Alternative investment

By Shin Jang-sup

"Alternative investment" is in vogue in Korea. Facing low interest rates and stagnant stock markets, the country's leading institutional investors including the National Pension Service (NPS) and Korea Investment Corporation (KIC) continue to increase their alternative investments.

It is of course imperative for large institutional investors to keep hunting for alternative assets so they can achieve higher yields for their investments. However, they should also keep asking themselves whether the alternative investments they put their customers' money into are really alternatives for conventional investments. A recent study of the investments by the Roosevelt Institute in U.S. pension funds, titled "All That Glitters Is Not Gold," tells us that alternative investments at least in hedge funds are not really alternatives.

The study examined the hedge fund performance for 11 large public pensions in the U.S. during 88 fiscal years (8 fiscal years for each pension fund), which had $638 billion in assets under management, $43 billion of which was in hedge funds as of the most recent fiscal year. It concluded that hedge fund investments actually resulted in "high costs with low returns." During three quarters of the years analyzed in the study, hedge funds underperformed compared to a same-sized total fund's returns and this incurred $8 billion in lost investment revenue. On the other hand, hedge fund managers collected an estimated $7.1 billion in fees from pension funds. The fees amounted to 57 percent of the net returns earned by the pension funds. In contrast, the fees these pension funds paid to other funds were 5 percent on average.

California Public Employees' Retirement System (CalPERS), the largest pension fund in the U.S., stopped investing in hedge funds for similar reasons. CalPERS was in fact a vanguard to lead in hedge fund investments among U.S. pension funds, starting from 2002. Since then, pension funds drastically increased their investments in hedge funds and, as a result, about 40 percent of $2.7 trillion under management by global hedge funds today comes from pension funds.

However, CalPERs last year announced it could no longer justify hedge fund investment because of "high costs and complexity." In 2013, for instance, CalPERS paid $40 million in fees for managing conventional assets that accounted for 80% of its total assets. But it paid 20 times the total fees, i.e., $8 billion for hedge fund investments that accounted for about 20% of its total assets. An investment director of CalPERs said there was also no evidence that hedge fund investments generally brought about higher returns and that there was no systematic way to ascertain which hedge fund would perform better than others.

It is certainly true that some prominent hedge funds such as Soros Fund Management and Renaissance Technologies have long outperformed the market. But there have been various reports indicating that the performance of hedge funds on average is not really encouraging. For instance, Ilia Dichev and Gwen Yu argued in their article, "Higher risk, lower returns _ What hedge fund investors really earn" which was published in the Journal of Financial Economics in 2011, that annualized dollar-weighted returns of hedge funds were on the magnitude of 3 percent to 7 percent lower than corresponding conventional fund returns and, in absolute terms, dollar-weighted returns were reliably lower than the returns on the Standard & Poor's (S&P) 500 index, being only marginally higher than the returns on the U.S. treasury bills.

Dan McCrum, who runs "No Alternative: The zombie hedge fund industry series" in the Financial Times, also contends that hedge fund investment are a higher risk with lower returns. According to his compilation, 16,237 hedge funds _ about two thirds of 24,749 total hedge funds registered in major commercial databases _ are now defunct. They are of course not included in calculating hedge fund returns publicized by the hedge fund industry. If they are included, the actual hedge fund returns would decrease significantly.

The study by the Roosevelt Institute is the first one on performance of hedge funds based on customers' experiences, namely 11 pension funds. U.S pension funds are now reducing their investments in hedge funds and the number of zombie hedge funds is increasing. It seems that actual performance assessments by their customers have contributed to this new trend.

In Korea, however, investments in hedge funds are rapidly increasing and voices to increase alternative investments through pension funds are becoming stronger among policymakers and politicians. What is solely missing here is any convincing assessment of hedge fund performance from the customer's side. The debate is dominated by numbers on investment returns provided by suppliers.

Which numbers are more reliable? Those from customers or those from suppliers? Alternative investment strategies of Korean institutional investors should be radically re-examined in view of the customers' assessments of hedge fund returns before it is too late.

Shin Jang-Sup is an economics professor at the National University of Singapore and a former adviser to Korea's finance minister.