1. Prudential Concerns for Pension Fund Investment In Hedge Funds and Derivatives Randall Dodd Financial Policy Forum Washington, D.C. January 7, 2005 Prepared for presentation at ASSA conference, Philadelphia, January 7, 2005

2. Abstract: This paper studies the public interest concerns with the use of derivatives, hedge funds and hybrid instruments in the portfolio investments of pension funds. While these alternative investment strategies offer the potential for improved risk- adjusted rates of return, they also pose some new risks to the portfolio and the overall financial sector and economy in which they are traded. This study also makes some recommendations to help protect the national public interest embodied by pension funds and that of financial markets.

3. OUTLINE I.Introduction II.Background III.Public Interest in Pension Funds IV.Derivatives and the Public Interest V.Hybrid instruments and investments VI.Hedge Funds and the Public Interest VII.Public Interest Nexus of the PF, Derivatives and HF VIII.Recommendations IX.Conclusion

4. I. Introduction This paper studies the public interest concerns with the use of derivatives, hedge funds and hybrid instruments in the “alternative” portfolio investments of pension funds. While these alternative investment strategies offer the potential for improved risk-adjusted rates of return, they also pose some new risks to the portfolio and the overall financial sector and economy in which they are traded. This study also makes some recommendations to help protect the national public interest embodied by pension funds and that of financial markets.

5. II. Background Pension funds have a national public interest. Legislative language explicitly defines this public interest in the Employee Retirement Income Security Act (ERISA 1974) Pension Funds perform important economic functions –mobilize savings –managing savings, –help provide income stability, –make labor markets more efficient –Linked to systemic risk in financial markets Pension fund investments include conventional securities (stocks and bonds), real estate, and alternative investments (such as hedge funds and structured securities). Pension fund investment portfolios also include derivatives.

6. III. Public Interest in Pension Funds ERISA (1974) – Employee Retirement Income Security Act of 1974 Created the PBGC to insure pension funds Defined the “National public interest” in Pension funds “effect the well-being and security of millions of employees and their dependents” An important factor affecting the stability of employment and industrial relations Involve interstate commerce There is otherwise a lack of employee information and adequate safeguards Thus disclosure and reporting are required, and safeguards are mandated Current Pension Fund policy goals include Foster and facilitate interstate commerce Encourage the maintenance and growth of pension plans Maintain pension insurance at a low cost Other Public Interest Issues in Pension Funds Major source of mobilized, investment funds for economic growth Relation to systemic risk – both as source of vulnerability and as a consequence

7. Pension Fund: Investment Policy Safety and Soundness Investment Classes Equity Bonds Real Estate AIM – Alternative Investment Management –Derivatives –Hybrid Instruments and Investment Strategies –Hedge Funds –Structured Finance – Hybrid Instruments ERISA regulations on extent of AIM in portfolio ERISA regulation on asset managers with minimum amount of managed assets from ERISA pensions

8. Box 1. Definition of Typical Derivatives Forward contract. The original and most basic form of a derivative contract, a forward transaction is an agreement to buy or sell a certain quantity of an asset or commodity in the future at a specified price, time and place. For example, party A agrees to sell 1 million Euro in September at $1.1402. Futures. A standardized agreement to buy or sell a certain quantity of an asset or commodity in the future at a specified price, time and place. They are standardized as to the quantity, the specific underlying assets or commodities and the time. Only the price and the number of contracts are negotiated in the trading process. For example, party A sells 10 contracts – worth approximately $1 million – to sell U.S. Treasury bonds at 112 14/32 in December. Option. An agreement that grants the options buyer the right, but not the obligation, to buy or sell an asset or commodity at a specified “strike” or exercise price on or before a certain date. A call option grants the right to buy at the specified strike price, and a put option grants similar right to sell. An option seller or “writer” has the obligation to deliver payment or the asset when the options buyer exercises their right. Standardized options are traded on exchanges and all varieties are traded in OTC derivatives markets. For example, party A buys a call that grants them the right to buy 1 million Euros in September at $1.1400. Swap. An agree to swap the net value of two series of payments in which one is usually based on a fixed rate or price and the other is linked to a variable interest rate, index, price an interest rate in another currency. For example, a vanilla U.S. dollar interest rate swap pays the net of a fixed dollar interest rate less LIBOR with payments made semi-annually for 10 years. * See: www.financialpolicy.org for Primers on derivatives instruments and markets. IV. Derivatives A derivative is a financial contract whose price is determined by the value of an underlying asset, commodity, rate, index or event.

9. Pension Fund: Investment Policy CalPERS Approach to using derivatives Permitted Derivatives Uses Substitution – derivatives can be used in place of actual asset or security as a substitute to avoid withholding taxes or make better market timing movements Risk Control Prohibited Derivatives Uses Arbitrage - Speculation Leveraging of portfolio Permitted Derivatives Instruments Futures Forwards in currency Options on stocks, stock indices, bonds, currency Swaps – total return swaps Structured Notes – are not considered derivatives through may be prohibited through manager’s investment guidelines Prohibited Derivatives Instruments Options on futures (prohibited in 2000, but later amended) Prohibited unless attached to a permitted security

10. Derivatives Public Interest Concerns with Derivatives Markets in General –Price Discovery Manipulation Fraud Market transparency Pricing efficiency –Risk Shifting Liquidity Adequate credit risk management through capital and collateral requirements –Systemic risk issues Involvement of key financial institutions Regulatory Measures related to derivatives –Prohibit fraud and manipulation –Market surveillance to detect and deter fraud and manipulation –Registration and reporting requirements to prevent fraud and manipulation, and to make key market information publicly available –Requirements for capital and collateral (margin) –“Know thy customer” rule

11. V. Hybrid Instruments and Investment Strategies Hybrid Instruments –Often organized as Chapter S or Limited Liability Partnership structures –Combining conventional instruments with derivatives –Conventional or familiar examples Bond and one or more derivatives –Callable bond –Convertible bond Loan and one or more derivatives –Home mortgage –Loan with no prepayment penalty Convertible stock –Structured notes, less familiar Conventional bullet note plus one or more derivatives –Principle protection note Note with earnings from equity position and potential appreciation from equity position but also protection of principal and limited liquidity

12. Hybrid Instruments and Investment Strategies Hybrid Investment Strategy –Absolute Return Strategy 1.Through hedge funds – invest directly in assets, short sell to take advantage of market trends, use leverage to borrow to invest, and use derivatives to enhance returns or manage risk 2.event-driven strategies – a strategy that aims to profit from special situations or opportunities, by taking advantage of price movements or inefficiencies 3.arbitrage strategies - strategies that take advantage of the temporary miss-pricing of two securities that are similar –Capital Guaranteed Funds Constant Proportion Portfolio Insurance (dynamic hedging technique) Options structure (long put position technique)

13. Hybrid Investment Strategies Constant Proportion Portfolio Insurance (dynamic hedging technique) –CPPI is defined as a portfolio insurance technique that exposes a constant multiple of a cushion over an investor's floor -- or 'insured' value -- to the performance on a risky asset or portfolio. –Consider the following example. A constant proportion of a portfolio’s value that exceeds a threshold is invested in a risky asset while the remainder is invested in a riskless or low risk asset. If the floor is 75% of the portfolio (the price at which the principal can be converted to a zero coupon note worth 100% of price at maturity), then 25% time some constant multiple can be invested in the risky asset. If the factor is four, then 100% of portfolio goes to the risky asset. If the investment goes badly and the NAV falls to 90% of initial principal then only 15% of that amount times the multiple is invested in the risky asset (i.e. 60% of initial principal). –The upside: a chance to invest so as to gain from risky investments while protecting principal in a market where principal preservation is a great concern. –The downside: the opportunity cost of funds from earning zero over the five years of the investment. Options structure (long put position technique) –Option are expensive, and sometimes very, very expensive – hence most if not all of upside is loss through cost of insurance.

14. VI. Hedge Funds Definition –A hedge fund is a managed fund, often set up as a limited liability corporation or partnership, which pools money from wealthy individuals and institutional investors in order to employ more sophisticated investment strategies in stocks, bonds, foreign currency and derivatives. At present they are unregulated for all practical purposes. They are exempt from U.S. securities laws if they have less than 500 investors, investors have more than $2 million in income and the minimum investment is over $1 million. Hedge funds that pool money and take investment positions on futures exchanges are subject to registration as commodity pool operators or commodity trading advisors. Regulation –Investment Advisors Act of 1940 –Exemptions –December 2, 2004 Rule – requiring … Public Interest –Investor protection from fraud (SEC has filed 51 cases since 1998-2005) –Systemic risk Prime broker relations Selling credit risk insurance (with no capital standards)

15. Hedge Funds Investment Strategies. There are many different investment strategies. Hennessee calculates rates of return for 23 different strategies. Not all investment strategies involve leverage or high degrees of leverage. There are risks without leverage as well as risks due to leverage; some relative value strategies involve leverage but not large degrees of risk. Some examples of investment strategies –Directional Strategies Macro Long/Short or Relative Value –Event Driven Strategies Distressed securities Merger and Acquisition Risk Arbitrage –Arbitrage Strategies Convertible arbitrage Fixed Income Arbitrage

16. Hedge Funds Growth –“Everybody is starting a hedge fund.” –There are currently an estimated 8000 hedge funds –In 2005, an estimated $1 trillion in assets (measured NAV of funds) –Projections are that they will grow to $4 trillion by 2010 –Rates of return are high, and volatility is relatively low – see Chart 1 and Table 1 –Problem with this claim: attrition rate is high – see Chart 2

17. Hedge Funds Returns from 1987-2003 Table 1. Returns and Volatility: 1987-2003 Hennessee Group, authors calculation using US Treasury bill rate for risk free rate (5.019%)

18. Hedge Fund Returns/ Volatility Since 1987 Chart 1

19. Hedge Funds: Attrition Since 1996 Table 2

20. Pension Fund Investment in Hedge Funds “By far the biggest contributor to the current hedge fund boom is the widespread participation of pension funds.” Greenwich Report Hennessee Group Report –the percentage share of individual participants have dropped from 57% in 2003 to 51% in 2004 –endowments increased from 16% in 2003 to 19% in 2004 –foundations made up 7% of the hedge fund investor base in 2003, while in 2004 they were 11% –The fastest growing share is pension funds that rose from 4% in 2003 to 8% in 2004 SEC –Pension investment in hedge funds has increased from $13 billion in 1997 to $72 billion in 2003 –20% of U.S. pension plans were using hedge funds in 2002, up from 15% in 2001 Greenwich Associates –Survey found that corporate pension funds planned to expand their pension fund investment to 7% of assets, while public pension funds planned a 5% expansion. If these targets are reached, pension fund assets in hedge funds will reach at least $250 billion.

21. VII. Nexus of Public Interest in Pension Funds, Derivatives and Hedge Funds Public Interest Concerns 1.Pension funds should not “chase yield” 2.Pension funds should be inexpensive and not incur high management fees 3.Investment guidelines or policies might be (are likely) out of date 4.Problems with pricing and monitoring exposure to embedded derivatives 5.Problems with monitoring hedge fund exposures 6.Fraud The SEC reports that it took enforcement action against 51 hedge funds for defrauding investors of $1 billion since 1998 The types of fraud include gross overstatement of performance, payment of unnecessary and undisclosed commissions and misappropriation of client assets Inadequate rules governing auditing and performance reporting - 35% of hedge funds show no dates for their last audits 7.Hedge fund failure - HedgeFund.net reports that 10% of the hedge funds it tracks “became defunct” in the 12 months ending May 2004 (see Table 2). 8.“It’s amateur hour in the hedge fund business” -- Hedge Fund Research reported that 900 hedge funds are less than one year old 9.Correlation between mainstream portfolios and alternative investments are likely to tighten as arbitrage profits are eliminated and range of hedge fund investments becomes similarly diversified. 10.Poor investment data on the industry

22. Nexus of Public Interest in Pension Funds, Derivatives and Hedge Funds Pension funds should not “chase yield,” yet a recent report from Greenwich Associations warns of just that. Quoting from the report: “Beset with funding gaps that are proving stubbornly resistant to the market recovery, U.S. pension plans are hiring new managers at an almost unprecedented rate as they seek out ideas and products that can help them keep pace with their hefty obligations.” “[Pension funds are working] to identify investments that promise greater returns with a slightly higher degree of risk.” “Likewise, they are shifting out of core equities and into enhanced index, and spicing up international equity portfolios with stocks from exotic regions. Sponsors are also increasing allocations to equity, real estate and hedge funds.”

23. Nexus of Public Interest in Pension Funds, Derivatives and Hedge Funds Public Interest Concerns 2. Pension funds should be inexpensive and should not incur high management fees. Hedge funds are expensive. They generated 12% of all brokerage commission revenue – or $3.4 billion – according to Sanford C. Bernstein. The management fees are an even bigger issue. Box 2. Hedge Fund Fees Hedge funds much higher fees than other professionally managed funds. The management fee usually ranges between 1% and 2% of assets or the initial investment principal. In addition, the fund management company earns 20%-25% of the positive returns on investments. This high remuneration has been of public concern because it gives incentives to managers to pursue high yield – and hence high risk – investment strategies. It has lead also, in some cases, to fraudulent misrepresentations of the performance of their hedge funds returns. Many funds also include a “high water mark” provision in the fee arrangement whereby a manager has to recoup a certain amount of past losses before being able to earn a share of future profits.

24. Nexus of Public Interest in Pension Funds, Derivatives and Hedge Funds Public Interest Concerns 10. Data on hedge funds is inadequate. According to UBS study (Tehhaar, et al, 2003): “[The data] suffer from illiquidity and infrequent pricing biases, … also are fraught with membership and survivorship biases”

25. VIII. Regulatory Measures to Protect the Public Interest Pension Fund Investment Policy. Regarding improvements to pension fund investment policies, the following measures would help protect the safety and soundness of the role of pension funds as well as their contribution to overall efficiency in financial markets. The following apply to their participation in derivatives markets 1. Pension funds should accurately assess the total risk arising from derivatives positions – not just the credit risk from counterparty exposure – and the potential future gain or loss arising from these positions. This should include the likelihood of the positions moving out of the money (i.e. losses), but also the possibility of losses by counterparty affecting their creditworthiness and in turn the credit exposure of the pension fund. This total risk assessment should also include the potential loss of liquidity (especially when use for dynamic hedging), possible failure of collateral arrangement and bilateral netting provisions and the potential for basis risk to undermine the effectiveness of derivatives used for hedging. 2. Pension fund should buy, sell or engage in transactions that they do not have the professional, analytical ability to price accurately and efficiently. For example, they should not transact in credit derivatives with embedded options or options features that make them very difficult to price. Derivatives instruments such as synthetic collateral debt obligations and first to default swaps are examples where there is likely to be the case. 3. The pension fund should have an explicit investment policy addressing the use of credit derivatives and this is especially the case for investments and transactions that involve the selling of credit insurance or credit risk protection.

26. Regulatory Measures to Protect the Public Interest Pension Fund Investment Policy Regarding improvements to pension fund investment policies, the following measures would help protect the safety and soundness of the role of pension funds as well as their contribution to overall efficiency in financial markets. The following apply to investment in hedge funds and other alternative investment activities. 1. Pension funds policy and fund management strategy should recognize that credit exposure to investments in hedge funds is very different from that of investing in investment grade securities or diversified stocks or stock indices. 2. The pension fund policy should recognize that monitoring some hedge fund investment strategies is very difficult if not prohibitive. 3. The difficulty in monitoring hedge fund investment strategies and activities in turn makes it difficult to assess correlations of those investment positions with the remainder of the pension fund portfolio. 4. Pension fund policy should recognize the greater potential for financial fraud arising from hedge fund investments and in turn take appropriate prudential measures to protect against the event.

27. Regulatory Measures to Protect the Public Interest National Regulation of Derivatives Markets and Hedge Funds Derivatives Markets – Three Pillars of Prudential Regulation I.Registration and Reporting Requirements II.Capital and Collateral Requirements III.Orderly Market Rules Hedge Funds – Creating a well-light, level playing field I.Registration and Reporting Requirements (the SEC is only part way there) II.Collateral and margin requirements commensurate with other financial institutions and managed funds

28. IX. Conclusion Pension funds are responding to recent changes in interest rates and securities prices by moving into higher return and higher risk investments This has lead them towards a greater investment in hybrid instruments and hedge funds Not all derivatives are dangerous, and not all hedge fund investment strategies are reckless or pernicious However some of them are, and this raises public interest concerns Pension fund investment policies need to be updated and improved to reflect the risks and dangers involved with these new investment instruments and investment classes National financial market regulations need to be updated and improved to better protect pension fund and the larger financial sector from the dangers presented by derivatives markets and hedge fund activities

29. Prudential Guidelines for Pension Fund Use of Derivatives and Hedge Funds Randall Dodd Financial Policy Forum Washington, D.C. January 7, 2005 Prepared for presentation at ASSA conference, Philadelphia, January 7, 2005