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Portfolio > Alternative Investments

State Pensions Seek Higher Returns Through Alts

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Texas, North Carolina, California, Pennsylvania and New Jersey have all jumped into alternatives in a big way, with public-sector pension plans now allocating nearly one-quarter of their assets to hedge funds, private equity, real estate and commodities.

Ramped-up state participation has paid off for them, but other times it has come back to bite them — like in the case of Pennsylvania, which had 46% of its investments in riskier alternatives in 2012 but paid exorbitant fees, which brought its annual return to 3.6%, well below its target of 8%.

Still, Vern Sumnicht, CEO at iSectors LLC in Appleton, Wis., a financial services company, said alternatives have become very popular in the public-sector realm in large part because of how successful David Swensen’s Yale Model has been in boosting the Yale University Endowment Fund for 15 years.

And while most pension plans are not investing 60% or more in alternatives, like Yale’s endowment, many have boosted their investment in alternatives by 3% to 5% a year, Sumnicht said.

According to a recent report by Cliffwater LLC, an advisor to institutional advisors, state pension funds more than doubled their allocations to alternative investments between 2006 and 2012 — about a $600 billion increase. They now make up about 24% of total public pension fund assets. Investments in stocks went way down during the same time period.

So why have alternatives caught the eye of pensions? It’s simple, said Sumnicht. Alternatives offer efficiencies and opportunities that aren’t available through traditional equity or bond investments. On the other hand, to make investing in alternatives work, people have to leave their investments in them for 10 years or more, he said.

The “liquidity in a private equity partnership could easily be 10 years or more and, for a lot of investors, that’s a big problem. But you can imagine for an endowment fund, liquidity is not a problem. These are long-term investments. They can easily manage the liquidity. They can keep enough money in short-term bonds or cash for their needs easily but then have billions of dollars very long-term,” Sumnicht said. The same is true for pensions.

Of course, the popularity of hedge funds and other alternatives with institutional investors has had its negative effects. Some of the country’s largest hedge funds announced this year they would give money back to the institutions that were investing with them. The problem, they have found, is that they have so much capital invested now they don’t have enough of the right investments to buy into. They don’t feel they can get the returns they have in the past because they are growing too big.

Most hedge funds are exclusive, with 100 or fewer investors who pay a premium to be included in the investment.

The advent of exchange-traded funds has made it even easier for institutional and smaller investors to put money into alternatives. Companies have developed funds that specialize in everything from timber and oil and gas to real estate investment trusts.

As ETFs become more popular, the fees to participate in them will drop and the amount of money needed to invest in them also will decrease, he said. Right now, it takes thousands of dollars to participate in many alternative investments. That could drop to as little as $1,000 as time goes on, Sumnicht said.

Cliffwater’s 2013 Report on State Pension Performance and Trends found that pensions that invested in traditional portfolios of stocks and bonds returned single-digit returns over the last 10 years with a bit too much volatility. Looking ahead, Cliffwater said it doesn’t expect that to change.

It pointed out that larger endowments outperformed pensions from 2006 through 2012, but that their performance advantage has narrowed in recent years.

“Better performing state funds generally had more alternative investments,” the report found. “In fact, the top-performing state pension plan over the last 10 years had the highest allocation to alternatives.”

The top-performing state fund was the Missouri State Employee’s Retirement System, which returned an average 8.1% over 10 years. South Dakota Retirement System saw a 7.8% average return, followed by Delaware Public Employee Retirement System and Oklahoma Teachers’ Retirement System with 7.6%.

The one thing all of these plans had in common was their above-average investment in alternatives. The average allocation to alternatives among the top-performing pension plans was equal to 29% at the end of June 2012.

The amount of money state pension plans invested in alternatives varied greatly from 0% to 65%, indicating that nobody knows the right amount of alternatives to invest in, Cliffwater found.

“There is no relationship between state pension fund size and performance, contrary to endowments where a strong positive relationship has existed between fund size and performance,” the report stated.

Many state pensions are moving toward global stock allocations and putting equity hedge funds in their stock allocations, Cliffwater found. Private equity made up 42% of the alternative asset mix of state pension plans in 2012, followed by real estate at 32%, hedge funds at 17% and real assets at 9%.

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