Hedging Bets

With slow growth from traditional investments, pension fund managers are tempted by the snappy returns of alternatives.
January 2006
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.

Pension fund managers are fretful. Returns on routine investments in stocks and bonds are lackluster and, with baby boomers on the verge of retirement, the demand for more dramatic results is inescapable. What to do? Increasingly, private pension fund mangers are thinking outside the box. Or, perhaps more correctly, thinking about a black-box alternative--namely, hedge funds.

So, too, are some of the big public funds, such as the California Public Employees System and state systems in Pennsylvania and Virginia. They are investing hundreds of millions of dollars in hedge funds, and smaller systems are taking notice. For all institutional investors, both public and private, investment in hedge funds has skyrocketed from $5 billion in 1995 to $100 billion in 2004. That's a drop in the bucket of their investable assets, but those drops are dropping faster and faster.

The question is, how safe is the vessel into which that money is landing? Hedge funds are pools of capital that are not listed on the investment exchanges, are not regulated by the Securities and Exchange Commission and have no disclosure requirements under the securities acts. They are essentially private capital funds that make a wide variety of market bets, ranging across selling securities short, using derivatives, investing in special situations and currency speculation. Managers of the funds (investment advisers) are largely free from SEC registration so long as they manage 14 or fewer funds. They are also well paid, charging 1 to 2 percent of the capital under their management and 20 percent of any profit.

Hedge funds are notoriously secretive. Since their investment strategies involve outsmarting the rest of the market, they tend to keep their moves under wraps. The right to work covertly, however, does not include the right to commit fraud: Hedge funds are subject to the anti-fraud provisions of the securities laws. But the securities cops are put in a wait-and-see position: The train wreck and losses must occur before any enforcement is undertaken. Like the rest of us, the SEC--without a registration process, examinations and ongoing disclosure rules--is flying blind when it comes to hedge funds.

In years gone by, pension funds, like other investors, stuck close to the regulated financial markets to make money. In recent years, they put 70 percent of their assets into the equities market. But after a decade of robust growth in the 1990s, the stock markets plunged in 2000 and have not regained their highs. Most pension funds show some positive growth from the depths but have posted a negative return on their investments for the past five years.

Not surprisingly, they are now tempted by alternatives, and the historically snappy returns earned (by one means or another) by some hedge funds are alluring. The longer-term question, however, is how hedge funds will perform in the future.

Pension funds are the quintessential long-term investor and are able to take the cyclical bumps in the road. But what if the road itself changes direction, and the days of double-digit or even high single- digit returns are over?

What seems true for the listed securities market may soon apply to the hedges. Are we seeing a replay of the dot-com bubble--where in early 2000 it was suddenly and painfully realized that selling dog food over the Internet might not be a viable business model? In other words, the crowded landscape of hedge funds--there were 3,900 of them in 2000; 8,500 today--makes special situations increasingly rare, and their returns will flag or go negative. According to recent reports, hedge funds are returning on average 6 to 7.5 percent (which is about how the stock markets are performing). Of course, some funds are doing a lot better--but half are doing worse. Commentators such as economist Bill Sharpe foresee the hedge fund returns as soon converging with those on U.S. Treasury securities. If that happens, clients will think twice about the handsome fees they pay to invest in hedge funds, and the pressure will be on to goose up earnings. That, folks, is when you really begin to worry. Hedge funds can value their investment holdings as they choose, so long as it conforms to the method that they told investors they would use. That is a very big loophole.

Black boxes are risky. The black box of Enron blew a hole in thousands of pensions, both public and private. The black box of Long- term Capital Management almost brought down the international credit markets. Cultures rooted in making money by any and all means without the checks of surveillance and disclosure can careen out of control. In the financial markets, money is made by taking it from somebody else. Markets are not by nature benign. By design they are murderous so as to weed out the weak, inefficient and uninformed. We can't all be the smartest guy in the room. But we should at least turn the lights on.