Unsophisticated Investors Come In All Sizes

The hallmark of the unsophisticated, or perhaps more accurately, the undisciplined investor is a tendency to buy high and sell low – in other words, to follow the market herd.

The California Public Employees’ Retirement System, better known as CalPERS, recently announced its decision to liquidate all of its hedge fund investments. The decision itself is not unwise, but its timing is a reminder that big investors can be as undisciplined as anyone else.

CalPERS’ Chief Investment Officer, Ted Eliopoulos, told Bloomberg that the pension’s hedge fund allocation “did not offer [CalPERS] the ability or the promise to effectively diversify or hedge any meaningful portion of [its] total portfolio.” CalPERS’ announcement cited large fund fees and the funds’ complexity in the decision to pull out of the asset class.

The classic hedge fund promise is that it won’t move in lockstep with the stock market, therefore providing a “hedge” against other investment losses. By following any one of many strategies, or a combination of several, hedge fund managers have traditionally sought to make money when the overall stock market falls – or at least to lose less money than other investments do. At the same time, hedge funds promise to at least make some money when the market rises.

So when the financial panic hit the market in 2008-09, and stocks typically lost half their value, investors wanted something more appealing. They looked to hedge funds, saw something that glittered (at least relative to most everything else), and assumed it was gold. A few hedge funds actually made a bundle during the panic by astutely betting on a housing crash or other consequences of the financial panic. Investors crowded into those funds when they could, and often into other hedge funds when they couldn’t, hoping for similar results.

CalPERS, as the biggest institutional investor around, can typically get into any fund it wants.

But good investing is a pretty boring exercise, at least if you are prepared to hold on to your investments during downturns and wait for an eventual recovery. Recovery has come with a vengeance since 2009, with the S&P 500 index at around triple its early 2009 low. Few hedge funds have kept up. In fairness, many of those funds are not designed to keep up with a rapidly rallying stock market. That is why they are called hedge funds.

In truth, it never made much sense for CalPERS, or other pension funds, to get into hedge funds in the first place. Pension funds are long-term investors by definition; their obligations span decades. Their fundamental problem is not the result of short-term market moves. Their problem is that they are underfunded relative to their long-term obligations.

Some are trying to hide that problem by seeking a magic investment bullet – something that promises to give them better-than-market returns over the long term. Despite some fund managers’ claims, no such magic bullet has been proven to exist. In any given period, some managers will outperform the market, occasionally by impressive margins. But it never lasts. The strategies that work wonderfully in one set of circumstances stop working when circumstances change.

So the real problem isn’t that CalPERS is getting out of hedge funds. The problem is that CalPERS felt the need to get into them in the first place. CalPERS ought to be able to meet its obligations by gathering actuarially reasonable contributions from California state and local government agencies and investing those contributions in a well-diversified mix of stocks and bonds, in an environment that includes sound fiscal policy, a nonrepressive interest rate environment, and a tax and regulatory regime that promotes capital formation and economic growth.

Of course, a lot of those ingredients are absent or diminished in the world we inhabit today. It would be nice if, as it corrects its hedge fund mistake, CalPERS threw its weight behind those other policies as well. But we are, after all, talking about the California public employees’ retirement system, and these prescriptions are not exactly the fashion in the Golden State today.

So don’t take the hedge fund abandonment as a sign that CalPERS is becoming a wise investor. It is just doing more of what it has been doing, which is following the crowd.

About Larry M. Elkin 552 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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