The Great Pension Hedge

I have written before about my worries and fears regarding the future of American pensions. I am neither unique, nor first to the party with said sentiment. Everybody is watching the Titanic cruise towards the iceberg and nobody can do a damn thing to stop it. Much like the captain of that famed ship, we refuse to try to steer away from trouble or even recognize what lies ahead.

Roger Lowenstein’s “While America Aged” remains a book every last one of you should read. I bring it up every now and again, when I hear stories like this one. I don't know whether to laugh or whether to cry. The only thing I know is that reason and logic have little place in this discussion. A discussion which will cost all of us dearly in the long run.

The Ohio Public Employees Retirement is looking to invest $1.2 of its $76 billion with a hedge fund as yet to be determined. Meanwhile The Pennsylvania Public School Employees Retirement System is doing the exact same thing with the exact same amount of money. The only difference is that these bureaucrats only have $51.2 billion to play with. To add, there are numerous other pension funds up to the same sort of unsavory tactics.

Now I love me some good ol' fashioned speculation. I have always stood by a hedge fund’s value to the financial system. Specifically the smaller ones, which bring a level of liquidity to markets which is especially important in the transitional period during which the fast paced world of finance adjust to the full and total takeover of high frequency and algorithmic trading. Hedge funds, however, are not the layman’s investment vehicle and pension funds are the ultimate layman. Pension funds are investment pools of millions of laymen and laywomen. People who (for the most part) are not the least bit savvy investors. People who have spent the majority of their lives paying dues to unions whom they trusted to manage their retirements. Those unions have failed them and are now taking risks which any dime store financial consultant would warn against.

With the inevitable pressure of the baby boomer retirement cycle beginning to rear its ugly head, America is once again at a crossroads about what to do with public pensioners. After all of the fraud and shade we have witnessed over the past few years. After all the scapegoating hurled upon financial professional and hedge funds in particular, is it really wise to now attempt to recoup lost pension funds in this fashion?

Let me remind you guys that a ton of pension money was already lost in a multitude of municipal bond sales gone awry and not to mention the ever present MBS bundles of sludge that won’t take a write down. What is really on this minds of public union managers when they begin to make investments which are generally known to be reserved for only two types of investors:

High net worth and savvy.

Attempting to chase back lost returns and maintain unreasonable and unrealistic return standards for public pensioners will not only lead to more fiscal problems, it will ultimately impede hedge fund managers’ abilities to take the risks necessary to generate returns for their investors.

Co-mingling pension funds with speculative capital can only hurt markets in the long run. In fact, I am very much afraid it will hurt markets in the short run by creating a more timid money manager and an even more low volume, illiquid market.

 

A pension fund should invest small portions in hedge funds and other alternative investments as part of a diversified portfolio. You make it sound as Joe the brick layer and Patty the teacher are making these investment decisions when you equate the type of investors that hedge funds are suitable for. We recommend hedge funds and alternative investments for high net worth clients, why would you not recommend them for a $76B pension fund? Shouldn't their collective buying power give them some advantages like investing in asset classes that they would otherwise be excluded from?

 
Chicago85:
A pension fund should invest small portions in hedge funds and other alternative investments as part of a diversified portfolio. You make it sound as Joe the brick layer and Patty the teacher are making these investment decisions when you equate the type of investors that hedge funds are suitable for. We recommend hedge funds and alternative investments for high net worth clients, why would you not recommend them for a $76B pension fund? Shouldn't their collective buying power give them some advantages like investing in asset classes that they would otherwise be excluded from?

Read between the lines. Pension funds are in trouble due to unrealistic expectations, (i.e. the eternal 8%) which led them to collectively make insane plays such as buying MBS bundles. Now that they are faced with not being able to bring returns to their clientele (pensioners) they are looking to speculate, not diversify. They are essentially hoping to hedge their own inability to invest soundly, by betting on others to do the job for them.
This would not be the end of the world if they continued to allocate a couple of percent to hedge funds, my worry is that we will see 2% go to 20% very quickly when they see some quick returns.

I agree that $76B is a ton of money it does not, however, compare favorably with $7.6 million of the high net worth investor's funds. Joe and Patty need guaranteed safe returns for retirement, even though they are not the one's making the calls, it is their money. Millions of people like our imaginary pair may combine for a large pool numerically, however, their buying power and (much more importantly) their risk profiles are in no way comparable to your clientele. There are reasons why hedge fund investing is not so easily accessible to everyone.

This without even getting into the effects on the HFs themselves.

 
Midas Mulligan Magoo:
my worry is that we will see 2% go to 20% very quickly when they see some quick returns.
This is where my head jumped to as well. It's not so much the immediate potential losses, but the gains that will cause the trouble - as soon as they make money, they're very liable to start pushing the ratio higher.

The lottery ticket mentality is contagious....

Get busy living
 
alexpasch:
, so long as they don't go overboard as far as allocation and know what they're investing in.

Precisely the point:

1) there is no guarantee that they know what they are investing in

2) going overboard is their recent modus operandi

For prime examples of both, dig up some MBS related investments by large pension funds a few years ago...or go back to Enron. The same logic defended those decisions, as well.

 
Best Response
Midas Mulligan Magoo:
alexpasch:
, so long as they don't go overboard as far as allocation and know what they're investing in.

Precisely the point:

1) there is no guarantee that they know what they are investing in

2) going overboard is their recent modus operandi

For prime examples of both, dig up some MBS related investments by large pension funds a few years ago...or go back to Enron. The same logic defended those decisions, as well.

1) they may not be the brightest institutional investors, but definitely better than the Joe Six Pack whose money they manage (and who if managing it by themselves, would either put it all into Netflix, or put it all into bonds)

2) I don't think it's overboard...they're not levering up to go into hedge funds. Many hedge funds have lower volatility than general market indices. They're be better off taking money out of mutual funds and putting it into hedge funds...

 

I think the biggest problem with public pensions investing in Hedge funds is when they try timing their exits. At least in Private Equity, there's a 10 year lock-up, so institutions are guarded from their own [poor] decision making.

Increasing their allocations to hedge funds can be good, as long as they aren't going beyond their risk tolerance. If they allocate to distressed or credit funds, it could very well have less risk than their public exposure. Hell, most pensions have venture capital exposure that haven't made money in over a decade.

 

8%. That's the problem. What would you do if you were a pension fund manager, and you had to hit 8% every year with an infinitely lived liability stream and US long bonds yielding 440 bps? You'd be totally F'ed in the A.

You have almost no options. There is some decent academic work by Steve Kaplan at the University of Chicago that says you get an extra 2% or so for a liquidity premium in investing in private equity vehicles. That's not a lot given the lock up periods, it still doesn't get you to the 8% you need, and PE cannot handle the size of the US pension community. There is over $15.25 trillion in US pension assets alone, and their interest in alternative investments is definitely part of the reason there is a $376 billion private equity overhang in the US at the moment.

At some point, GPs at PE and hedge funds just become asset gathers (isn't that right, Carlyle Group?). They cannot possibly generat alpha off their assets, but that doesn't really matter if your management fees are large enough. Instead of deploying all of their capital, then, they just sit on it. That's how you get the overhang. And since most PE limited partner agreements are structured so that LPs pay a management fee on committed capital (though, that has changed a bit after the financial crisis to incur fees only on called capital), they don't worry about throwing good money after bad investments to generate returns through levered beta (though they do that too), they simply sit on it.

It's a good feeling to have a pile of money swell ever-larger under your ass like the most glorious hemorrhoid of all time.

I digress. Alternative investments are not an asset class. It's a bit of a misnomer that you get diversification through investing in them. Alternative investing is a means of investing in other asset classes. I have only ever seen a few truly alternative strategies that are not correlated with market returns in any meaningful way. We're talking about litigation private equity, water rights sales on American farmland to water poor regions, and soft agricultural commodity financing to emerging market economies. But these all represent the tyranny of the special case. None of these strategies can handle a pension fund's size.

Let me put it this way. If you're Ohio, and you need to put $76 billion to work, you're probably going to have a 5-10% alternatives bucket. You're not going to invest in more than 50-60 funds because the paperwork is a pain, and you have to get your investment consultant and board to approve it. You then have to get NAVs for each fund every month, and you're going to probably have a staff of 2 accountants helping you. Despite having huge amounts of cash, these pension funds are run by a rather small number of people, so the paperwork alone prohibits large numbers of small hedge fund investments. Let's say you have a 10% allocation to alternatives. Let's say 5% goes to PE, and 5% goes to hedge funds. That's $3.8 billion going to hedge funds for Ohio. That's not a huge fund-of-funds, but it's not a small one either. Ostensibly, they're running their own fund of hedge funds and their own fund of PE funds. Let's say they invest in 100 funds (pretty much impossible for a man and his dog, but let's say they do it). That's $38 million per fund. That's a lot of size for most funds. That will make you the single largest investor in most funds.

Don't believe me? 82% of all hedge funds won't have to register with the SEC due to Dodd-Frank regulations. Why? Because that's the percent of all hedge funds that have less than $150 million in AUM. Most funds don't want or can't handle a $38 million investor. It's a real problem, because it forces all of the $10 billion+ pension funds, endowments and foundations to invest in the same small number of funds. That's part of the reason those funds--on average--have suffered a bit in their performance of late. They simply cannot handle the size of assets they currently have.

They definitely cannot handle more. Nearly 90% of the entire alternative investor market is comprised of institutional investors. There isn't more room for pension funds to take. Their options suck, though. I would not want to take a job as a pension fund manager. They are seriously underpaid and there is almost no way for them to change the status quo even if they wanted to.

Regardless, throwing more money into hedge funds is not a particularly good idea.

 

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