The idea that a state pension fund would use a large amount of leverage to “reduce risk” seems problematic in several areas covering both theory and implementation (“Wisconsin may pioneer leveraged approach,” Jan. 11, Pensions & Investments).
While the Markowitz mean/variance optimization model uses standard deviation or volatility as a risk proxy, it is just that, a proxy. Volatility is not equal to risk. (The model is not the reality; the map is not the battlefield.) Volatility may be a good — or even the best — risk measure, but it is not equal to risk from either an ex post or ex ante perspective. (Does anybody think the historical volatility of Lehman, or the S&P 500, prior to the recent financial crisis truly represented the risks involved?)
As for hedge funds mitigating risk without sacrificing returns, who in the market is assuming that risk without requiring a higher return as compensation? (Especially if a bunch of multibillion-dollar pension funds now allocate more to hedge funds and leverage.)
I would suggest: (a) They keep the risk but it is just hidden in a skewed distribution that's blamed on a black swan long after the higher fees are paid. (b) It ends up hidden in some banks' balance sheets or other items not quite marked to market. (c) There are hedge fund winners and losers, some with skill/luck and some without. Either way it's a zero-sum game. (d) Some or all of the above and more.
When it comes to implementation, as many “portable alpha” programs experienced, raising cash when markets are down can aggravate instead of mitigate losses.
Senior investment officer
New York City Comptroller's Office