What a Squirrel Taught Me About Pension Plan Investments in Hedge Funds

I was sitting on my porch the other evening unwinding after another day in the markets.  Suddenly, the external telephone wire into my house started bouncing up and down.  I looked down the telephone wire.  Nothing on it.  I got up and walked to the junction site with the main wire.  Nothing on it.  I looked down the wire one way.  Nothing on it.  I looked down the other way - a squirrel.  Somehow, this squirrel had a created a transverse wave which rippled from far away and had the effect of creating havoc at my house. 

This got me thinking about connections in our economy. This transverse wave is analogous to the chaos roiling our financial markets.  It starts from far away and rolls through.  You might not even be close to the root cause, but the vibration is going to affect you. 

As I sat there pondering what this squirrel was trying to teach me, I had another thought.  Don’t just think about one squirrel, think about many squirrels.  All creating their own vibrations.  What would this do to my telephone wire and thus the economy?  Then, I had my final thought – look to whomever has the most squirrels, they are going to be affected the most. 

Now this may seem a little nuts (notice the bad pun between squirrels and nuts), but city and state governments have the most squirrels.  They have a quadruple-whammy which will hit them at the same time.  First off, due to declining housing  values, property tax will be much lower.  In most case, there is at least a 1 year lag between declines and tax collections.  Therefore, this decline in revenues is just beginning to show.  Secondly, rising energy and heating costs are starting to take its toll on city and state coffers.  On an inflationary front, healthcare costs and general inflation are all taking a greater slice of the pie.  Lastly, pension contributions continue to rise.   

I am not an expert in operating state government or municipalities but I will say this with certainty.  City and State pension fund administrators will have more pressure than ever before to produce high returns.  This leads me to conclude that Hedge Funds are an excellent fit for state and city pension funds.  First off, in bear markets hedge funds have the ability “protect” assets due to short positions.  Secondly, hedge fund investing can produce uncorrelated returns to the overall market.  Lastly, history shows two important lessons:  1) a diversified portfolio of hedge funds can yield higher returns than the market and 2) the best overall returns from hedge funds as an industry come just as the economy “turns the corner” out of a slowdown. 

I must not be alone in thinking that state and city pension funds are going to put more into hedge funds.  According to Pensions & Investments Magazine, here are a few pension funds that have upped their investment in hedge funds:

• Illinois State Board of Investment
• California Public Employees’ Retirement System
• New York State Common Retirement Fund
• South Carolina Retirement System Investment Commission