Wednesday, December 14, 2011

Uh, Oh - Public Pension Funds Making Bigger Bets to Cover Shortfalls

The current market environment is incredibly frustrating for most investors.

Interest rates are at 60 year lows. Bank deposit rates are mostly below 1%. Stock returns will be flat in 2011 - again. The S&P 500 remains 17% below year end 2007 (talk about depressing!).

If you believe - as I do - in Regression to the Mean, and the under performance of stocks relative to bonds over the last few years will reverse itself.

In particular, I think that investors in large cap, dividend paying US stocks will earn good returns for the next few years, although it will almost certainly be a bumpy ride.

In other words, in my opinion, patience is the most important investment consideration at this juncture.

Unfortunately, if you're on the investment committee of a large pension plan, there is a constant pressure to improve returns, even if it means taking on more risk.

For example, this morning's New York Times discusses the increased allocation of public pension plans to private equity investments.

Private equity has an aura about it. The idea that a small group of incredibly savvy investors will be able to invest in the next Apple, Facebook or Google and deliver outsized returns is very attractive after the disappointing returns in the public market over the last decade.

Whether this is truly the case is debatable, but that hasn't stopped billions from flowing into private equity. Here's an excerpt from the article:

At the same time, pension plans everywhere are also desperate for yield. Pension plans are reportedly underfinanced by anywhere from $700 billion to as much as $4 trillion, depending on the calculations. Poor returns over the last few years have not helped. Over the last five years, the average state and local pension fund has returned 4.7 percent, according to Callan Associates.

Pension plans hope to make up these lost years and reach performance targets that in some cases are still set at a hopeful 7 to 8 percent a year. Private equity has traditionally been a high-performing asset class, and shifting more assets into this and other alternative investments like hedge funds is seen as a possible solution. Wilshire & Associates recently found that the average pension fund had increased its allocation to private equity to 8.8 percent in 2010 from 3 percent in 2000.

I hope this shift works out, but past history is not hopeful.

Hedge funds were once thought to be the panacea to institutional funds, for example,but recent data indicates that more than 75% of the hedge funds in existence have produced mediocre, or no, returns to investors.

The problem is when large sums of money are allocated to areas where investment opportunities are limited, overall returns are usually disappointing.