Hopped Up On Hedge Funds

Pension plans like Indiana's are taking bigger risks -- with taxpayers' money

Public pension funds have taken heat lately for a slew of problems. From New York to Ohio, critics have lambasted them for inadequate disclosure, mismanagement, and promises to retirees that could leave taxpayers holding the bag. So it seems an odd time for a smallish fund to plunge deeply into hedge funds and other risky so-called alternative investments.

Yet that's precisely what the Indiana Public Employees' Retirement Fund wants to do. The board of the $14.6 billion pension fund, which oversees the retirement of 220,000 state employees, voted in late August to bump up its alternative investment target to 15% from 5%. It also broadened the menu to include not only private equity and real estate but also hedge funds and commodities. And Indiana said it would cut its safest holdings, bonds, from a target of 30% to 20%. All this from a state that began investing in stocks only 10 years ago.

Indiana is following the lead of other state and local pension funds trying to catch up with bigger funds such as the $210 billion California Public Employees' Retirement System, which has been sinking money into alternative investments for years. The goal is the same for all: to diversify portfolios and generate higher returns. New Jersey's $74 billion pension funds, for example, moved last year to devote 13% to alternative investments, from zero before, while the Philadelphia pension system wants to nearly double its allocation to 11%. The average public fund has around 8%.

But there's a key difference: New Jersey and Philadelphia are underfunded and feeling pressure to juice returns. Indiana is nearly fully funded. State pension fund director David J. Adams says his board set the 15% target after a routine asset allocation review. He says he expects annual returns of 8.1% from the new mix, compared with the current target of 7.25%. The extra gains, he says, could reduce the amount taxpayers must kick in. Sounds simple, in theory.

Is jumping in right now prudent, though? Private equity funds, hedge funds, commodities, and real estate have all enjoyed strong returns in recent years. The best investments are made when there's blood in the streets, not confetti.

Of course, pension funds aren't market timers; their investment horizons are long. And a central tenet of investment theory is that broad diversification increases returns and lowers overall volatility. Asset allocation specialists barely bat an eye at Indiana's decision. "The number '15' by itself is not an unreasonable allocation," says Jack M. Marco, chairman of Marco Consulting Group, which advises pension funds on such matters.


But what might Indiana's 15% consist of? It's an important question for a state that currently invests less than 1% in alternative investments -- far below its present allocation -- and has only recently begun to dabble outside the comfy confines of bonds. Adams has done well since he was named to the top spot 18 months ago. His fund reaped a 10.4% gain in the 12 months ended in June, thanks to stakes in alternative assets like the private-equity fund Lindsay, Goldberg & Bessemer and an Indiana-based real estate fund, both of which combined to return 21%. But those investments total $88 million. Indiana is proposing to invest $2.2 billion and reach that goal within six years.

Choosing a top-flight private equity or hedge fund isn't easy. There was a 10-percentage-point performance gap between top-tier private-equity firms and those in the median range, according to Thomson Venture Economics (TOC ). And Indiana might not be able to get into the funds it truly covets. Top performers can be picky with so much money pouring in.

Consider the Arizona Public Safety Personnel Retirement System, which manages $6.2 billion for the states' firefighters, police, and the like. It began looking at private equity just over a year ago. But even though the fund can put 5% to 6% of its money in such investments, it has less than 2% in today. "We're new to the space, so it's more difficult to get access to the better funds," says the pension's chief investment officer, James Nielsen. But given the current environment in alternative investments, any resistance Indiana meets from funds might be a blessing.

By Adrienne Carter

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