Illinois Teachers’ Pensions Increase Allocation to Alternative Investments in Order to Do the Impossible

Posted by Jeffrey Brown on Apr 21, 2011

Filed Under (Retirement Policy, U.S. Fiscal Policy)

Just a short note today (which I learned from reading Institutional Investor) to point out that the Illinois Teachers’ Retirement System on April 8 approved a change in portfolio allocation.  Specifically, they are going to increase by 5 percentage points the fraction of the pension portfolio going to hedge funds and private equity.  The increase is coming primarily from a reduction in domestic equities from 26% to 20% of the portfolio.

What I find ironic (indeed, it would be amusing if the stakes were not so high) is the statement by the Chief Investment Officer that they are doing this to “minimize risk and maximize returns.”

There is a major problem with this statement.  Namely, it is impossible to do both.

It is possible to minimize risk, while holding the return constant.  Or one can maximize returns, while holding the risk constant.  Indeed, these are two different ways of – in financial economics lingo – to get to an “efficient” portfolio.

But it is impossible to do both simultaneously.  In financial markets increased market risk and increased expected returns go hand-in-hand.  As Frank Sinatra said about love and marriage, “you can’t have one without the other.”