The use of economically targeted investments appears to be increasing, yet the lack of any consistent reporting, or even definition, makes counting of ETIs, let alone analyzing their performance, difficult.
In examining the financial reports of many large public employee retirement systems for dollars invested in ETIs, I found, in fact, none of them uses the term economically targeted investment.
That might not sound too surprising, because ETIs fit into other asset classes for accounting purposes. Yet outside financial reports, ETI has become a common term for pension investments targeted to specific goals, primarily housing and job creation, within their geographic areas. The importance of the term is that it helps to distinguish these targeted investment from other "social" investments. The "economic" in the term is intended to emphasize that the investments have an economic purpose and do not provide financing at a subsidized rate.
The term hasn't caught on everywhere. For example, a 1993 survey by the Pennsylvania state treasurer suggests some variations in identifying ETIs. To the question, "Does this public pension fund actively pursue ETIs in the state's economy?" only 15% of the 41 responding state pension funds answered "yes." On the other hand, answering the question, "Does this public pension fund have a specific policy for targeting investments?" the funds reported "yes" for the following enterprises in these percentages: female-owned firms, 9%; minority-owned firms, 11%; in-state firms, 9%; venture capital funds, 28%; and real estate, 32%.
Which type of targeting are we talking about? Clearly there must be a definition of the term ETI before ETI investments can be counted. The definition of ETIs is nearing consensus, partly because of strong interest by the Department of Labor, which is reviewing proposals for a national ETI clearinghouse. Most definitions now include such details as: prudent investments made by pension funds that provide competitive, risk-adjusted rates of return, target capital gaps created by market inefficiencies and produce collateral economic benefits.
However, the counting of ETIs remains a problem. Without consistent definitions and counts, as well as reporting, retirement systems have little opportunity for comparison of their ETI programs with others. Furthermore, without such precision, observers inside and outside the retirement systems have difficulty measuring ETI results.
Trying to define ETIs consistently for the Brancato Report, we came up with a total of $23.5 billion in ETIs among the 20 largest public retirement systems, or 3.6% of their total assets. More than 86% of the ETIs were in housing, mortgage-backed securities or real estate. In addition, a little more than 10% of the ETIs went to venture capital and other partnerships. Another 3.5% was invested in in-state private placements and other direct investments.
To date, the dominance of housing-related ETIs is overwhelming. But the use of other kinds of ETIs is also growing rapidly and gaining significant backing. As analysts maintain and revise the statistics, it's helpful to look at each component of the ETI definition in more detail. The five components suggest a serious challenge to the new Labor Department-sponsored clearinghouse and to the rest of us who attempt to analyze ETIs.
Prudence and fiduciary responsibilities: Many of the previous analyses of ETIs have discussed the legality of such investments. The recent ERISA interpretive bulletin further clarified some of the fiduciary questions (Pensions & Investments, June 27). It is clear ETIs may meet ERISA's fiduciary requirements so long as the investment has an expected rate of return comparable to alternative investments with similar levels of risk.
Competitive risk-adjusted rate of return: Determining the "market rate of interest" on specialized investments is a complex calculation. It requires defining the risk and the "competitive" or market rate of return on investments that basically are non-market investments. Appropriate benchmarks must be developed.
Collateral economic benefits: The rationale for making economically targeted investments is an expected collateral return from the investment - beyond the competitive return. Simply counting the number of "jobs created" or "houses built" does not tell the whole story about economic impact. Would these benefits have occurred without the pension investments? Will the money spent or earned as a result of the investments "leak" out of the state, or will it "multiply" into more jobs, more houses? Economists continue to wrestle with how to quantify local economic impact; and it cannot be easy for retirement systems.
Capital gaps resulting from market inefficiencies: By definition, no investment by a pension fund will have an impact on its target if the investment would have been made in any case, even in the absence of the pension fund investment (that is, if it merely "displaced" other investments). Non-displacement investment opportunities exist when there is a capital gap - that is, when markets are not operating efficiently and therefore some projects are not funded despite their ability to pay competitive rates.
The types of projects that will be subject to capital gaps often include important sectors of our society, such as small businesses, venture capital for new firms and affordable housing. A full understanding and inventory of specific capital gaps relevant to a fund's investments requires up-to-date information on a local level, including an analysis of current institutional capacity and lending practices.
Targeting: The targets for ETIs are, by definition, "economic," but more generally include any investments in the public interest. Infrastructure investment recently has been added as a potential ETI target.
There is still much analytic work to be done before legitimate claims can be made about the role of ETIs in pension fund portfolios. We need better measures of investment performance and risk of ETIs. We need better measures of local economic impact. And locally, the pension funds need to develop information on the capital gaps in their geographic areas.
When more of this groundwork is complete, ETIs will be easier to count. It also will be easier for policy-makers to determine the desirability of ETI programs and for pension funds to judge the success of their programs.
D. Jeanne Patterson is a professor in the School of Public and Environmental Affairs at Indiana University, Bloomington. She worked on the Brancato Report (Pensions & Investments, May 16), preparing the section examining economically targeted investments at large public pension funds. The views expressed in this commentary are hers and don't necessarily represent the report.
