When one of the world's biggest, smartest investors gives you a tip, it pays to listen.
In this case, the tip comes courtesy of the California Public Employees' Retirement System (Calpers), the largest pension fund in the United States, and it's something all of us can apply in our portfolios.
The message? Forget about expensive attempts to outwit the market. Focus instead on reducing your investment costs.
The announcement this week that Calpers would be ditching all its hedge fund investments amounts to a slap in the face for the $2.8-trillion (U.S.) global industry that has grown up around the notion that a handful of brilliant money managers can reliably beat the market, or at least smooth out its volatility.
Calpers' decision, by itself, will have only a limited effect on the hedge fund business because its investments in that area amount to only about $4-billion of its $300-billion portfolio. But the California pension giant is seen as an industry leader and its move is nearly certain to cause other large investors to rethink their love affair with hedge funds.
What's less clear is whether the decision will have similar effects on small investors. In an ideal world it would, because it demonstrates that even a huge, sophisticated investor like Calpers is growing disenchanted with the notion of picking superstar investors. More important, it thinks, is trying to invest wisely at the lowest possible cost.
It's about time for such an acknowledgment of reality. Actively managed mutual funds have long demonstrated an inability to beat low cost, market-hugging index funds over the long haul. Now hedge funds are facing similar scrutiny.
These investment vehicles got their name because they were originally conceived of as a way to "hedge" risk. Early hedge funds would take both long and short positions, allowing them to make money both when markets soared and when they tanked.
Or at least that was the theory. In practice, "hedge funds" quickly became a catch-all term for professional investors who would make aggressive bets and pursue exotic strategies, often with the aid of borrowed money.
The results were about what you would expect from any situation in which hundreds of bright people are given large amounts of funds to gamble. A few (think George Soros or Julian Robertson) did very well. Many didn't.
A study by Ilia Dichev of Emory University and Gwen Yu of Harvard found that hedge funds, as a group, produced profits for their investors that were below market returns between 1980 and 2008. The average payoff from the clients' perspective was barely above what they could have earned by sitting in government bonds.
Hedge fund returns have been particularly ugly since the financial crisis, with the HFRX Global Hedge Fund Index lagging far behind the world's leading stock markets. Calpers, which has been investing in hedge funds for 12 years, evidently decided it had finally had enough.
A big part of the problem with hedge funds is their lofty fees. It's typical for a hedge fund manager to charge 2 per cent of assets under management as well as 20 per cent of profits. That may provide a powerful incentive to perform well but it also provides a strong motivation to take risk in pursuit of big returns – one reason that many hedge funds fail to survive for more than a few years.
Rather than playing the unpredictable hedge fund game, Calpers is focusing on what it can control – expenses. "Reducing costs remains paramount," it declares in its annual report. It prides itself on managing its huge portfolio for a management expense ratio that amounts to about half a cent for every dollar invested.
By comparison, many Canadian investors pay more than 2 per cent a year on their investment portfolios. By shifting to lower-cost mutual funds and ETFs, they could shave their costs considerably and become a bit more like one of the world's biggest, smartest investors.