As public pensions shift from hedge funds, hedge funds look to Main Street

Institutional investors took notice last year when CalPERS, the giant California public employee pension fund, declared that it would no longer invest in hedge funds. Disappointed with the high fees it was paying and the mediocre performance it was getting, the pension fund announced its plans to pull $4 billion from the 24 hedge funds and six hedge fund-of-funds in which, on the recommendation of financial advisers, it had invested. Hedge fund results have trailed the Standard & Poor's 500 since 2009, continuing a trend that led Bloomberg Business to run a story with the headline "Hedge Funds Are for Suckers."

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A study of the experience of 11 pension funds that invested in hedge funds tells a similar story. Net return rates on hedge fund investments lagged behind the overall performance of the pension fund three-quarters of the time, costing retirees billions of dollars in lost investment returns. Yet hedge fund managers still collected billions of dollars in fees from the pension funds.

As I noted in an earlier column in The Hill, institutional investors are becoming less able or less willing to invest in alternative investment funds like private equity and hedge funds. These alternative investment funds now want to be able to tap the rapidly growing 401(k) retirement savings. With alternative investments so dependent on workers' retirement savings, future growth prospects for private equity and hedge funds are likely to be tied to their ability to tap the estimated $6.6 trillion in 401(k) accounts.

Washington-based private equity firm Carlyle Group has been at the forefront of efforts to open up these individual retirement accounts to investments in private equity. The giant private equity fund Blackstone Group launched Blackstone U in 2011, offering two-day seminars designed to persuade financial advisers of the benefits of private equity investments for their clients.

Now Blackstone has turned its attention to getting tax-advantaged 401(k) retirement plans to invest in hedge funds. At the Reuters Global Investment Outlook Summit in New York earlier this month, Blackstone Vice Chairman J. Tomilson Hill reported progress in getting so-called "liquid alts" — essentially a portfolio of hedge fund investments — into workers' 401(k) plans. According to Hill, Blackstone would like to see liquid alts on the menu of options available to employer-sponsored 401(k) retirement savings accounts.

The Department of Labor is responsible for setting the rules that govern financial advisers to 401(k) and Individual Retirement Account (IRA) accounts. Currently, the rules do not require these advisers to act as "fiduciaries" and put the interests of their clients first when advising 401(k) plans or individual IRA investors. As a result, it is perfectly legal for financial advisers to put retiree savings into investments that yield high fees for them but may not yield the best returns for the workers whose retirement savings are at stake. The Department of Labor has now proposed new rules to address this situation. The proposed rules require investment advisers to exercise fiduciary responsibility and act in the best interest of their clients when providing investment advice.

Some members of Congress from both sides of the aisle have joined Wall Street investment firms in opposing the Department of Labor's rule requiring financial advisers to 401(k) plans and IRAs to put retirees' interests first when considering risky investments. Some very risky investments such as private equity and liquid alts would likely not be available to these plans. According to the Financial Services Roundtable, these members of Congress have asserted that the proposed rules "will unjustifiably discriminate against workers at small businesses by reducing the scope of investment advice they can receive." They argue that financial advisers would be prohibited from proposing certain investment options that are available to employees working for government agencies or large companies with defined benefit pension plans.

These congressional concerns are misplaced. It might make more sense to limit pension fund allocations to these risky investments. The big public pension funds, as The New York Times editorial board noted and the CalPERS withdrawal from the asset class has confirmed, have found that hedge funds do not live up to their hype. The editorial board concluded: "The end result [of hedge fund investments] is poorer pensions and richer hedge funds."

Most workers assume that their financial adviser is legally required to provide them with the best possible investment advice and are shocked to learn that some advisers consider their own fee income when advising clients. The Department of Labor should stand firm on the requirement that financial advisers must act as fiduciaries when advising companies and workers on where to invest their tax-favored retirement savings and should exclude from the menu of investment options those that are too risky to be included in individual workers' retirement savings accounts.

Appelbaum is senior economist at the Center for Economic and Policy Research and co-author of "Private Equity at Work: When Wall Street Manages Main Street."