Following a ruling passed in December 2013, which declared that the City of Detroit had entered bankruptcy and therefore benefits for the city’s pension schemes should be reduced, major ripple effects have been seen throughout the US pension fund industry. The ruling brings to the forefront the issue that the decisions made by investment professionals, who are managing pension portfolios, have a direct effect on retirees that depend upon their benefits.
Moving forward from this ruling, it is likely that there will be a shift in investment strategy for public pension funds across the US, as they look to avoid falling into the same traps as Detroit, which could lead to an increase in pension funds’ appetite for hedge funds going forward. It has generally been the case that pension funds adopt relatively low risk portfolios, which focus on generating healthy, consistent returns, as opposed to maximizing risk-adjusted returns. However, the investor type may be realigning this strategy to focus more on asset classes that can deliver higher returns, such as hedge funds. Not only do hedge funds typically offer higher rates of return than standard fixed income portfolios, they can also offer a layer of diversification to a pension portfolio and this can be crucial in difficult financial climates.
Public pension funds are the leading source of institutional capital in the hedge fund industry, representing 22% of all hedge fund capital contributed by institutional investors. The US represents the majority of this capital and Preqin’s Hedge Fund Investor Profiles online service tracks 254 US-based public pension funds that are actively investing in the asset class. These pension funds have an average target allocation to hedge funds of 9.3% of total assets, which is an increase from an average target allocation of 8.3% of total assets in 2012. This indicates that there has already been an increase in appetite for hedge funds over the last few years and, in particular, Municipal Employees’ Retirement System of Michigan and City of Phoenix Employees’ Retirement System are examples of public pension funds that have increased their target hedge fund allocations. In Q4 2013, Michigan doubled its target from 5% of total assets to 10%, while Phoenix moved from having a 10% target allocation for solely investing in long/short equity funds, to having a 15% target allocation to the whole hedge fund asset class.
Looking towards the rest of 2014, US public pension funds will continue to be key players in the hedge fund industry and we could see hedge fund allocations from these investors increase further. It remains to be seen how the Detroit-based pension funds, such as the $2.2bn City of Detroit General Retirement System, will react to the bankruptcy ruling, and what immediate effects it will have on their hedge fund investment strategy.