investment fees each year.

Unlike some people, I am not against hedge funds and private equity funds in principle. I think it’s highly likely that there are people who can beat the market on a sustained basis—particularly if they are people who are especially good with computers—both for theoretical reasons (someone has to be the first person to discover each relevant piece of information or actionable pattern) and empirical reasons (see Fama and French 2010, for example). Hedge funds have lagged the stock market in recent years, but what critics sometimes overlook is that they are supposed to trail the market in boom periods, because many target a beta of around 0.5. But I am mystified by the fact that, in what is supposed to be a highly competitive and innovative industry, the price of investing in a hedge fund has stayed virtually fixed at 2-and-20 (2% of assets, plus 20% of investment returns) for decades.

The consequences of these high prices are added up in The Big Squeeze, a new report sponsored by the American Federation of Teachers. Because true investment fees are usually not disclosed—fund managers insist that they are confidential and require investors not to divulge them—the report simply quantifies the potential savings from reducing fees from 1.8-and-18 to 0.9-and-9. This may seem arbitrary, but I know anecdotally that some funds, even big ones, are charging something like 1-and-10 even to ordinary investors. Since state pension funds are some of the biggest investors that exist, you would think they would be able to negotiate even lower fees.

Not surprisingly, the numbers involved add up quickly. Lower fees over the past five years would have saved the average pension fund included in the study $1.6 billion; to put things in perspective, it would have improved the aggregate funding ratio for these funds by more than two percentage points, which is nothing to sneeze at.

The important question is why high fees persist despite the potential market power of big pension funds. There are probably multiple explanations. One is a culture of secrecy, which makes it difficult for any fund to find out what other funds are paying. Another is the marketing prowess of fund managers, who are adept at explaining when their fund is unlike any other in the world and therefore merits its high fees. A third is that pension fund managers are playing with other people’s money (in this case, the other people are the fund’s beneficiaries—teachers, firefighters, and other government employees)—and may be more interested in ingratiating themselves with the asset management industry than with getting the best deal they can. (This is even more likely the case for the investment consultants who match pension funds with asset managers.) But in a political climate that makes tax increases on rich fund managers unlikely, state governments could achieve the same results by taking a harder line on investment management fees: requiring public disclosure of all fees or even imposing hard fee caps for pension fund investments. With the amount of money involved, it’s hard to imagine that major pension funds couldn’t find anyone competent to take their money for 0.9-and-9.

5 responses to “Fees Add Up

  1. James, you overlook the role of ‘placement agents’ in corrupting public pension boards. Both California and New York have in recent years seen senior pension officials go to jail in connection with bribes they took from hedge funds.

    Please look at the cases of Fred Buenrostro, chair of CalPERS, and Alan Hevesi, comptroller of NYC. The only thing unusual about these cases is that the perpetrators were caught. Weak oversight and double dealing is the rule, not the exception

  2. With respect to the ‘ingratiation factor’ discussed above, do pension fund managers tend not to drive hard bargains on behalf of their clients because they may be looking for jobs with the same hedge funds, private equity, et al? Or are there regulations to prevent such conflicts of interest? I’m curious to know.

  3. Private equity is predatory equity, a form of rent seeking. It loads up corporations with debt gifts profits to the predators and no benefits for the workers. That peoples pensions should be used as capital for such a scam is shameful. Any pension trustee that pays 2 and 20 should be shot. They ever get together with the trustees from other pensions and negotiate a price? Only the limited partners pay when the investments go sour? Shadows on the cave wall: that’s what your mannered analysis amounts to. You can’t recognize a crime for what it is..

  4. On the eve of the hundredith anniversary (if anyones counting), and just as the law itself is now on trial. The unsustainability of western economic beliefs is rolling over and comming home to roost,(never mind the fact that someone butchered the language leading to anything said being interpreted 3 different ways, a never ending spin cycle in its own right) first in the form of pensions, and secondly in the form of debt. A public pension insures that taxes must rise, and private pensions insure that prices must rise, both to cover past promises which should have been managed by truth in design, manufacturing, and advertising, but instead was managed by law, the same law which today is now on trial.

    No better example than James’s current state location and home of my birth place, Hartford, CT (http://www.zerohedge.com/news/2017-05-26/connecticut-credit-risk-soars-record-high-tax-receipts-tumble) a perfect example of the kids running the candy store and then cant afford to find the cure to what ailes them, the only answer is to contribute more money today, to reap much more money, and/or potential cure, tomorrow. But tomorrow now lives on borrowed time and the state and federal full faith and credit leverage has evaporated, leaving behind only a pile of debt which cant be repaid, only hidden under the rug of future stastical numbers and lies.

    Now there’s already enough chum in the water to attract every big fish for miles around, but perhaps James and a few of his economic whale buddies can make up the difference to fill the funding gap left by departing CT hedge funds, a State bailout is tanamount to a generational wave crashing onto another generational wave, and we already know how that ends.

    So I concluded by saying the thing I recall most about JFK was how during WWII after his pt boat was sunk in the Pacific and one of his sailors badly injured, he grabbed the injured sailor by his shirt with his teeth and backstroked the both of them to an island until they were rescued, the beginning of his claim to fame. I cant help but think he would then willingly remain in that hole in the ground, perhaps he snuck out at night and bought that island he got rescued from and remained there forever, he certainly had the money. As for the future of interpretational law, follow the laws of nature, for the ice is to thin to cross over on anymore, and the crowd wanting to cross, is too large.

  5. James. I used to think you were smart. Now you drank the Koolaid Funny you mention beta in your argument excusing hedge funds from underperforming market rallies. While probably true in a laughable académic way no long short hedge fund manager is trying to underperform the market. They would gladly return 1000% a year if they could. The most celebrated funds think SAC or Renissance both probably cheating have or had massive returns year after year. They real money is in the 20% not hedgeing against losing money. Go back to your books now