The market blizzard freezing super

The massive challenges investors face as they battle to tease out satisfactory returns from turbulent markets were starkly highlighted this week with the giant US pension fund Calpers revealing that it had only generated a dismal 1 per cent return in the year to June.

The California Public Employees' Retirement System – Calpers – said the past year had been challenging, as the ongoing European debt crisis and slow global growth had increased market volatility and depressed equity returns.

Calpers – the largest US pension fund with assets of $US233 billion – suffered a 7.2 per cent loss on its equity market investments, partly as a result of losses in emerging markets, but also because of the poor performance of certain external fund managers. It also lost 11 per cent on its forestry investments. But it did have some successes, with its fixed income investments generating a handsome 12.7 per cent return, and its real estate portfolio returning an impressive 15.9 per cent.

Analysts were quick to point out that the Calpers result shows the difficulty investors face as they struggle to eke out returns in a low interest rate, low yield environment. They also noted that the Calpers result demonstrated a major fallacy in conventional investment thinking – that low interest rates are good for equities, and bad for fixed income investments, such as bonds.

Although Calpers said its stock market losses partly reflected a poor choice of managers, many equity funds (along with hedge funds that specialise in equities) reported lamentable results in 2011, and are struggling to do much better this year. Meanwhile, most fixed income funds are posting strong returns, as bond prices climb ever higher, pushing bond yields to record lows.

Analysts also noted that Calpers would have been particularly disappointed at the 5.4 per cent loss it suffered on its private equity investments, particularly given the drawbacks of this asset class – such as hefty fees, lack of liquidity and high levels of leverage. Calpers said it would continue reorganising its private equity portfolio, having recently culled it by $1 billion.

Other analysts pointed out that Calpers' 1 per cent return – well shy of its 7.5 per cent target – raises alarm bells over the future of superannuation savings. They point out that unless future returns improve substantially, there would be growing pressure on debt-strapped states to make larger contributions to pension funds. Alternatively, they will put pressure on employees to contribute more to their retirement savings, or cut the level of benefits that retirees receive.

Ominously, a high-profile taskforce chaired by the former US central bank chief, Paul Volcker, this week warned that US state governments are facing massive budgetary problems as a result of soaring pension and healthcare costs.

According to the taskforce's report, state and local governments are now burdened with about $3 trillion in unfunded pension liabilities and more than $1 trillion in healthcare liabilities. The taskforce warned that the current spending and taxation patterns of US states are unsustainable, and that budget reform is desperately needed.

Volcker warned that although municipal bond yields were currently trading at record lows, there could be a negative reaction when investors realised the extent of the budgetary challenges that state and local governments faced.

"It is characteristic of markets that they don't react until there is a crisis and they don't perceive this as a crisis. We don't want to stir that up but that is why you have to deal with it now,” he told a news conference.