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Pension Funds Become Hedge Funds, Roll the Dice on Exotic Investments

by John Rubino on January 28, 2013 · 11 comments

Running a pension fund used to be one of the easier jobs in finance. The money came in steadily and predictably from member contributions, and you invested it conservatively (in investment grade bonds and blue chip stocks) to meet a modest annual return target of around 8%. It was cook-book money management, nice and cushy and low-stress.

But today’s pension funds have, in effect, two sets of criminally incompetent bosses making incompatible demands. At the national level the US borrows too much and lets its banks run wild, causing a debt crisis to which it responds by lowering interest rates to levels where investment-grade bonds yield next to nothing. At the state and local level, governors and mayors – loath to raise taxes or cut benefits to bring pension plans into balance – pressure funds to keep making their traditional 8% even though, with interest rates way down, that is now wildly optimistic.

So pension fund managers, forced to meet unrealistic goals in an inhospitable environment, have begun  acting like hedge funds by turning to dangerous, sure-to-eventually-blow-up strategies like the this:

Pensions Bet Big With Private Equity
AUSTIN, Texas—On the 13th floor of a sleek downtown office building here, the trading desks are manned overnight. The chief investment officer favors cowboy boots made of elephant skin. And when a bet pays off, even the secretaries can be entitled to bonuses.

The office’s occupant isn’t a highflying hedge fund but the Teacher Retirement System of Texas, a public pension fund with 1.3 million members including schoolteachers, bus drivers and cafeteria workers across the state.

It is a sign of the times. Numerous pension funds are still struggling to make up investment losses from the financial crisis. Rather than reduce risks in the wake of those declines, many are getting aggressive. They are loading up on private equity and other nontraditional investments that promise high, steady returns in the face of low interest rates and a volatile stock market.

The $114 billion Texas fund has hit the trend particularly hard. It now boasts some of the splashiest bets in the industry, having committed about $30 billion to private equity, real estate and other so-called alternatives since early 2008. That makes it the biggest such investor among the 10 largest U.S. public pensions, according to data provider Preqin Ltd. Those funds have an average alternatives allocation of 21%.

Including all assets, the pension’s annual return from Dec. 31, 2007, to Dec. 31, 2012, was 3.1%—better than the median preliminary return of 2.46% among large public funds, according to Wilshire Trust Universe Comparison Service.

Texas pension officials say private equity helped offset declines in its other investments. Britt Harris, the pension’s chief investment officer, says he aims to “smash” the stereotype that government pension funds are on the losing end of most investments.

In November 2011, the Texas fund made one of the largest single commitments in the private-equity industry’s history, investing $3 billion in KKR and another $3 billion in Apollo Global Management APO. Three months later, Texas teachers bought a $250 million stake in the world’s biggest hedge-fund firm, Bridgewater Associates—a first such equity stake for a U.S. public pension.

For the fiscal year ended Aug. 31, the Texas teachers fund had a 7.6% return, and pension officials say they expect their bet on alternatives can help the fund hit its 8% annual target return over the long term. Over a ten-year period ending Aug. 31, 2012, the fund has had an annual fiscal year return of 7.4%.

And this:

Money Magic: Bonds Act Like Stocks
Pension funds across the U.S. are desperate to overcome low interest rates and churn out returns big enough to pay future retirees.

Now some hedge funds and money managers are pitching something they see as a Holy Grail: a strategy that often uses leverage to boost returns of bonds that usually occupy the low-risk, low-return portion of pension-fund investment portfolios.

Leverage relies on borrowing money or using derivatives to make large investments while putting up less cash. The tactic’s widespread use helped inflate the world-wide debt bubble that burst during the financial crisis, and it was blamed for ruinous losses at banks and securities firms.

But money managers such as Bridgewater Associates, the world’s largest hedge-fund firm, and a growing number of pension funds say this type of leverage is different. By using leverage through derivatives, such as bond futures, and by investing in commodities, some pension funds believe they can reduce their typically large exposure to the turbulent stock market and still earn solid returns.

Other proponents of this strategy, known as “risk parity,” include AQR Capital Management and Clifton Group, a Minneapolis-based investment firm.

Adding leverage to bonds, you can ‘lower your risk in your overall portfolio,’ Mr. Dalio says.

In Virginia, officials at the Fairfax County Employees’ Retirement System have revamped the entire $3.4 billion portfolio around a risk-parity approach. About 90% of the pension’s portfolio now is exposed to bonds, when factoring in leverage.

“We think we can improve returns while reducing the risk level of the portfolio,” says Robert Mears, the pension fund’s executive director.

Pension officials that employ risk parity say they are using a modest amount of leverage, and nowhere near what investment banks used leading up to the crisis. They also are trading in large, liquid markets, and say they have ample liquidity should they ever need to settle trading losses with cash.

Bridgewater is known as a pioneer of risk parity. Executives from the Westport, Conn., firm have pitched the idea to pension trustees across the U.S., even making a documentary-style online video about risk parity featuring founder Ray Dalio.

Pension funds and other institutional investors typically take most of their risks in the stock market. Mr. Dalio says risk parity spreads the risk to a pension’s bonds and other holdings.

“Ironically, by increasing your risk in the bonds you are going to lower your risk in your overall portfolio,” he said in an interview.

A core tenet of risk parity is that when stocks are falling, bond prices typically rise. By using leverage, bond returns can help make up for losses on stocks. Without leverage, bond returns in a typical pension portfolio of 60% stocks and 40% bonds wouldn’t be large enough to compensate for low stock returns.

Some thoughts
One of the tell-tale signs of a late-stage bubble is the ease with which tried-and-true business practices get tossed aside in favor of “innovations” that are really cons designed to maintain the deal flow. Day trading during the tech stock bubble and house flipping during the housing boom, for example, were hailed as genius at the time and revealed to be impossible (or at least too hard for amateurs) when those bubbles burst. Loading up on equities (private or public) or using leverage (inherently, unavoidably risky) to goose a portfolio of bonds simply creates a portfolio that behaves more like equities, which is to say far more erratically than bonds. Just like all go-long-the-bubble strategies, it’s brilliant while the markets are going the right way and catastrophic when they turn.

Already, interest rates are rising, which must be causing havoc with those leveraged bond portfolios.


Ten year

 

Pension funds, because of their conservative institutional character, tend to be among the last to be pulled into the really crazy stuff, right before it all falls apart. They are, along with small retail investors, the market’s dumb money. Go back to the middle of the last decade and you’ll find stories (some of which I wrote) chronicling the innovative pension funds then loading up on alternative investments – and outperforming their peers in the short run. Most of them got creamed in 2009.

{ 6 comments… read them below or add one }

BillH January 29, 2013 at 2:31 am

Cats like Ray Dalio are pretty sharp, they’ve been around the block many times and survived, but there’s always that weird anomaly where both “hedged positions”, meant to counterbalance risk, plunge together like never before. There is no way to insure a pension fund against a big systemic fail, and if that mountain of paper crumbles many many will have lots less than they figured on, and as they in turn can’t pay mortgage or taxes other parts of the economy also crumble unexpectedly cascading down. When you are 60-70 and retired there is no chance to reboot and rebuild.

Us baby boomers have failed our descendant generations, passing down debt rather than a legacy and spending wealth of the future to maintain our crumbling dream empire. We may pay for this neglect in that our poorer children won’t be able to support us as our pensions and Soc Sec collapse in upon a foundation built of folly

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Bruce C. January 30, 2013 at 5:46 pm

One of the best pieces of advice I’ve ever heard is that you should run away from any one who says they want to make you money. Maybe Ray Dalio is “pretty sharp”, as “BillH” says, but he ain’t working for “you”. For that matter, neither are the likes of “Cowboy” Brit Harris. I’m sure Brit, et al has a fine severance package for tryin’ in case his lofty goal isn’t reached.

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Chris January 31, 2013 at 12:52 am

Ray Dalio did not deny that he is invested in gold. Bill Gross whose name is synonymous to bonds recommends gold. Ray recommends leveraging on bonds? Since Bernanke started QE, he was already providing live support for the safest AAA investment. When something is considered risk free will become the riskiest if no careful thoughts are put to limiting its supply. Banks use tier one assets as reserves and AAA rated bonds are tier one assets. When US treasuries are downgraded, ther should be a lack of tier one assets for reserves. Wonder what happened? Ray recommends leveraging on bonds? With QE happening in US, UK, Japan, Europe, we would expect the other little ones will follow. Every currencies is being trashed. Most bonds would not be rated AAA and what currency would best replace US$ as reserve or as a yardstick for all currencies to be pegged at. I recommend gold and also gold to be used as tier one asset for banks. We are nearing the end game. All that is needed to topple the house of cards is the rise in interest rate. Inflation rate can be manipulated but it is easier to control inflation when it is at less than 2 or 3%. When inflation exceed a critical point, interest rate has to be increased dramatically to bring down inflation. The present inflation is manipulated and it is not good for the manipulators as they actually cause them to lose control. Hope other Fed board members come to their senses. I have given up on Bernanke and Yellen.

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BillH January 31, 2013 at 2:40 am

I’ve heard Ray Dalio say he holds 10% gold personally….I wonder if he has his pension funds thusly invested.

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Chris January 31, 2013 at 6:42 am

I wonder too. Hope he is not treating the funds like Goldman treat their clients like muppets.

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Chris January 31, 2013 at 1:04 am

Manipulated inflation figures are like faulty thermometers.

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