Public pension plans, long considered laggards in embracing new trends in investment management, appear to have shoved corporate plans aside in their zeal to explore absolute return strategies.
Public funds as big as CalPERS and as small as the $259 million New Haven (Conn.) Police & Firemen's Pension Fund have combined to commit some $3.5 billion to hedge fund strategies since Sept. 1, 2001, according to published reports.
Many in the industry find this development noteworthy, but not all that surprising. Public pension funds, after all, have struggled for years to become fully funded. Some still have not. A number of them achieved fully funded status only recently, just in time to see equity returns melt away, along with the plans' assets.
Additionally, many public pension plans offered benefit increases to public employees in the late 1990s, when the stock market boom was providing plans with 20% annually returns - or more. Those chickens have come home to roost now that the Standard & Poor's 500 stock index is sitting at -20% for the one-year period ended June 26.
There also are political considerations. Often, one or more trustees are elected officials. The recent recession has led to slashed budgets and a climate in which pension funds come under heavy fire for seeking increased funding from taxpayers. It's the rare politician who will support increasing funding to a public pension fund over saving a couple hundred jobs.
All this has combined to form a sort of perfect storm of funding doom for public pension funds, said David Russell, a principal at Ennis Knupp & Associates Inc., Chicago.
Huge pressure
"There is huge pressure on public funds," Mr. Russell said. "They are being forced to go to their legislative bodies and say, `You know that zero contribution you've had for five years? Well, that contribution is now a whopping big number.' These guys (the plan sponsors) are under an awful lot of pressure to make money. It's probably an unprecedented amount of pressure because of the confluence of all these forces."
Some public funds that enjoyed contribution holidays thanks to strong equity returns - including the $84 billion New Jersey Division of Investment, Trenton - are now asking the legislative bodies that oversee them for additional funding to help them meet projected liabilities.
"This is at a time when the economy is heading downhill and revenues are down," Mr. Russell continued. "State and sometimes county revenues are down. There are tremendous budget pressures. This means politicians are putting on pressure, taxpayers are putting on pressure, and constituent groups like unions are putting on pressure."
Of course, corporate pension plans face the same pressures, albeit often without the glare of the public spotlight and the political aspect. And one other consideration, Mr. Russell noted: Corporate plans generally were much further ahead on the funding curve than public plans. Many were overfunded, and the recent market weakness either has merely eroded the amount of overfunding or driven them to a slightly underfunded status. With five-year accounting smoothing, the situation on the corporate side isn't as dire as it seems for public funds.
Hence the public funds' heightened interest in generating alpha, and their interest in hedge funds as a way to do that.
Christopher C. Sugrue, chairman of PlusFunds Ltd., New York, which offers hedge fund investments and services, said that just a year or so ago it would have been unusual for his firm to get a call from a public pension plan or a consultant representing a public plan inquiring about hedge funds.
Now it's commonplace.
"It's not surprising to get a call from a consultant doing research on behalf of a public pension fund, or having the funds themselves call," Mr. Sugrue said. "The pervasiveness of the interest is a dramatic shift. The fact that today nobody is surprised to get that phone call is itself a little surprising."
Published reports indicate a long list of public funds searching for or allocating to hedge fund or fund-of-funds managers. They include: the $143 million Arapahoe County pension plan, Littleton, Colo.; the $338 million Duluth Teachers' Retirement Fund, Duluth, Minn.; the $6.1 billion Louisiana State Employees' Retirement System, Baton Rouge; the $3 billion Contra Costa County Employees' Retirement System, Concord, Calif.; and the $22.8 billion Illinois Teachers' Retirement System, Springfield.
High-profile commitments
Larger funds have made some high profile commitments to hedge fund strategies. The $149 billion California Public Employees' Retirement System, Sacramento, has promised to allocate $1 billion to hedge funds, but so far has allocated about $60 million, according to CalPERS officials.
CalPERS' planned allocation is small but typical of the cautious approach many public pension plans are taking to hedge funds. Such a small allocation is unlikely to have much effect on the plan's overall returns.
The most popular hedge fund strategy is a sort of enhanced index strategy that uses hedge funds to add alpha to an S&P 500 index portfolio. Joe Nankof, a partner at Rocaton Investment Advisors LLC, Darien, Conn., said the best most pension plans can hope for from a 5% allocation to an enhanced index strategy like that is 15 basis points added onto the total portfolio return.
That number can grow, depending on the variation in the hedge fund investment strategy, the amount of assets committed and the use of leverage, but when pension funds are looking at returns 10 percentage points and more below actuarial assumptions, plenty of people make the argument that the modest hedge fund allocations most plans are making won't do much to affect the big picture.
Still, it seems that some public pension funds are eager for even a small additional return.
"If you're running a pension fund and you have these obligations to meet, it's difficult to meet them with long-only strategies," Mr. Sugrue said. "That's driven pension funds to see that they shouldn't necessarily be fixed only on the long side. They need someone to play opportunistically on the long and the short side."
Mr. Sugrue said he suspects that even when the markets do recover, pension plans will stay in hedge fund strategies. After all, they will have put a lot of time and energy into researching them, and many will be getting comfortable with hedge fund strategies and how they fit into an overall portfolio.
And somebody, of course, must lead the leaders. In this case, it appears to be the $24 billion Pennsylvania State Employees Retirement System, Harrisburg.
Jumping headfirst
While CalPERS is easing into the hedge fund waters one toe at a time, Pennsylvania has jumped headfirst into the river, although not without carefully checking the depth of the water, fund spokesman Sean Sanderson said.
Pennsylvania has allocated some $3.1 billion to funds of funds run by Blackstone Alternative Asset Management, New York; Pacific Alternative Asset Management Co., Irvine, Calif.; Morgan Stanley Alternative Investment Partners, New York; and Mesirow Advanced Strategies Inc., Chicago.
That's 12% of the fund's total assets, Mr. Sanderson said. The goal is to gain incremental return.
Rocaton, Pennsylvania's consultant, did "extensive due diligence," Mr. Sanderson said, and the fund also has used Cambridge Associates LLC, Boston, as a consultant on hedge funds.
There are, of course, cautionary tales. One involves the Art Institute of Chicago's $650 million endowment. In December, officials announced the endowment had lost at least $23 million - and perhaps all $43 million - of the money it invested with Dallas-based hedge fund Integral Investment Management LP. The Art Institute at the time had some 59% of its total portfolio in hedge funds.
Following the Integral losses, the Art Institute fired its longtime consultant, Kennedy Capital Advisors Inc., Atlanta, and hired Cambridge Associates.
Cautious approach
The Illinois Teachers fund is taking a cautious approach to hedge funds. The plan's interest stems not from an overwhelming desire to generate additional return, but from a general interest in diversifying the portfolio, said Charles Self, chief investment officer.
The plan is 60% funded, and is in the eighth year of a 50-year state-backed plan to become 100% funded. The system's trustees will spend part of a three-day meeting in August discussing hedge funds and what they can do for the portfolio.
"The state is facing a severe budget crisis, and in the face of all the negative budget pressure, the General Assembly and the governor still gave us the full amount of funding required by law," Mr. Self said.
Still, the system's funded status probably will continue to decline, thanks to growing numbers of teachers and poor market returns. Hedge funds may offer some help.
"There's openness to look at alternatives, and probably this market environment has helped that," Mr. Self said.
