With pension fund allocations to hedge funds increasing over the past two years, institutional investors are refining asset allocation investment philosophies into risk-based approaches. A risk-based approach, however, is only as good as its methodology. For an investor considering private equity and hedge funds, this raises two questions: What is an appropriate risk-based approach; and what risks does it consider?

Until recently, issues other than investment performance of alternatives played a secondary role for institutional investors and their consultants. With the 2008 financial crisis and resulting scandals, investors shifted to back-office risks in areas such as custody, valuation and audit. Today, operational due diligence teams are just as important in vetting managers as investment teams.

Despite these changes, due diligence efforts still minimize legal and regulatory risks. In many cases, regulatory risks are weighed only after a scandal erupts. This backward-looking mindset leaves significant risks unrecognized — until the next scandal breaks — and creates risks for pension fund investors.

Alternatives investment managers have gone from being relatively unregulated to heavily regulated. Additionally, the glare of regulatory scrutiny has only intensified. Indeed, activity by one regulator will typically draw the focus of others both in the U.S. and international markets…

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Uncertainties about what to do in rebalancing and the uncharted waters of central bank accommodation are among the things that’ll bring sleepless nights to investment executives and money managers in the coming year.

“The scary thing is the thing you don’t expect,” said James Keohane, president and CEO of the C$47.4 billion (US$44.6 billion) Healthcare of Ontario Pension Plan, Toronto. “It’s hard to know what there is in store.”

“Everything keeps me up at night,” said David Cooper, chief investment officer of the $28.3 billion Indiana Public Retirement System, Indianapolis.

“Asset allocations are probably out of whack right now,” generally overweight stocks and underweight fixed income, added Tim Barron, CIO at investment consultant Segal Rogerscasey in Darien, Conn. But given the 2013 jump in stock prices and the ongoing concern over core fixed income, he added, “how do you feel about selling stock and buying fixed income? That’s a struggle.”

What’s expected is the continued tapering of the Federal Reserve’s quantitative easing strategy, and that equities will continue to see growth, but not at a breakneck pace…

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Health-care companies with deep pockets and shallow product pipelines are poised for a busy year of acquisitions, with biotechnology firms likely to be among the most prominent targets even as they trade at record highs.

The seeds of this year’s deals may be planted next week at JPMorgan Chase & Co. (JPM)’s annual health-care conference in San Francisco, where more than 300 companies will present to thousands of investors about the year ahead. Meanwhile, business development executives will be meeting in hotels surrounding the conference that begins Jan. 13.

Large drugmakers from Merck & Co. (MRK) to Bristol-Myers Squibb Co. (BMY) are dealing with patent expirations on top medicines and cutting researchers as they refocus their product development strategies. At the same time, prices on targets are expected to stabilize after last year’s run-up, said Jeff Stute, JPMorgan’s head of health-care investment banking.

“We see M&A in the health-care sector being up materially in 2014 at all size levels and across all subsectors,” Stute said in a telephone interview. “Buyers and sellers will get comfortable with the new reality of where assets are priced.”

Biotechnology companies in particular had a standout 2013, with the Nasdaq Biotechnology Index gaining 66 percent, topping a 30 percent increase for the Standard & Poor’s 500 (SPX), and closing yesterday at a record high of 2,449.25. The industry saw the most IPOs since 2000, as investors were drawn to the prospects of revenue growth in an industry seeing a record number of new drug approvals over two years….

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In morning trading, the Standard & Poor’s 500-stock index was off 0.1 percent, the Dow Jones industrial average fell 0.2 percent and the Nasdaq composite was 0.4 percent lower.

With uncertainty over the raising of Washington’s borrowing limit temporarily resolved, investors have focused on other matters, notably when the Federal Reserve will reduce its mammoth monetary stimulus that has been a boon for stock markets.

American hiring and durable goods orders for September were weaker than expected, signaling that growth momentum might be slowing and reinforcing expectations that a scaling back of stimulus, known as tapering, would not begin until next year, Mitul Kotecha of Crédit Agricole in Hong Kong said in a market commentary.

Further data releases on the United States economy this week, including September industrial production, retail sales, inflation and consumer confidence, as well as a Fed policy meeting, could reaffirm that expectation, he said. The Fed is buying $85 billion of government bonds and other securities each month with the aim of keeping interest rates low to support economic recovery….

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Today’s low-interest-rate environment has made the hunt for investment income tougher than ever. Many overseers of public pension funds, desperate to bolster returns and meet ballooning retiree obligations, have turned from traditional investments like stocks and bonds to hedge funds and private equity.

These so-called alternative investments now account for almost one-quarter of the roughly $2.6 trillion in public pension assets under management nationwide, up from 10 percent in 2006, according to Cliffwater, an adviser to institutional investors. Investments in public companies’ shares, by contrast, fell to 49 percent from 61 percent in the period.

Fans of alternative investments argue that they can generate higher returns. But the increased risks, higher fees and lack of transparency associated with such investments make them problematic. A 2007 paper by Fiona Stewart at the Organization for Economic Cooperation and Development in Paris said that “lack of transparency makes the level of risk and type of exposure hard to gauge” in hedge funds.

Last week, an investigation of the Rhode Island pension system’s recent foray into alternative investments raised fresh questions about the high costs and considerable risks of investing in hedge funds and whether their returns are indeed worth it.

The investigation, by Benchmark Financial Services, a forensic firm hired by a Rhode Island council of the American Federation of State, County and Municipal Employees, concluded that the $7.7 billion Employees’ Retirement System of Rhode Island was at risk because of its increased concentration in high-cost and opaque alternative investments. The union represents workers whose pensions are invested by the state.

In less than two years, the Rhode Island pension system has ramped up its investments in hedge funds, private equity and venture capital from zero to almost $2 billion, or more than one-quarter of its assets under management. But this mix of investments hasn’t outperformed the fund’s peers, the Benchmark report said. For the year ended June 30, 2013, the fund returned 11.07 percent, versus 12.43 percent earned by the median public pension fund.

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In early trading, the three main indexes — Standard & Poor’s 500-stock index, the Dow Jones industrial average and the Nasdaq composite — were 0.1 percent lower.

The government will reach its borrowing limit, or debt ceiling, by Tuesday. If Congress does not raise that limit, the government will not be able to pay all its bills, possibly shaking confidence in the economy, the world’s biggest.

That leaves just days for the White House and Republican lawmakers, who disagree on spending cuts and other important budget issues, to reach a compromise. Republicans are demanding that any increase must result in expenditure cuts of an equal amount. President Obama is demanding a debt-limit increase with no conditions attached….

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For the first time since before the credit crisis, bond buyers are demonstrating more confidence in the U.S. banking system than in industrial companies as lenders fortify balance sheets while firms from Verizon Communications Inc. (VZ) to Apple Inc. (AAPL) borrow record amounts.

Relative yields on bonds from Citigroup Inc. (BAC) to JPMorgan Chase & Co. (JPM) were 3 basis points less than the average for industrial notes last week, the first time since September 2007 that investors didn’t require more from bank borrowers, Bank of America Merrill Lynch index data show. The relationship reversed after bank bond spreads surged to an unprecedented 365 basis points more than industrials amid the worst financial crisis since the Great Depression.

Lenders sitting on a record $9.5 trillion of deposits are winning over the bond market after increasing a measure of their capital cushions by about 54 percent to meet regulations intended to prevent a repeat of the turmoil that followed the 2008 bankruptcy of Lehman Brothers Holdings Inc. and contributed to more than $2 trillion of writedowns and losses at the world’s biggest financial institutions….

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Hilton Worldwide Holdings Inc., the hotel operator owned by Blackstone Group LP (BX), filed to raise $1.25 billion in a U.S. initial public offering as lodging shares trade at close to their highest level in six years.

The world’s largest hotel chain plans to use proceeds from the offering to pay down debt, according to a regulatory filing today. New York-based Blackstone, the world’s largest manager of alternative assets, will own a majority of the voting power in Hilton following the IPO, the filing shows.

At $1.25 billion, the IPO would be the largest for a lodging company and would move Blackstone closer to realizing gains from its biggest single investment, with more than $6 billion of equity invested from its real estate and other funds. The offering coincides with increases in industry revenue and income that have spurred stock gains for hoteliers such as Starwood Hotels & Resorts Worldwide Inc. (HOT) and Marriott International Inc. Both are trading close to their highest levels since 2007.

“For Blackstone, it doesn’t make sense to keep something this valuable on the books,” said Jeffrey Sica, who oversees about $1 billion as chief investment officer of Morristown, New Jersey-based Sica Wealth Management LLC. “Hilton’s business has been doing well, so it makes very good sense for them to do it now.”

The McLean, Virginia-based hotel operator didn’t say how many shares it will offer or at what price. The offering amount is a placeholder used to calculate fees and may change. Deutsche Bank AG, Goldman Sachs Group Inc., Bank of America Corp. and Morgan Stanley will arrange Hilton’s IPO, the filing shows…

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For companies looking to raise money through the debt markets, and the bankers egging them on, it seems no sum is too large.

Verizon Communications shattered records and shook up the bond world on Wednesday when it sold $49 billion of investment-grade corporate debt at one time.

It was the largest deal of its kind, exceeding Apple’s $17 billion bond sale in April and illustrating the degree to which low interest rates are enabling corporations to borrow money inexpensively.

Verizon undertook the huge sale of corporate debt as it moves to finance its $130 billion deal to buy out Vodafone’s 45 percent stake in their Verizon Wireless joint venture.

The ease with which Verizon raised so much money caught even longtime market participants by surprise and fed speculation that more companies might tap the debt markets before interest rates begin to rise, as is expected.

“We’re starting to see the animal spirits pick up again,” said Kathy Jones, a fixed-income strategist at Charles Schwab. “Usually, once it gets going, it doesn’t let up.”

One banker involved in the offering said he was counseling corporate clients that now was an ideal time to raise more money for acquisitions.

“From an M.& A. perspective, nothing is out of reach,” he said. He spoke anonymously because he did not want to damage his relationship with his clients. Verizon’s buyout of the Vodafone stake in the wireless business — the third-largest corporate acquisition after Vodafone’s $203 billion takeover of the German cellphone operator Mannesmann in 2000, and the $182 billion merger of AOL and Time Warner in 2001 — was in the works for years, but it was finally struck last week, in part because Verizon wanted to take advantage of low interest rates while they lasted….

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Hilton Worldwide Holdings, the hotel company owned by the Blackstone Group, filed for an initial public offering on Thursday, seeking to raise at least $1.25 billion in what will be one of the most closely watched I.P.O.’s of the year.

Though details of the offering were not yet available, Hilton could be valued at about $30 billion once it goes public, capping a remarkable turnaround for what was once considered one of the worst deals of last decade’s private equity boom.

Blackstone took Hilton private in 2007, paying $26 billion for the company, which is based in McLean, Va. The deal was among those that came to symbolize the outsize ambitions of buyout shops in the years before the financial crisis as firms including Blackstone went after ever-larger targets.

Hilton did not disclose the precise sum it was looking to raise or how it intended to price shares. But Blackstone does not intend to issue so many shares that it loses control of Hilton. Instead, the private equity firm will continue to own a majority of the voting shares, allowing it to control the makeup of the board.

With comparable hotel chains like Starwood and Marriott trading at about 12 times earnings before interest, taxes, depreciation and amortization, and Blackstone growing at a healthy clip, its valuation could be about $30 billion by the time shares start trading, which is likely to be sometime early next year….

Read the rest of the article at the NY Times.