State Treasurer Curtis Loftis On Tuesday afternoon, January 31, S.C. State Treasurer Curtis Loftis appeared before a Senate Finance subcommittee to lodge his complaint, “ We have an underperforming pension plan that is expensive, overly complicated, and places the taxpayers and pension plan members at excessive risk.” Loftis further explained, “So if the fund doesn’t make much money, we all have to pay more, and that’s the state employee and the taxpayers. So this affects literally everybody in South Carolina.”

The S. C. pension fund has about $26 billion, but if everyone in the system were in retirement, the fund would be short $ 13 billion. Loftis thinks the state pays way too much in fees while its state retirement system is underfunded.

In fact, to somewhat counter the Loftis complaint, if the pension fund makes more money, the pension fund has to pay more for the added success. That’s part of the hedge fund formula.

Ordinarily, with mutual funds, the fund’s owners, the clients, pay about 1% of the fund’s value in management fees on an annual basis. If the mutual fund has $100 billion in value, the management gets $1 billion at the end of the year.

With hedge funds, the management gets 2% annually instead of the 1% paid to mutual funds managers, and if the hedge fund rises in value, management gets 20% of the gains. And typically, the client doesn’t complain about the 20% profit sharing because the remaining 80% that goes to the client is still a whole lot better usually than the much lower gains in a mutual fund.

The term hedge fund began soon after WWII with the concept of running an investment portfolio that bought both for the long term and for the short term. Going long, as the brokers put it, is to buy stocks under the assumption they will rise in value over the long term.

Taking a stock short, on the other hand, means a stock is borrowed at what the buyer assumes to be peak value, anticipating a drop— maybe and hopefully a drastic drop— in value. The buyer sells what was just borrowed at peak value and waits for the stock to drop in value; whereupon, the buyer can scoop up cheap shares to pay back the number of shares earlier borrowed at peak value. The buyer pockets the difference. Going short, however, is considered riskier than going long on a studied bet, and taking a stock short can lose more money more quickly than simply going long.

As of last June 30, 21% of the state retirement pension fund was invested in hedge funds, while less than 3% of 91 other public pension funds with at least $1 billion was invested in hedge funds.

The hedge fund is called an alternative investment, like venture capital is called an alternative investment. Venture capital is at risk usually with a startup company, but since the investment is made when the company is in its incubator, the venture capitalist can end up with a large piece of a valuable pie when the company is sold or is going through an initial public offering, like what is currently happening at Facebook.

Also included under the heading alternative investments is private equity funds, or buyout specialists. A private equity fund can offer the shareholders of a publicly held company a premium, an increase in value per share well above recent values. The shareholders like what they hear, and the company is sold to the private equity fund. The private equity fund takes all the shares off the market, and, thereby, takes the company private. There are no publicly traded shares. Later, maybe about five years later, after trimming the fat and redeveloping the company into something far more valuable than it was just five years before, the company might return to the stock market, and the private equity fund profits handsomely and distributes among its investors.

The S. C. pension fund has been participating in alternative investments and doing almost all right. The objections Loftis was raising had to do with the amounts in fees paid to the managers of the various investment funds that did really well in the past year. S.C.’s Retirement System investments managed an 18.3% rate of return through June 30, 2011, but a survey of 91 other public pension systems in the country reported a median return of 21.7%. The American stock market as a whole had a return of 34% for the year ending last June 30.

Loftis says little S. C. with half the pension size of Virginia paid out twice the Virginia rate in management fees as a percentage of the size of the pension fund. S. C. paid 1.3% and Virginia paid .06%. With about half the size of Virginia’s pension fund, S. C. paid out almost $350 million in fees last year, and Virginia, $303 million.

That’s because the fee structures tied to alternative investments are higher than what gets paid in fees in conventional investments. S. C. puts 49.3% of its pension fund at risk in alternative investments, while the rest of the country averages 12.7% of pension funds in alternative investments. If that much risk came back in far greater returns, says Loftis, the risk is justified by the reward. But S.C.’s rate of return is 18.3%, and the other pension funds had a median return last year of 21.7% with about half the risk in alternative investments.

The debate over alternative investments is fairly recent. Before 1997, the state pension fund could invest in only fixed income investments, like bonds. Now that the state has freed up its investment opportunities, Loftis urges his state to free up more information. He is asking for more transparency and more accountability. Loftis, as the state treasurer, sits on the six-member commission that manages the state’s retirement fund portfolio. The commission was formed in 2005, and alternative investments were allowed as of 2007 when voters approved a change in the constitution.

In response to the Loftis campaign for changes in the way S. C. decides on pension fund investments, the fund’s chief investment officer Bob Borden quit last month to move to North Carolina for another job in the investment field.

According to research from New York University’s Stern School of Business, as reported in The Columbia Star in late 2009, one in five hedge fund managers misrepresents her (or his) fund or its performance to investors during formal due diligence investigations. Put another way, hedge fund managers can be expected to lie in their reports about 20% of the time.

In California, as reported by The Columbia Star in 2004, a group of news organizations sued Calpers (the California pension fund, at the time with $166 billion invested) in state court to disclose the management and advisory fees—assumed to be as much as $500 million—paid to private equity and hedge funds and other alternative investments.

If S.C. just paid out about $350 million in fees for management of $26 billion invested, and California followed the same fee schedule in 2004 with $166 billion invested, instead of $ 500 million California should have paid $2.2 billion.