16 Pages Posted: 12 Sep 2011
Date Written: September 13, 2011
A recent Washington Post editorial, “The perilous state of pensions,” opined “…public sector pension funds typically incorporate optimistic assumptions about the returns they will earn on their investments…(reducing the assumptions)…would have exposed the emptiness of their past promises.” In fact, a variety of institutions, from university and philanthropic endowments to public and private pension funds, have all endured a difficult and volatile period in the financial markets. The case of public pension funds is perhaps the best-known example of this problem.
Against this backdrop, a rising number of these institutions are devoting larger shares of their portfolios to hedge funds. Once considered an elite investment for wealthy individuals, a majority of hedge funds assets - by one independent measure 61 percent - are now owned by institutional rather than private investors. Thus, the role of hedge funds in the economy is changing as new classes of institutional investors come to embrace them. As hedge funds accumulate a longer investment track record on which to be judged, and, following the passage of the Wall Street Reform and Consumer Protection Act (Dodd-Frank), the role of hedge funds in the financial system is an important consideration.
In this paper, I examine the confluence of these issues. The paper explains the objectives of hedge funds, estimates their potential value to institutional portfolios, and examines some of the basic public policy concerns surrounding the role of hedge funds in financial markets. Campbell & Company, one of the world’s innovators in quantitative model development, supplied the allocation modeling and additional data necessary to complete my research and analysis.
Hedge funds have evolved from an elite investment to a standard component of investment portfolios, and in so doing, offer institutional investors, such as pension funds, the opportunity to improve returns. The modeling performed for this analysis suggests that a modest allocation to hedge funds would improve the returns to public pension funds by approximately $13 billion annually. Moreover, the track record of recent years further illustrates that hedge funds have not been a source of greater systemic risk - rather than “too big to fail,” they are generally not an important source of systemic risk.
Keywords: Alternative investments, Hedge funds, pensions, institutional investors, public and private pensions, university endowments and philanthropic foundations
JEL Classification: G2, G23
Suggested Citation: Suggested Citation