Investing and Banking & Finance and Public Pensions and Government & Economic Development and Government

Basic investments are best for Indiana pension funds

January 5, 2009
IBJ reported in November that the Indiana Public Employees Retirement Fund will allocate 15 percent to 30 percent of its investments in "alternatives." Unfortunately, the term means nothing to those of us outside PERF and probably confuses PERF itself.

Fundamental investment choices are limited to equity and debt. Every financial instrument is one of these two choices or a contract relating to them. Choices beyond these fundamental investments are exotic creations of man. So PERF should further explain what "alternatives" means.

Our planet offers limited investment opportunities. These are businesses, collectibles, real estate and nature's most important contribution—the commodities that give us life. Financed by equity or debt, these are the only known investment assets. But humans being human, we create, manipulate and then obfuscate.

Today, most strategies arising from new financial instruments and computer capabilities are carried out by hedge funds, which are likely to be the alternatives chosen by our public retirement plans.

Unfortunately, this appellation also has no precise, commonly understood meaning. The term covers dozens, perhaps thousands, of money-management techniques in which one asset is paired with another to theoretically limit loss, while, unfortunately, also limiting gain.

Some of these efforts have been created and supervised by famous economists whose names lend credence to the strategies. A few hedge funds have become so large as to be unmanageable and a threat to the financial system should they fail. Their management fees are higher than fees to manage straightforward portfolios of stocks and bonds. As a result, we have hedge-fund millionaires.

A lamentable element is that outsiders such as trustees and journalists rarely understand the inner dynamics of an alternative investment. Most people understand that an oil company searches and drills for oil and then transports and refines the petroleum, and that the stock of an oil company is likely to rise and dividends increase as energy consumption increases. The man on the street can observe and understand the investment in oil.

On the other hand, hardly anyone understands precisely what happens inside a hedge fund. The strategies are too complicated, the language too obscure, the disclosures inadequate. I'll bet that no trustee of our public retirement plans can explain a specific strategy used by one of its alternatives providers. Instead, providers are selected on blind faith.

Alternative investments have yet to prove themselves over meaningful periods, which are the 40- to 60-year investment life expectancies of individuals. Also, anecdotal evidence indicates that the alternatives industry has had an above-average incidence of both misleading information and financial failures.

Personnel in the business tend to be young and aggressive. And the number of transactions is so large that an individual cannot handle them. Only computers can process the strategies.

I suspect also that operators are more likely to change a strategy, without announcement, during periods when the strategy does not work, a hypothesis that recalls the market adage, "When a technique is understood, they change the rules." Without question, when a strategy appears to be successful for a time, others attempt to duplicate it, leading to self-defeat.

The economic life of a nation depends exclusively on natural resources and human productivity that no computer or exotic derivative can outperform. Over lifetimes, classic equity and debt instruments will do the job. The Indiana Public Employees Retirement Fund should stick to the basics, or explain and defend the specific alternatives it has selected so that we can evaluate them.

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Guy is president of locally based Wealth Planning & Management LLC.
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