Public Pensions and Hedge Funds
In "States Double Down on Hedge Funds as Returns Slide," Bloomberg reporters Adam Cataldo and Michael McDonald (August 14, 2008) suggest that public pensions may get a double whammy if alternative investments go south. New York, New Jersey, South Carolina and Massachusetts are just a few of the large public plans now allocating monies to non-traditional investments such as hedge funds, real estate and private equity. This is not necessarily good or bad though one wonders about the timing. Will current market volatility help or hinder plans in search of higher returns? This blogger is quoted as follows:
"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."
Managing director Eileen Neill, with Wilshire Associates, states the need to "diversify some of the equity risk" and to attempt strategies that will help match the growth in liabilities. As I told the Bloomberg reporters (though not included in this article), how one measures diversification potential is key to understand. Correlation analysis only goes so far when markets are turbulent and bad news tends to adversely impact otherwise uncorrelated markets. Additionally, correlation assumes a linear relationship when comparing returns for a particular investment pair (hedge fund versus a large cap equity index for example). When the relationship is non-linear, correlation is less useful as a gauge of potential risk reduction.
Just as important, past is not prologue. Assessing historical returns can be misleading at best. Stan Rupnik, Chief Investment Officer at the Teachers' Retirement System of the State of Illinois, is quoted as saying that "Chasing performance, especially in a public fund, can be a dangerous thing." It is important for trustees to make sure that "what if" analysis is being done on a regular basis, taking into account relevant risk drivers. Consider private equity and venture capital. An accelerating credit crisis has made it extremely difficult for companies to go public or for potential suitors to finance their bid. As a result, returns suffer. No surprise that pension investors (and their plan participants) take a hit too.
Editor's Note:
- Check out "29 States Faced Total Budget Shortfall Of At Least $48 Billion in 2009" by Elizabeth C. McNichol and Iris J. Lav, Center on Budget and Policy Priorities, August 5, 2008
- Read "The Tech I.P.O. 2008, R.I.P." by Tom Steinert-Threlkeld, "Between the Lines," August 8, 2008
- An online statistics textbook, courtesy of Stat Soft, provides some insight about correlation and linearity.
