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Like many sophisticated investors, the nation's largest insurers drank the hedge fund Kool-Aid, pouring billions into the high-fee investment funds and helping drive hedge fund assets to more than $3 trillion.
Now comes the hangover.
Steep losses in hedge fund investments during the last quarter damaged many insurance company earnings, reinforcing decisions to rethink the premises that led them to follow the Pied Pipers of finance in the first place.
American International Group said it would cut its hedge fund exposure in half, to $5.5 billion by the end of 2017 from $11 billion at the end of last year. MetLife said it would slash its hedge fund portfolio by two-thirds, to $600 million from $1.8 billion.
The pain from the last quarter has shown up most visibly in recent insurers' results, but it is also spreading to pension funds, endowments and other giant investment funds. Last month, New York City's largest pension fund said it was abandoning hedge funds entirely, and the Illinois State Board of Investments voted to reduce its hedge fund portfolio by $1 billion.
"They're finally getting the mediocre results they deserve," said Simon Lack, an early skeptic about hedge funds and author of"The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True."
"I imagine you'll see more and more institutional investors re-examining their commitment to hedge funds," Lack added,"as they see what they're getting for those outrageously high fees they pay."
Listen to the chorus of recent hedge fund criticism. Warren E Buffett blasted their high fees and mediocre performance at his recent investors' conference in Omaha, Nebraska. Activist investor and hedge fund manager Daniel Loeb called their recent performance"catastrophic" in his latest letter to investors.
Even the legendary hedge fund manager Stephen A. Cohen, whose fund averaged 30 percent annual returns before Cohen's close brush with insider trading charges, complained this month:"It's very hard to maximize returns and maximise assets."
Apart from industry experts, most people probably didn't realize that insurance companies, which belong to one of the most heavily regulated industries in the country, were big investors in hedge funds, one of the most lightly regulated of all investment vehicles. Then again, before the financial crisis, hardly anyone realized AIG was exposed to trillions of dollars in derivatives tied to mortgage-backed securities until catastrophe struck and the company had to be bailed out by taxpayers for more than $180 billion.
Luckily, there's little danger of that now with hedge funds, because they make up only a small fraction of insurers' vast investment portfolios. Even at AIG, the $11 billion hedge fund portfolio represented just 3 percent of its approximately $340 billion in total investments. At MetLife, hedge funds account for less than one half of a percent.
Still, losses from even these small percentages can have a big impact on earnings. AIG reported pretax hedge fund losses of $537 million for the first quarter, which wiped out operating profit and led to an overall loss of $183 million. MetLife reported a 19 percent drop in operating earnings for the quarter, in part because of what Steven J. Goulart, its chief investment officer, said were"negative" results from hedge funds.
Insurers strive to match their liabilities to their assets, which generally means low-volatility US Treasurys, along with other bonds and fixed income positions. But they are allowed to invest their excess capital any way they see fit.
To be sure, those investments are subject to stiffer capital requirements: generally 30 percent in the case of stocks and equity-like investments, which include hedge funds and other alternative investments.
Hedge funds promised to provide high equitylike returns, with less volatility, that were uncorrelated with the ups and downs of the stock market ” in other words, a variation on the age-old siren song of higher returns with lower risk.
Hardly any of that turned out to be true, at least for insurance companies.
What went wrong? Pretty much every everything, based on conversations I had this week with chief investment officers at several insurance companies."Their marketing skill proved to be much better than their investing ability," Lack said of hedge fund managers.
For starters, hedge funds didn't deliver equitylike returns. Hedge funds have trailed the benchmark Standard & Poor's 500 index every year since 2009, often by significant amounts. Even ordinary investors can earn very close to that simply by buying a low-fee index fund.
To some extent, that was to be expected in a strong bull market. But the volatile market of the last year was exactly the environment in which so-called long-short hedge funds were supposed to thrive. They didn't.
A major culprit, everyone I spoke to agreed, was the sheer size of assets managed by hedge funds.
