BULLS & BEARS: Behind the mumbo-jumbo lie risky pension strategies

Let me introduce you to the hottest thing going in institutional investing (pension plans)-it’s called “portable alpha.” One salesman for a large money management firm hails this as a new era in investing:

“The new paradigm rejects total return as the measure of a strategy’s worth. It instead holds steadfast to the principle that any strategy’s total return can be divided into a market return and (ideally) a net excess return.

“The market return component is quantified as beta and the excess return component is quantified as alpha. What is of real value is the strategy’s ability to consistently generate alpha.”

If you got through that without your eyes glazing over-Greek letters and all-congratulations. Anymore, the world of institutional investing is not all about stocks and bonds. Today, it is characterized by a complex maze of asset-allocation strategies, partly designed-in our opinion-to bewilder pension boards and compel them to seek the advice of expensive Wall Street advisers. (For all the cost, effort and arcane formulae employed in managing pension funds, the resulting returns have rarely been impressive).

Skipping all the fancy terminology, this portable alpha mumbo-jumbo is basically a justification for pension plans to allocate a much greater percentage of their portfolios into “alternative assets”-hedge funds, private equity, venture capital, commodities, currencies and derivatives, et al.

What is driving this “new paradigm” in investing where “total return is no longer the measure of a strategy’s worth,” you ask? Very simply, it’s the meager investment returns achieved by institutional investors over the past several years.

Most pension plans had a heavy allocation to large company stocks, and the S&P 500 index has, over the last five years, returned a puny 0.5 percent annually (with dividends reinvested).

When you consider that typical pension plans estimate they must earn 8 percent annually to honor their employees’ retirement obligations, it is understandable that there is panic among the ranks. That gap, between actual returns and expected returns, is quite a shortfall and can necessitate millions of dollars in additional yearly contributions to keep a pension plan adequately funded.

So consultants are advising pension boards to move massive amounts of money into private equity funds, hedge funds and their ilk, in an effort to earn “excess returns non-correlated” to the movement of the stock market. (It is, of course, interesting that these are the same advisers who were promoting the investment strategies that sorely underperformed in past years.)

What should be alarming to shareholders, or the taxpayers who are on the hook for bailing out private or public pension plans, is that investing in private equity and hedge funds is often presented to pension boards as a way to decrease the risk of their overall portfolios via diversification. This contention is laughable.

To keep pension plans financially healthy, the prudent course of action would be to reduce the expected return on their portfolios to, say, 6 percent; and make larger annual contributions to cover future liabilities.

As an individual investor, you can create your own “portable alpha,” or excess return, by avoiding areas where the crowd is gravitating and instead seek bargains in opportunities that have been discarded. Right now, the message would be to steer clear of most alternative assets.