The kind of investment "hedging" practiced by the Ohio Bureau of Workers' Compensation in its failed investment in Pennsylvania was intended to help moderate losses in uncertain financial times.
At its core, the practice involves betting against yourself, investment experts said.
In September, 2003, guessing like many others on Wall Street at the time that interest rates were about to rise, the managers of the $22 billion state fund began taking "short positions" on long-term U.S. treasury bonds.
The state, acting through Pittsburgh-based MDL Capital Management, an outside investment adviser, began selling the bonds on the belief that it would be able to repurchase them at a steep discount later as bond prices fell.
The theory is that the bonds, which carried set interest rates, would be less attractive to investors - and command a lower price - because competing investments such as bank certificates of deposit, stocks, and other instruments would offer better returns.
It wasn't an unreasonable assumption, investment experts said.
The Federal Reserve and Chairman Alan Greenspan raised short-term interest rates 2 percent over the last two years. If markets behaved as they have in the past, longer-term interest rates would have followed.
But that didn't happen. Instead, long-term interest rates fell. Speaking this week on the subject, Mr. Greenspan said the development is "without precedent."
For the Ohio fund that insures injured workers, the anomaly caused a $215 million loss, officials acknowledged yesterday.
Had markets behaved as normal, the gains from the hedge fund, dubbed the Active Duration Fund, would have helped offset losses in the state's traditional bond fund, which bought and held bonds, and once was worth $355 million.
Instead, the value of those types of bond funds rose. But because many of those bonds were sold off in the state's hedging strategy, the benefit was diminished.
"It's not unusual for pension funds to invest relatively small segments of their assets in hedge funds," said Keith Brainard, research director for the National Association of State Retirement Administrators. "One of the things about these funds is that they are engaged in a range of often exotic investment instruments."
But he said the practice is risky and the strategy followed by the Ohio fund was somewhat unusual.
Hedge funds, which Ohio used to make the investment, have become increasingly common.
Wealthy people use the unregulated investment pools in pursuit of better returns on often nontraditional investments.
Pension funds use them as a way to moderate risk, by balancing investments against one another.
When such an investment is made, it is imperative that there be strong oversight of investment managers and for superiors to step in when losses begin to mount, fund experts said.
As one pension expert put it: "A fund shouldn't go down, down, down without you doing something about it."
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