Monday, December 16, 2013

Absolute Returns on Trial in Pennsylvania

Absolute Returns on Trial in Pennsylvania

Two years ago, the Pennsylvania State Employees’ Retirement System (PSERS) hired Anthony Clark as its new CIO.  Facing a large pension deficit, Mr. Clark pushed the pension plan to increase its commitment to hedge funds after replacing the system’s general and alternatives consultants.  Unfortunately, one of Mr. Clark’s first moves was an ill-timed $250 million bet on an absolute return strategy managed by Tiger Management.  Instead of generating an 8% to 12% return, the investment lost about 4% in its first year.[1]

This fall, Mr. Clark urged the board to maintain the investment despite the shakiness of its initial start.  However, Tiger Management decided to liquidate the fund and return PSERS’s capital.  The story has taken a strange twist in the last couple of weeks.  Mr. Clark has announced his retirement at the end of the year after a whistleblower alleged that Mr. Clark had attempted to hide the losses.  There’s also an allegation that Mr. Clark may have engaged in some sort of improper personal trading.[2] 
Cost Sharing (1999)
As you might expect, there’s now an investigation underway, and the politics have heated up.  The state’s Democratic Treasurer, Rob McCord, called on the Republican Governor, Tom Corbett, to remove PSERS’s chairman, Nicholas Maiale.  He also urged the trustees to suspend all investments until the Clark matter is resolved.  Both of Treasurer McCord’s requests were denied.  The Democratic Attorney General, Kathleen Kane is conducting the investigation.  One more political item:  the State Treasurer is contemplating a run for governor.

While the allegations against Mr. Clark are serious, and the political reaction is predictable, the real issue has been forgotten.  PSERS was seduced by one of the most misleading investment labels in money management:  absolute return strategies.  The idea is to invest in hedge fund strategies that will produce consistent returns without generating losses.  It’s an appealing concept that works particularly well to allay the concerns of politicians and pension trustees alike.

When I arrived at the North Carolina Treasurer’s office in 2001, the state had just enacted a 5% investment basket allowing the pension plan to invest in private equity and hedge funds.  The draftsmen were very clever because they never used the scary words “hedge fund” or “private equity” in the bill.  After it was enacted, I was instructed to only use the term “absolute return strategy” when I was actually talking about hedge funds.

In other words, absolute return strategies or investments are a very clever marketing ploy.  You cannot earn 6%, 8%, or 10% year in and year out without taking risk.  The risks may be well hidden, but they exist if you dig around a bit.  In some instances, like PSERS’s Tiger investment, the returns will be more volatile than advertised and produce small losses.  In other instances, the risks will only manifest themselves under extreme conditions.  If financial markets fall apart, the promised absolute returns become absolutely painful losses.

Over the next several months, we’ll see if Mr. Clark did anything wrong.  However, it should already be clear that Mr. Clark misled Pennsylvanians when he promoted an investment strategy to close PSERS’s pension liability.  In fairness to Mr. Clark, he’s far from the only one selling absolute return investments as a painless cure to closing a financial gap.


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