By John Cheves

One of the biggest investments held by the $14.9 billion Kentucky Retirement Systems is a hedge fund that's also one of its worst performers -- and yet the financially troubled agency is doubling down.

KRS, which provides retirement benefits for more than 355,000 state and local government retirees, had $455 million invested June 30 in Prisma Capital Partners' Daniel Boone Fund, representing 3.3 percent of its assets. But KRS trustees recently voted to increase the agency's stake in the fund to 5 percent of its assets, so Prisma now holds more than $700 million of the state's money.

It's been a bumpy ride. During fiscal 2016, Prisma's fund return was negative 8 percent, contributing to KRS' overall 0.5 percent investment loss. The fund's return over the last three years was 1 percent. By comparison, the Dow Jones Industrial Average rose 15 percent over the same period.

KRS officials, some of whom previously worked at Prisma, counsel patience.

"Well, obviously, everyone would like to make more and particularly not lose. But that doesn't necessarily mean it's a bad investment, and it certainly doesn't mean that, looking forward, it's a bad investment," said William S. Cook, whom Gov. Matt Bevin appointed to the KRS board of trustees in June. "You know, if you look at the oil industry for the last three or five years, it's not been a pleasant place to invest. But going forward, there may be a lot of opportunity."

Cook retired from Prisma in March 2015 after 11 years as a director and senior portfolio manager. Although he is a member of the KRS board's investment committee, which must approve where the systems' assets are placed, Cook said he will abstain from action related to Prisma because he still has financial holdings in the company.

Hedge funds are privately run investments put together in hopes of beating the stock market or at least hedging against an economic downturn. Angered by the expensive management fees and lackluster returns associated with hedge funds, public pension systems in California, New York and elsewhere have announced plans to drop them.

Another problem with hedge funds is their secrecy, said Chris Tobe, a Louisville financial consultant who sat on the KRS board from 2008 to 2012. People who own corporate stock can track the company's activity and monitor the value of their holding. But people who own shares in a hedge fund only know what the fund's managers tell them about their investment, Tobe said.

"You don't know where your money is," Tobe said. "I sat on the KRS investment committee, and I literally didn't know where in the world our money was being held or by whom. It's a horrible lack of transparency when you're dealing with taxpayer money."

KRS remains bullish on hedge funds. The Daniel Boone Fund, created exclusively for KRS five years ago, is actually a "hedge fund of funds," a collection assembled by Prisma from 30 to 40 other hedge funds that employ a variety of strategies. This sort of diversification can protect a large portfolio from changes in the market, such as the expected rise in interest rates, said KRS chief investment officer David Peden.

Peden recommended raising the state's stake in Prisma at the May meeting of the KRS investment committee. The trustees agreed. To get the necessary money, KRS has been withdrawing its assets from similar funds operated by Blackstone and Pacific Alternative.

"There's no doubt we are disappointed not only by the performance of that one fund but also our entire hedge fund portfolio," said Peden, who worked as an alternative investments analyst at Prisma from June 2004 to December 2005. "But we're not going to make our investment decisions based on one year's performance."

While Prisma does not publicly disclose what assets its funds hold, any KRS trustee or member of the Kentucky legislature who wants to learn more about the Daniel Boone Fund can request a private briefing at the KRS office in Frankfort, Peden said.

"It's OK for us to share that with key decision-makers," Peden said. "If someone is uncomfortable, they can come in here and we'll have a very thorough conversation with them about the investments. They (Prisma) just don't want it posted on the Internet where their competitors can get it."

In addition to the Daniel Boone Fund, KRS employs Prisma as an expert adviser when it selects other hedge funds in which to invest, Peden said.

"We essentially use them as an extension of our staff," Peden said.

State law allows KRS to withhold information about fees paid to individual investment managers, but Prisma has agreed to transparency in this area, Peden said. KRS paid Prisma a management fee of about $3.85 million for the year, based on the size of the assets under its control, Peden said. It did not receive a performance fee because it lost money. KRS typically pays its investment managers a performance fee of 5 percent of profits above an agreed-upon level, he said.

Prisma's New York and Louisville offices did not respond to requests for comment Monday. The company began in 2004 as a $1.5 billion venture between three former Goldman Sachs partners and Louisville-based Aegon USA Investment Management. By 2012, when Prisma was acquired by global investment firm KKR, it had $7.8 billion under management.

Given KRS' poor financial health -- its primary state pension fund has only 17 percent of the assets it's expected to need to cover future liabilities -- the promise of hedge funds is understandably attractive, said Larry Totten, president of Kentucky Public Retirees.

The state's separately managed pension fund for legislators invests in simpler assets, like corporate stock, but it's also much better funded, so it's not searching for large payoffs the way KRS is, Totten said.

"It reminds me of when you're playing poker," Totten said. "When you really need to score, you're more likely to take big chances in the game then when you're sitting on a big pile of chips. We're not sitting on a big pile of chips."

(c)2016 the Lexington Herald-Leader (Lexington, Ky.)