Horny For Hedge Funds?

They're back! Facing severe funding shortfalls, public pension funds are popping a few blue pills, horny as ever for hedge funds:

• Hedge fund firm RAB Capital confirmed clients are returning to its funds that were battered by the credit crisis, after it swung to a loss in 2009 and cut its dividend.
• Citigroup expects to double the size of its team that advises institutional and government fund clients on hedge fund investments, the bank's global prime finance head, Nick Roe, told Bloomberg in an interview.
• Standard Life Investments (SLI) will pay a "modest upfront" fee for a 75.1 percent stake in the fund of hedge funds firm, which runs more than $50 million in assets, a spokesman said.
• Investors are flocking to hedge funds that bet on mergers and acquisitions (M&A) in the hope that a revival in takeover activity will help deliver more of the bumper returns they enjoyed in last year's rally.

Investing in event-driven hedge funds makes sense since according to the OECD, global investment in mergers and acquisitions has shrunk to its lowest level year-on-year since the onset of the economic crisis in 2007 (just make sure you're paying for alpha, not disguised beta!).

And there's no doubt in my mind that faced with the prospect of stricter regulation and a huge shift in investor sentiment post financial crisis, hedge funds are coming of age.

But not everyone is horny for hedge funds. Opalesque reports that although public pension plans and their corporate counterparts were hit equally hard by the global market crisis, a new study from Greenwich Associates shows they are responding to historic funding shortfalls in dramatically different fashions:

With an eye toward constraints imposed by tougher accounting rules, companies that sponsor defined benefit pension plans are shedding risk from their investment portfolios and are apparently preparing for the inevitability of much higher cash contribution requirements.

Public pension funds, meanwhile, are shifting money into riskier asset classes in what is looking like a “swing-for-the-fences” attempt to close shortfalls with future investment returns that far outpace those of the broad market.

“Corporate funds have traditionally invested much larger portions of their assets in equities, while public funds took a more conservative stance with bigger allocations to fixed income,” explains Greenwich Associates consultant Dev Clifford. “As a result of their differing strategies in the wake of the crisis, public pension funds and corporate funds are approaching parity in their U.S. equity allocations, and public funds are making and planning meaningful investments in private equity, international stocks, hedge funds and real estate.”

The typical U.S. defined benefit pension plan saw the value of its assets fall by approximately 19% from 2008 to 2009 before the recovery that began in March-April last year, bringing the overall value of assets in the portfolios of U.S. defined benefit plans down to levels last seen four to five years ago. Although recovering markets reversed some of those declines, asset values have yet to return to those seen in 2007. At the same time, the value of pension liabilities soared due to persistently low interest rates and the demographics of an aging population.

The resulting damage to pension funding status was sudden and severe. Among public pension funds, the combination of growing liabilities and a drop in asset values to $2.7 trillion in 2009 from $3.2 trillion in 2008 depressed average solvency ratios to 83% from 86%. More than 30% of U.S. public funds now have solvency ratios of 79% or lower, and more than one in 10 public funds have a solvency ratio of 69% or lower. Average solvency ratios for state funds declined to 80% in 2009 from 84% in 2008 and average ratios for municipal funds dropped to 84% from 88%. Average funding ratios for the projected benefits obligation of U.S. corporate pension funds fell to 80% in 2009 from 101% in 2008. The proportion of U.S. corporate pensions funded at less than 85% rose from approximately 8% in 2008 to 57% in 2009 and the share funded...

So why are public pension funds increasing risk - allocating more to alternative investments like hedge funds, private equity, real estate and infrastructure - while corporate plans are dialing down risk?

In his Streetwise blog, Andrew Willis notes that funds that are making these shifts in asset allocation expect to be rewarded for their moves:

Public funds with assets of $500 million or less increased their stated expected outperformance to a staggering 180 basis points in 2009 from an already aggressive 135 basis points in 2008.

“These are very aggressive expectations,” says Greenwich Associates consultant Chris McNickle in a report. “Most investment managers struggle to generate the levels of outperformance expected by institutional investors; it would be rarer still for an entire portfolio to achieve that level of outperformance for any number of years.”

Another key reason as to why public pension funds are aggressively allocating to alternative investments is that it's much easier to game the benchmarks for hedge funds, private equity, real estate and infrastructure. Public pension fund managers know this, so they continue to shovel billions of dollars into private funds, looking to collect big bonuses at the end of their fiscal year - bonuses based on bogus benchmarks for alternative investments.

It's also nice to travel first class across the world, getting wined and dined at top restaurants by alternative investment managers looking for that big public pension fund cheque.

I can just imagine the next big hedge fund, private equity, real estate or infrastructure conference. All those beautiful young sales ladies peddling their funds to horned up public pension fund managers swinging their big pension penises, many of whom have no idea of what investment and operational risks lurk behind these funds.

But it's not their money they're investing, so what do they care if a fund implodes when the next crisis hits? Right now they're mesmerized by the allure of "absolute returns", completely impervious to the systemic risks they're creating by collectively chasing after these hot alternative investments. They should be careful or else they risk catching the next systemically transmitted disease.