MILWAUKEE - Economically targeted investments can be viable for pension funds, a recent case study concludes.
The study was sponsored by the International Foundation of Employee Benefit Plans, Brookfield, Wis., and the University of Wisconsin-Milwaukee Center For Economic Development.
"One of our main conclusions in the study was that there were resources out there that could be garnered from various pension funds to make ETI investments," explained Marc Levine, the study's author and director of the center.
"The venture capital area, in particular, is one that seems to be underinvested." Fewer than 1% of the assets of public and private pension funds are devoted to venture capital, the study noted.
The study acknowledged that pension funds have a "legal obligation to beneficiaries to maximize their risk-adjusted return on investment." But, it added ETIs can provide the required returns as well as "non-financial benefits such as economic development and job creation."
However, the study cited few examples of pension funds willing to examine ETIs.
Intermediary proposed
To successfully develop a regional ETI program in Wisconsin, the study calls for the creation of a private intermediary called The Wisconsin Investment Forum. A cross-section of pension funds would work together, voluntarily, to:
* Identify promising ETI opportunities;
* Solicit proposals from outside investment managers for products to carry out one or more of the ideas;
* Co-invest in the new programs; and
* Monitor the investments.
Characterized as a "type of investors' cooperative," the Wisconsin Investment Forum would be organized and controlled by the participating funds. Additionally, it would have a "very small staff" of investment professionals monitoring the program, assessing the impact and helping to implement initiatives with qualified private investment professionals.
The study found that, in Wisconsin, the 75 largest pension funds have combined assets of more than $50 billion. Yet the allocations to private equity, real estate and "especially to venture capital" are lower than the national average.
As well, the allocation to small-cap and midcap stocks is also below the national average.
These differences, the study suggests, could provide opportunities for Wisconsin-based ETIs.
Venture capital questioned
One reason venture capital may not be an attractive destination for Wisconsin pension funds is that returns do not justify the research required. The study found that to compensate for the high risk involved, venture capital investments typically require a 30%-35% annual return and a "patient" capital time horizon. Although pension fund capital is often considered patient, in a bull stock market where indexed investing can bring 25% returns or more, venture capital investments lose their luster.
Small-cap and midcap companies, as well as "microenterprise programs" also offer opportunities for ETI investments, according to the study. It cited as an example "enterprises" such as the Wisconsin Women's Business Initiative Corp. that has helped low- and moderate-income women start their own businesses with loans up to $25,000; the study added that pension-funded ETIs could "clearly provide important capital to efforts such as" the women's corporation.
But while the opportunities for ETI programs can be identified, is there a willingness on the part of pension funds to stray from the security of Wall Street investment?
'Cautiously optimistic'
Mr. Levine said his research findings left him "cautiously optimistic" about the potential for attracting pension funds to ETI programs.
"For example, the Milwaukee Employees' Retirement System and some other local pension funds are interested in looking at ETIs," he said. "I don't, however, think that by any means there is a consensus on the issue. There is still some reticence, and in some cases, a misunderstanding about what ETIs might be.
"So my view would be that, yes, there is some interest but there's no formed consensus (from pension funds) as of yet."
Mr. Levine added that, to this point, there's greater interest expressed in ETIs among public pension funds than there is from private funds.
For his part, Patrick Cronin, financial manager of the Milwaukee ERS questions whether ETIs would be worth exploring.
"We don't as yet have ETIs as a separate category or type of investment," he said.
"Our statutory requirements are such that we are bound to require an investment manager to buy any type of security for us. It's therefore problematic if we would just focus on ETIs. But if they're a publicly traded security, an investment manager could invest in them for us. However, I think it would be problematic to find an investment manager who had particular skill investing in ETIs, should the board want to do that."
Mr. Cronin added that before his fund would consider an ETI investment, "the return offered would have to be there commensurate with the risk. We would not surrender return and take on additional risk."
The risk/return dilemma
Of course, risk vs. return remains one of the primary reasons for pension fund reluctance to invest in ETIs.
Mr. Levine conceded that's a "legitimate issue" with regard to what he termed "conventional ETIs." He defined conventional as being those ETIs that are bound by rules that say you "can't incorporate social considerations and that there has to be a competitive risk-adjusted rate of return."
In the study, the California Public Employees' Retirement System and New York City Employees' Retirement System are cited as two examples of large pension funds using ETIs successfully.
"CalPERS targets real estate investments that create housing, jobs and community development," said the report, "while NYCERS makes investment in fixed-income instruments that offer loans to small business for export finance with resultant small business growth and export expansion."
However, one controversial example of a non-conventional ETI cited in the study is that of the Quebec Solidarity Fund. Unlike ETIs financed by pension funds, the labor fund in Quebec can legally accept a "nonoptimal" rate of return on investments in return for "other benefits such as job creation or technological innovation."
How Quebec fund works
The Solidarity Fund was established in 1983 by Quebec's largest labor union, the 475,000-member Quebec Federation of Labor. Originally, the fund was financed by the provision of tax incentives by the Quebec and Canadian governments; individual contributors to the fund received tax credits of up to 40% of the amount of their investment; it is principally involved in venture capital programs.
The study found the Solidarity Fund practices "rigorous due diligence, similar to that practiced by U.S. security analysts, and portfolio diversification."
Still, Mr. Levine acknowledged the return for the Solidarity Fund has been less than stellar. "The Quebec fund has become even more controversial in the last year as the rate of return for mutual funds, for example, is up 25% or 30%, while the Solidarity Fund returned only 7%," he explained. "Clearly that spread is an issue in the short term. In the long term, however, it's not quite as serious. Over a 15-year period, the Solidarity Fund has delivered around that 7% or 8% return, where a conventional mutual fund might on average have provided 11% or 12%.
"There's still a spread there, but it's less stark when viewed over the long term," said Mr. Levine. "But we're in a very peculiar time now, with this bull market, so the spreads will be higher between conventional and more targeted investments. Of course, the other big question is how do you factor in the collateral economic benefits that something like a Solidarity Fund creates? While a pension fund can't do that, a more hybrid form of investing might be able to."
Estimates show the Solidarity Fund has either helped to create or maintain about 40,000 jobs in Quebec; the fund is also a major investor in "locally important companies," Mr. Levine said.
Although the case study focussed solely on Wisconsin, Mr. Levine contends that there are ETI opportunities in every part of the country.
"I think that one of the main findings that we had was that it was possible to get a competitive rate of return while accentuating the collateral benefits on areas such as employment and housing in most parts of the country," he said.
