It is a strategy that tries to make money even in down market years, says the retirement system's chief investment officer, Peter Gilbert.
Does the system know where this money is actually going? "We get aggregate numbers," but not detailed investment lists, from hedge managers, Gilbert said.
"We recognize there's not the disclosure you get in more traditional market activities," he added. "Some give you almost no disclosure, others almost total, others on a lagged basis, others only if you go into their office."
But the retirement system believes that the wide range of hedge funds its managers buy reduces the overall risk.
Limited to wealthy investors, hedge funds are free from regulations, reporting and restrictions that apply to mutual funds and other registered investments. They typically bet on strategies such as short selling (betting that a stock's price will drop) and arbitrage (exploiting small price gaps) to "take advantage of anomalies in the financial system," Gilbert said.
Lured by high fees, scores of money managers have quit mutual funds and other traditional portfolios to run hedge funds in recent years.
The State Employees' Retirement System pays pensions to 91,000 retired legislators, judges, and other state workers, funded by a mix of investment profits and taxpayer subsidies.
In 2002, the system invested $2.5 billion in four hedge funds that spread their money among other hedge funds ("funds of funds") in an effort to make money (for a positive "absolute return") even when stock prices dropped.
Is this working? The value rose to $2.8 billion by the end of 2003, but the four hedge funds' collective return trailed the increase in the retirement system's overall investment portfolio by about 50 percent.
Still, Gilbert said he was encouraged by the prior performance of U.S. hedge-fund managers, who claimed modest profits during the market's 2000-2002 downturn.
The retirement system board, headed by Nicholas Maiale, a Philadelphia lawyer and former state representative, voted in December to double its hedge-fund target to 20 percent of the system's total assets over the next two years. The City of Philadelphia pension system also is looking for hedge managers; the larger New Jersey state and Pennsylvania teachers' funds are weighing such a move.
Hedge investors have plenty of company, including big universities such as Harvard and Yale. Total assets of hedge funds managing $10 million or more each rose from an estimated $27 billion in 1994 to $214 billion last year, according to hedge-fund tracking firm CSFB/Tremont Index L.L.C.
Hedge funds are hot today, like venture capital was in the 1990s and commercial real estate in the 1980s. Hedge investors hope this bubble doesn't burst.
The four hedge-fund pools with State Employees' Retirement System money are:
Blackstone Alternative Asset Management, New York ($750 million invested by the system in 2002).
Mesirow Advanced Strategies Inc., Chicago ($575 million).
Morgan Stanley Alternative Investment Partners, New York and West Conshohocken ($575 million).
Pacific Alternative Asset Management Co., Irvine, Calif. ($575 million).
What do those funds do with the retirement system's taxpayer-subsidized investments?
Blackstone Alternative Asset seeks "risk-adjusted returns with low volatility and low correlation to traditional asset classes," its brief online sales brochure says.
What does that mean? "If you want to speak about the fund itself, we cannot possibly do that," spokesman John Ford said.
Mesirow advertises "nontraditional investment strategies" that "provide meaningful diversification to an existing core portfolio."
Founder Howard Rossman promised to explain, then said he was too busy. Rossman holds a doctorate from the California Institute of Integral Studies, whose mission is to "embody spirit, intellect and wisdom in service to individuals, communities and the Earth."
Morgan Stanley Alternative advertises a "liquid markets fund of funds strategy." A flier distributed by the Harvard Business School Club of Philadelphia for a November talk by a Morgan Stanley Alternative manager stated that funds similar to those managed by the firm "are delivering a 5-year IRR [Internal Rate of Return] of over 80% even in today's conditions!!!" Morgan spokeswoman Andrea Slattery declined comment.
Pacific Alternative's Web site says the firm invests in convertible bonds, foreign debt, mortgage debt, distressed debt, merger arbitrage and short sales. Founder Jane Buchan did not return a call.
Officials at Blackstone and Morgan Stanley have made small donations to Gov. Rendell and, in Morgan's case, several other candidates in Pennsylvania elections since 2000. The retirement system says it picks investment managers based on competence, not cash or connections.
Contact staff writer Joseph N. DiStefano at 215-854-5957 or firstname.lastname@example.org.