Key Takeaways
- • Persistent underperformance: The average hedge fund trailed the S&P 500 benchmark for eight consecutive years through 2016, with average annual underperformance exceeding 5 percent, yet top managers continued to earn extraordinary compensation regardless of results.
- • Top-tier compensation misalignment: The 10 highest-paid hedge fund managers earned average annual compensation of approximately $765 million in 2016, with James Simons commanding $1.6 billion and Ray Dalio $1.4 billion despite his largest fund (Pure Alpha, $62 billion in assets) returning only 2.4 percent.
- • Massive pension fund exposure and losses: More than half of the $3 trillion held in hedge funds nationwide represents pension fund and retirement plan investments, with an estimated cumulative $600 billion in opportunity losses over eight years compared to passive index investment strategies.
- • Direct impact on public finances: Underperformance in hedge fund allocations forces pension plans to either reduce promised benefits or raise taxes on middle-class workers to fund shortfalls in public retirement obligations.
- • Policy urgency: The San Francisco Employees' Retirement Fund and other public pension boards are facing calls to divest from hedge fund allocations due to the structural misalignment between manager compensation and fund performance.
Summary
Public pension funds hold substantial capital in hedge funds despite consistent underperformance relative to passive investment benchmarks. Data through 2016 reveals that the average hedge fund underperformed the S&P 500 for eight consecutive years, with performance gaps averaging more than 5 percent annually. This pattern contradicts the traditional justification for hedge fund allocation—that active management delivers superior risk-adjusted returns.
The compensation structure within the hedge fund industry exacerbates the performance problem. The 10 highest-paid hedge fund managers earned average annual compensation of approximately $765 million in 2016, with compensation levels disconnected from investment outcomes. James Simons, the highest-paid manager, received $1.6 billion despite mixed performance across his funds. Ray Dalio, the second-highest earner at $1.4 billion, managed Pure Alpha, a $62 billion fund that returned only 2.4 percent in 2016—substantially trailing benchmark returns. The disconnect between compensation and performance across the broader top-paid manager cohort reflects a structural flaw in how pension allocations flow to hedge funds.
The scale of pension fund exposure amplifies this concern. More than half of the $3 trillion held in hedge funds nationwide represents pension and retirement plan capital. Over an eight-year period through 2016, pension plans are estimated to have cumulatively forfeited approximately $600 billion in potential returns by selecting hedge fund allocations over passive index strategies. This opportunity cost directly threatens pension sustainability for public systems, forcing boards to either reduce promised benefits to retirees or increase tax levies on working-class taxpayers to cover funding shortfalls.
Given these metrics, institutional stakeholders including the San Francisco Employees' Retirement Fund face pressure to reassess hedge fund allocations within their investment mandates. The empirical case for hedge fund exposure rests substantially weakened when eight years of underperformance coincide with compensation structures that reward managers regardless of results.
The compensation structure within the hedge fund industry exacerbates the performance problem. The 10 highest-paid hedge fund managers earned average annual compensation of approximately $765 million in 2016, with compensation levels disconnected from investment outcomes. James Simons, the highest-paid manager, received $1.6 billion despite mixed performance across his funds. Ray Dalio, the second-highest earner at $1.4 billion, managed Pure Alpha, a $62 billion fund that returned only 2.4 percent in 2016—substantially trailing benchmark returns. The disconnect between compensation and performance across the broader top-paid manager cohort reflects a structural flaw in how pension allocations flow to hedge funds.
The scale of pension fund exposure amplifies this concern. More than half of the $3 trillion held in hedge funds nationwide represents pension and retirement plan capital. Over an eight-year period through 2016, pension plans are estimated to have cumulatively forfeited approximately $600 billion in potential returns by selecting hedge fund allocations over passive index strategies. This opportunity cost directly threatens pension sustainability for public systems, forcing boards to either reduce promised benefits to retirees or increase tax levies on working-class taxpayers to cover funding shortfalls.
Given these metrics, institutional stakeholders including the San Francisco Employees' Retirement Fund face pressure to reassess hedge fund allocations within their investment mandates. The empirical case for hedge fund exposure rests substantially weakened when eight years of underperformance coincide with compensation structures that reward managers regardless of results.
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