Thursday, June 27, 2013

NC Pension wants to increase allocation to alternatives - and why this is a bad idea.

In todays News and Observer it was reported that the State Treasurer, Janet Cowell, is formally requesting that the $80bn state pension fund be allowed to increase its allocation to alternative investments to 40%.   (Alternatives are a broad category that includes commodities, private equity and hedge funds).

Ms. Cowell correctly points out that the current return objective of the fund of 7.25% is going to be hard to meet in the current or even foreseeable future given market conditions.  A cut of this return objective to 7% would cause the pension fund to be underfunded by $280 Million per year.   

The hope is that by increasing the alternatives allocation, the fund can boost returns to cover this shortfall.   This is a very risky strategy.   First, alternatives are risky - this is the first rule of finance - if you want a higher return, you better be prepared to take more risk.   Therefore, this proposal is to increase the risk profile of the fund.   Alternatives are good at artificially masking this risk because they are not traded on public exchanges and so we don't get to observe daily price gyrations.  

Alternatives are are risky in another way because we don't know what their expected returns should be.   Stocks and bonds, for example, while risky, have provided us with a long history of data.  Furthermore, their returns can be linked to fundamental measures (such as corporate profits).  As a result we can make a reasonable guess at the expected returns on these assets.   Figuring out the expected return on alternatives, on the other hand, is a complete shot in the dark.   We have no real idea what a hedge fund or private equity fund should return.   So making a big bet on alternatives is just that - a big bet.

An alternative to alternatives, is to cut the return assumption of the fund to 7% and then try to come up with the $280 million.   This may be actually easier than you'd think.   Based on recent numbers, the pension fund incurs over $350 million of fees to outside managers each year.   By moving all of the fund into low cost passive investments, the fund could save a large portion of these fees which would then offset the lower return projections.   This idea is not quite as crazy as it seems - in fact one municipality in Pennsylvania has done just that.