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February 13, 2006
Pension plans turn to hedge funds
If you had a chance to look under the hood of your pension fund, you just might find a hedge fund or two inside.
Public pension funds, like other investors, have been struggling to boost returns amid sluggish stock and bond markets. Many have turned to hedge-fund managers and their often-unorthodox ways to get a bigger bang for the buck.
Hedge funds have been on a roll anyway. The snooty, unregulated and byzantine investment partnerships now count more than $1 trillion in assets and outnumber mutual funds, by some estimates.
Their ability to ride unconventional tactics to modest gains during the stock-market slump of 2002 generated fans among rich individuals, endowments and other upscale investors.
Many pension funds, which invest on behalf of various employee groups, are showing interest.
"Once they start marching down a road, pension funds don't get deterred easily," said Edwin Burton, a trustee of the Virginia Retirement System, at a recent hedge-fund conference in Scottsdale. "And they won't get deterred in this case."
Pension funds in Virginia, Texas, New Mexico and other states use hedge funds to manage a portion (usually small) of their assets. Arizona's largest public fund, the Arizona State Retirement System, uses hedge tactics in moderation.
"If you don't think you can make your 8 percent a year, you look anywhere you can to add value," said Paul Matson, ASRS director, citing a common investment target of pension managers.
Hedge funds mean different things to different people. Some associate them with scandals such as those involving Long-Term Capital Management, Bayou Management and Canary Capital. Others see nimble vehicles run by astute Wall Street pros.
"What sets hedge funds apart is that the tool kit available to managers is extremely large and varied," wrote Bernstein Investment Research & Management in a report.
The tools include short selling of stocks, options and futures contracts, dabbling in currencies and other non-traditional assets, and potentially high use of leverage, with the power to magnify gains or losses.
Although hedge funds have a reputation for being risky, many are highly conservative, seeking to eke out modest gains regardless of whether stocks are rising or falling. A key reason hedge funds are growing popular with pension funds is their ability to diversify away risk.
"Hedge funds allow us to get an acceptable return at low risk levels," said Bob Boldt, CEO and chief investment officer of University of Texas Investment Management Co., speaking in Scottsdale. "We then can take (greater) risks elsewhere in the portfolio."
Certain public Texas funds have roughly one-quarter of their portfolios in hedge funds, representing $5 billion in investments, he said.
Hedge funds also have proven popular with other institutions: Yale University's endowment recently held about one-quarter of its assets in hedge funds.
The partnerships really shine at times when Wall Street is in full retreat. Hedge funds whose results are tracked by the Hennessee Hedge Fund Index lost 2.9 percent on average in 2002, when the Standard & Poor's 500 index slumped 22.1 percent. By contrast, the S&P 500 beat the Hennessee index by about 10 percentage points in 2003, while the past two years have been a wash.
"When you hit bear markets, you want to be able to earn positive returns," said James Marten, a Merrill Lynch financial adviser in Phoenix who counsels foundations and endowment funds on hedge funds.
Over the 19 years from 1987 through 2005, the Hennessee index returned an average 13.7 percent yearly compared with 11.6 percent annually for the S&P 500 - and did it with less volatility or risk.
A Bernstein study spanning 10 years showed hedge funds performing in line with the S&P 500, with less risk.
So why don't all pension funds clamor for hedge funds? High fees are one reason. Hedge-fund managers typically charge 2 percent yearly and take 20 percent of all profits over whatever benchmark or target the manager selects.
"That's significantly more than anything we currently pay," Matson said.
ASRS doesn't use hedge funds but utilizes certain hedgelike tactics for a small portion of the portfolio, relying on traditional money managers inside separate accounts.
Hedge funds haven't been popular for all that long - one or two decades, depending on whom you talk to. Matson cites this as a problem. "There's no good historical database on how things have done," he said.
Also, when you factor in trading costs and tax considerations, hedge-fund results come up short compared with traditional market measures, according to the Bernstein report. Pension funds don't have to worry about taxes, but this is a factor for wealthy individuals. (Individuals generally can qualify with a net worth of at least $1 million or income exceeding $200,000.)
Hedge funds also come with other blemishes. For example, information about their investment holdings is tough to obtain, and investors often must agree to lock up their money for six months to two years, Marten said.
Even fraud appears to be a bigger danger with hedge funds compared with pension or mutual funds, as the Bayou Management scandal involving a fictitious Pinal County gold mine showed.
"There is a place for them so long as everyone understands the risks," Marten said.
-The Arizona Republic-
Posted by su at February 13, 2006 10:20 AM