Institutional Investor magazine put “The Great Hedge Fund Experiment” on the cover of its June 2011 issue. Inside, the magazine described how in little over a decade, state pension funds had gone from considering hedge funds as “too risky and secretive” to embracing them in their asset allocation schemes.The magazine argued the interchange had left both pension funds and hedge funds profoundly changed.
The Florida State Board of Administration (SBA) (which managed the Florida Retirement System, one of the country’s largest state pensions), had been slow to consider hedge funds, not gaining statutory authority to invest in them until 2007. Since then the Florida Legislature had increased the statutory limit and by 2015, the SBA could put up to 20 percent of the FRS’s assets into hedge funds and other alternative investments. The SBA maintained a flexible asset allocation scheme, investing in hedge funds not as an asset class but to opportunistically capture attractive opportunities or improve the FRS’s portfolio efficiency through diversification. In 2015, the SBA invested nearly seven percent of the FRS’s funds in strategic investments.
For Florida and other state pension systems, any allocation to hedge funds remained controversial, especially after the California Public Employees' Retirement System (CalPERS) decided to close its hedge fund program in 2014. CalPERS’s decision reverberated throughout the industry – the New York Times described it as a watershed moment for the hedge fund industry – not only because the pension fund was the nation’s largest, but also because CalPERS had actually been one of the first state pension funds to invest in hedge funds in 2002. However in 2014, CalPERS threw in the towel, arguing that hedge funds were too expensive, opaque, and complicated for its money managers. Many analysts agreed.
Nonetheless, many state funds believed that hedge funds could be part of the mix to gain attractive investment returns. In 2015, most state pension funds in the United States were severely underfunded, having taken massive hits during the Great Recession of 2008. Lawmakers who had legal obligations for paying these defined benefit plans faced a number of unattractive options. They could raise taxes to increase funding, never a popular stance for a politician. Or they could try to decrease current benefits, an action of questionable legal merit in many jurisdictions, and face litigation and the ire of public employees and their sometimes powerful unions. (Legislatures have clear legal authority to change benefits prospectively, but this provides no immediate remedy for underfunding issues relating to prior and or current benefits. ) Or they could attempt to grow the pension fund assets through investments, such as hedge funds.
Ashbel “Ash” Williams Jr., the Executive Director and CIO of Florida’s State Board of Administration (SBA) – the body that oversaw the investments of the FRS, faced similar problems. After the market crash of 2008, the FRS was 87 percent funded, down from 107 percent only a year before. While a funded ratio of 87 percent was very good compared to most other states, it nonetheless unsettled a group of Florida lawmakers. Seeing the FRS as just another underfunded, unsustainable public pension plan, some lawmakers argued that the state should close its defined-benefit plan and offer only its defined-contribution plan for new employees.
Williams had to re-establish the integrity of the SBA and insure that the SBA could meet its obligations for all clients, including the FRS. The SBA’s hedge fund program was in a formative stage, strategy, policy and resources were works in progress.
There were also practical matters of assembling a hedge fund program. How were funds to be chosen? How would hedge funds relate to liquid equity or credit portfolios, distressed debt, private equity or activist equity funds? Who should advise the SBA on structuring and executing the hedge fund program? How should the alternative investments area of the SBA to be staffed? How were hedge funds to be monitored? When should funds be terminated?
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Jaan Elias, William Goetzmann and Lloyd Baskin, “Role of Hedge Funds in Institutional Portfolios: Florida Retirement System,” Yale SOM Case 16-016, September 26, 2016.
- Hedge Funds
- Private Equity
- State Pension Funds
- Asset Management
- Financial Regulation
- Metrics & Data
- State & Society
Funding support for this case study generously provided by The Center For Alternative Investment Education