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Public pension funds have been doing something new recently - investing in hedge funds. These are the often secretive investment firms led by supposedly super-smart fund managers. Sometimes, they go bust. One recently got shut down for insider trading. And another thing - hedge funds charge high fees. NPR's Chris Arnold reports some experts are questioning whether public pension funds should be investing them at all.
CHRIS ARNOLD, BYLINE: Back 10 years ago, public pension funds - they stayed away from hedge funds. Maybe hedge funds seemed too pricey or opaque or exotic. After all, pension funds invest money so they can afford to keep sending checks to retired school teachers and police officers and firefighters.
DAVID KOTOK: They didn't have anything in hedge funds.
ARNOLD: That's David Kotok, the chief economist at Cumberland Advisors. He advises public pension funds on their investments. Hedge funds claim to be able to provide a good return while protecting the investors if, say, the stock market crashes. That's why they're called hedge funds, as a hedging your bets. And in recent years, more public pension funds have invested in them.
KOTOK: Our concern has been that, in some cases, this seems to have become a fad.
ARNOLD: A very expensive fad. Hedge funds generally charge what's called two and 20. That is, every year they take two percent of the money that you invest with them, plus 20 percent of any profits. If they lose money, they still get the two percent. For public pension funds that invest billions of dollars, those are very steep fees - more than 10 times the percentage cost of, say, a stock market index fund.
JULIA BONAFEDE: The fees are extraordinarily high.
ARNOLD: That's Julia Bonafede, the president of Wilshire Consulting. Both she and David Kotok advised their public pension fund clients not to invest in hedge funds.
KOTOK: We think that a high-cost structure works against the investor.
ARNOLD: Still, some pension funds are plowing money into hedge funds. Julia Bonafede...
BONAFEDE: What has happened since the financial crisis is you've seen a huge flow of assets into hedge funds.
ARNOLD: Actually, most pension funds are not investing heavily in hedge funds, but some definitely are. The Teacher Retirement System of Texas is investing 10 percent of its money in hedge funds. The state of New Jersey - around 12 percent. The Ohio teachers pension fund...
FAROUKI MAJEED: ...Fifteen percent.
ARNOLD: That's Farouki Majeed, the chief investment officer of the School Employees Retirement System of Ohio. By last year, his pension fund had 1.9 billion dollars invested in hedge funds. That means the pension fund is paying about $35 million a year in fees to those hedge funds. That's money that could have been used to pay teachers pensions. Majeed says, he, of course, doesn't like paying those fees, and he's actually getting some hedge funds to lower them a bit. Also, he says...
MAJEED: ...Particularly, you know, with hedge funds, you don't have transparency or a look-through into their portfolio.
ARNOLD: I guess if part of the goal is to create less risk, but they won't really let you see what they're doing exactly - (laughing) - it's hard to know.
MAJEED: That's not...
MAJEED: That's not good either. (Laughing) No, you're right.
ARNOLD: So why is Majeed so much money into hedge funds? To be fair, actually, he took the top job after those decisions were made. He's not reducing hedge fund investments. But he says, it's just tough right now to make a good return. Super-safe securities, long-term treasury bonds - they offer very low returns.
MAJEED: So you've got to try to be more creative.
ARNOLD: The thing is that many of the pension funds that are being more creative are on shakier footing. And that makes all this part of a much bigger problem. There are a lot of public pension funds that are in trouble. David Kotok...
KOTOK: The most under-funded pension system is Puerto Rico. They have nearly run completely out of money. Other states are in trouble, too - Illinois, New Jersey.
ARNOLD: Meanwhile, those hedge fund investments, overall, haven't been doing so well. So, Julia Bonafede says, many public pension funds are pulling some money out, but not everybody. The San Francisco Employees Retirement System is considering whether to invest 15 percent of its assets in hedge funds. Chris Arnold, NPR News.
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