Last week, the Wall Street Journal reported that pensions are moving more money back into hedge funds:

Also, pension officials are using the historically strong returns of hedge funds to justify a rosier future outlook for their investment returns. By generating more gains from their investments, pension funds can avoid the politically unpalatable position of having to raise more money via higher taxes or bigger contributions from employees or reducing benefits for the current or future retirees.

The Fire & Police Pension Association of Colorado, which manages roughly $3.5 billion, now has 11% of its portfolio allocated to hedge funds after having no cash invested in these funds at the start of the year.

…

While pensions have been investing in private equity and what are called alternative investments for many years, hedge funds have represented a smaller part of their portfolio. The average hedge-fund allocation among public pensions has increased to 6.8% this year, from 6.5% for 2010 and 3.6% in 2007, according to data-tracker Preqin. (Emphasis added.)

PERA’s own investments in hedge funds are unclear from the latest data, but if the “Other of Other” category is representative, it could be about 10% of their holdings.

This may be good in the short run.  There’s no doubt that some of these funds have done well, being able to hedge some of their risk away and focus on capturing industry or sector returns.  But there are some serious dangers here, and they are complicated by the problems already noted with pension accounting.

First, there’s no such thing as risk-free alpha.  Remember, the market tries to match risk with return.  If someone is selling an investment with 10% return and the risk associated with equities, beware.  Because if that were possible over the long run, enough people would pull money from equities and pile it into this mythical investment, so the returns would match.  Either that, or there’s hidden risk in there that justifies the extra return.

Either way, in the long run, the funds are taking on more risk, or will have the additional return arbitraged away as more people invest in these strategies.  Also, if many of the funds are using the same strategy, it may be difficult for them to execute trades that actually allow them to limit risk, as they may all be trying to sell overperformers, or buy hedges, at the same time.

Another threat to pension funds is in the bolded sentence above.  Managers are not only using these returns to justify higher projected returns.  What goes unstated is that they’ll also use them to justify the higher discount rates, that make their pensions look better-funded than they are.  It’s a perfect example of the perverse accounting incentives built into fund management.

Last, these strategies are not necessarily transparent, making it difficult for independent auditors to even assess the risk that these pensions are taking on.

I’m all for finding ways to hedge away risk, and there’s no reason that pension funds can’t participate in some of those techniques.  I’m skeptical that, in the absence of fixing the underlying problems, this approach is going to do any more than paper over problems, yet again.