Start with a few speculative stocks. Add a distressed-debt corporate bond portfolio, and two quantitative-based hedge funds, and a momentum-based hedge fund for the British pound/Japanese yen currency pairing.

Sounds like a typical, assertive portfolio for a wealth management group or, perhaps, for an accredited investor.

But a public pension fund?

Public pension funds in the United States are increasing bets on high-risk hedge funds and real estate in an attempt to fill deficits in retirement plans and recover ground, due to the worst performance by pension funds in six years, Bloomberg News reported Thursday.

Public funds, which manage more than $2.45 trillion in assets, are trying to reverse losses averaging 5.5% for the year ended June 30, according to Merrill Lynch data, and stem the tide of deficits, Bloomberg News reported. The State of New York's comptroller is asking its Legislature to increase its alternative investment spending cap; in February, the State of South Carolina upped its alternate investment / private equity / real estate cap to 45% from 0%.

'Investment distortions of the very worst sort'

Economist Glen Langan told BloggingStocks Thursday he doesn't like the sound of the new stance by state / local governments, if the aforementioned represents a trend.

"I view it as another manifestation of the U.S. stock market slump," Langan said. "The underperformance of stocks and the drive for outsized return on equity is leading to investment distortions of the very worst sort. We saw this in the mortgage market with their securities. It got to a point that if the interest rate was high enough, banks made the loan. We've seen it in oil, where the unattractiveness of stocks led institutions to dive into oil futures, driving up prices well above historic gains. And now it looks like public pension funds are catching the bug or flu."
And as with all flus, Langan expects hardship to follow. "Some of these high-risk investment tactics will work, but many won't, but the bottom line is I don't think it's an acceptable risk for a public pension fund. It's too much risk for their mission," Langan said. "These are public pension funds for civil servants, teachers, firemen, police, not supplemental investments for $20-million-level accredited investors with a spare million or two to park."

Langan added that "more than likely the new Congress will have to re-visit regulations on public investments next year."

Economic Analysis: That Congressional debate is likely to be a spirited one, after the new Congress convenes in January 2009. Look for Congressional Democrats to push for more-rigorous public investment restrictions, particularly if they retain majorities in both the House and Senate. Look for the Dems to be especially tough on public pensions / retirement funds that are backed by Federal insurance.