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Casting for Returns

To juice up their sagging portfolios, pension fund managers are seeking alternative investments.
Randy Myers, CFO Magazine
August 1, 2003

Last year, Bill Einhorn finally had enough. With 2002 drawing to a close, the $1.1 billion pension fund that Einhorn administers for the Teamsters union in Philadelphia was set to post its third straight year of lackluster investment returns up a measly 2 percent in 2000, flat in 2001, and down 5.98 percent in 2002. During that time, it had slid from being more than 90 percent funded to only about three-quarters funded. Now, all the analysis Einhorn could put his hands on was telling him that returns on fixed-income investments — the only portion of his portfolio that had been making money in the past couple of years — were heading toward single-digit levels.

His decision: dip a toe in alternative investments. With the agreement of the board of trustees, Einhorn took 5 percent of the fund's portfolio out of fixed income and put it into private real estate investments managed by New York-based General Motors Asset Management (GMAM), the $100 billion-plus (in assets) pension arm of General Motors Corp.

"What we were looking for was a higher return with some additional risk, but not too much risk, to help us meet our 7.5 percent earnings assumption," says Einhorn, who until this year had his fund's assets split 60-40 between publicly traded stocks and bonds. (The Teamsters checks its earnings assumption every five years; the current assumption was set in 1998.) As administrator of the Teamsters Pension Trust Fund of Philadelphia and Vicinity, a multiemployer plan that covers more than 27,600 active and retired union members, Einhorn had begun evaluating private real estate as an investment option in the first quarter of 2002. He signed papers committing to the investment in December, and in February 2003 he oversaw the fund's first infusion of capital into the limited-liability corporation that GMAM set up to manage the investment, a real-estate portfolio diversified by market sector and geography.

Einhorn may well achieve his objective, assuming he hasn't bought in at a market top. Over the past 3 calendar years, private real estate has generated average annualized returns of 8.73 percent, according to the National Council of Real Estate Investment Fiduciaries, versus an annualized loss of 14.57 percent for Standard & Poor's 500 stock index. Over the next 15 years, private core real estate should earn about 7 percent a year net of management fees, predicts consulting firm Frank Russell & Co., just under the 8.1 percent expected for an indexed portfolio of U.S. equities.

Whatever his timing, Einhorn is clearly not the only plan sponsor confronting a funding crisis, nor the only one casting around for fresh ways to invest pension monies. Thanks to slumping equity markets, companies in the S&P 500 saw their aggregate pension assets shrink by $173 billion from 1999 through 2002, estimates Credit Suisse First Boston. The average S&P 500 corporate pension plan lost 8.65 percent in 2002 and 7.37 percent in 2001, according to CSFB.

At the same time, declining interest rates drove up the present value of the S&P 500's collective pension obligations by $289 billion, leaving those plans underfunded to the tune of $216 billion. Further declines in interest rates since then have exacerbated the problem. Now, many corporations that enjoyed a pension funding "holiday" in the 1990s are confronted with having to make sizable contributions to their plans.

Fearing that neither equities nor fixed-income investments will generate the returns they produced in the past two decades, many plan sponsors are looking at alternative investments — a term generally applied to hedge funds, real estate, and private equity — to juice up their portfolios.

Ignorance: Not Bliss
To be sure, there has been no mass piling into any of these sectors, especially by company-sponsored pension plans. The vast majority of corporate plan sponsors continue to invest their pension assets exclusively in publicly traded equity and fixed-income markets. (Government-sponsored pension plans have been quicker to embrace alternative investments, and endowments and foundations have been even more aggressive.)

Still, data from consulting firm Greenwich Associates indicates that among large corporate pension plans, allocations to hedge funds doubled last year, to 0.4 percent of all plan assets, while allocations to real estate rose from 2.1 percent of assets to 2.3 percent. Among plans that have gone so far as to make a strategic commitment to alternative assets, actual allocations to hedge funds typically range from 0 to 2.5 percent, while allocations to real estate generally range from 5 to 10 percent, according to Barry McInerney of Mercer Investment Consulting in New York. (Private equity isn't stirring the same sort of enthusiasm, at least for the moment. Returns there swooned in sympathy with the public-equity markets in the past two years, and total allocations by corporate pension plans to that sector declined from 2.3 percent in 2001 to 1.9 percent in 2002.)

No one is suggesting that all plan sponsors should follow Einhorn's lead, but consultants do suggest sponsors have a fiduciary duty to at least consider alternative investments. "Ignorance is not bliss anymore," says McInerney. "Fiduciaries need to be aware of all types of investment opportunities and understand what they are in terms of their return-risk characteristics and how they might fit into their portfolios."


Fiduciaries will find, in fact, that returns on alternative investments, particularly real estate and hedge funds, have a low correlation to returns on domestic equities — as little as 0.02 for private real estate and 0.22 for private equity, and virtually zero for some hedge-fund strategies, says John Ilkiw, a New York-based consultant at Frank Russell, which advises plan sponsors on asset allocation and investment decisions. That means corporations can tap alternative investments to achieve either higher returns with risk levels comparable to those of a conventional portfolio, or comparable returns with less risk.

Illiquid and (Maybe) Spectacular
Not that it's an easy proposition. For starters, most alternative investments are illiquid, long-term investment vehicles, often structured as limited partnerships that can tie up an investor's capital for 5 to 10 years. They offer far less transparency than publicly traded stocks and bonds, particularly in the case of most hedge funds. And historical performance data is not as reliable as historical data for public-market investments, in part because the underlying assets are less commoditylike and, for much of their investment life, are valued by appraisal rather than market transactions.

Expenses are high, too: it's not unusual for hedge funds to charge investment-management fees of 100 basis points and then keep 20 percent of any investment gains they generate. First-time investors are strongly advised to invest with an experienced manager or the guidance of an outside consultant, especially since they are unlikely to have the expertise in-house to navigate what could be a minefield for the uninitiated. "These are investments that require more attention, more oversight, more work for someone," says McInerney. "There's a sharp learning curve to understanding what they're about."

To be sure, hedge-fund investors have been burned. In 2001, the Art Institute of Chicago sued Dallas-based hedge-fund manager Integral Investment Management LLP, claiming that Integral deceived the institute about the safety of its funds. The institute, which had invested about 6 percent of its portfolio with Integral, said one of Integral's funds subsequently lost about 90 percent of its value. More recently, the $300 million Japanese hedge fund Eifuku was wiped out in just one week early this year after large, highly leveraged bets on a handful of Japanese stocks went bad.

Nonetheless, hedge-fund returns can be spectacularly good. In the private-equity or hedge-fund arenas, the spread in performance between first-quartile and fourth-quartile managers is far greater than the comparable spread for managers of, say, large-cap domestic equities. "The median private-equity investment we see performs no better than the public markets," asserts Ilkiw. "But the dispersion of returns is high."

GE Asset Management (GEAM), which runs approximately $180 billion for General Electric's pension funds and insurance subsidiaries as well as for other companies, has been steering money into private equity for 25 years and using hedge funds for about 10. GEAM executive vice president Don Torey, who heads the organization's alternative investment operations in Stamford, Connecticut, says he expects those investments over the long term to generate returns 400 to 500 basis points above those available in the public markets as measured by the S&P 500. In fact, he says, GE's Pension Trust has "outperformed that target over any long-term time period."

In real estate, where GEAM has been investing for about 50 years, the goal is steadier returns "in the 9-to-11 percent range annually," says Torey. Overall, he adds, GEAM has about 15 to 18 percent of GE's pension plan allocated to alternative investments, with the largest share in private equity and the smallest share in hedge funds.

"[Alternative investments] is definitely an area that people should be looking at as part of their program," says William Quinn, president of Fort Worth-based AMR Investment Services, the pension-management arm of airline holding company AMR Corp. His organization has a 10 percent targeted allocation to alternative investments but currently has only about 5 percent of its pension assets actually invested in them, some in real estate and some in private equity. He's steered clear of hedge funds thus far, expressing misgivings about their lack of transparency and, in some cases, their use of leverage and nearly boundaryless investment charters. Like GEAM, AMR Investment Services has enjoyed long-term realized gains from alternative investments of about 400 to 500 basis points above public-equity-market returns, says Quinn.

A Question of Timing
The question, of course, is whether similar results await investors moving into these markets right now. Many investment professionals wonder whether real estate, for example, is ready for a correction, following the sizable gains recorded in the past few years. While that may be true for some sectors of that market, McInerney cautions against making overly broad generalizations. "There are so many different real estate vehicles, and so many different sectors, that real estate is still being looked at very seriously," he says.

Both GEAM and GMAM manage real estate investments for their own employers' pension plans and for other plan sponsors. In June, GMAM, which has been investing in real estate for two decades, launched its Core Plus Real Estate Co-investment Trust, which it developed specifically as a real estate investment vehicle for employee-benefit plans. The trust invests in multiple sectors of the real estate market. GM's pension plan takes a significant position in each deal, investing side-by-side with its outside clients.


If some investors are wary of the real estate market because it's been on a roll, others are wary of private equity because it, like the public-equity markets, has been in a slump. Thomson Financial Venture Economics's Private Equity Performance Index posted a total return of -14.7 percent last year on the heels of a -20.5 percent return in 2001. "People who already have a private-equity program are licking their wounds and keeping their powder dry," says Ilkiw. "They're not abandoning their program, just recognizing that there tends to be long cycles in this market."

Of all the major sectors of the alternative investment marketplace, hedge funds are attracting the most interest right now, says Ilkiw. "When people talk about alternatives these days, that's really the code word for hedge funds," he says. Among the types of hedge funds attracting the most attention are those that employ relatively conservative strategies, such as equity market neutral, in which the portfolio manager buys stocks expected to outperform a market or sector and shorts stocks expected to underperform.

GMAM invests in hedge funds, for example, but only at what president and CEO W. Allen Reed calls the "shallow end of the pool" — meaning funds that employ little leverage and fairly conservative investment strategies, including equity market neutral, relative value fixed-income arbitrage, and convertible arbitrage. "What we're looking for is to create a program with consistently positive returns that are somewhere between the returns available on stocks and bonds," says Reed.

Caveat Investor
Plan sponsors that have embraced alternative investments, and consultants who advise pension clients on their use, cite a common list of precautions for would-be corporate investors: take a long-term approach to these investments; avoid funding them with assets that may be needed short-term to meet pension liabilities; avoid making large bets on any one deal or manager; and, to mitigate transparency risk, spend a lot of time with your managers to understand their investment philosophy and process (and be sure they stick with them).

GEAM's Torey also advises sponsors to be opportunistic rather than dogmatic in committing funds that have been allocated to alternative investments. "We don't believe in setting hard targets and pushing dollars out the door to meet those targets," he says. "We think it's much wiser to be totally opportunistic and bottom-up driven. When we see a good transaction or a good manager, we invest with them. When we're not seeing what we like, we slow down the activity."

Remember, too, that dipping a toe into the alternative investment arena won't wipe out substantial unfunded pension liabilities. "It's not a silver bullet," says GMAM's Reed. "What plan sponsors should expect is they're going to change the risk-return profile of their fund. We like to say we think you're either going to get more return for the same risk or the same return for less risk. That's what all this diversification is all about."

Slow Growth
Fund allocations to alternative investments.
All plans*2002200120001999
Hedge funds1.0%0.6%N/AN/A
Private equity3.1%3.1%2.9%2.1%
Real estate3.4%3.1%2.4%2.3%
Public pension funds
Hedge funds0.1%0.2%N/AN/A
Private equity3.1%3.0%2.5%1.7%
Real estate4.2%3.9%3.2%2.8%
Endowments/Foundations
Hedge funds7.8%4.8%N/AN/A
Private equity8.0%7.3%10.3%6.1%
Real estate4.2%4.2%2.9%2.4%
Corporate pension funds
Hedge funds0.4%0.2%N/AN/A
Private equity1.9%2.3%2.0%2.0%
Real estate2.3%2.1%1.6%1.8%
*Source: Greenwich Associates. From interviews between August and October 2002 with 574 corporate funds, 246 public funds, and 212 endowments and foundations. Table shows average fund allocation for all respondents; many respondents had 0% allocation to each asset class.




Consider The Alternatives
Total returns for alternative investments (in %).

Q1
2003
20022001200019991 Yr. Ended 20023 Yrs. Ended 20025 Yrs. Ended 2002
Real estate*1.886.757.2812.2511.366.758.7310.72
Private equity**NA-14.7-20.512.171.9-14.7-5.57.7
Venture capitalNA-29.2-32.927.9183.9-29.2-6.828.1
BuyoutsNA-8.0-15.43.231.3-8.0-5.71.0
MezzanineNA-5.5-1.68.433.7-5.51.46.4
Hedge funds***2.233.044.424.8523.433.044.106.77
Equity mkt. neutral 7.429.3114.9915.337.4210.5212.03
Fixed-income arb. 5.758.046.2912.115.756.694.57
S&P 500-3.6-22.10-11.88-9.1921.14-22.10-14.57-0.56
* NCREIF Property Index. Source: National Council of Real Estate Investment Fiduciaries
** Private Equity Performance Index. Source: Thomson Financial Venture Economics
*** CSFB/Tremont Hedge Fund Index. Source: Credit Suisse First Boston/Tremont Index LLC






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