The following is a report by Edward J. O’Boyle, Ph.D. of the Mayo Research Institute raising serious questions about not only the practices of the administrators of the pension fund for Louisiana’s teachers but the exposure of the state to the effects of those practices. It’s an issue with potentially grave implications for the state’s budget in future years…
A hedge fund is an aggressively managed portfolio that uses advanced investment strategies such as leveraged, long, short, and derivative positions in both domestic and international markets with the goal of generating high returns. Investors in hedge funds include corporate treasuries, endowments, fund of funds, private banks, and pensions. The investor pays the management fee on assets held within the fund, but performance fees are applicable only after positive performance has been achieved. Typically, an established minimum return on investment is required before performance fees are paid.
In 2003-2004 Teachers’ Retirement System of Louisiana adopted an aggressive investment strategy designed to yield returns of 14 to 20 percent over 10 to 12 years. This strategy involved investing in asset/liability based derivatives including collateralized mortgage obligations, options on futures, forward foreign exchange contracts, and futures. These derivatives were held in order to maximize yields and in part to hedge against a rise in interest rates. Initial commitments as of June 30, 2004 and at June 30, 2003 totaled $4.375 billion. At that time, the TRSL trustees gave their investment advisors a real return objective of 3.9 percent above the Consumer Price Index. The 2010 TRSL trustee-approved objective is a long-term compound rate of return that is the greater of (a) 3.9 percent above the CPI or (b) the actuarial rate that currently is 8.25 percent.
The TRSL portfolio currently includes domestic and international stocks and bonds, domestic and international money market funds, real estate investments, mezzanine financing investments, private equity investments, and domestic and international derivatives. TRSL permits hedge vehicles for currency exposure management on forward foreign exchange contracts, currency futures contracts, options on currency futures contracts, and options on spot currencies.
Among the current TRSL investment guidelines are the following:
● Holdings of individual issues are to be of sufficient size to accommodate easy liquidation.
● Private placements may be held, provided that holdings do not exceed 25 percent of the market value of the bond portfolio. High-yield portfolios and Mezzanine Limited Partnerships are excluded from this restriction.
● High yield portfolios are to be invested in debt securities rated from Ba1 to Caa (Moody’s) or BB+ to CCC (S&P) and in unrated securities determined to be of comparable quality by the manager. Unrated securities and securities rated Caa, CCC, or below shall not exceed 20 percent of the market value of the portfolio.
● The use of derivatives (such as ETFs, options, warrants, and futures to establish unleveraged long positions in equity markets) is permissible.
● Currency options contracts may be exchanged traded or OTC traded in the interbank market. Additional instruments, such as swaps, or other derivatives, may be used if the risk/return tradeoff is perceived by the manager to be suitable and competitive with above-stated [in the FY 2010 report] hedge vehicles.
Current foreign investments expose TRSL to changes in foreign currency exchange rates that could adversely affect the fair value of an investment or deposit. At the end of FY 2010 TRSL had a $2,789,716,180 foreign currency risk. Included were investments denominated in the Brazil real, Czech koruna, Hungarian forint, Indonesian rupiah, Malaysian ringgit, Mexican new peso, Pakistan rupee, Polish zloty, and Thai baht.
Net income from investment for the ten-year period ending in 2010 totaled $3,035,662,922. Total investment expenses over this period amounted to $673,001,172 of which $265,978,103 was spent on advisor fees. In 2010 TRSL engaged 36 companies to provide investment advice and consultation including ING Investment Management Americas, J.P. Morgan Investment Management, Prudential Real Estate Investors, and UBS Global Asset Management. In 2009 TRSL used 49 professional consulting organizations.
Investment advisors were paid $108,116,186 in the four years (2001, 2001, 2008, 2009) when investment income losses amounted to $5,666,530,483.
The TRSL portfolio currently has two holdings of Lehman Brothers bonds with a par value of $1,549,000 but a market value of only $546. Also in that portfolio are bonds issued by 8 other companies including Genesis Health Ventures, Weirton Steel, and Telecom Techniques with a par value of $6,803,709 and a market value of $7.
A September article in the Wall Street Journal by Kim and Tergesen warned that target-date mutual funds designed primarily for persons who are planning for retirement “might be acting more like a hedge fund” by revamping their asset allocation models and using derivates to hedge positions to achieve higher returns or sidestep losses. Moving quickly into and out of asset classes requires making the right call at the right time. Frequent trading in turn inflates investment expenses thereby cutting into returns.
Two financials from the TRSL annual report for FY 2010 are particularly troubling.
● Between 2001 and 2010, net asset holdings increased by $166,460,788, or 1.4 percent, at the same time investment expenses totaled $673,001,172.
● Unfunded actuarial liability mushroomed from $3,328,300,000 to $10,806,300,000, or 224.7 percent. The latest information from the Louisiana Revenue Estimating Conference indicates that in FY 2009 actual general fund revenue for the State of Louisiana amounted to $9,385,835,338.
The clear winners over the past 10 years have been the TRSL investment advisers who were paid handsomely even in years when an overly aggressive investment strategy turned portfolio investment income negative and did little to hold back a more than $7 billion increase in unfunded actuarial liability. If down the road TRSL collapses under the weight of that liability, the losers will Louisiana taxpayers and possibly U.S. taxpayers who will be called on to bail out the system.
TRSL indeed has become a hedge fund that is on-track for a financial train wreck.