Underfunded and mired in a kickback scandal, the state-run pension for Illinois teachers has settled on a new plan to help resolve its fiscal woes: Sink almost a billion dollars into hedge funds.

In coming years, the $39 billion Teachers' Retirement System will join as many as 40 percent of the nation's public pensions in these complicated and lightly regulated investment partnerships.

The decision to embrace hedge funds raises a host of concerns, starting with fundamental doubts about their suitability for the nest eggs of elementary and secondary school employees, according to experts who follow them. Their high fees and the difficulty of monitoring their secretive trading activity also present significant hurdles.

Yet the move into hedge funds reflects the times. With lawmakers unwilling to financially support the pension system, pressure to boost returns is mounting. The Teachers' fund and smaller state plans have achieved considerable success with investments far removed from the ultrasafe Treasury bills that were standard in the past.

The next logical step is hedge funds, private pools of capital that permit their managers to keep a hefty share of investment gains. Foundations, college endowments and corporate pensions that took the plunge sooner have produced mostly encouraging, and sometimes eye-popping, results.

Today a total of $1.33 trillion is invested, and the temptation to join the crowd is becoming irresistible.

"When it comes to hedge funds, public retirement systems are grabbing their surfboards and saying, `Surf's up!"' exclaimed state Sen. Jeff Schoenberg (D-Evanston), who is co-chairman of a state oversight panel.

The Illinois State Board of Investments dove into hedge funds 18 months ago with no problems so far, said William Atwood, executive director of the $12 billion pension for state workers, judges and legislators. "The only reason we would change it is if it wasn't working out, and it's working out."

At the same time, the $15 billion State University Retirement System for Illinois' higher-education employees has steered clear, mostly because of difficulties in tracking hedge fund trading activity, said Dan Slack, its executive director. "When they tell us to `Just trust us...,'" he said, "that makes us as a public fund very nervous."

Even some hedge fund boosters doubt that kindergarten teachers belong in the same financial pool as the nation's wealthiest sharpies.

When market conditions change, state pension officials will have their hands full ensuring "the hedge fund is doing what they say they are doing," warned Charles Gradante, managing principal at the Hennessee Group financial advisory firm. "They can be blue one day, and green the next."

To a degree, hedge funds set their own rules, exploiting inefficiencies in the marketplace unencumbered by the registration and reporting requirements of conventional mutual funds. The Teachers' Retirement System understands the risks embedded in these fast-moving investments, and it is well-equipped to monitor them, according to spokeswoman Eva Goltermann. "We go in with eyes wide open."

The decision to enter hedge funds came Dec. 8 as part of a sweeping revision of its investment strategy. Among other changes, Teachers' is cutting its exposure to U.S. stocks while boosting bonds and foreign stocks. The goal, as always, is to generate higher returns with less overall risk.

The big money shift comes in the midst of a scandal centered on Stuart Levine, a former Teachers' director who pleaded guilty to federal charges of shaking down firms that were seeking investment business from the fund.

Another top political insider, Antoin "Tony" Rezko, has pleaded not guilty to federal charges stemming from the same kickback scheme, which U.S. Atty. Patrick Fitzgerald described as "pay-to-play politics on steroids."

Since the scandal erupted in 2005, the Teachers' Retirement System has imposed new "checks and balances" to prevent insiders from soliciting kickbacks in exchange for influencing its investment decisions, Goltermann said. "Now there's a lot more scrutiny, I assure you."

The fund has faced questions about its investment decisions before. In the 1990s it came under fire for hiring a former employee at 25 times his previous salary who proceeded to lose $266 million in less than two years. Though the losses were said to be offset by gains in other assets, the pension's reputation took a beating.

Likewise, during the economic malaise of 2001 and '02, the sluggish performance of Illinois' public pensions raised concerns even as hedge funds, which they did not hold, in notable cases outperformed the market. Some observers view the biggest downside of hedge funds to be "headline risk"--when losses that sophisticated investors would take in stride serve to alarm a skeptical public.

The $7.5 billion pension for San Diego County public employees felt the heat last summer when the collapse of hedge fund Amaranth Advisors in less than a month cost it $85 million of its initial $175 million investment. Since then, more than half the loss has been repaid, and other investments have performed adequately, but it remains under fire for failing to get its money out before the crash.

So far, the Teachers' Retirement System has not picked its hedge fund managers, and some observers suspect it will have a hard time finding the best. Accepting the money of public pensions can expose hedge funds to Freedom of Information Act requests from nosy competitors. It also binds them to restrictive laws such as the Illinois statute banning investments in Sudan.

Although the flow of money into hedge funds has slowed post-Amaranth as the stock market has surged, top managers can afford to discriminate.

"Successful hedge fund operators can basically pick and choose who they want as clients," explained Howard Pohl, principal at Chicago's Becker, Burke Associates financial advisers. "If they have to disclose their investment portfolio, the hedge fund guy says, `I don't need you.'"

For public pension managers, hedge funds demand stepped-up oversight, and the San Diego experience has raised doubts about whether public officials in charge are up to the task. In 2003, Teachers' considered making a hedge fund allocation but dropped the plan partly because it would have required too much attention from its staff.

Watchdogs such as Laurence Msall of Chicago's Civic Federation say the state should mandate stronger qualifications for those appointed to its pension boards. "As you move beyond publicly traded securities, it requires a greater level of financial expertise," Msall said.

One approach to boosting due diligence is a "fund of funds," in which a lead manager selects the rest. The pension for state employees, judges and legislators took that route in allocating the 5 percent of its assets earmarked for hedge funds. But that option typically layers on fees as well.

It remains to be seen if Teachers' will follow the same strategy. Under goals established Dec. 8, it intends to move cautiously into hedge funds, investing over the course of one to three years and limiting its exposure to 2.5 percent of assets, Goltermann said. That's far below the 10 percent recommended by outside consultants who advocated revamping the state fund's portfolio in the first place.

"TRS wanted to take it slowly and get its feet wet," said Goltermann. "As it stands now, we have the internal staff to manage that allocation."

As at many other pensions, so-called alternative investments have turned in some of the best performances lately. At Teachers', private-equity stakes in firms not listed on public markets returned 27.41 percent before fees in the 12 months ended Sept. 30, while real estate holdings returned 20.63 percent, well ahead of the overall 12.2 percent gain.

Still, no matter how well Teachers' performs, its investments stand virtually no chance of making up its shortfall. After decades of stingy contributions from the state, coupled with rising benefits, Illinois' public pensions are among the nation's worst funded.

The Teachers' fund, which holds just 62 percent of the money needed to meet its projected obligations, was forced to liquidate $1.2 billion in assets last year to pay benefits rather than reinvesting the proceeds.

Pohl, the Chicago financial consultant, sees the problem growing no matter what investment objectives the pension funds pursue.

"Illinois is a laughingstock," he said. "It doesn't matter if you invest in hedge funds or wrought iron fences, you've got to throw some money in the kitty."

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gburns@tribune.com