Future expected returns should be estimated by looking at historical returns of an asset class, then applying a probable estimate of outcomes. This is done for stocks, bonds, cash, real estate and so on. Hedge funds, however, are not a discrete asset class. Calculating expected returns doesn't generate a reliable or real number. Instead, it is an exercise in making assumptions -- about the skill of the manager, the process employed to make decisions and how replicable past above-market returns might be.
It is at best a guessing game.
This is the heart of the problem. Pension-plan managers aren't dumb; but as I noted at the start, there is an obvious reason they intentionally buy a false promise of higher returns.
In the end, taxpayers loses in three different ways: First, they pay much higher investment fees than they would via other available options -- and those fees act as a drag on returns. Second, there's the outright underperformance mentioned above. And third, the public is on the hook for making up the unfulfilled promises made to state employees, including teachers, fire fighters, police and other government workers.
The result is a ticking time bomb that will go off at some point that can only be dealt with through either unimaginable tax increases or stiffing government employees who worked hard in the expectation they would have enough money for a secure retirement.
In the past, I've summed up the bargain that hedge funds offer investors thusly: Come for the high fees, stay for the underperformance. It is funny because it was true, though I'd add one other element: Taxpayers and pension funds get duped in the process. There is no other explanation for why there is so much money parked in so many expensive funds with subpar returns.
This column was provided by Bloomberg News.