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The Managed Funds Association has published a paper by Everett Ehrlich, a former U.S. under-secretary of Commerce, that seeks to quantify the contribution that investment in hedge funds of up to 10 percent of their portfolios could make to the performance of certain hard-pressed institutional investors.

The paper has a rather dormative title: “The Changing Role of Hedge Funds in the Global Economy.” The content is more intriguing than the title, though. Ehrlich, who holds a doctorate in economics from the University of Michigan, maintains hedge funds could play a major role in rescuing state and local pensions from the avalanche that has nearly swamped them of late.

The Avalanche

Ehrlich begins with a statistic from the Pew Center on the States, “The Widening Gap,” April 2011: that 31 states had their pension funds less than 80 percent funded in fiscal year 2009.

They’ve been buried in the fall in interest rates, and so in the fall of dependable rates of return. Ehrlich asks us to consider a company – or a public entity – that must pay out $1 million for each of the next 30 years. If management is working with an earnings assumption of 8 percent, it needs only a present value of $11.26 million. But with a working assumption of 6 percent, the amount necessary for the full funding of those obligations is $13.76 million. Voila! A once fully-funded pension has become only about 80 percent funded.

For a real-world example, Ehrlich describes a recent deliberation by the California State Teachers’ Retirement System (CalSTRS), over whether it should lower its earnings forecast from 8 percent to 7.75 percent. It determined that the 25 basis points reduction “would require contributions of 3 percent of payroll to restore balance,” he writes. Nonetheless, the reduction reflected economic reality, so CalSTRS tried to implement that change. Elected officials blocked it. Thus, such pension funds are torn between two painful alternatives: sticking with now-unrealistic assumptions on the one hand, or moving to realistic assumptions that imply the need to raise more capital on the other.

Some Assistance

Ehrlich notes that the hedge fund industry has grown impressively over the last two decades. In 1990, it had only $38.9 billion in assets under management; in 2011, though, that AUM number was $2.04 trillion. This represents nearly a fifty-fold increase.

Of this growth, 60 percent comes from asset appreciation and the generation of income. But the remaining 40 percent comes from new capital given to funds by clients over that period. Thus, that chunk of the industry growth may be attributed to the fact that, as Ehrlich puts it, hedge funds have transformed themselves “from an ‘elite’ investment used by wealthy individuals to a standard component of any institutional portfolio, whether it is the placement of university or philanthropic endowments or the assets that support both public- and private-sector pension funds.”

Pensions have played a part, then, in the transformation of hedge funds from elite to a mass phenomenon. Will hedge funds return the favor by rescuing the pension funds?

Modeling

In order to get at this, Ehrlich drew on assistance from Campbell & Company, which modeled a “standard” pension fund portfolio, one without hedge funds, and a “hedged” portfolio – one with 10 percent of its assets in hedge funds. In order to make room for this 10 percent, the other components of the portfolio were reduced pro rata. In other words, U.S. equities were reduced from 50 percent to 45 percent, foreign equities and bonds were reduced from 20 percent to 18 percent, and so forth.

The results for this model portfolio improved considerably, both as to performance and as to risk. On the one hand, the average annual compound return rose to 7.54 percent from 7.03. On the other hand, average annual volatility fell to 10.39 percent from 10.95.

The value gained by such a move toward a 10 percent allocation is something public policy makers must bear in mind. It “has the potential to add $13.67 billion to public pension plans annually.”

It has a similar potential in the case of university endowments, “which stand to add more than $1.73 billion in expected returns per year by shifting 10 percent of assets to hedge funds.”

Everyone in trouble should have such a St. Bernard standing by.

Source: Hedge Funds To Pension Funds: Help Is On The Way