VideoIn April 1998, the California State Teachers' Retirement System (Calstrs) decided to allocate 10 percent of its pension assets to investments other than publicly traded stocks and bonds. Calstrs chose instead to put the money into lightly regulated partnerships that invest mostly in privately held Þrms and real estate.
Calstrs's alternative investment portfolio hasn't performed as well as hoped of late. During the year ended last May 31, the portfolio's value rose from $2.2 billion to $2.6 billion, a 16.5 percent return, compared with 18 percent for the Russell 3000 index, its benchmark.
But handsome returns aren't the only reason Calstrs has boosted its commitment to the nonpublic markets. The lofty levels reached by the public markets are making the plan sponsor squeamish about keeping all of its assets there. Simply put, Calstrs sees more downside than upside in the stock and bond markets.
Calstrs isn't the only pension fund to move money from the public markets to the private. Over the past five years, the average pension- fund allocation to alternative investments has more than doubled, from 2 percent of assets to 5 percent, according to Wilshire Associates, a Santa Monica, California-based pension consultant. And Wilshire expects those allocations to rise as high as 10 percent in the foreseeable future. No wonder the total amount of dollars flowing into private equity funds and partnerships reached a record level last year.
Interest in alternative investments isn't limited to public pension plans. Among the companies whose plans are allocating at least some assets to the category are AT&T; General Motors; Mobil; SBC Communications; Sears, Roebuck; and Sempra (the recent combination of Pacific Enterprises and Enova). And many, if not most, are increasing their allocations. AT&T, for instance, has upped its target allocation to 10 percent of plan assets from 8 percent in 1996.
But so far, at least, corporate participation has been limited to the largest plans. Since alternative investments are considered riskier than traditional ones, most plans still limit their exposure to less than 5 percent. To get sufficient diversification at that level, generally speaking, a plan needs to have at least $500 million in assets.
And even many plans of that size have yet to take the plunge. "For the most part, corporate plan sponsors have been pleased with the returns they've gotten from their public market portfolios," says Jeanne Murphy, a consultant with the Bethesda, Maryland-based firm Watson Wyatt & Co.
Another likely reason for limited participation in alternative investments has to do with the experience of pension fund managers who have gotten burned in the past on private partnerships that made particularly risky bets on derivative instruments. As a plan fiduciary, "making a little extra money on the upside won't necessarily get you a big bonus," says James Abbott, a partner in the New York law firm Carter, Ledyard & Milburn. "But having a really bad downside return can get you fired."
Yet that view seems shortsighted. Modern portfolio theory holds that allocating a portion of a portfolio to riskier assets can actually decrease its overall volatility, if those assets move in the opposite direction of the less risky holdings that dominate the portfolio. In theory, at least, there should be a higher correlation of returns among publicly traded securities than between public and private ones.
Fans of private equity are confident the theory would hold up if the public markets turn down. "When the markets are down, there is some impact on private equity, but not 100 percent, because the companies have different growth characteristics," says Barry Gonder, senior investment officer for alternative investments at the California Public Employees Retirement System (Calpers), which has also been increasing its exposure to such alternatives.
An Exclusive Club?
Granted, portfolio theory may not be enough to overcome other obstacles. For one thing, private equity funds are organized as limited partnerships, so access to the top performing ones is limited. General partners can choose the investors they want as limited partners. And the better the performance, the harder it will be to get in.
One way around this obstacle--as well as that of lack of asset size -- may be to invest in a fund of funds, which is a private equity fund that invests in a mix of other private funds. The fund-of-funds arrangement has been ridiculed, because the fund's fees, typically 1 percent of assets under management, are layered on top of those charged by the funds it invests in. The typical underlying fund's fees run about 2.5 percent of assets. But in addition, they charge a percentage of profits after they reach a certain level, typically 15 percent to 20 percent of the additional profits.
The total cost, to be sure, can be sizable. But the extra return added by a fund of funds may more than offset the extra expense, says Murphy of Watson Wyatt. "You're really paying somebody a small percent of that return enhancement to gain their expertise," she says. And because of the steep learning curve in alternative investments, she thinks a fund of funds makes particularly good sense for pension plans just getting into the category.
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