Order Code RS22679
June 15, 2007
Pension Funds Investing in Hedge Funds
William Klunk
Actuary
Domestic Social Policy Division
Summary
The proportion of U.S. corporate-defined benefit pension funds investing in hedge
funds has increased to 24% in 2006, up from 19% in 2004 and 12% in 2000. Although
statistics vary, total corporate pension fund assets allocated to hedge funds in 2006 was
2.1%. Because of hedge funds’ risky nature, rapid growth, lack of oversight, and recent
losses, some wonder if they are appropriate investments for workers’ retirement funds.
In 2004, the Securities and Exchange Commission (SEC) issued a rule requiring many
hedge fund advisers to register as investment advisers under the Investment Advisers
Act. The rule took effect in February 2006, but in June 2006 a court challenge was
upheld, and the rule was vacated. In early 2007, while the Bush Administration called
for increased vigilance rather than new government rules to handle industry risks,
Congress has asked the Government Accountability Office to examine the use of hedge
funds by public and private sponsors of defined benefit pension plans.
What is a Hedge Fund?
Although there is no precise accepted or legal definition, the term “hedge fund”
generally refers to an entity that holds a pool of securities or other assets, whose interests
are not sold in a registered public offering, and that is not registered as an investment
company under the Investment Company Act of 1940.1 Alfred Winslow Jones is credited
with establishing one of the early funds in 1949 by investing in equities and using short
selling to “hedge” the portfolio’s exposure to movements in the equity market.2 Today,
hedge funds trade in a variety of investment vehicles such as equity and fixed income
securities, currencies, derivatives, futures contracts and other assets. Hedge funds often
1 For more information on regulation of hedge funds, see CRS Report 94-511, Hedge Funds:
Should They Be Regulated?, by Mark Jickling.
2 A “long” investment involves buying a stock today in order to sell it in the future; long investors
realize a profit if the value of the stock rises. Alternatively, “short” investors sell stocks first and
buy them back at a future date; short investors realize a profit if the value of the stock declines.
Brokers facilitate these transactions by loaning stocks to short investors who then sell them on
the market. When investors subsequently buy the stock back, they then return it to the broker.

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seek to profit by using leverage (investing borrowed money, which can increase gains or
losses) and other speculative investment practices that may increase the risk of investment
loss.3
Because hedge funds do not register the offer and sale of their interests under the
Securities Act, they may not offer their securities publicly or engage in a public
solicitation. Generally, they sell their interests in private offerings. They may sell their
interests to “accredited investors,” which includes individuals with a minimum annual
income of at least $200,000 ($300,000 with spouse) or $1 million in net worth and most
institutions with at least $5 million in assets. Alternatively, they may sell to “qualified
purchasers,” a standard with significantly higher financial requirements than those
necessary for accredited investors.4
Hedge funds are also characterized by their fee structure. Advisers typically receive
1% to 2% of assets as a management fee and a share of the capital gains and capital
appreciation, commonly 20%. Hedge funds often employ a “lock-up period” during
which investors may not liquidate their investments.
Concern About Hedge Funds
Hedge funds are coming under scrutiny due to their rapid growth, lack of oversight,
high risk, and recent fund losses and failures. Pension funds have increased their
allocation of assets to hedge funds in recent years. Some question the appropriateness of
exposing workers’ retirement savings to the potential losses of hedge funds.
Growth Rate. The hedge fund industry is experiencing rapid growth in both the
number of hedge funds and the amount of assets associated with them. It is estimated that
in 2006, there were approximately 8,800 hedge funds managing about $1.2 trillion in
assets, which represents a 3,000% increase in assets over 16 years.5
Hedge Fund Oversight. Because hedge funds are not required to register with the
Securities and Exchange Commission (SEC), they are exempt from standardized reporting
requirements and from examination by the SEC. The SEC claims these exemptions deny
investors material information from which to make informed decisions and hamper their
ability to detect hedge fund fraud.6
Riskiness. Hedge funds can be characterized as high-risk, high-return operations:
they pursue high returns by taking risks. Often they seek what is called alpha return, that
is, returns uncorrelated to market performance. That means that hedge funds can be
profitable when the market in general is not. For that reason, successful hedge funds
provide not only high returns to their investors, they contribute to financial markets’
3 U.S. Securities and Exchange Commission’s Staff Report, “Implications of the Growth of
Hedge Funds,” September 2003.
4 Qualified purchasers include individuals with more than $5 million in investments.
5 Benefits Law Journal, “Monitoring Hedge Funds Investments,” Summer 2007, p. 65.
6 SEC Staff Study, Implications of the Growth of Hedge Funds, September 2003, p. 76.

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efficiency, liquidity, and stability.7 However, unsuccessful hedge funds can cost investors
everything they have invested.
Hedge funds often use borrowed money to produce high returns, which is commonly
called leveraging.8 Prior to the 1929 stock-market crash, customers could buy stocks with
as much as 90% borrowed money, called margin debt. Today, the Federal Reserve limits
margin borrowing by most investors to 50% of a stock’s purchase price. However, that
limit doesn’t apply to “leveraging tools such as derivatives,” which allow funds to add
leverage without borrowing money.9 Tanya Azarchs, who analyzes banks and brokers at
Standard & Poor’s Corp., expresses concern about the growth of leverage fueled by hedge
funds when she says, “There’s leverage everywhere. It sort of feels like something’s got
to give.”10
Recent Fund Losses and Failures. In 1998, Long-Term Capital Management’s
(LTCM’s) capital shrank from $4 billion to $360 million in a matter of weeks, which led
to a bailout engineered by the Federal Reserve Bank of New York. The bailout was based
on the belief that the fund’s failure might have caused widespread disruption in financial
markets because of the fund’s size (it held $125 billion in assets, nearly four times the
amount of the next largest fund), its highly leveraged position (assets to capital ratio
greater than 25-to-1), and the large size of its investments in certain markets (e.g.,
LTCM’s position represented more than 5% of the open interest in a number of futures
markets).11 Regardless, the Fed’s intervention was unusual and triggered concerns that
funds would take greater risks on the assumption that the Fed was there to bail them out.
In September 2006, Amaranth Advisors fund lost $6.4 billion from a peak of $9
billion. Amaranth’s losses were attributed to ill-timed speculation in natural gas prices.
The losses did not affect the overall market, as was feared with LTCM, and did not trigger
action by the Fed.12 In the period between LTCM and Amaranth, the industry saw several
major hedge fund losses and failures due to financial issues and fraud.13
7 Ibid.
8 Leveraging refers to investing with borrowed money as a way to amplify potential gains (at
the risk of greater losses). However, investors can obtain leverage through various investment
vehicles without explicitly borrowing money. These include short selling, derivatives, futures,
options, etc.
9 Wall Street Journal, “Outer Limits: As Funds Leverage Up, Fears of Reckoning Rise,” April
30, 2007, p. A1.
10 Ibid.
11 Report of The President’s Working Group on Financial Markets, Hedge Funds, Leverage, and
Lessons Learned from LTCM, April 1999, p. 12. The difference between an entity’s capital and
its assets are its liabilities. That is, LTCM’s $125 billion in assets and $4 billion in capital
implies liabilities (e.g., loans and other obligations) of $121 billion.
12 Wall Street Journal, “Outer Limits: As Funds Leverage Up, Fears of Reckoning Rise,” April
30, 2007, p. A1.
13 For more information, see CRS Report RL33746, Hedge Fund Failures, by Mark Jickling and
Alison A. Raab.

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Pension Funds and Hedge Funds
The proportion of U.S. corporate pension funds investing in hedge funds has
increased from 12% in 2000 to 24% in 2006; these pension funds invest, on average,
about 5.4% of their assets in hedge funds.14 Total pension assets allocated to hedge funds
has grown from 1.3% in 2003 to 2.1% in 2006.15 Boeing, for example, announced that
it was increasing its bond allocation from 37% to 45% and cutting equity from 55% to
28%. At the same time, Boeing will increase its investment in alternative investments —
including private equity, real estate, and hedge funds — from 2% to 14%.16
Pension funds’ increased interest in hedge funds, coupled with the concerns listed
above, have led some to question the appropriateness of pension funds investing in hedge
funds. In addressing this question, however, it is important to distinguish between the
riskiness of a single investment and the risk to a portfolio. Individual hedge fund
investors seek high returns, but they risk losing their entire investment. And the LTCM
and Amaranth collapses show that this can happen in a short period of time.
As part of a portfolio, though, hedge fund investments can mitigate risk. “Due in
part to their non-correlation to traditional stock markets, hedge funds are powerful tools
for portfolio diversification, and help to enhance returns, reduce volatility and increase
risk-adjusted returns, especially during bear markets.”17 During the first quarter of 2001,
when the S&P 500 Index experienced its worst quarter since 1987, pension fund managers
saw hedge funds perform well while their stock values suffered.18
The San Diego County Employees Retirement Association’s (SDCERA’s) recent
experience illustrates the effects — good and bad — that hedge funds can have on
pension funds. In 2005, the SDCERA invested with Amaranth. When the hedge fund
failed, SDCERA estimated the losses to its portfolio at $100 million.19 Even with this
loss, though, SDCERA’s fund earned 14.57% last year. And, although SDCERA is suing
Amaranth, it continues to invest $1.2 billion (or 15%) of its $8 billion portfolio in hedge
funds and other alternative investments.20
14 Greenwich Associates, Investment Management: The Calm Before the Liability Storm,
February 2007, p. 4.
15 Greenwich Associates, New Products and Strategies Shake Up “Traditional” Assets
Allocations for U.S. Institutions, February 2007, p. 1.
16 Fundfire, Boeing Cuts Equity, Raises Bonds, Alts, April 2007, at [http://www.fundfire.com/
articles/20070426/boeing_cuts_equity_raises_bonds_alts].
17 Journal of Pensions, “The Role of Hedge Funds in Pension Fund Portfolios: Buying Protection
in Bear Markets,” April 2002, p. 237.
18 Ibid.
19 Chicago Tribune, “Worries Grow over Pension Investments in Hedge Funds,” May 20, 2007.
20 Wall Street Journal, “Your Money: Rest Later; Check Pension Plan Now; You May Have
Money in Hedge Funds or Other Risky Bets. They Can Win Big or Lose Big, as San Diego
Learned the Hard Way,” May 13, 2007.

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Existing Forms of Regulation. Pension funds are not prohibited from investing
in hedge funds. The Employee Retirement Income Security Act (ERISA) codifies the
legal requirements for defined benefit pension plans. Although it provides few
restrictions on the investment of pension funds, it does require that pension funds must
be managed in accordance with fiduciary responsibilities, which include acting solely in
the interest of plan participants, defraying reasonable expenses of administering the plan,
diversifying investments so as to minimize the risk of large losses.21 Accordingly, the
protection of pension plan participants from hedge fund losses falls to pension fund
investment fiduciaries.
The Pension Protection Act of 2006 (P.L. 109-280 or PPA) modified the rules under
which hedge funds become fiduciaries of pension funds. The PPA provides that
investment funds and limited partnerships (including hedge funds) will not be treated as
plan fiduciaries under ERISA if investments by ERISA-covered plans account for less
than 25% of assets of the investment fund or limited partnership. Investments of
governmental and foreign plans, which are not subject to ERISA, will not be taken into
account in this calculation, as they were under prior law.
In 2004, the Securities and Exchange Commission issued a rule requiring many
hedge fund advisers to register as investment advisers under the Investment Advisers Act.
The rule took effect in February 2006, and some basic information on registering hedge
funds appeared on the SEC website. In June 2006, however, an appeals court found that
the rule was arbitrary and not compatible with the plain language of the Investment
Advisers Act, and vacated it.
In December 2006, the SEC proposed a regulation that would raise the accredited
investor threshold from $1 million to $2.5 million in assets. If adopted, the rule would
significantly reduce the pool of potential hedge fund investors but would not be expected
to have a strong impact on the largest funds, which rely more on institutional investors
and qualified purchasers.22
Policy Considerations. Corporate pension funds are backed by the Pension
Benefit Guaranty Corporation (PBGC), a wholly owned government entity. Although it
receives no appropriations, some fear that its failure could require a taxpayer-funded
bailout.23 Although Congress does not regulate public pensions (e.g., the San Diego
County Employees Retirement Association), shortfalls in those plans are also borne by
taxpayers in those jurisdictions. As pension funds increasingly invest in hedge funds,
their influence on pension funds’ returns grows.
Opinions differ on whether pension funds are adequately protected from hedge fund
losses. Former Treasury Assistant Secretary Emil Henry characterizes corporate pension
funds as risk averse investors that diligently investigate investment opportunities before
21 ERISA §404, 29 U.S.C. §1104.
22 For more information, see CRS Report 94-511, Hedge Funds: Should They Be Regulated?, by
Mark Jickling.
23 For more information, see CRS Report RL33937, The Financial Health of the Pension Benefit
Guaranty Corporation (PBGC), by William Klunk.

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committing their funds.24 He believes that these characteristics will be embraced by hedge
funds as they seek to attract pension funds dollars. “I think it is safe to say that as
pensions continue to invest in hedge funds, the industry will further adjust and further
impose upon itself a ... risk management strategy which should — at some level —
mitigate risk.”25 The President’s Working Group on Financial Markets, which was
formed in 1999 in the aftermath of the LTCM failure, recently noted that “[i]n our
market-based economy, market discipline of risk-taking is the rule and government
regulation is the exception.”26
Senators Baucus and Grassley have expressed interest in learning whether hedge
funds pose a threat to workers’ retirement security.27 The Senators have asked the
Government Accountability Office (GAO) to investigate the benefits and risks that hedge
funds pose to pension funds and their participants.
ERISA does not currently require pension plan sponsors to report the number of
hedge funds they use or the amount of money invested in them. Some say this
information could enable policymakers to quantify the portion of pension assets that are
being invested in hedge funds. It could, they say, also help distinguish pension funds
whose hedge fund investments are concentrated in one or two funds versus those more
diversified, that is, spread over a larger number of hedge funds.
24 Wall Street Journal, “Treasury Official Henry Addresses Federal Reserve Bank of Atlanta,”
April 16, 2006.
25 Benefits Law Journal, “State Pension Funds Are Hedging Their Bets,” Autumn 2006, p. 70.
26 PWG Releases Agreement on Private Pools of Capital, at [http://www.treasury.gov/press/
releases/reports/hp272_principles.pdf], February 2, 2007.
27 U.S. Fed New Service, Sens. Baucus, Grassley Question Hedge Fund Investments for American
Workers’ Pension Plans, March 1, 2007.

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