Pension Fund Investment in Hedge Funds Vs. Bonds

Last year, Simon Ruddick of Albourne Partners told attendees at the National Association of Pension Funds Investment Conference, ”More pension funds are taking direct stakes in hedge funds and steering clear of funds of hedge funds to slash their fees and boost performance.” Financial Times reported that “a straw poll of pension funds conducted by Albourne reveals that 63 per cent are set to increase their direct exposure to hedge funds.” The trend appears to be strong.

The Institutional Investor reports, “The average share of U.K. defined benefit pension fund assets invested in hedge funds jumped from 2.6 percent to 4.1 percent last year, according to the recently published annual survey by the National Association of Pension Funds (NAPF).” The US Government Accountability Office (GAO) reports that “the percentage of large plans investing in hedge funds grew from 47 percent in 2007 to 60 percent in 2010.”

According to the New York Times, “Searching for higher returns to bridge looming shortfalls, public workers’ pension funds across the country are increasingly turning to riskier investments in private equity, real estate and hedge funds.”The problem is that pension funds are having very mixed results in the hedge fund market and, while the fees these pension funds pay have swelled dramatically, returns are not keeping pace. “In fact, a number of retirement systems that have stuck with more traditional investments in stocks and bonds have performed better in recent years, for a fraction of the fees.”

The GAO completed a study in February 2012 on the subject of pension plans and hedge funds. It found that most of the pension plan representatives it interviewed were generally happy with their hedge fund investments, even with the losses sustained during the financial crises, and that “given the long-term nature of private equity investments, almost all of the representatives were generally satisfied with these investments over the last 5 years.” However, there were some pension funds that were disappointed with the performance of their hedge fund investments and almost all took some steps to improve their relationship with hedge funds. Of the 22 pension plans interviewed, “three plans have reduced their allocations to hedge funds or private equity. Other plan representatives also took steps to improve investment terms, including more favorable fee structures and enhanced liquidity.”

Obviously, improved terms will improve the returns pension funds receive.

Take the $26.3 billion Pennsylvania State Employees’ Retirement System, for example. It has almost half of its assets in riskier investments. “The system paid about $1.35 billion in management fees in the last five years and reported a five-year annualized return of 3.6 percent,” writes the New York Times. ”That is below the 8 percent target needed to meet its financing requirements, and it also lags behind a 4.9 percent median return among public pension systems.” Were the pension fund able to negotiate a 1% decrease in fees, it would add $13.5 million to its realized returns. In comparison, the $14.4 billion municipal retirement system in Georgia “has earned 5.3 percent annually over the same time frame and paid about $54 million total in fees.”

While five years may be a short time frame, “An analysis of the sampling presents an unflattering portrait of the riskier bets: the funds with a third to more than half of their money in private equity, hedge funds and real estate had returns that were more than a percentage point lower than returns of the funds that largely avoided those assets. They also paid nearly four times as much in fees.”

It doesn’t sound very good but there just isn’t any more in stable, traditional investments like Treasury bills. The last time a T-bill was above 4% was in mid-2008. Right now, bonds are near historic lows – 10-year Treasury notes recently swelled past 2.3% – after trading at less that 2% for months. Pension funds are going to be looking for a fair bit more than that – but it is a double-edged sword. According to the Wall Street Journal, “if 10-year yields moved back to 4% over the next year, investors would lose about 14% of the market value of existing bonds.”

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