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Why Are Pension Funds Investing in Hedge Funds?

roulette wheel; John Wardell via Flickr

Question: Why were pension funds allowed to “invest” in a hedge fund? Hedge funds are nothing more than gambling.

Paul Solman: Because pension funds are supposedly big enough and therefore sophisticated enough to know what they’re doing and take considered risks. Look, all investing is, to a certain extent, gambling, with one big difference: It’s gambling with a positive expected return instead of pure gambling, which is a zero-sum game (as much money won as lost). Gamble through a third party like a casino or state lottery, and the expected return in generally negative, because the house takes a cut.

But with gambling, so with investing: The return you anticipate can best be interpreted as a direct function of the odds. If you want the best odds of getting your money back as an investor, invest in a low-risk instrument like TIPS (Treasury Inflation-Protected Securities), as this page has often urged folks to consider doing. (I’m just putting my mouth where my money is: About half of our family financial assets are in TIPS.) The analogue, at a casino, might be betting red (or black) at the roulette wheel. Or betting both, and losing just a little with each spin.

TIPS pay only a very modest return: 2 percent or so, plus the inflation rate. Invest in a hedge fund — a largely unregulated private pool of capital from investors with enough money to supposedly know what they’re doing — and you anticipate much bigger rewards. But as any investor ought to realize, that means taking much bigger risks.