Public Pension Systems Betting on Hedge Funds

By Tomoeh Murakami Tse
Washington Post Staff Writer
Tuesday, July 24, 2007

Determined to keep its promise to the state's public employees, teachers, police officers and firefighters, the Montana pension system may venture into a high-stakes corner of the investment world: hedge funds.

The idea was proposed in two recent studies commissioned by the $8 billion retirement system, which also recommended opening up to other nontraditional investments to keep generating the annual returns necessary to meet its obligation to retirees.

"That's what [they] indicated we needed to make our 8 percent return," said Carroll South, executive director of the board, which oversees investing for all state funds, including nine pension funds. "Over the last 12 years, we have slightly beaten the 8 percent requirement. But no one expects the public-equity market to return what it has going forward."

With a flood of baby boomers set to retire in coming years, pension funds across the country are shedding their stodgy stocks-and-bonds-only portfolios and ratcheting up investments in hedge funds. The move comes as hedge fund returns have cooled, as two high-profile hedge funds came close to failing and as concerns have mounted that more problems are around the corner.

"There's an inconsistency between the concept behind hedge funds, which is high-risk, high-return, and the concept behind pension funds, which is little risk, guaranteed return," said William F. Galvin, the Massachusetts secretary of state. "Unfortunately, what's happening is, increasingly, managers of pension funds -- most of whom have large debt or potential debt in the future -- see this [investing in hedge funds] as sort of a panacea for their growth needs. And it's not. It's a very dangerous approach."

Once reserved for the wealthy, hedge funds are lightly regulated investment vehicles that are handling an increasing amount of money for middle-class workers through pension funds as well as retail investors through funds of funds. By pooling money, funds of funds allow investors who do not have the minimum required investment -- often in the millions of dollars for hedge funds -- to gain access to the exclusive club.

Now an estimated 9,000 hedge funds with assets of $1.4 trillion are making big bets on movements in multiple markets -- stocks, bonds, commodities, currencies, futures and derivatives. The contents of a hedge fund can be arcane and difficult to value because they are not actively traded.

And that can trip up even the most sophisticated money mangers. This week, Bear Stearns, a Wall Street firm known for its expertise in bond-trading and cautious approach to risk, notified clients that their investments in two prominent hedge funds were worth pennies on the dollar, if that. The funds had made bets on risky bonds backed by subprime mortgages, loans made to homebuyers with shaky credit.

Some regulators see the rise of hedge funds, which borrow as much as 10 times their cash holdings to execute their investment strategies, as a double-edged sword. On one hand, they have become an important source of capital to markets, allowing securities to be traded efficiently and helping to spread risk across many investors. Experts estimate that hedge funds account for more than half of the trading on the New York Stock Exchange.

Meanwhile, regulators are concerned that hedge funds could be making dicey bets that, if they go wrong, could spread and strain entire financial markets. Hedge funds are fiercely protective of their trading strategies, and unlike mutual funds, are not required to register or disclose their holdings to the Securities and Exchange Commission.

Pension fund managers say they are making their investments with their eyes wide open. Those with large exposures to hedge funds say their risk is spread out over many funds with varying investment strategies, including some hedge funds designed to benefit when stocks fall.

"This is not all about reaching for return," said Larry Swartz, executive director of the Fairfax County pension funds' board of directors. "It's about developing a smoother return stream and managing the level of volatility in the retirement system year to year."

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