Abstract

Driven by funding and actuarial considerations, state and local public pension plans have been seeking additional investment options and are increasingly using alternative investments in their portfolios. Pension fund managers are potentially motivated to invest in alternative investments by several factors. The concerns of unfunded liabilities and systemic risk are stimulating possible further legislative attention.

What’s Inside?

State and local public pension systems over the past decade have been under increased strain because of several factors, including demographic shifts, general budget challenges, and two recessions. In trying to deal with these challenges, state legislators have changed laws and state pension systems have decided to shift their allocation strategies away from traditional equity and fixed-income investments to alternative investments. These alternative investments include hedge funds, private equity, and real estate. The authors consider the history and justification for adding these investments to public pension plans and suggest considering new legislation that caps their use in order to mitigate the effect of possible systemic exposure.

How Is This Research Useful to Practitioners?

The authors examine several reasons pension plans are using alternative investments, but the most obvious reason is the perceived performance enhancement, or alpha, that may help funds reduce their unfunded liabilities. These alternative investments have been marketed, possibly more so to large plans, by offering the elusive free lunch—higher returns with lower volatility. Furthermore, adding an asset class that is not perfectly correlated with traditional portfolios adds diversification and dampens volatility, which the authors refer to as the “beta” justification.

Beyond the alpha and beta justifications, two additional factors might explain why public pension systems are using alternative investments. The first is the prudent investor rule, which itself creates a natural herding effect: As more pension funds move in a particular strategic direction, the rule causes more funds to follow. The prudent investor rule also serves as a form of “criticism insurance” because it provides social acceptance of the investment thesis.

The final factor is cause for greater concern: Alternative investments are not as easy to mark to market as publicly traded investments, and therefore, their performance information is limited and their measured volatility is suppressed. This result can lead to higher agency costs. The obscured information is challenging to manage because the beta justification of a particular alternative investment may be unknowingly jeopardized by other alternative assets in the plan. Consequently, pension funds may be paying high fees for beta strategies that they have no way of directly monitoring.

How Did the Authors Conduct This Research?

The authors use data from the National Conference of State Legislatures for annual legislative changes. They also gather public pension data from the Center for State and Local Government Excellence, which collaborates with the Center for Retirement Research at Boston College, for the period 2001–2011. The 126 defined benefit plans cover police officers, firefighters, teachers, and general public employees. The authors also use Public Fund Survey data, which are maintained by the National Association of State Retirement Administrators, and data from Preqin, a private firm that tracks alternative investments.

Using univariate, bivariate, and multivariate regression analysis, the authors find that plans held an average alternative investment allocation of 3.62% over the study period. Overall, there is an increasing trend in both the number of plans holding alternatives and the proportion of assets allocated to them, and by 2013, alternative investments made up 21.8% of plan assets—8.3% real estate, 7.2% hedge funds, and 6.3% private equity.

The authors find no evidence of outperformance. Conflicting with their observations, the monthly hedge fund data from Preqin suggest hedge funds deliver some amount of both alpha and beta. After reviewing three- and five-year Sharpe ratios, they conclude that although hedge funds may outperform over short time periods, the benefit of either alpha or beta is much weaker over longer periods, especially since 2007. Further evidence suggests that the rationale for alternatives has evolved from one emphasizing superior returns to one based on reducing variability of returns.

A legislative change occurs approximately every three years, which correlates with low funding ratios. Larger pension plans and plans with lower funding ratios are more likely to use alternative investments. The amount allocated to alternatives is positively related to the future investment return assumptions. The presence of plan participants on the investment board decreases their use.

Abstractor’s Viewpoint

My thoughts go back to Warren Buffett’s 2008 $1 million bet with a fund manager. The bet was simple: Buffett bet $1 million that over a 10-year period, the S&P 500 Index would beat a hand-picked portfolio consisting of five hedge funds. As we head into the final two years of the bet, Buffett’s bet looks most assured. He explained that the costs of active investing, despite the intelligence of hedge fund managers, are greater than the benefits to the investor. In 2014, CalPERS, the largest public pension in the United States, stated that it is no longer investing in hedge funds. The decision was primarily driven by costs and complexity.

About the Author(s)

Paul R. Rossi

Additional Information

Published by CFA Institute

https://doi.org/10.2469/dig.v46.n6.13

ISSN: 0046-9777

Original Publication

Rose P Seligman J 2016 Are Alternative Investments Prudent? Public Sector Pension Use and Fiduciary Duty Journal of Alternative Investments Vol. 18 No. 3 01 Dec Winter 15

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