Recent market turmoil is likely to test the mettle of public pensions invested in hedge funds.
While it will not greatly impact the retirement system for Utah's public employees, the recent problems with some hedge funds could prove a drag on the retirement systems in other states.
Craving returns that are higher than plain-vanilla stocks and bonds, public pensions poured billions of dollars into hedge funds at a time of low volatility and solid returns. This month, though, some hedge funds have suffered double-digit percentage losses, which could sting pensions that have recently embraced this asset class.
Bob Newman, executive director of the Utah Retirement Systems, said that they have not invested in the companies suffering because of their forays into the subprime mortgage market. But the losses incurred in the general stock market because the subprime problems have lowered the value of their portfolio.
The contagion effect of the subprime problems has impacted us, but it's probably about the same as a lot of funds," he said. The losses are not anything to panic about, however, because "we're long-term investors and we just ride out these drops."
In July, before the market upheaval took hold of a widespread array of hedge funds, California's and New Jersey's massive pension funds endured mild losses in their hedge fund investments for the month. And while the California Public Employees' Retirement System, New Jersey's State Investment Council and other well-heeled investors are no strangers to difficult markets, this will be the first time many pensions have had to navigate broad turbulence in their hedge fund portfolios.
"Frankly, we haven't had much of an opportunity to test it until now," said Robert Gentzel, spokesman for Pennsylvania's State Employees' Retirement System, of the pension's $8.5 billion hedge fund portfolio.
Done right, hedge funds should help pensions mitigate their losses when markets sour. Hedge funds aim to profit from downturns by investing in an array of assets and investment tools, such as currencies or derivatives.
But hedge-fund declines can also be more rapid and severe than declines in straight stock or bond portfolios, due to their heavy reliance on borrowed money to make trades. At the start of August, for example, a wave of losses hit funds that use computer models to pick which stocks and other securities will rise and fall. The damage incurred by this strategy was by no means limited to hedge funds, but their losses were far worse. Some hedge funds had losses in the double digits in less than two weeks because of their leveraged positions.
How pensions' investments in hedge funds hold up when the dust settles will help determine how they manage these tricky portfolios going forward, industry watchers say. For example, recent volatility will likely scare pensions away from moving assets out of funds of hedge funds and into direct hedge-fund investments, even though such a move would save them investment fees, said Carl Hess, head of the U.S. investment consulting group at Watson Wyatt Worldwide.
So far, public pensions appear to have lost minuscule amounts in their hedge fund portfolios in July, a period when the Standard & Poor's 500 index was down 4.2 percent. CalPERS, the nation's largest public pension, lost 0.3 percent in its hedge fund portfolio in July. New Jersey's pension lost roughly $10 million in its $2.4 billion hedge fund portfolio last month, versus $900 million in its $31.6 billion domestic stock portfolio. The Pennsylvania pension saw gains of 0.5 percent in its hedge fund portfolio.
But the damage to funds in August is likely to be worse. The August performance numbers aren't yet available for most of the funds, but Hedge Fund Research Inc.'s HFRX Global Hedge Fund Index was down 5 percent for the month as of Friday, bringing the index down less than 1 percent for the year.
To be sure, hedge funds have been instrumental in propelling pension returns forward in recent years, and that will be a matter for consideration. Just last month, CalPERS trumpeted its best annual performance in a decade and said it was fully funded with $247.7 billion in assets at the end of June. The month prior, CalPERS announced plans to double its investments in hedge funds to $10 billion, following five years of strong performances.
By mid-August, however, the fund was dealing with a different investment environment, as stock and bond markets endured a beating. As of Aug. 13, just six weeks into its 2008 fiscal year, CalPERS' assets had declined by 1.3 percent, or $3.3 billion since June 30, according to a report to the CalPERS board by Chief Investment Officer Russell Read.
In the report, Read said the recent turmoil was creating investment opportunities that would lead to higher results in the future. But he also warned that "we are virtually certain that this year's returns will not be as strong as last year's."
Deseret Morning News business writer Josh Loftin contributed to this report.