Scott Sumner  

How government worsened inequality by ignoring the EMH

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I often do posts defending the Efficient Markets Hypothesis. Sometimes it's just fun to debate these ideas. But there are also serious real world costs to ignorance of the EMH. Government pension funds have wasted large amounts of public money, and worsened inequality in America, by paying hedge fund billionaires to manage public pensions:

New York City's largest public pension is exiting all hedge fund investments in the latest sign that the $4 trillion public pension sector is losing patience with these often secretive portfolios at a time of poor performance and high fees.

The board of the New York City Employees Retirement System (NYCERS) voted to leave blue chip firms such as Brevan Howard and D.E. Shaw after their consultants said they can reach their targeted investment returns with less risky funds.

The move by the fund, which had $51.2 billion in assets as of Jan. 31, follows a similar actions by the California Public Employees' Retirement System (Calpers), the nation's largest public pension fund, and public pensions in Illinois.

"Hedges have underperformed, costing us millions," New York City's Public Advocate Letitia James told board members in prepared remarks. "Let them sell their summer homes and jets, and return those fees to their investors."

The move is a blow to the $3 trillion hedge fund industry where managers like to have pensions as investors because they leave their money in for longer than individuals, sending a signal of stability to other investors.

Hedge fund returns have been lackluster for some time. The average fund lost about 1 percent last year when the stock market was flat, prompting institutional investors to leave.

Research firm eVestment said investors overall pulled $19.8 billion from hedge funds in January, marking the biggest monthly outflow since 2009.

Performance at some of the funds with which New York City invested was far worse. Luxor Capital Group, a long-time favorite with many pensions, lost an average 18.3 percent a year for the last two years.

Of course if they'd asked me they could have avoided those losses, merely by putting the money into index funds. And the poor performance of hedge funds is not just due to the past couple years, the hedge funds have been doing poorly since the famous bet with Warren Buffett:

After eight years of the 10-year bet, Buffett's chosen index fund holds a commanding lead over a collection of hedge funds even though the hedge funds performed slightly better in 2015. . . .

The low-cost Vanguard S&P 500 Admiral index fund Buffett chose is up 65.7 percent since the bet began. Protege picked five funds that bundle hedge funds that are collectively up 21.9 percent, on average.

It's not often that a public policy change is such a win-win. Having the public sector exit hedge funds will (slightly) improve the nation's underfunded public pensions, and also reduce inequality at the top. It's been a depressing year so far, in fact it's been a depressing millennium so far, but here's one tiny ray of hope.

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COMMENTS (7 to date)
ThaomasH writes:

Asked you or any other economist. The conventional wisdom is that "management" has no value since "A Random Walk Down Wall Street." (1973)

MikeP writes:

Government pension funds have wasted large amounts of public money, and worsened inequality in America, by paying hedge fund billionaires to manage public pensions...

With respect to government pension funds, it is even more fundamental than that.

The biggest crime of government pension funds is that they shackle future taxpayers to obviously ridiculous investment returns. The ostensible reason that government pension funds exist is that they believe they can get a better return than other investors. But by the EMH they can't.

If everyone understood that the EMH was at least close to correct, then governments would give the pension contribution to their employees at the time it is earned, and future taxpayers would not be stuck with the bill when returns are lower than predicted. Certainly the government funds can offer to manage the accounts if they underestimate their employees' investment competence. But EMH tells us that Calpers, et al., do not need to own the investments until they are paid out as pension.

LK Beland writes:

Investing in a hedge fund that trades publicly traded securities is certainly not consistent with the EMH. However, investing a part of a portfolio in private equity, which is not fully correlated with publicly traded securities, does make a lot of sense, even if one believes in the EMH. Likewise for arbitrage strategies and alternative financial products/markets that can help diversify a portfolio.

Mark Anderson writes:

In Piketty's book, he had a section that I found convincing that the largest university investment funds had a significant edge over the smaller university funds. The implication is that these larger funds are not investing in index funds but are taking advantage of their size to invest profitably in areas that the smaller ones can't because of liquidity or economies of scale, or something. I don't know what size these NYC pension funds are, but maybe they could do better than index funds? Of course it is possible that political considerations inevitably result in worse results than index, but I'd like to know why this would always be true for pension funds if not for university funds.

Benjamin Cole writes:

EMH works and besides that index funds are clear and above-board, and besides that it is KISS.

In a koo-koo sort of way there might be a path for California Pension funds to beat the market. They could take short-term equity positions in housing developments in California and use political muscle to get permitted. Money in the bank, jack.


Scott Sumner writes:

Thanks everyone, Good points.

Mark, Perhaps it's partly due to less liquid assets. I seem to recall that Harvard owns lots of timber producing land in Maine

MikeP writes:

My guess on Piketty's point is that the largest endowments (a) don't need all they return and (b) have century-long time horizons. Therefore, they can risk more to gain greater returns.

Of course, this isn't beating EMH. It's simply being less sensitive to potential losses an therefore choosing a more aggressive risk-reward path.

Indeed, I suspect the largest endowments have an amount they need next year, an amount they want in five years, and a surplus they can put into very high return investments at greater risk than other funds can afford to.

Presumably the lesson that Piketty was trying to get across was that the rich can get richer faster than the not rich. But I think empirically the time horizons of an old university are quite a bit greater than the time horizons of the next generation inheriting a fortune.

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