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More Bad Ideas and Broken Promises

by John Rubino on June 2, 2011 · 15 comments

While we’re on the subject, consider the fact that pension funds are once again loading up on “alternative investments”, this time in the form of hedge funds:

Pensions Leap Back to Hedge Funds
Public pension plans are lifting hedge-fund investment, seeking to boost long-term returns despite losses suffered in some funds in the financial crisis.

Also, pension officials are using the historically strong returns of hedge funds to justify a rosier future outlook for their investment returns. By generating more gains from their investments, pension funds can avoid the politically unpalatable position of having to raise more money via higher taxes or bigger contributions from employees or reducing benefits for the current or future retirees.

The Fire & Police Pension Association of Colorado, which manages roughly $3.5 billion, now has 11% of its portfolio allocated to hedge funds after having no cash invested in these funds at the start of the year. “There has been some deserved criticism of hedge funds, but many hedge funds during the market downturn in 2008 did better than the S&P 500,” said Dan Slack, the chief executive of the system.

While pensions have been investing in private equity and what are called alternative investments for many years, hedge funds have represented a smaller part of their portfolio. The average hedge-fund allocation among public pensions has increased to 6.8% this year, from 6.5% for 2010 and 3.6% in 2007, according to data-tracker Preqin.

The number of public pension plans investing in hedge funds has leapt 50% since 2007 to about 300, according to Preqin. State pension systems had $63 billion invested in hedge funds as of their fiscal 2010 and are expected to invest another $20 billion in hedge funds in the next two years, according to a recent report by consultant Cliffwater.

In March, the New York City Police Pension Fund voted to invest in a firm that puts money into a variety of hedge funds, the first such move by the city’s pension funds, which manage $117 billion. In the past few months, two more New York City pensions made the same decision. Together the three funds invested $450 million with hedge-fund firm Permal Group.

It is a “first step into hedge funds,” said Larry Schloss, the New York City chief investment officer. He says he hopes the investment will help the city’s pension system avoid the “wild ride” it has taken in recent years. The system had $115 billion before market tumble in 2008, when it fell to $77 billion.

New Jersey’s State Investment Council, which sets investment policy for the state’s pension fund, voted last week to raise the target allocation for hedge funds to 10% from 6.7%, which would make hedge funds the $73 billion fund’s largest alternative investment asset.

Some thoughts:

  • Once upon a time pension funds invested mostly in low risk-assets like bonds, because risk was unacceptable for money that had to be there. Pensions are legally binding promises made by governments to their workers, so non-payment isn’t an option; when a pension fund fails taxpayers are generally stuck with the bill.
  • But with the US government keeping interest rates artificially low in order to ease its debt burden, the available returns on low-risk investments has fallen to a fraction of the rate that pension funds need to cover the promises made by government officials to buy union peace. So pension funds are “diversifying” into “alternative” investments like hedge funds that promise higher yields.
  • This will work beautifully in the aggregate as long as the markets are generally moving up, i.e. as long as the “risk-on” trade is profitable. As soon as a slowing economy, the dissolution of the Eurozone, a Middle East crisis, or just a technical 20% correction sends capital scurrying away from high-risk strategies, hedge funds — and real estate and private equity and foreign growth stocks — will not only fail to generate the necessary 8% return; they’ll suffer losses, which will pull the entire pension fund complex into the red, moving them even further from their promised trajectory.
  • Of course, the alternative is to load up on bonds and cash, which, with the dollar being depreciated at an accelerating rate, will probably be the worst possible investments going forward. So given the mess the US has made of its financial markets, maybe hedge funds are actually the lowest-risk alternative.

{ 14 comments… read them below or add one }

JEL June 2, 2011 at 9:29 pm

Reward spenders and speculators
Punish savers

This has been the MO of the FED for 30 years.

What a country….!

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Dave Ziffer June 2, 2011 at 10:17 pm

Smart money is moving out of the US as fast as it can escape.

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CompassionateFascist June 2, 2011 at 10:23 pm

Beautiful. I love the way this is all interconnected. One more major tremor anywhere in the pyramid, and it all goes. I’m assuming, based on precedent, that the Republicrats aren’t really serious about hardening the debt ceiling….but if they are, that tremor could come real soon.

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hollow man June 3, 2011 at 2:58 am

ha ha ha, legally binding promises to employees by the GOVERMENT. Ha Ha HA!!!! The goverment now defines what a word means. The almighty state. No moral code is in place in the USA. The guy with the money sets the rules and that is the big O and his commie buddies. Yea the other side helped out too. 15,000,000,000,000.00 Ha Ha Ha Go ahead, invest in US bonds or whatever goverment investment vehicle you wish. Run industry run: to China where you are a little more free. You gotta laugh!!! Ha Ha Ha or I would be angry , oh wait I am past that. Just waiting for the collapse with my chickens, goats cows and 20 acres of heaven. I know, they will get mine too. Done rambling Have a wonderfull day.

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Bruce C. June 3, 2011 at 3:22 am

“Of course, the alternative is to load up on bonds and cash,…”

or gold and/or other currencies.

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Brad Thrasher June 3, 2011 at 6:52 am

or long wheat, corn and soy.

Regardless of today’s employment numbers, I see no reason yet to implement Plan B. Grow pot and/or start a church.

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Brad Thrasher June 3, 2011 at 8:44 am

BTW, an under the radar bit of news worth noting is that the Atlanta Thrashers of the National Hockey League have been sold and are relocating to Winnipeg, Manitoba. The move reverses a previous trend of the 1990′s that saw Canadian based NHL teams packing up and relocating to the US.

The near par exchange rate between the CDN and USD is credited for the new found financial health of the NHL. The league has 30 member teams, 7 of which are now based in Canada.

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Greshams-law.com June 3, 2011 at 4:15 pm

Very interesting.

But with the US government keeping interest rates artificially low in order to ease its debt burden, the available returns on low-risk investments has fallen to a fraction of the rate that pension funds need to cover the promises made by government officials to buy union peace. So pension funds are “diversifying” into “alternative” investments like hedge funds that promise higher yields.

This sounds like such a terrible idea! It’s like when individuals invest in a speculative asset just to get a quick tax break etc. These guys always pile into the wrong thing with great animal spirits at the wrong time. All of this seems to be another symptom of the desperation to speculate in this ‘risk-on’ rally.

Of course, the alternative is to load up on bonds and cash, which, with the dollar being depreciated at an accelerating rate, will probably be the worst possible investments going forward. So given the mess the US has made of its financial markets, maybe hedge funds are actually the lowest-risk alternative.

I get what you’re saying here, and I kind of agree. But, I would venture to say that it’s all about timing. It’s quite conceivable that bonds (especially) & cash would be the worst investments going forward, but they become that bad by being incredibly (and even frustratingly) good first.. They could potentially be completely debauched in a gut wrenching rush for central bank notes. That would occur at a time when redemptions are killing (most) hedge fund managers.

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Chris June 4, 2011 at 12:28 pm

US debt is $14 trillion. Foreign countries are owed $4 trillion. So who are the creditors for the other $10 trillion. Are the banks owning a large amount by borrowing short term from Fed to buy longer term bonds. If this is true, then QE will be a permanent thing otherwise the banks will go bust again if short term rates shoot past the long term rate of bonds they already owned. This is a funny money game.

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Jason Emery June 5, 2011 at 2:36 pm

Chris-”So who are the creditors for the other $10 trillion.”

I think other govt. agencies [social security, medicare, etc.] hold well over $4 trillion of it, and corporations, pension funds, savings bonds, state and local governments, etc. all hold chunks of varying size.

See this link for general categories, but with a 2005 date, it obviously quite out of date in terms of totals:
http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2005/0507.html

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downunder June 7, 2011 at 12:03 am

1. Pensions are generally a form of salary that is sacrificed to purchase an income.
2. Governments /States/Cities/ Industries based their pension models on a real and and sustainable rate of interest that was economically viable and rewarded savers. We all agree that interest rates need to be higher and that Pension Funds were mandated to be good custodians of their memeber’s money.
3. The government (through the Federal Reserve) trashed the interest rate to allow for the vast majority of Americans to reap a lifestyle that is unsustainable.
4. This destroyed the pension models for returns to promote sustainability.
Therefore, why are you all blaming hard working citizens for this mess? If the government can bail out a few psychopaths and cronies why should tit not be responsible to make good the loses it is causing by its borrowing (and required zero interest rates)?
5. Taxpayers, we are the government……………………….

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Jason Emery June 7, 2011 at 2:40 pm

downunder-”If the government can bail out a few psychopaths and cronies why should tit not be responsible to make good the loses it is causing by its borrowing (and required zero interest rates)?”

The government could issue some treasury bonds to make up for the financial pain inflicted, or have Bernanke print up some more unbacked fiat reserve notes, and give that to the pension funds. However, aside from the political reality that neither of those outcomes will happen, it wouldn’t matter anyway, since fiat reserve note and Treasury Bonds are basically worthless, backed only by hot air.

Sadly, the only logical outcome is to throw all the monopoly money back in the box and start over with a new game, preferably one with some sort of gold backing to restrain the issuance of paper liabilities.

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itavoli June 11, 2011 at 12:47 pm

All talks are about external debt? but what about internal debt of amerika

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Jenna Thalia June 12, 2011 at 6:51 pm

Accepting financial advice from AMERICANS is like asking an AXE MURDERER to watch your back for a second while you do something risky.

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