Florida Rolling the Dice with Pensions?
Chasing bigger investment returns, the agency that manages Florida's $113.8 billion public pension fund wants to make far riskier investment bets.
The state wants to reduce the pension fund's holdings in publicly traded stocks and bonds and triple its allocation to hedge funds and other private investments that are less liquid and harder to value.
Earlier this month, the head of the State Board of Administration told his bosses that rearranging the state's portfolio would benefit the nearly 1 million public employees and retirees who depend on the fund, as well as the taxpayers who underwrite the system.
"We will probably have a slightly higher level of return, with a slightly lower level of risk," SBA executive director and chief investment officer Ash Williams told Gov. Charlie Crist, Chief Financial Officer Alex Sink and Attorney General Bill McCollum.
All three voted to approve Williams' plan after a few questions from McCollum and Sink and no comment from Crist. The Legislature still must approve the expansion of the alternative asset class.
Several financial experts said that expecting higher returns with lower risk is as realistic as promising weight loss on an all-you-can-eat diet.
"It's basic Finance 101: There's no such thing as reducing risk and increasing return," said Lawrence Weinman, a financial adviser in Los Angeles who teaches endowment investing.
Edward Siedle, an attorney formerly with the Securities and Exchange Commission, said Williams' assertion that he can make the SBA's pot of money grow bigger, faster, with less risk is "the perfect political response. But it's an absurd investment scenario."
Andrew Biggs, former principal deputy commissioner of the Social Security Administration and resident scholar at the American Enterprise Institute, said it may be possible to produce higher returns in the short term. But in the long term, the risks catch up with you.
"There are lots of studies of what percent of active managers beat the market and the answer is, in any given year, it's very low. Over the long term, it's even lower," he said. "People who are doing it may just be lucky. It's like a monkey with a dartboard."
Biggs believes Florida's pension fund, which needs to earn 7.75 percent a year to meet its pension commitments, already has taken on too much risk.
He asked: "Do Florida's taxpayers really want the pension plan to be running a hedge fund on their dime?"
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After years of being in charge of the SBA's stodgy fixed income assets division, veteran SBA money manager Michael Lombardi was thrilled to be transferred to the pension fund's new strategic investment asset class. In an e-mail May 19, 2008, he shared the news with a contact at Lehman Brothers.
"Instead of managing a portfolio with the highest quality and shortest maturity, I'll be recommending limited partnerships to invest in unrated securities and lock up our money for 5 to 10 years," he said. "Should be way more interesting and a lot less compliance!"
Less compliance, because unlike publicly traded stocks and bonds, hedge funds are not registered or regulated by the SEC.
Now Lombardi's boss wants to move even more money into these types of strategic assets, which include commodities, timberland and hedge funds. In his presentation to the elected officials who oversee the SBA, Williams downplayed concerns over hedge funds.
"Hedge funds are an area I have a pretty significant amount of experience in, and it's an area a lot of people express a lot of anxiety about," said Williams, who handled investor relations for a New York City hedge fund. "But this is not something that should cause you to lie awake at night."
Williams told the trustees the SBA would not invest in secretive, "black-box" hedge funds that refuse to disclose their strategies, "because that's what leads you to people like Bernie Madoff."
"We're talking about fundamentally-oriented funds, with modest leverage to the extent they use leverage at all," he told Crist, Sink and McCollum. "They'll have the appropriate institutional-level transparency, institutional-quality investment teams and institutional-quality investor bases."
Experts said transparency in hedge funds is a laudable but unrealistic goal.
"There's a limit to their transparency,'' Biggs said, ''because hedge funds make above-market returns by exploiting inefficiencies in the market. These profits go away if everyone knows what you're doing."
Leo Kolivakis, a former senior investment analyst at two of Canada's largest pension funds, said true transparency would mean that Florida's pension fund would retain control of the account and be able to withdraw its money at will.
"Some hedge funds want you to invest for a three-year lock-up," he said. "But the pension plan should be able to pull the plug."
Williams dismissed this option, saying in e-mail, "I wouldn't want to invest with a fund that would allow any investor to pull its assets from the fund at will if the investment strategy is in fact one for which more stable capital is appropriate, and other investors are subject to an appropriate lock up."
Kolivakis, who publishes Pensionpulse.blogspot.com, said Canadian pension funds are moving away from hedge funds, even as they find favor with many public pensions in the United States.
"Not all alternative investments are bad, but it's all about finding the right manager," he said. "And lots of pensions are chasing the same funds."
The transparency Williams said he would demand of hedge funds has not been extended to the taxpaying public. The SBA's website includes limited information on the number, nature or value of its current alternative holdings. Nor does the agency make public how much it pays in fees to these managers, who typically get 2 percent of the state's investment plus 20 percent of any profits.
In response to a public records request from the St. Petersburg Times, the SBA disclosed that since the early 1990s, it has funneled nearly $12 billion into more than 130 privately held funds. The funds have spun off about $8 billion in distributions and had a market value of $6 billion at the end of 2009.
The SBA said it's difficult to assign an interim value to long-term alternative investments, which are not easily converted to cash and often lose money in their early years.
"Due to numerous factors, including the lack of standardized valuation and reporting standards,'' the SBA said, "the return information . . . may not reflect the expected returns of the partnerships."
Reviewing the SBA's data, Biggs, the economist, calculated that the alternative asset portfolio's weighted average return was less than one-half of 1 percent.
"Good Lord, that's a crappy return," he said. "It doesn't mean you'll get lower returns in the future, but it's not something that makes you say, 'This is how we'll rescue the pension fund.' "
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Along with reducing its allocation to stocks and bonds, the SBA plans to reduce the number of outside managers handling these assets. Williams said it could save the fund $2 billion in fees over 15 years.
"The economic stresses on our member employers is going to be pretty significant," he said, referring to the counties and school districts that contribute to the pension fund. "So $2 billion in savings looks significant."
Williams did not mention the flip side: the increased fees the pension fund will pay hedge fund managers, who are paid considerably more than traditional money managers.
Even allowing for higher management fees, Williams said, hedge funds have shown strong returns.
"Look at the misery of 2008," he told the trustees. "The broad equity average was down north of 40 percent. At hedge funds, the average across the industry was down about half that or less.
"This is an asset area that a lot of people think of as exotic or potentially risky. In reality it preserved capital better than what are perceived as less risky areas."
A longer-term perspective on hedge fund performance found the opposite.
Yale finance professor Roger Ibbotson is chairman of Zebra Capital Management in Connecticut. In March, he reported his analysis of the return on investment from 8,400 hedge funds going back 15 years, from January 1995 through December 2009.
After accounting for the 60 percent of funds that failed, Ibbotson found that the return on hedge funds was lower than the return on the S&P 500.
Even Ennis Knupp, the pension consultants who developed the SBA's reallocation strategy, concluded that the new approach would do little to improve the chances of getting the return the pension plan needs to be fully funded.
Biggs, the researcher who is studying the growing funding gap in public pensions nationwide, said in today's tight times, no state or municipality is willing to put more money into its pension funds. So making up for shortfalls with riskier bets is one of the limited options available.
"The plans are effectively doubling down on their bets as the unfunded liability gets bigger," he said. "That puts a lot of risk onto taxpayers who may or may not want to take it. But if the investments don't pan out, they're on the hook."
There are so many points to cover here. First, I am not against hedge funds or other alternative investments, however, I don't think they're the panacea that many claim. And in the hands of incompetent pension fund managers chasing the latest 'hot" fund, these alternatives can come back to haunt you for years.
Let's say you followed the pension herd and invested billions in private equity at the top between 2005 and 2007, then you got creamed on those investments. Sure, if you hold these investments long enough, you might realize some gains, but the likelihood is that you will underperform the S&P500 over this period. (See Private Equity Returns: Myth and Reality).
As for hedge funds, there are some that focus on illiquid strategies, but be careful. They will sing you a whole song & dance and how they "exploit market inefficiencies", but the reality is they're locking up pension money, collecting 2% management fee, and if a liquidity crisis hits them, their portfolios will get whacked hard. Again, tread very carefully with illiquid hedge fund strategies. Lots more hype than substance behind these strategies.
In the environment we're in, which could last a very long time, I prefer liquid hedge fund strategies (global macros, CTAs, Long/Short Equity). I would be very selective with illiquid strategies, committing only a fraction of my hedge fund portfolio in these strategies. In fact, I would group illiquid hedge fund strategies with my private equity portfolio, allocating no more than 5%-7% of my total pension fund portfolio there.
Back to Florida's SBA. They're doing exactly what every other large US public pension fund is doing, allocating more into alternative investments to meet their required rate of return with supposedly less risk. But taking on illiquidity risk is a huge risk, one that might end up costing Florida taxpayers billions to make up the shortfall. Let's call a spade a spade and stop using the same marketing pitch that hedge fund and private equity managers use when fighting for a piece of the pension pot.