More Bad Ideas and Broken Promises
While we're on the subject, consider the fact that pension funds are once again loading up on "alternative investments", this time in the form of hedge funds:
Pensions Leap Back to Hedge Funds
Public pension plans are lifting hedge-fund investment, seeking to boost long-term returns despite losses suffered in some funds in the financial crisis.
Also, pension officials are using the historically strong returns of hedge funds to justify a rosier future outlook for their investment returns. By generating more gains from their investments, pension funds can avoid the politically unpalatable position of having to raise more money via higher taxes or bigger contributions from employees or reducing benefits for the current or future retirees.
The Fire & Police Pension Association of Colorado, which manages roughly $3.5 billion, now has 11% of its portfolio allocated to hedge funds after having no cash invested in these funds at the start of the year. "There has been some deserved criticism of hedge funds, but many hedge funds during the market downturn in 2008 did better than the S&P 500," said Dan Slack, the chief executive of the system.
While pensions have been investing in private equity and what are called alternative investments for many years, hedge funds have represented a smaller part of their portfolio. The average hedge-fund allocation among public pensions has increased to 6.8% this year, from 6.5% for 2010 and 3.6% in 2007, according to data-tracker Preqin.
The number of public pension plans investing in hedge funds has leapt 50% since 2007 to about 300, according to Preqin. State pension systems had $63 billion invested in hedge funds as of their fiscal 2010 and are expected to invest another $20 billion in hedge funds in the next two years, according to a recent report by consultant Cliffwater.
In March, the New York City Police Pension Fund voted to invest in a firm that puts money into a variety of hedge funds, the first such move by the city's pension funds, which manage $117 billion. In the past few months, two more New York City pensions made the same decision. Together the three funds invested $450 million with hedge-fund firm Permal Group.
It is a "first step into hedge funds," said Larry Schloss, the New York City chief investment officer. He says he hopes the investment will help the city's pension system avoid the "wild ride" it has taken in recent years. The system had $115 billion before market tumble in 2008, when it fell to $77 billion.
New Jersey's State Investment Council, which sets investment policy for the state's pension fund, voted last week to raise the target allocation for hedge funds to 10% from 6.7%, which would make hedge funds the $73 billion fund's largest alternative investment asset.
- Once upon a time pension funds invested mostly in low risk-assets like bonds, because risk was unacceptable for money that had to be there. Pensions are legally binding promises made by governments to their workers, so non-payment isn't an option; when a pension fund fails taxpayers are generally stuck with the bill.
- But with the US government keeping interest rates artificially low in order to ease its debt burden, the available returns on low-risk investments has fallen to a fraction of the rate that pension funds need to cover the promises made by government officials to buy union peace. So pension funds are "diversifying" into "alternative" investments like hedge funds that promise higher yields.
- This will work beautifully in the aggregate as long as the markets are generally moving up, i.e. as long as the "risk-on" trade is profitable. As soon as a slowing economy, the dissolution of the Eurozone, a Middle East crisis, or just a technical 20% correction sends capital scurrying away from high-risk strategies, hedge funds -- and real estate and private equity and foreign growth stocks -- will not only fail to generate the necessary 8% return; they'll suffer losses, which will pull the entire pension fund complex into the red, moving them even further from their promised trajectory.
- Of course, the alternative is to load up on bonds and cash, which, with the dollar being depreciated at an accelerating rate, will probably be the worst possible investments going forward. So given the mess the US has made of its financial markets, maybe hedge funds are actually the lowest-risk alternative.