Diving into the Hedges

Public pension funds are being drawn like bears after honey to these risky, unregulated but high-reward investments.
November 1, 2007
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Last year, I wrote a column about state and local pension systems investing in hedge funds, those privately run investment partnerships that inhabit the unregulated and secretive precincts of the investment world. What then appeared to be a trickle of interest has grown into a flood.

The reason, of course, is "yield chasing." Many funds have set high targets for investment returns in their actuarial calculations. Lower estimates of earnings would require either higher levels of contributions from government workers or a tightening up of retirement benefits. Both choices are politically unpleasant. So, the pressure is on for high returns.

The challenge has been, where to get them? Hedge funds have them, and public pension funds -- in the aftermath of the disastrous stock market crashes of the early 2000s -- have been drawn like bears after honey to these alternative investments. Hedge funds not only did spectacularly well during the 1990s, they also rumbled through the market declines unscathed, earning positive returns in the chilliest of markets. To pension fund investors, this has looked like a godsend: the ability to earn higher yields with apparently less volatility -- which implies that the underlying investments are safer. The huge public systems in California, Pennsylvania, New Jersey -- and a host of smaller state and local brethren -- are raising their bets on the hedges.

Here's what's wrong with this picture: It won't last. Investing in hedge funds can be compared to investing in earthquake bonds. The bonds pay high yields and perform very well year to year until an earthquake hits. Then, the principal disappears in payments to the victims.

Diversification should allay fears. But if the earthquake is, in fact, a widespread financial market meltdown, the apparent diversification can be a mirage. The worldwide slump in the stock markets in 2000-02 illustrated that the bust, initially stemming from the dot-com blow up, knew no boundaries. Sure, many hedges avoided the fall out, but then they were minor players. Now, hedge funds make up about half of the trading on the stock exchanges. In bad times, the markets become very interrelated -- a feature that the hedge funds' growth and global reach has amplified.

In Europe, there is more concern than in the United States regarding hedge funds, and louder calls for regulation. Among others, the European Union's commissioner of enterprise has criticized hedge funds as "locusts" that strip firms of assets for short-term profits and leave in their wake closed businesses and unemployment. And Angela Merkel, Germany's chancellor, and France's new president, Nicolas Sarkozy have called for greater regulation. It appears unlikely that the hedge funds will be able to operate so freely in the worldwide markets as they have to date.

Within the hedge fund industry there are already signs that the cowboys of the past decade will become farmers in the next. Some major hedge funds have gone public, and the largest are seeking to diversify their financial activities. As conflict-of-interest issues become more evident, the veil on hedge fund operations will be lifted, most likely by greater regulation.

For state and local investors, the lessons will likely be unpleasant. The substance of secure long-term investment is that it goes to building long-term capacity to pay. But, that type of "productive investment" in America's consumer-driven economy has been receding. Easy credit in the U.S. has fueled investments in residential housing and supported more consumption. This was accompanied by smooth economic sailing globally over the past 10 years, a period dubbed by The Economist magazine as the "Great Moderation," during which prices have been stable, profits high, credit available and growth continuous with only minor slowdowns.

But the Great Moderation brings a cost: a Gilded Age-like growth of inequality of incomes and wealth. Hedge funds have much to do with that. The top 25 hedge fund managers together made $14 billion in 2005. America loves rewarding success, but these enormous sums raise the question if we all might be better off were 1,000 people to earn a million dollars each as opposed to one earning a billion dollars -- and paying taxes, if any at all, at the 15 percent capital gains rate. Getting rich is good and surely we want many more people do so -- as opposed to concentrating wealth in a few hands.

The irony is that huge private profits in hedge funds are made using capital supplied in large part by institutions that represent ordinary working people -- in this case, the public employees who increasingly are the last refuge of the defined-benefit pension. After the party's over, will they (and taxpayers) be left to carry out the garbage?