Pensions turning to edgier investing

Seeking higher returns, 2 funds for city employees put money in hedge funds

August 24, 2005|By Laura Smitherman | Laura Smitherman,SUN STAFF

Two pension funds for city employees in Baltimore have turned to hedge funds - lightly regulated investment vehicles that can pursue exotic and sometimes risky trading strategies - in an effort to boost returns in their multibillion-dollar portfolios.

The Baltimore City Fire & Police Employees' Retirement System put $80 million into hedge funds this year, while the Baltimore Employees' Retirement System allocated about $55 million. In both cases, the investments amount to 5 percent or less of the assets in the pension systems.

The investments are part of a nationwide push by public pension systems into hedge funds in search of "alpha," which is what investment professionals call skilled money managers' edge in beating the market.

Finding an edge has become more important amid the lackluster returns in stocks and bonds in recent years, which have left many pensions underfunded for the long term.

"We're looking for ways to better returns, just like every other pension fund across the country," said Thomas P. Taneyhill, executive director of the city's fire and police system. "Sure, you hear about blowups in certain hedge funds all the time, but look at what's happened in the stock market and with the accounting scandals."

Hedge funds use complicated strategies and can make big bets, sometimes with borrowed money, on stocks, bonds, commodities, currencies and other securities. They also "short" stocks - bet that prices will fall - and promise returns that don't correlate with the rest of the market.

Up to half of the largest public pension funds - including the Massachusetts state pension, the New Mexico State Investment Council, the California Public Employees' Retirement System and the Virginia Retirement System - have money in hedge funds.

"The phenomenon has really accelerated in the last five years," said Keith Brainard, research director of the National Association of State Retirement Administrators.

Public pension funds set annual targets, typically for returns of 7 percent to 8 percent, to provide the systems with cash to pay to retirees. But the nation's largest pension funds posted a median return of 1.3 percent in the first six months of this year, Trust Universe Comparison Service said.

For the year that ended June 30, the median return was 9 percent; the year before, it was 16 percent. But in fiscal 2003 it was 4 percent after two years with losses of 5 percent to 6 percent.

Hedge funds manage more than $1 trillion. Investors began pumping money into them in 2002, after the dot-com bubble burst and stocks' heyday ended.

Hedge funds posted an average return of 1.9 percent in the first half of this year and an average annual return of more than 14 percent since 1990, according to Hedge Fund Research.

"The move by public pension funds into hedge funds picked up steam over the last few years because of the bear market," said Edwin Boyer of Asset Strategy Consultants, a Baltimore firm that advises endowments and retirement plans. "It didn't look good for them in 2002; things were looking a little bleak."

Boyer, who recommends hedge funds as a way to reduce the risk of losses by diversifying holdings, said public pension funds "want to remain fully funded without having to go to the taxpayer." State and local governments often make up for shortfalls in the funds.

Officials with the Baltimore pensions say their funds are on sound financial footing, and most pensions have sufficient cash flow to make current payments despite long-term shortfalls, said Julia Coronado, a senior researcher at benefit consultant Watson Wyatt.

"It's just that eventually they will need to pay for future benefits," Coronado said, "and eventually they will need to put the cash in, or the returns will have to improve, or both."

Not everyone thinks hedge funds are the way for pensions to achieve their targets for returns. Some market watchers are warning of a possible "bubble" in hedge funds, which number nearly 8,000, up from about 600 in the early 1990s, according to Hedge Fund Research Inc.

The Maryland State Retirement and Pension System, which administers benefits for teachers, state police and legislators, hasn't invested in hedge funds, partly because of the bubble-like signs and because of the funds' high fees.

"We have some discomfort with the amount of money that's flowing in, and we have questions as to whether historical returns can be replicated going forward," said Steven Huber, the state's chief investment officer, who said he has been "keeping an eye" on hedge funds. "Until we're comfortable, we won't begin to look into the details of it."

Once reserved for the wealthy, hedge funds have become popular among institutional and ordinary investors. In part, the interest has been driven by funds that pool money to invest in hedge funds for clients. Such funds accept minimum investments of $50,000 or less. Direct investment in a hedge fund generally requires at least $1 million.

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