Oregon officials searching for ways to blunt the impact of future stock market crashes on the state’s $70 billion pension fund have increasingly looked at hedge funds as part of the solution.
The state started to buy into the funds in 2011, and now has more than $300 million invested in them. That’s a small portion — roughly 0.5 percent — of the pension fund’s assets. But under its investment policy, the amount could grow. The policy calls up to 45 percent of the alternatives portfolio, or roughly 6 percent of the entire pension fund, to be invested in a category that includes hedge funds.
Pension officials are sticking with the strategy, in spite of recent critiques of pension systems’ investments in the funds and the 2014 decision by the nation’s largest pension fund, Calpers, to divest from hedge funds.
State Treasurer Ted Wheeler and other members of the Oregon Investment Council hope hedge funds and other alternative investments will help the state avoid a repeat of what happened in the 2008 financial crash, when the public employees’ pension fund lost a third of its value in six months.
The fund has largely recovered from the effects of the crash, but for a variety of other reasons the state now faces an $18 billion unfunded pension liability over the next two decades. The shortfall could grow if the state’s investment returns continue to fall short of the 7.5 percent assumed rate of return or if there is an economic downturn.
Oregon pension officials are most interested in hedge funds’ promise of uncorrelated returns, meaning that the funds will lose less — or perhaps even produce returns — in a down economy. Although research has shown hedge fund performance is correlated to the stock market, Oregon has invested in funds with “truly uncorrelated returns,” according to Oregon State Treasury Communications Director James Sinks.
“Currently, about 70 cents of every $1 in (pension) benefits comes from investment gains, so sustainable and strong performance is key,” Sinks wrote in an email.
In late November, researchers at the Roosevelt Institute released a report that examined hedge fund investments by 11 other states. The researchers, who also received support from the American Federation of Teachers and the Haas Institute for a Fair and Inclusive Society at the University of California, Berkeley, found “significant correlation” between hedge fund returns and overall pension fund investment performance. The researchers also cited market data that showed hedge fund performance was “highly correlated” with the stock market.
As it turns out other state pension funds have not followed Calpers’ decision to divest. The California pension system cited costs and complexity as reasons for its 2014 decision to exit from hedge funds.
The Oregon State Treasurer’s Office declined to release the fee schedules for the three hedge funds in which the pension system invested, citing an exemption in Oregon public records law. It allows the agency to keep hidden any documents submitted by hedge funds and other private funds not subject to federal disclosures and other regulations.
As a result, it’s impossible to know how much the pension fund will pay over the life of the investments. The Treasurer’s Office did release aggregate hedge fund fees for 2014, which suggest the state paid 0.27 percent in fees that year on two hedge funds — AQR Delta Fund II and AQR Style Premia Fund — and 1.07 percent on the third fund, Reservoir Strategic Partners Fund.
That is probably a tiny portion of what the state will eventually pay, given the typical hedge fund fee structure.
Keith Larson, a member of the Oregon Investment Council, said hedge funds typically charge a 2 percent management fee, plus a 20 percent cut of profits, which is partly why the funds have a negative image.
One of the AQR funds had a return of 5.6 percent as of June, while it was too early to calculate a return on the second fund, according to a state document. Reservoir Strategic Partners Fund had a return of 3.9 percent which, although it was below the state’s assumed overall pension fund return of 7.5 percent, was not bad compared with the state’s actual pension fund return of just under 3 percent during the first 11 months of the year.
Hedge funds enjoy strong support from the Oregon Investment Council, which has unanimously supported them every time there was a vote to invest in a new fund. The council’s experience during the 2008 financial collapse helps explain why.
The crash revealed that even fixed-income investments, such as bonds and other securities, were riskier than investment officials realized.
“Part of the reason for that was in order to try and achieve a high return for the state, the state had invested in a lot of corporate debt,” Larson said. The pension fund had also invested in mortgage-backed securities, many of which contained high-risk loans that went into default during the housing crisis.
Katherine Durant, chair of the Oregon Investment Council, said the 2008 crash was a pivotal moment. “We’ve never seen that kind of a global crash of the financial markets like we saw in the last downturn,” Durant said. “Usually it was just equities or bonds, it wasn’t everything. But everything went down.”
Larson agreed. “That was a bit of an ah-ha moment,” Larson said. “I think the people that were doing the day-to-day investing knew well and good pretty much what we were investing in. We were investing in these turbo-charged assets, that had higher returns but higher risk ... But I think it was a difficult thing to see across the entire portfolio, what the effects would be.”
Wheeler, who became treasurer in March 2010, said it was important to diversify the state’s pension fund investments so that various investments move in different directions, under different conditions. “In some cases, they can serve as countering forces to economic forces like inflation,” Wheeler said. “In 2008, there was no safe harbor. Everything went down.”
Larson said the situation taught him two things: The Oregon Investment Council needed to better understand the risks across investments, and it needed to build a better portfolio of alternative investments to prepare for economic downturns. The state purchased a system to better track assets and risk, and has been working to build the alternatives portfolio, which in addition to hedge funds includes investments in funds that own natural resources such as timber and infrastructure such as ports, airports and a power plant.
Uncorrelated returns are important to the pension fund because when its value dips, schools and other public employers can end up paying more into the fund.
“It’s as much about the uncorrelated returns as it is about the high returns,” Larson said of the alternatives portfolio.