Public Pension Systems Betting on Hedge Funds
By Tomoeh Murakami Tse Washington Post Staff Writer Tuesday, July 24, 2007; D01
Determined to keep its promise to the state's public employees, teachers, police officers and firefighters, the Montana pension system may venture into a high-stakes corner of the investment world: hedge funds.
The idea was proposed in two recent studies commissioned by the $8 billion retirement system, which also recommended opening up to other nontraditional investments to keep generating the annual returns necessary to meet its obligation to retirees.
"That's what [they] indicated we needed to make our 8 percent return," said Carroll South, executive director of the board, which oversees investing for all state funds, including nine pension funds. "Over the last 12 years, we have slightly beaten the 8 percent requirement. But no one expects the public-equity market to return what it has going forward."
With a flood of baby boomers set to retire in coming years, pension funds across the country are shedding their stodgy stocks-and-bonds-only portfolios and ratcheting up investments in hedge funds. The move comes as hedge fund returns have cooled, as two high-profile hedge funds came close to failing and as concerns have mounted that more problems are around the corner.
"There's an inconsistency between the concept behind hedge funds, which is high-risk, high-return, and the concept behind pension funds, which is little risk, guaranteed return," said William F. Galvin, the Massachusetts secretary of state. "Unfortunately, what's happening is, increasingly, managers of pension funds -- most of whom have large debt or potential debt in the future -- see this [investing in hedge funds] as sort of a panacea for their growth needs. And it's not. It's a very dangerous approach."
Once reserved for the wealthy, hedge funds are lightly regulated investment vehicles that are handling an increasing amount of money for middle-class workers through pension funds as well as retail investors through funds of funds. By pooling money, funds of funds allow investors who do not have the minimum required investment -- often in the millions of dollars for hedge funds -- to gain access to the exclusive club.
Now an estimated 9,000 hedge funds with assets of $1.4 trillion are making big bets on movements in multiple markets -- stocks, bonds, commodities, currencies, futures and derivatives. The contents of a hedge fund can be arcane and difficult to value because they are not actively traded.
And that can trip up even the most sophisticated money mangers. This week, Bear Stearns, a Wall Street firm known for its expertise in bond-trading and cautious approach to risk, notified clients that their investments in two prominent hedge funds were worth pennies on the dollar, if that. The funds had made bets on risky bonds backed by subprime mortgages, loans made to homebuyers with shaky credit.
Some regulators see the rise of hedge funds, which borrow as much as 10 times their cash holdings to execute their investment strategies, as a double-edged sword. On one hand, they have become an important source of capital to markets, allowing securities to be traded efficiently and helping to spread risk across many investors. Experts estimate that hedge funds account for more than half of the trading on the New York Stock Exchange.
Meanwhile, regulators are concerned that hedge funds could be making dicey bets that, if they go wrong, could spread and strain entire financial markets. Hedge funds are fiercely protective of their trading strategies, and unlike mutual funds, are not required to register or disclose their holdings to the Securities and Exchange Commission.
Pension fund managers say they are making their investments with their eyes wide open. Those with large exposures to hedge funds say their risk is spread out over many funds with varying investment strategies, including some hedge funds designed to benefit when stocks fall.
"This is not all about reaching for return," said Larry Swartz, executive director of the Fairfax County pension funds' board of directors. "It's about developing a smoother return stream and managing the level of volatility in the retirement system year to year."
Whatever the case may be, analysts say investments in hedge funds by retirement plans will only grow larger as they seek higher returns than what their traditional portfolio of stocks and bonds have offered.
Hedge funds, however, don't always beat the stock market. The average hedge fund has returned 7.7 percent this year, lower than the 9 percent return for the S&P 500-stock index, and less than the annual returns of more than 30 percent that put hedge funds on the map in the 1990s, according to Hedge Fund Research.
Institutional investors are expected to put more than $1 trillion into hedge funds by 2010, up from about $360 billion as of late 2006; pension funds will account for two-thirds of new institutional money flowing into hedge funds, according to a study by the Bank of New York and consulting firm Casey, Quirk & Associates.
The California Public Employees' Retirement System, the largest pension fund in the country, recently decided to increase its allocation to hedge funds to as much as $12 billion. It made its first foray into the hedge fund world five years ago, with an initial investment of $50 million.
The New Jersey retirement system is in the process of allocating up to an additional $3.8 billion to hedge funds. That would be nearly a sixfold increase from the original $800 million investment in 2006.
The Virginia pension fund, which covers more than a half-million teachers, state and local government employees, began putting money in hedge funds in 2003 and now has about $2.6 billion invested.
These are big investments, but they represent a relatively modest portion -- 4 to 6 percent -- of the three states' total assets. Others have larger stakes.
In Fairfax County, hedge funds represent 12 percent of the $900 million pension fund for police officers. Another county-sponsored pension fund, which manages more than $2.8 billion for public employees, has about 20 percent of its assets in hedge funds or investments with hedge-fund-like features, said Swartz, of the Fairfax funds' board.
The San Diego County Employees Retirement Association invests up to 20 percent of total assets in hedge funds through its Alpha Engine program, according to a report released in April. One of the funds was Amaranth Advisors, which collapsed last fall after a bet in the natural gas futures market turned sour. The fund lost billions in a matter of days.
Critics say pension funds, which are legally bound to pay out a steady stream of benefits to retirees, should be treading more carefully in hedge funds. They point to the high fees charged by hedge fund managers -- generally 20 percent of profits and 2 percent of assets under management -- and "lock-ups" that can restrict investors from withdrawing their money for months.
"Because of their unpredictability, because of the flexibility they're afforded, and the lack of transparency, these people really don't know exactly what they're buying," said Galvin, the Massachusetts secretary of state.
Some regulators worry that not all pension funds are equipped to choose the appropriate hedge fund managers. Some pension systems, they say, rely too heavily on consultants to hire and monitor managers and are not doing a good job of vetting for risk.
Susan M. Mangiero, chief executive of Pension Governance, an independent research company, is analyzing a survey of screening processes pension funds use when hiring outside money managers who deal in the derivatives market -- a complicated area navigated by many hedge funds.
"The questions they are asking are too basic," Mangiero said. "A pension fund manager really needs to ask some tough questions about how the hedge fund is valuing these assets."
Charles Grant, chief investment officer of the Virginia Retirement System, said "to pay the kind of fees that they're asking, and to have the transparency challenges that we have, the bar is very high. And we only put money with people we have the absolute highest level of conviction."
He said most funds give summary reports on how many securities they are holding and the types of sectors, markets and geographical areas they are invested in. While that "allows us to understand their aggregate risk exposures," Grant said, " it puts a very high burden on us to continually communicate with the manager."
Some pension funds have opted to avoid the risk and stay away from hedge funds. Gary Dokes, chief investment officer of the $28 billion Arizona State Retirement System, is authorized by the pension fund's board of directors to invest in hedge funds. But he doesn't.
"In our shop, we have a problem with the hedge fund structure in terms of visibility, transparency, fees," he said. "We need to know and be able to monitor and be able to fully understand what their process is, versus someone just saying, 'This is the returns, oh great returns.' How did they do it? They can't explain it in five sentences."
In Montana, South, the executive director of the state retirement system, will be considering the recommendations to venture into the world of hedge funds.
"I am not terribly comfortable with the idea," South said. "We still think it's an asset class we need to seriously look at."