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States Double Down on Hedge Funds as Returns Slide

Date: Friday, August 15, 2008
Author: Adam L. Cataldo and Michael McDonald, Bloomberg

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Public pension funds in the U.S. are increasing bets on high-risk hedge funds and real estate in an attempt to fill deficits in retirement plans and make up for their worst performance in six years.

New York Comptroller Thomas DiNapoli is asking lawmakers to increase a cap limiting the amount of so- called alternative investments in the state's Common Retirement Fund, the third-biggest U.S. public pension at $153.9 billion. South Carolina's retirement system adopted a plan in February to invest as much as 45 percent of its $29 billion in hedge funds, private equity, real estate and other alternatives, from nothing 18 months ago.

``We need some more flexibility,'' DiNapoli said at an Aug. 4 press conference in Albany. The Common Retirement Fund, whose 2.6 percent gain in the year ended March 31 was its worst since 2003, is authorized to invest as much as a quarter of its assets in alternative investments. DiNapoli declined to say how much he wants the limit increased. The fund doesn't have a deficit.

Public funds, which manage at least $2.45 trillion in assets, are trying to plug deficits and reverse losses that New York-based Merrill Lynch & Co. says averaged 5.1 percent in the year ended June 30. Yet in reaching for high returns while diversifying their assets, managers may be putting taxpayer money at risk at a time when the economy is growing at its slowest pace since 2001.

Hedge Funds

Massachusetts Pension Reserves Investment Trust lost $80 million in the last two years when Greenwich, Connecticut-based Amaranth Advisors LLC closed in September 2006 and Sowood Capital Management LP of Boston imploded in July 2007, according to reports last year. New Jersey's fund lost about $15 million when Amaranth collapsed.

``It doesn't come risk-free,'' said Susan Mangiero, president of Pension Governance LLC, a research firm based in Trumbull, Connecticut. ``You could end up having a worse performance and the chain of events is lower funding status and increased taxes.''

Alternative investments typically include private equity, hedge funds, real estate and commodities. That category is expanding to include timber and infrastructure.

As a group, ``It is going to increase,'' said Eileen Neill, a managing director Wilshire Associates. ``Because funds, number one, want to diversify some of the equity risk, and two, funds are anxious to try other strategies to try and meet their liability growth rates.'' Santa Monica, California-based Wilshire advises 600 clients with assets totaling about $12.5 trillion.

Falling Returns

Chicago-based Hedge Fund Research Inc.'s Weighted Composite Index, based on data from more than 2,000 funds, fell 2.4 percent in July and 3.5 percent year-to-date, which would be the worst annual performance since at least 1990. Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets and participate in profits from money invested.

Private-equity gains are also falling short as leveraged buyouts dry up and initial public offerings fall, reaching their lowest level in four years, according to data compiled by Bloomberg. Commodity prices in July fell 10 percent, the biggest decline since March 1980, as measured by the Reuters/Jefferies CRB Index. The index has plunged 19 percent from its July 3 peak.

``Chasing performance, especially in a public fund, can be a dangerous thing,'' said Stan Rupnik, the chief investment officer at the Teachers' Retirement System of the State of Illinois.

Alternative Investment

While states and local pension plans have invested in alternative assets for more than a decade, the trend is accelerating as returns on stocks and bonds sag. Between 2003 and 2007 the average allocation to alternative investments almost doubled to 5.3 percent, according to the National Association of State Retirement Administrators.

``The last couple of years have not been particularly good for equity markets, and plan sponsors are looking for ways to make up the difference,'' said Kurt Winkelmann, the head of global investment strategy at New York-based Goldman Sachs Asset Management. The firm had $354 billion of assets under management for institutional investors as of November 2007.

Stock Drop

The Standard & Poor's 500 Index is down 12.4 percent this year, heading for its first loss since 2002. Government, corporate and mortgage debt returned 1.2 percent on average, less than inflation, according to Merrill Lynch index data.

``We're in a long-term strategy,'' said Bob Borden, chief financial officer for South Carolina's retirement system. ``The risk we were taking by being 50-50 long only U.S. stocks and bonds was profoundly higher.''

Public pension funds are already overestimating their future performance, according to a survey of 147 retirement systems by Greenwich Associates. The Greenwich, Connecticut-based consulting firm found in April that fund managers forecast outperforming market benchmarks by 1.46 percentage points over the next five years, an outcome it called unlikely.

States owe about $2.35 trillion in pension payments over the next 30 years to retirees, the Pew Center on the States said in December 2007 report. Based on 2006 figures, the funds were short an estimated $361 billion, according to the nonprofit public policy group based in Philadelphia.

Texas Teachers

The Austin-based Teacher Retirement System of Texas, which manages $106 billion, said in May it will increase investments in alternatives to 30 percent from 11 percent over the next several years. New Jersey expects to increase its alternative investments to 18 percent of its holdings from 11.5 percent, said William Clark, director of New Jersey's Division of Investment, which oversees the statewide pension fund.

New Jersey's system, which has $77.7 billion in assets, earned 36.6 percent on commodities in the year ended June 30, partially offsetting a 10.3 percent loss on domestic equities.

``The risk is that if there is this rush to get into alternatives, investors could get crowded out,'' losing access to managers, Clark said.

California Returns

The California Public Employees' Retirement System, the largest U.S. public pension plan, said on July 18 it earned 22.9 percent in a new asset class linked to inflation during the nine months since those investments began. It had gains of 19.6 percent on private equity positions for the 12 months ended March 31, while real estate holdings advanced 8.1 percent.

The $239 billion fund, which lost 2.4 percent in the 12 months ended June 30, also approved an expansion into commodities in the past year, while increasing its target for private equity investment to 10 percent from 6 percent last December.

The need to maintain returns comes as 29 states are facing at least $48 billion in budget shortfalls for the 2009 fiscal year that for most began July 1, according to the Washington-based Center on Budget and Policy Priorities, a nonprofit group.

To contact the reporters on this story: Adam L. Cataldo in New York at acataldo@bloomberg.net; Michael McDonald in Boston at Mmcdonald10@bloomberg.net.