* LA Fire and Police Pension allots 5 pct to commodities
* About $200 million to go into actively-managed derivatives (Adds background on LA pension fund holdings in paragraph 15)
By Barani Krishnan
March 13 (Reuters) - The largest public pension in Los Angeles is investing $800 million in commodities over the next two years, a quarter in actively managed derivatives, as it tries to profit from markets that have frustrated many institutional investors.
The Los Angeles Fire and Police Pension System, with nearly $16 billion in assets, said it is allocating 5 percent of its money to commodities with investments that aim to maximize returns and minimize downside risks. That includes commodity futures, stocks and private equity.
One strategy is to put $200 million into an enhanced commodity index-based investing model it hopes will deliver gains above market expectations. The other is to invest in stocks of commodity-related firms and private equity partnerships in energy, agriculture, mining and healthcare.
Enhanced index-investing typically means actively buying and selling commodity futures contracts in a portfolio that otherwise passively follows a commodity index in the hope of profiting from price gains in underlying contracts.
"This is the first time the system has invested in commodities," William Raggio, interim general manager at LAFPP, told Reuters in an email this week.
"The board and staff thought over the long run, this (active) approach would provide better returns," he said.
Fresh worries over inflation from U.S. monetary easing have recently pushed some state pensions to boost their exposure to commodities, whose prices traditionally rise over time.
Vermont is one, planning to double the commodities allocation in its $3.7 billion retirement fund to 4 percent, state investment chief Stephen Rauth was quoted saying last month by Pensions and Investments Online, a trade publication.
But retirement funds are also moving away from the trend of passively investing in commodity indexes, a strategy that has cost them dearly during market downturns.
The $7.8 billion Municipal Employees Retirement System of Michigan demonstrated this last year, putting more money into actively-managed real assets such as cattle and sheep farms in Australia while trimming index-based exposure.
"Institutions looking to create real asset investments now often have a mandate to hire managers who would actively manage those portfolios," said Don Steinbrugge, managing partner at Virginia-based pension consultant Agecroft Partners, in an interview. He is also an investment committee member for the city of Richmond.
Some pensions have maintained passive strategies, but sharply pared commodity allocations. California-based Calpers, the biggest U.S. retirement fund with $240 billion, dropped its holdings in commodity derivatives to 0.6 percent by the end of last year from 1.5 percent at end-2011.
Calpers was one of the first pension funds to invest in commodity indexes when it made its first foray in 2007 to diversify its portfolio and protect against inflation. Its passive investment strategy caused it to lose hundreds of millions of dollars when oil, metals and grains prices tumbled during the financial crisis.
After more woeful returns until last year, the pension fund switched most of its investments in commodities to inflation-protected bonds in October 2012.
A TWO-YEAR PLAN
While the LA fire and police pension is much smaller than Calpers, it is the biggest of Los Angeles' three public retirement plans. A table of the city's pensions holdings from last year showed the LAFPP holding about $14 billion, or about 40 percent of the total $32 billion in assets.
Los Angeles also has the largest pension obligation of California's cities.
In LAFPP's case, it had approved its 5 percent allocation to commodities as early as December 2010, but only finalized the different investing models for the portfolio last October.
Raggio said the board approved for 50 percent of the commodity assets to be used for public securities investments, and 25 percent each for derivatives and private equity funds.
Breaking it down further, it mandated the derivatives portion be 70 percent based on enhanced-indexing and 30 percent on "active constrained" management.
"The allocation (is) to be carried out over a two-year period," Raggio said. He did not say in which specific markets or products it will invest.
According to documents on LAFPP's website, the active constrained strategy will focus on creating "alpha" -- or gains above market expectations -- while automatically capturing "beta" -- or regular returns -- through its index investments.
Alpha-generating strategies include buying commodity futures contracts further out on the futures curve of an index to minimize losses from near-term price drops, and tactically overweighting or under-weighting certain sectors of an index based on return expectations. (Editing by Josephine Mason and David Gregorio)