Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

Alternative fund managers and regulators will convene in Washington, D.C. from July 19 through 21, 2011 to talk about pension investing in hedge funds and private equity funds. Over several days, those who present before the ERISA Advisory Council will be asked to address questions such as those listed below:

• What differentiates a hedge fund from other types of investments?
• What differentiates a private equity fund from other types of investments?
• How are hedge funds and private equity funds, respectively, correlated with the returns of traditional equity and fixed income investments?
• How can defined benefit and defined contribution plan sponsors mitigate "the lack of liquidity that is characteristic of these investments?"
• How can fee transparency be enhanced?
• "Are there any unique diversification benefits offered by hedge funds and private equity investments as opposed to a fund of funds?"
• What is the view of target date fund managers with respect to including hedge funds and/or private equity strategies within their funds?

According to U.S. Department of Labor documents, the aim is to create best practices guidance in areas such as leverage, liquidity, transparency. valuation, operational due diligence, client and asset concentration and offering documents. Click to download "2011 ERISA Advisory Council: Hedge Funds and Private Equity Investments." Click to read the June 22, 2011 U.S. Department of Labor news release about the forthcoming meetings to address hedge funds and private equity investments by ERISA plans.

Interested readers may want to check out the following of many items that are available for further research:

• "Testimony of Dr. Susan Mangiero About 'Hard to Value' Assets Before the ERISA Advisory Council," September 11, 2008;
• "The Growth and Impact of Direct Investing," Citi Prime Finance, June 2011;
• "Pension Fund Investment in Hedge Funds" by F. Stewart, OECD Working Papers on Insurance and Private Equity Pensions, No. 12, OECD Publishing, 2007;
• "Defined Benefit Pension Plans: Plans Face Valuation and Other Challenges When Investing in Hedge Funds and Private Equity Funds," U.S. Government Accountability Office, July 20, 2010;
• "A Guide to Institutional Investors' Views and Preferences Regarding Hedge Fund Operational Infrastructures," Alternative Investment Management Association, May 2011;
• "The Hedge Fund of Tomorrow: Building an Enduring Firm," Casey Quirk, April 2009;
• "Pensions and private equity: where does the relationship go from here?" by Toby Lewis, Global Pensions, June 6, 2011; and
• "Private Equity Principles, Version 2.0," Institutional Limited Partners Association, January 2011.

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In "Risk Management Q&A: Risk is a four-letter word" (Perspectives, RBC Dexis Investor Services, April 2010), I talk about meaningful changes in terms of risk management as a result of the financial crisis. My comments about leverage in the same interview are nothing new. Leverage is not necessarily good or bad. Importantly, institutional investors must understand how to properly measure leverage and establish internal controls.

"All leverage is not created equal. A short position in an actively-traded instrument has a different risk-return profile than taking on debt or synthesizing exposure with puts or a combination of derivatives."

To read the full interview, go to page 10 of "The global power shift: New directions for the world economy". I am also quoted on page 8 in the article entitled "Reversal of Fortune: Regulators could push the consolidation trend back a few years" on the topic of reactionary regulation.

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If institutional investors thought of leverage as a bouquet of daisies, they'd be playing "(S)he loves me, (S)he loves me not" and hoping to still be respected in the morning. Now that the worst economic recession of modern times might be abating somewhat, more than a few buy side executives are looking for a sweetheart to help them replenish diminished portfolio values. Let's just hope that the love affair is not fickle, causing more hurt than help.

In "Wall Street's New Flight to Risk" (February 15, 2010), Bloomberg BusinessWeek reporters Shanon D. Harrington, Pierre Paulden and Jody Shenn write that investors are on the prowl for yield. With over $150 billion allocated to U.S. bond funds, returns are low and the only way to add some excitement is with exotics such as "payment-in-kind" bonds that encourage the issuance of more debt than a borrower's operating cash flow would ordinarily support. Derivatives are another Valentine, with banks "again pushing" collateralized debt obligations ("CDO's) that can increase in value (depending on the trade) as defaults increase. 

On January 27, 2010, Wall Street Journal reporter Craig Karmin writes that public pension funds are borrowing money to enhance returns rather than allocating to alternatives such as hedge funds and private equity pools. According to "Public Pensions Look at Leverage Strategy," funds can turn in a good performance with the use of leverage without having to resort to "volatile stocks" or illiquid assets. Others quoted in this recent piece suggest that risks exist and must be acknowledged.

Heartbreak hotel - here we come.

Call me crazy but a move towards leverage (possibly excessive) seems scary UNLESS and UNTIL asset managers and institutional investors alike can demonstrate that they know how to properly measure and manage. For every person who is asked to define investment leverage, the answer is seldom the same. AIMA Canada makes a good effort to add clarity to this important topic. See "An Overview of Leverage" (Strategy Paper Series Companion Document, October 2006, Number 4).

L'amour with leverage - how sweet it is, until it isn't. Then what?

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