Faced with growing obligations and shrinking returns, many of the largest U.S. public pensions have raised their exposure to alternative investments to record levels this year, despite ongoing criticism of the risks and costs.
Public pension fund managers have poured billions of dollars into alternative investments, ranging from Polish energy facilities to catastrophe bonds, as lackluster stock market returns and historically low interest rates have made it difficult for pensions to earn enough.
Public plans with more than $1 billion had a median of 15 percent in alternatives as of June 2012, the highest ever and up from 9.2 percent in June 2011, according to the Wilshire Trust Universe Comparison Service.
The increase carries risks of unstable performance and high fees amid a funding shortfall of $1.38 trillion as of 2010, according to Pew Center on the States data. Already, the vast majority of states have cut pension benefits or increased contributions from workers, or are trying to.
"There are several ways in which the economics can start to go against you," Martin Fridson, global credit strategist at BNP Paribas Asset Management, said of pension funds investing in alternative assets. He noted that hedge fund performance varies, while private equity firms may take the reward while shifting more risk onto the pension fund.
The California Public Employees' Retirement System - the largest U.S. public pension fund, with $237 billion - has a record 14 percent of its assets in alternatives, including venture capital, private equity, buyout funds and mezzanine debt. Calpers does not include hedge funds, real estate or commodities under alternative investments.
The South Carolina Retirement System still had a whopping 53 percent of its assets in alternatives as of May 30 despite a much-publicized debacle last year.
South Carolina's former chief investment officer made alternative bets that resulted in manager fees of $344 million in 2011. At the same time, the fund had a deficit of about $14.4 billion, raising doubts that the returns were worth the risk and fees.
A $20 BILLION LOSS
In recent years, market volatility and historically low interest rates have persuaded public pension funds to consider other options, especially because many are underfunded and unlikely to get large cash contributions in the current economy.
Almost all state pension systems were underfunded in fiscal 2010, according to the Pew Center.
Pension investment returns fell in 2011 to 4.4 percent, almost half of the historical target of 8 percent, according to data provided to Reuters by Callan Associates. Median returns were only 3.2 percent for the last five years.
In early August, New Jersey's $69.9 billion public pension system announced that after a meager return of 2.26 percent in fiscal 2012, it plans to increase alternative investments in fiscal 2013 to 30 percent, up from nearly 23 percent in 2012. In the first five months of 2012, it had increased its investments in alternatives by nearly $4 billion.
"This is a continuing response to the problems raised in 2001, when the market collapsed and we lost more than $20 billion in value from our pension fund because we were so strongly invested in stocks and bonds," said Andy Pratt, spokesman for the New Jersey Treasury Department's Division of Investment.
The California Public Employees' Retirement System has 14 percent of its assets in private equity, up from 12.5 percent at the end of fiscal 2010.
"There is a premium that goes with investing in alternative investments because they typically are a little bit riskier, but higher return," said CalPERS spokesman Brad Pacheco. He added that the risk is "measured risk that we're willing to accept within the portfolio."
One reason alternatives are appealing is that they are not linked to the performance of the stock and bond markets. Public pension plans earned an average 12 percent return from private equity investments last year, compared with a 7.2 percent loss from stock investments, according to alternatives research and consultancy firm Preqin.
Pennsylvania Public School Employees' Retirement System spokeswoman Evelyn Tatkovski said investments in catastrophe reinsurance- a type of alternative investment- through firms like Aeolus Capital Management Ltd. and Nephila Capital Ltd. are attractive because they are "uncorrelated" to traditional stock and bond markets.
The California State Teachers' Retirement System, which has $155.5 billion in assets, invested $500 million in Industry Funds Management in February, which has a 40 percent stake in energy services provider Dalkia Polska - a Polish heating network.
"People need heat, so from a pension fund's perspective, it's highly valuable because there's a continuous sort of cash-yield," said Christian Seymour, head of European infrastructure for Industry Funds Management. "You're certainly going to see an excess return, if you like, over government bonds" while avoiding the volatility associated with stocks, he said.
But not everyone is convinced that the added risk and costs of alternatives make them a good choice for pensions.
"Public pension plans are being forced into more alternatives, including the 'exotics,' in an effort to meet their assumed rate of return," said Curtis Loftis, South Carolina's state treasurer. That worries him because of their high and "opaque" fees.
Private equity firms typically charge a 2 percent management fee, and once they achieve returns of about 8 percent, collect 20 percent of the profits. Hedge funds charge an average management fee of 1.57 percent and a performance fee of 17.6 percent, according to Preqin. The average fee for mutual funds last year was 1.1 percent, according to Lipper.
The fees don't guarantee performance, especially given lagging returns for hedge funds this year. The HFRI fund-weighted composite index, which tracks about 2000 hedge funds globally, was up 1.87 percent for the first six months of 2012.
In comparison, the S&P 500 has outperformed its exotic counterpart, with a return of 8.31 percent over that period.
Bottom line: US pensions are listening to their brainless consultants, getting out of stocks at the worst possible time, plowing billions into all sorts of 'exotic' alternatives, getting raped on fees.
Moreover, this nonsense of "uncorrelated alpha" is a dangerous myth. During the 2008 financial crisis, everything got hit except good old Treasuries. Many investors suffered huge losses on their liquid and illiquid portfolios. Just because it's illiquid, doesn't mean it's immune to a crisis!
And Curtis Loftis is right to sound the alarm on fast times in Pensionland. Part of the reason behind the pathetic state of state pension plans is that pension fund managers are all gunning for yield, making costly investments in alternatives that often don't deliver the returns they need. It's no secret that most US pension funds got burned on their hedge fund investments and doubt they did any better in private equity.
Meanwhile, the fees being doled out to these "alpha" managers are outrageous. It's scandalous that state pensions are paying high fees, getting low profits in return. State legislators should pass laws forcing all public pensions to list their external managers and the fees they paid out to them over the years, comparing this to how much better or worse off they would have been if they indexed this money (don't hold your breath, that will never happen!).
The truth is US public pensions need to nuke their governance model once and for all, hire talented managers that can manage portfolios in-house, cutting these fees significantly. In short, they need to adopt a governance model similar to the one in Canada, Denmark and the Netherlands.
Let me tell you that when the junk bond bubble pops, it will wreak havoc on markets, but we're not there yet.
In an effort to nurse the long-ailing global economy, central banks around the world have maintained near-zero short-term interest rates for many years now. The Federal Reserve has even gone so far as to buy up billions of dollars worth of government and mortgage bonds and hold them on its on balance sheet, in order to hold down long term interest rates too.
While these actions are arguably justified by an epidemic of unemployment, and undergirded by decades of economic theory, they’re not without negative side effects. It’s the Federal Reserve’s intention to have low rates ripple through the the economy, but heavy central bank intervention can give investors headaches because it causes the market to behave in strange ways.
And lately, these ripples have been felt at the farthest end of the bond market spectrum — the so-called junk, or high-yield, bond market. Junk bonds are those rated ‘BB’ or lower by ratings agencies, and they are issued by companies that either have relatively risky business plans, or that already carry a large amount of debt. And because of the relative riskiness of loaning money to them, these companies typically have to pay 3% or 4% more in interest than the U.S. government does to borrow for the same amount of time.
In fact, as Bloomberg reports, companies left behind in the biggest U.S. bond-market rally ever are catching up as investors from Legg Mason Inc. (LM) to New York State’s biggest pension fund seek an alternative to junk-bond yields at record lows:
There you go. Running out of alternatives, everyone is still chasing yield. For now, everything is fine, but when the music stops, watch out, it's going to be another bloodbath in the bond market. As I said, we're not there yet but keep an eye on stocks and bond yields over next three months.
Legg Mason, the Baltimore-based money manager overseeing $636 billion, is starting a fund to invest in loans to so-called middle-market companies, joining Tennenbaum Capital Partners LLC and the New York State Common Retirement Fund. The funds are proliferating as the Federal Reserve says it expects to hold interest rates near zero through at least late 2014.
“The middle-market right now is extraordinarily competitive,” said E.A. Kratzman, president of Katonah Debt Advisors LLC in New York. The most-active investors “are willing to take down very, very large swaths” of loans to the smallest issuers, he said.
Below, a CNBC interview with Mohamed El-Erian, CEO and co-CIO at PIMCO. El-Erian says Paul Ryan's definition of "misguided policies" are different than his own. He also offers insight on Peter Thiel's sale of Facebook stock and talks about ECB intervention. Always interesting but way too bearish for my taste!