PROVIDENCE, R.I. (WPRI) – General Treasurer Seth Magaziner announced Wednesday the state will slash its pension portfolio’s investments in hedge funds, acknowledging an expensive strategy implemented by then-Treasurer Gina Raimondo didn’t succeed.
Magaziner, a Democrat who took office last year, said the state will reduce the portion of its $7.7-billion pension portfolio invested in hedge funds from 15% to 6.5% over the next two years, moving more than $500 million into other types of investment classes, notably private equity.
Raimondo and her aides explained her 2011 decision to invest in hedge funds as an effort to reduce the volatility of the pension portfolio in the wake of the Great Recession, when it lost more than 20% of its value. They said the system couldn’t afford such large swings because it’s underfunded and has negative cash flow, and argued the hedge funds they chose would limit the damage when markets went south.
Magaziner said Raimondo was right to prioritize limiting investment losses, but he thinks a new strategy is needed to accomplish the goal. He said he informed the now-governor of his decision last week; she is a fellow Democrat and generally his political ally.
“I don’t think it’s necessarily a bad thing that we’re being more cognizant of risks than other funds, but the hedge funds have posed some problems,” Magaziner told reporters. “Some of them have performed very well – most have not,” he said. In too many cases, he explained, the hedge funds charged enormous fees yet provided little or no protection during broad market downturns.
“Some of the funds performed very well,” he said. “I would say most of them didn’t meet expectations.”
Rhode Island joins a growing list of pension systems that are moving away from hedge funds, which have come under attack for their fees and performance. Raimondo’s decision to embrace them helped land her on the cover of Institutional Investor magazine, but she went on to receive heavy criticism for the move, particularly during her 2014 campaign for governor.
Marie Aberger, a spokeswoman for Raimondo, declined to comment directly on the move to cut hedge funds, but highlighted the future governor’s passage of the 2011 pension overhaul that sharply reduced the system’s shortfall. “The pension system is much stronger today than it was when Gina Raimondo was first elected treasurer,” she said.
“Businesses are taking a fresh look at our state because of our more stable, more predictable finances,” Aberger said. “Treasurer Magaziner and the State Investment Commission are keeping with the strategy of having a diverse mix of investments to protect against risk, and the governor continues to support that approach to make sure people’s pensions are there when they need them.”
Magaziner emphasized that the entire pension portfolio has posted a positive return since he became treasurer in January 2015, saying its investments have earned more than $390 million since then. However, its value only rose by about $154 million over that period because of cash withdrawals to pay retirement benefits.
The decision on hedge funds is part of a larger shift in the state’s investment strategy that Magaziner’s team is calling “Back to Basics” and which was approved Wednesday by the State Investment Commission, which he chairs. The treasurer said a multi-month review indicated the new strategy will increase returns, lower fees and protect against risks.
“It’s been a really in-depth process,” Magaziner said.
As of Aug. 31, Rhode Island’s pension fund had $1.06 billion invested in hedge funds. Magaziner said the overall hedge-fund portfolio has posted a return of 4.85% after fees since its creation in 2011, but noted that many of the individual funds inside it have not met expectations. He also noted that more than half the gains the hedge funds managed to generate were eaten up by the high fees they charge.
In choosing which hedge funds will remain in Rhode Island’s portfolio, Magaziner said, they’ve “got to be truly non-correlated to the market” and they’ve “still got to make us money.”
Among the state’s 18 current hedge funds, the best performer is its $95-million investment in D. E. Shaw Composite Fund LLC, which has risen 14% since November 2011, while the worst performer is its $305,000 investment in Indus Asia Pacific Fund LP, which has fallen 17% since January 2012, according to State Investment Commission data. The latter investment is being unwound.
The second-largest public pension fund in Rhode Island, the independent plan run by the city of Providence, had 14% of its $293-million portfolio invested in two hedge funds as of Sept. 19. Providence’s two hedge funds have posted returns of 5% and 11% since its investments in them in 2001 and 2006, respectively, according to city data.
Beyond hedge funds, Magaziner said the new investment strategy was organized by sorting assets into three categories: those meant to provide growth (55%), those meant to throw off income to pay benefits (6%), and those meant to protect against volatility, inflation or crises (39%). The latter category includes a new commitment to invest 4% of the portfolio in long-duration U.S. Treasury notes.
Magaziner’s office said the median compounded rate of return it expects the new investment strategy to generate over the next 22 years is 7.3%, which is higher than the 7.0% for the current strategy but lower than the 7.5% assumed rate of return the state uses to calculate how much taxpayers need to contribute each year to keep the pension fund solvent.
Magaziner said the State Retirement Board, a separate body from the investment commission, will take up the question of whether to lower the rate of return next spring as part of a broader review that will also include other factors such as mortality rates. He indicated he’s leaning toward proposing to lower the rate, which would impact the state budget starting in 2019-20 if the board agrees.
The shortfall in Rhode Island’s two major pension funds stood at $4.55 billion as of June 30, 2015, with their overall funding levels coming in at 57% and 59%, according to an annual report by the state’s outside actuary, Gabriel Roeder Smith & Co. of Texas. Newer numbers will be released in the coming months.Ted Nesi (firstname.lastname@example.org) covers politics and the economy for WPRI.com. He writes The Saturday Morning Post and hosts Executive Suite. Follow him on Twitter, Facebook and Instagram