Friday, August 29, 2014

Avoid the Hottest Hedge Funds?

Lawrence Delevingne of CNBC reports, Why you should avoid the hottest hedge fund hands:
Investors who don't have money with Pershing Square Capital Management are likely salivating at the hedge fund's industry-leading 26 percent return from January through July.

But investing with Bill Ackman and other top-performing managers after a great run is probably a bad idea, according to a new study of long-term hedge fund industry performance.

A white paper by Commonfund, which manages nearly $25 billion for close to 1,500 endowments, pensions and other institutions, shows that putting money with the hottest hedge fund managers can work in the short term, but that sticking with them for three years or more is worse than picking managers at random. Picking up losing hedge fund strategies can even produce slightly positive performance.

"Not only does positive-return persistence tend not to work as a selection strategy, but it is especially ineffective in the medium-to-long-range horizons that institutional investors may prefer, and indistinguishable from a strategy of selecting losers," authors Kristofer Kwait and John Delano wrote.

Kwait and Delano found that picking winning hedge funds produced returns of 13.29 percent after 18 months, versus an average of 10.62 percent for all funds. But the same group held for 36 months gained the same as the average; over 48 and 60 months, they rose just 9.49 percent and 8.48 percent, respectively.

In theory, hedge fund allocators could invest with the best managers and then quickly cash out within 18 months. But the vetting and subscription process to get in can take months or even years, especially for cautious institutional investors. Plus, hedge funds often require that their investors commit money for at least a year, and then restrict redemptions by spreading them out over several quarters.

Commonfund said its findings were consistent with a point made by Cliff Asness of AQR Capital Management.

The hedge and mutual fund manager has written that investors often try to catch short-term results in various asset classes but use a multiyear time frame, which often means they instead get hit with losing reversals—or miss winning ones—when the trade inevitably reverts to the mean. Asness declined to comment on the Commonfund study.

Ackman, for example, underperformed stock indexes in 2013 with a 9.3 percent gain, hurt by losses on J.C. Penney (JCP) and a short position on Herbalife (HLF). But Pershing Square has rocketed back this year with wins on Allergan, Canadian Pacific, a reversal in fortune for Herbalife and others, according to a recent letter to investors.

Another famous example of a hedge fund reversal is Paulson & Co. John Paulson saw his client base increase dramatically after he scored huge returns with bets against the housing market before it crashed. But heavy losses in 2011 and 2012 from too-early bets on the U.S. economic recovery caused investors to pull their money (Paulson's hedge funds snapped back in 2013).

The study also found that teasing out manager skill, or "alpha," from the general market ups and downs, or "beta," is critical to selecting hedge fund managers who will outperform.

"For an allocator, that this relationship between observed alpha and skill is not necessarily certain may leave a door open for inferring a sort of skill even from beta-driven returns, perhaps on the basis of a hard to define but powerful argument that a manager is 'seeing the ball,'" the paper noted.

The Absolute Return Composite Index, which aggregates hedge fund returns across all strategies, gained 3.79 percent this year through July. By comparison, the S&P 500's total return was 5.66 percent and Barclays Aggregate Bond Index gained 2.35 percent.

The challenge is parsing out what alpha really is; hedge fund managers are quick to attribute their gains to skill rather than market forces.

Large investors—and their teams of advisors—appear convinced they can draw the distinction. No less than 97 percent of 284 institutional investors surveyed recently by Credit Suisse said they plan to be "highly active" in making hedge fund allocations during the second half of 2014. That's even more than the 85 percent who already made allocations in the first half of the year.

According to industry research firm HFR, investors allocated $56.9 billion of new capital to hedge funds in the first half, pushing total global assets to more than $2.8 trillion, surpassing the previous record of $2.7 trillion from the prior quarter.
No doubt about it, the big money still loves hedge funds. You should all take the time to read the white paper by Commonfund, which is truly excellent.

I can't say I'm shocked by the findings. A long time ago, I wrote a comment on the rise and fall of hedge fund titans, where I wrote the following:
Should you always add more when a hedge fund or external manager gets clobbered? Of course not. Most of the time you should be pulling the plug way before disaster strikes. You need to look at the portfolio, assets under management, people, process, and risk management and make a quick decision.

This isn't easy but if you don't, you'll end up holding on and listening to a bunch a sorry ass excuses as to why you need to be patient. And no matter who he is, I would never accept any hedge fund manager 'chiding' me for redeeming from their fund. That's beyond insulting, but in an era where hedge fund superstars are glorified, this is what routinely happens.

Been there, done that, it's a bunch of BS. The media loves glorifying hedge fund managers but the bottom line is all these 'superstars' are only as good as their last trade. Institutional investors should stop glorifying these managers too and start grilling them hard.

The problem is too many institutions don't have clue of what they're doing when it comes to investing in hedge funds or private equity, so they end up listening to the useless advice of their brainless investment consultants.

I know that might sound harsh but it's the truth which is why I continuously poke fun at how dumb the entire hedge fund love affair has become. Sure, there are some good consultants, but the bulk of them are totally useless.

I used to go to these silly hedge fund conferences where institutional investors were getting all hot and horny over hedge funds and think to myself what a total waste of time. Most of these bozos don't have a clue of the underlying strategies and more importantly the risks of these strategies.

So what do they end up doing? They all chase performance, getting bamboozled by some hedge fund manager with his head up his ass, telling them to "hurry up and invest because they are setting a soft close at $X billions and a hard close $Y billions."

I used to get phone calls all the time when I was managing a portfolio of directional hedge funds at the Caisse. The pressure tactics were a total joke. I ignored third party marketeers and any arrogant hedge fund manager who was trying to pressure me into investing.

I recall my first meeting with Ron Mock at Teachers back in 2003 when he explained his hedge fund strategy and the way they allocate and redeem. Teachers was and remains very active in hedge funds. I recall specifically asking him about redemptions and how hedge funds react. Ron told me flat out that while "most hedge funds don't like, if you do it in a professional manner, they'll understand and won't take it personally."

I also asked him what happens if they threaten not to allow him to invest with them ever again or if they act arrogant with him? He told me: "I have no time for arrogance and typically what happens in this industry is when the tide turns, the arrogant managers come back to plead for money. I've seen it happen many times. When they need money, they will come back to you and embrace you with open arms."

And even Ron Mock, who I consider to be one of the best hedge fund allocators in the world, experienced a few harsh hedge fund lessons in his career as a hedge fund manager and as an allocator. Following the 2008 crisis, Ontario Teachers now invests the bulk of their hedge fund assets into a managed account platform (they use Innocap), but they still invest a small portion in less liquid hedge funds (the flip side of transparency is liquidity; no use putting an illiquid hedge fund onto a managed account platform).

Allocating to external managers isn't easy, especially when you're dealing with overpaid and over-glorified hedge fund managers. This is one reason why there is a hedge fund revolt going on out there, led by CalPERS which announced it was chopping its hedge fund allocation back in May and recently confirmed it was rethinking its risky investments.

Most investors, however, aren't backing away from hedge funds. Instead, they're rethinking the way they allocate to hedge funds. For example, co-investments are entering the hedge fund arena. And Katherine Burton of Bloomberg reports, Hutchin Hill, Citadel See Assets Jump as Pensions Call:
Neil Chriss is hitting his stride.

The math doctorate turned hedge-fund manager founded Hutchin Hill Capital LP more than six years ago and built it to cater to large investors. After posting annualized returns of 12 percent, about six times the average of his peers, he finds himself in the sweet spot for fundraising. Hutchin Hill’s multistrategy approach is the most popular hedge fund style this year, helping the New York-based firm double assets by attracting $1.2 billion.

Chriss, 47, is one of the prime beneficiaries as investors are on track to hand over the most cash to hedge funds since 2007, driven by a search for steady returns and protection from market declines. The biggest firms, such as Citadel LLC, Och-Ziff (OZM) Capital Management Group LLC and Millennium Management LLC are bringing in the biggest chunks of money, yet a select group of smaller firms like Hutchin Hill have collected more than $1 billion each.

“There are huge sums of money being put to work,” said Adam Blitz, chief executive officer at Evanston Capital Management LLC, an Evanston, Illinois-based firm that farms out $5 billion to hedge funds. “You are getting some big checks coming into a fairly small universe of brand-name managers who want to grow and are on the approved list of hedge-fund consultants.”

Hedge funds attracted a net $57 billion in the first half of this year, compared with $63.7 billion for all of 2013, according to Hedge Fund Research Inc. Ten firms, including Hutchin Hill, gathered about a third of that amount, investors in the funds said.
Assets Swell

Industry assets have swelled to a record $2.8 trillion even though funds, on average, have posted 7 percent annualized returns since the financial crisis, compared with 12 percent over the previous 18 years, according to the Chicago-based research firm.

Inflows are coming from pension plans, sovereign wealth funds and high-net worth investors. Some of the institutions, such as the Hong Kong Jockey Club, are making direct investments in hedge funds for the first time, rather than going through funds of funds. The club, which controls horse-racing in the city, said in April it gave money to Och-Ziff and Millennium.
Multistrategy Popularity

Multistrategy firms, which use a range of tactics to invest across asset classes are the most popular this year after collecting a net $29.5 billion, according to Hedge Fund Research. The funds returned 4.4 percent through July 31, compared with 2.5 percent for hedge funds overall.

“Pension funds see multistrategy hedge funds as a one-size-fits-all investment,” said Brad Balter, head of Boston-based Balter Capital Management LLC. “It’s very difficult right now to identify attractive opportunities, so they are letting the manager make the tactical decisions rather than wait for their own investment committees to re-allocate capital.”

Hutchin Hill, which employs more than 60 investment professionals, uses five main strategies, including equities, credit and one that makes trading decisions based on quantitative models.

Chriss’s goal is to provide better and more consistent returns than he might using just one approach. His background is in computers and math: He taught himself to program at age 11 and sold a video game to a software company when he was a high-school sophomore.
Lured Away

After obtaining his Ph.D. from the University of Chicago, he was lured away from a teaching job at Harvard University in 1997 to go to Wall Street. He set up his firm in 2007 after working for Steve Cohen’s SAC Capital Advisors LP with early backing from Renaissance Technologies LLC founder Jim Simons.

Hutchin Hill has gained 8 percent this year, according to a person with knowledge of the performance, who asked not to be identified because the results are private.

While firms like Hutchin Hill are beginning to climb the ranks of multibillion-dollar managers, the domination of the biggest funds in raising assets hasn’t slowed, even when they report bad news or post mediocre returns.

Och-Ziff, the biggest U.S. publicly traded hedge-fund firm with $45.7 billion under management, pulled in a net $3 billion into its hedge funds this year, even as it warned shareholders that the Securities and Exchange Commission and the U.S. Department of Justice were investigating the firm for investments in a number of companies in Africa. Its main fund returned 2 percent in the first seven months of the year, less than half the average of multistrategy funds tracked by Bloomberg.
Sovereign Wealth

Chicago-based Citadel, run by billionaire Ken Griffin, helped spark a backlash against multistrategy funds after it lost 55 percent in 2008, one of the worst hedge fund declines stemming from the financial crisis. Six years later, its $22 billion in assets have surpassed its previous peak in 2008.

Its main hedge fund, which is up 9.9 percent this year, has pulled in a net $1.2 billion in 2014, even though it’s limiting inflows primarily to sovereign wealth funds, according to an investor. The firm’s Global Fixed Income fund, run by Derek Kaufman, attracted $2.7 billion.

Millennium, founded by Israel “Izzy” Englander, has collected a net $2.6 billion this year, after only taking in enough money to replace client withdrawals in 2013. The New York-based firm, which manages $23.5 billion, decided to raise money again because it’s adding more teams to the 150 that currently work at the firm. The fund has climbed about 4.2 percent this year and has posted an annualized return of 14.6 percent since January 1990, said investors, who asked not to be named because the fund is private.
Balyasny Assets

The popularity of the multimanager, multistrategy approach that Millennium helped pioneer a quarter-century ago has been a boon to some smaller managers. Dmitry Balyasny’s Chicago-based Balyasny Asset Management LP attracted $1.5 billion this year, bringing total assets to $5.9 billion, while Jacob Gottlieb’s New York-based Visium Asset Management LP pulled in $700 million into its multistrategy fund this year, after raising $1 billion in 2013.

Event-driven funds, which include managers who take activist roles at the companies in which they invest, continue to attract investors this year as the strategy gained 6 percent through July.
Loeb, Solus

P. Schoenfeld Asset Management LP climbed to $4.1 billion in assets as clients invested a net $1 billion and Solus Alternative Asset Management LP attracted $1.25 billion. Dan Loeb’s $15 billion Third Point LLC, which is known for taking activist positions, had been closed to new investments since 2011 and returned capital last year. It recently told investors it would open Oct. 1 for a limited amount of capital that clients expect will be about $2 billion, they said.

A few start ups have also received a billion dollars or more this year, in part because they are coming out of firms with strong track records that are closed to new investments. Herb Wagner, who started FinePoint Capital LP this year and raised $2 billion, was a co-portfolio manager at Baupost Group LLC, the Boston-based firm run by Seth Klarman. Matthew Sidman opened Three Bays Capital LP, another Boston firm, in January and is now managing $1.2 billion. He worked at Jonathon Jacobson’s Highfields Capital Management LP for 14 years.

Spokesmen for all the firms declined to comment on inflows and performance.

Big Money Raisers 2014

Firm PM Net AUM
Inflows

Citadel Ken Griffin $3.9 bln $22.0 bln
Och-Ziff Dan Och $3.0 bln $45.7 bln
Millennium Israel Englander $2.6 bln $23.5 bln
FinePoint Herb Wagner $2.0 bln $ 2.0 bln
Balyasny Dmitry Balyasny $1.5 bln $ 5.9 bln
Solus Chris Pucillo $1.25 bln $ 4.6 bln
Hutchin Hill Neil Chriss $1.2 bln $ 2.5 bln
Three Bays Matthew Sidman $1.2 Bln $ 1.2 bln
Passport John Burbank $1.0 bln $ 3.9 bln
P. Schoenfeld Peter Schoenfeld $1.0 bln $ 4.1 bln
It looks like I'm going to have to update my quarterly updates on top funds' activity to include new funds and to reclassify others. For example, Visum used to specialize in healthcare stocks and Balyasny was a L/S Equity and global macro fund. Now they've rebranded themselves as multi-strategy shops because they see the potential of garnering more assets.

I suspect you'll see more and more funds rebranding themselves into multi-strategy shops to boost their assets under management and start collecting that all important 2% management fee on multi billions. The name of the game is asset gathering which is understandable but also troubling.

I like managers like Neil Chriss and think he has the potential of being another great multi-strategy hedge fund manager. I'm not worried about Ken Griffin or Izzy Englender as they have proven track records and still deliver great results despite their enormous size.

But I'm warning all of you, even these great multi-strategy shops are not immune to a severe market shock and most of them got clobbered in 2008 and some made matters worse by closing the gates of hedge hell. Of course, Citadel came back strong, as I predicted back then because most fools didn't understand why his fund was hemorrhaging money, but it doesn't mean that it can't suffer another major setback.

When you're investing with hedge funds, you really need to have a smart group of people who can drill down into their portfolio and understand the risks and return drivers going forward. Stop chasing returns, you'll get burned just like those who blindly chase the stocks top hedge funds are buying and selling.

By the same token, don't invest in hedge fund losers thinking they're going to be tomorrow's winners. Volatility in commodities is shaking up many hedge funds in that space and I expect this trend to continue. Some will adapt and survive but most will close up shop.

It doesn't matter which fund you're investing with, you've got to ask tough questions and grill these managers. If they start acting arrogant or cocky, grill them even harder. I mean it, don't be intimidated and don't fall in love some hedge fund manager because he's a billionaire and fabulously wealthy. Trust me, you're just a number to them and that's exactly what they should be to you.

Finally, while many of you are getting ready to write a big fat ticket to your favorite hedge fund manager, I kindly remind you that I bust my ass to provide you with brutally honest and frank insights, so take the time to click on the donation or subscription buttons on the top right-hand side. You simply aren't going to find a better blog on pensions and investments out there so take the time to show your appreciation and contribute.

Below, a CNBC panel discusses hedge funds with Onur Erzan, senior partner at McKinsey & Company. And Gregory Taxin, president of Clinton Group Inc., talks about hedge-fund investor Bill Ackman's plan to raise money in a public sale share this year of his Pershing Square Capital Management LP. Taxin speaks with Betty Liu on Bloomberg Television's "In the Loop.”

I've got an emerging manager up here in Canada who I think has the potential to be a really great activist manager if someone is willing to step up to the plate and seed him. I can't share details on my blog but if you're interested in discovering a real gem, email me at LKolivakis@gmail.com and I'll put you in touch with him. Enjoy your long weekend and please remember to contribute to my blog.



Thursday, August 28, 2014

What Will Derail the Endless Rally?

Gene Marcial of Forbes reports, Ride With The Bulls Even As Warnings Of A Big Correction Are On The Rise:
With the market’s major indexes continuing to climb to new all-time highs, investors are getting increasingly jittery about the incorrigible bears’ warnings that the huge correction they have been predicting is on its way. The selloff will signal the market has hit its peak, they assert. What to do?

Ride with the bulls — and face any pullback with enough cash firepower to buy the battered shares of fallen angels with proven track records. The proven antidote to a massive pullback is to embrace it and prepare to buy shares of companies that are fundamentally sound and equipped to thrive after a market pullback. The key is to be prepared – not by selling but to be an opportunistic buyer as prices plummet.

“The bears keep seeing market tops as the bull charges ahead,” notes Ed Yardeni, president and chief investment strategist at Yardeni Research. Even some of the bulls had warned about an imminent correction but instead, after a 3.9% drop from July 24 through Aug. 7, the S&P 5000 made a new record high on Monday, Yardeni points out.

But should perplexed investors really worry about the coming of a Big Correction? Not if you listen to savvy market watchers and analysts who recommend running with the bulls. True, the bull market is over five years old now, but Yardeni looks at it this way: “It seems to be maturing rather than aging. It is certainly less prone to anxiety attacks, and has treated buying dips as buying opportunities.”

Indeed, although the market continues to gain and treks to higher grounds, it appears more persistent in climbing walls of worries in the U.S. and overseas.

“While the bears continue to look for signs that the bull market is about to break up, I don’t see any significantly bearish divergences, or decoupling, between key internal stock indicators and the overall market,” says Yardeni. “It’s a well-adjusted bull,” is how Yardeni describes it.

The market’s technical picture looks particularly healthy, according to some veteran technical analysts. “The trend remains bullish and an extension above 2,000 (in the S&P 500) would favor a strong push higher into 2030, where we would expect some initial profit taking,” says Mark D. Arbeter, chief technical analyst at S&P Capital IQ. He notes that the S&P 500 has been in an uptrend within an ascending trend channel for the last few years.

So where is the index headed from here?

“The long-term outlook is pointed higher, while above support at 1,838 – 76. Only a drop below the lower trend channel boundary and support at 1,738 would substantially damage the structure of the big picture rally,” says the analyst.

And based on the fundamentals, the market’s outlook seem as positive, as well. “Indeed, the market may be feeding off of consensus expectations for a near 11% climb in yearly earnings-per-share growth through the second quarter of 2015, as compiled by Capital IQ,” says Sam Stovall, chief investment strategist at S&P Capital IQ. He sees the S&P 500′s “fair value around 2,100 a year from now, based on earnings per share growth forecasts, the expectation that inflation will remain around 2%, and that we get a meaningful digestion of gains along the way,” says Stovall.

Meanwhile, the bears aren’t getting much confirmation for their bearishness, notes Ed Yardeni – not even from the Dow Theory, which postulates that the Dow industrials and transportation groups should both be moving higher in a sustained bull market. Well, both the Dow Jones Transportation and the S&P 500 Transportation indexes rebounded to record highs in recent days, notes Yardeni.

Now that the S&P 500 is almost at our 2014 yearend forecast of 2014 for the S&P 500, well ahead of schedule, we remain bullish and continue to favor financials, health care, industrials and information technology.

These groups appear to be the stocks of choice for continued strength and stamina in this long-running bull market? As the S&P Investment Policy Committee sees it, the energy, health care, industrials, and information technology are the attractive sectors, which they recommend to clients to overweight in their portfolios. The committee rates the financial sector as “underweight.”
In my last comment on the real risk in the stock market, I discussed why I believe the real risk in the stock market right now is a melt-up, not a meltdown that many bears are warning about.

Admittedly, my thinking centers around the big picture, meaning there is an abundance of liquidity in the global financial system -- even if the Fed continues tapering -- and some risky sectors of the stock market are going to take off.  If the ECB finally engages in quantitative easing to combat the euro deflation crisis, it will unleash another massive dose of liquidity which will further bolster global equities and other risk assets.

Soon after I finished writing my comment yesterday, perma bear David Tice,  President of Tice Capital, came onto CNBC calling quantitative easing a "short-term economic fix" and warning that a 50% correction in coming. Abigail Doolittle, Peak Theories founder, also appeared on CNBC proclaiming that the range has started to reverse the QE 3 uptrend, and a major move down is coming.

Another perma bear, SocGen's Albert Edwards, wrote a note to clients warning the S&P is running on fumes:
With U.S Federal Reserve policy easing drawing to a close, Societe Generale's uber-bearish strategist Albert Edwards predicts that a bubble in stock markets is on the verge of bursting.

"Is that a hissing I can hear?" Edwards quipped in his latest research note, published on Thursday.

Edwards claimed the "share buyback party"—which some analysts see as the key driver for recent record Wall Street highs—was now over.

"Companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes," Edwards said.

Buybacks occur when firms purchase their own shares, reducing the proportion in the hands of investors. Like dividend payments, buybacks offer a way to return cash to shareholders, and usually see a company's stock push higher as shares get scarcer.

According to Societe Generale's research, share buybacks fell by over 20 percent the second quarter versus the first quarter. However, TrimTabs Chief Executive David Santschi said in a research note on Sunday that buyback announcements were "solid" as earnings season wrapped up.

Some firms borrow cash to buy back their shares, taking advantage of ultra-low interest rates in the U.S. and other developed nations. Edwards warned that as companies had issued cheap debt to buy expensive equity, a "gargantuan" funding gap could yet emerge.

"The equity bubble has disguised the mountain of net debt piling up on U.S. corporate balance sheets. This is hitting home now QE has ended. The end of the buyback bonanza may well prove to be decisive for this bubble," Edwards wrote.

Edwards is known for his markedly pessimistic predictions, and regularly touts the idea of an economic "Ice Age" in which equities will collapse because of global deflationary pressures.

Some analysts remain unconvinced. MacNeil Curry, head of global technical strategy at Bank of America Merrill Lynch, sees no imminent hit to equities. He predicts further upside for the S&P 500—currently near all-time highs—over the next few weeks, and sees the benchmark index reaching 2,050-to-2,060 points by late September.
Global deflation is coming and the bond market knows it, but Edwards is wrong if he thinks the S&P is running on fumes and won't continue to grind higher. Some of the riskiest sectors, like biotech, are booming again after a spring selloff. When the ECB starts engaging in massive quantitative easing, risk assets (and gold) will really take off.

Of course, nobody really knows where the stock market is heading. A million things can derail this rally and cause jittery investors to pull the plug and sell their stocks. But with pension deficits rising as bond yields fall, pensions will be forced to take on more, not less risk. And where will they be taking that risk? Stocks, corporate bonds and alternative investments like real estate, private equity and hedge funds.

I leave you with an interesting clip below. Charles Biderman, TrimTabs Investment Research CEO, analyzes current market conditions saying the market is essentially rigged and you have to "ride the tide." You sure do but make sure you're in the right sectors because some tides will be a lot bigger than others.

Wednesday, August 27, 2014

The Real Risk in the Stock Market?

Alex Rosenberg of CNBC reports, The strange dynamic that’s guiding stocks higher:
The S&P 500's surge past the 2,000 level this week for the first time ever is just the latest milestone for the great rally that stocks have enjoyed over the past 5½ years. But Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, doesn't think the latest splashy market headlines will do anything to bring in the many retail investors who have long been staying on the sidelines.

Individual investors are "still nervous, they're concerned," Silverblatt said on CNBC's "Futures Now" on Tuesday. "Even though we're into this rally over five years now, and they're getting very little if they're sitting in a bank or some alternatives, they are not moving back into the market." And he said the S&P's crossing of 2,000 won't lure retail investors.

After all, many small investors will not soon forget the market collapses of 2000/2001 and 2008/2009, which robbed them of their confidence in stocks. And in fact, the S&P has taken more than 16 years to get from 1,000 to 2,000—yielding a mere 6.2 percent annualized compound return, including dividends, from then to now.

So if that's the case, what explains the market's drumbeat of new highs? Silverblatt looks to the other key group in the market.

"On the other side you've got institutions, who are sitting in the market. They're reallocating somewhat, but they're not pulling out. These institutions appear to be more concerned with missing out on potential gains than the market declining."

"Both of these groups are just sitting tight," Silverblatt added. "And the market, in between, has taken small steps upward."

So what will shake the confidence of institutions or the reticence of retail investors?

"I'm not sure what kind of event, ... but it's going to be major," Silverblatt said. These two groups are "really difficult to move."
I'll tell you what I'm positioned for, a major melt-up in stocks, especially in biotech and social media sectors, which ironically are the two sectors Fed Chair Janet Yellen warned about. There will be a few more corrections along the way but they will be bought hard as we're fast approaching the "Houston, we have lift off!" phase of another historic parabolic move in stocks that will likely be the Mother of all bubbles.

Why am I so sure? Because there is unprecedented liquidity in the global financial system and the European Central Bank (ECB) is getting ready to crank up its quantitative easing to counter low growth and slowing inflation. Never mind Fed tapering, the baton has been passed to ECB President Mario Draghi, and there is plenty of liquidity to drive risk assets much, much higher.

And that scares the hell out of institutional investors, especially nervous hedge funds that are turning defensive on concerns over asset prices:
Equity long-short managers cut net exposures on average to 40%-45% from 50%, said Anthony Lawler, who manages portfolios of hedge funds at GAM.

Some managers are also using put options—the right to sell at a predetermined price—to protect against market falls, taking advantage of what some investors say is low pricing in these instruments.

Anne-Sophie d'Andlau, co-founder of Paris-based investment firm CIAM, bought puts at the end of June, citing market nervousness over the timing of a rise in U.S. interest rates and possible "negative surprises" in the European Central Bank's review of euro-zone bank assets, which is set to be completed later this year.

Ms. d'Andlau, whose fund is up 12.3% in the year to the end of July, said she was "not so confident on the direction of the market."

"Our analysis is that the current environment is more unstable on a macroeconomic level," she said. "You're buying puts for almost nothing."

Pedro de Noronha, managing partner at London-based Noster Capital, which runs $100 million in assets, has owned default protection on emerging-market sovereign debt for some time but recently sold some stocks and is holding more cash. He said he wanted "to make sure I have dry powder for a tough September/October. I see the market as offering very little value, and this is one of the times where the opportunity cost of sitting on the sidelines isn't so big."

But while funds have generally reduced their bets on rising prices, few believe that markets are in a speculative bubble such as the dot-com boom of the late 1990s, which preceded tumbles in stock markets.

"This isn't a greedy rally," said Chris Morrison, portfolio manager on Omni Partners LLP's Macro hedge fund, which made 5.8% in July as a call against U.S. small-cap stocks paid off. "I don't see people high-fiving. They're not saying 'get your moon boots, this stock is going to the moon.' It has been driven by a desperate need to earn a return."
This isn't a greedy rally? Maybe not but check out some of the monster moves in the biotech sector which are worrying some market watchers, and you'll see the beginning of the next major bubble brewing. And wait, Janet Yellen hasn't seen anything yet. By the time it's all over, she'll need a bottle of the next anti-anxiety biotech breakthrough to calm her nerves.

But be careful with all this bubble talk on biotechs and social media stocks. I happen to think we're at the cusp of  a major secular uptrend in these sectors and talk of bubbles just scares many retail and institutional investors away. I see plenty of great biotech stocks that have yet to take off and Twitter (TWTR) remains my favorite social media stock (it can easily double from here).

Which biotechs do I like at these levels? My biggest position remains a small cap biotech, Idera Pharmaceuticals (IDRA), a company that has revolutionary technology that is grossly underestimated by the market. But there are others I like a lot at these levels like Biocryst Pharmaceuticals (BCRX), Catalyst Pharmaceutical Partners (CPRX), Progenics Pharmaceuticals (PGNX), Synergy Pharmaceuticals (SGYP), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA).

The thing with biotech is there is a lot of hype which is why it's best to track the moves of top funds that specialize in this space. For example, Perceptive Advisors' top holding is Amicus Therapeutics (FOLD), a stock that has taken off in recent weeks. The Baker Brothers which focus exclusively on biotechs made a killing when InterMune (ITMN) got bought out by Roche for a cool for $8.3 billion earlier this week. I track their portfolio closely but be careful as all these biotechs are very volatile.

Big pharma is hungry for the next big blockbuster drugs. Just like big hedge funds, they are large and lazy, so they'll be looking to gobble up smaller and more productive biotech players which are actually discovering amazing drugs which are more specific and have less side-effects.

But it's not just about biotech and social media. The big deal earlier this week was Burger King's (BKW) acquisition of Tim Hortons (THI), sending both stocks way up. Hedge fund manager Bill Ackman, who runs Pershing Square Capital, had a huge payday on Monday, cementing his top spot among large hedge funds this year.

And maybe there won't be any parabolic move in stocks, just a slow, endless grind up. One pro who appeared on CNBC earlier this week said we're only 5 years in a 20-year bull stock market:
As the S&P 500 topped 2,000 for the first time Monday, Chris Hyzy said that the stock market is just five years into a 20-year bull market.

"I know it sounds easy to say," U.S. Trust's chief investment officer said on CNBC's "Halftime Report." "When you really think about this, this is an elongated business cycle. You're going to have fair value through most of it. You're not going to get a lot of overvaluation."

Hyzy identified what he saw as key for the continued bull market.

"You're going to have some very big opportunities inter-sector and themes. M&A is running wild. But the key to all of this is the manufacturing in the next decade," he said. "It's already happening. You've got energy independence on its way. The private sector's piercing through whatever restrictions are being put out there, and you've got technological advancement that we haven't seen since the early 1990s.

"That sets us up for an elongated business cycle, which is about five years into a pretty long secular market."

Hyzy, who expects GDP growth of 3 percent to 3.25 percent for the United States this year, said that he liked the financial sector best of all, with selected technology and oil-service plays.

Europe, he added, resembled Japan at the outset of its 20-year deflationary spiral. With credit growth contracting, weakness in Germany and French bond yields below that of the U.S., European Central Bank President Mario Draghi "has to act at some point, and it's a little too late."

"I would argue that the first movement on QE in Europe is a good thing for low-quality assets," Hyzy said. "You'll get the big rally. And then you'll levitate for a while if growth doesn't get there."
Are we only 5 years into another 20-year bull cycle? I doubt it but with bond yields at historic lows, stocks are the only real game to play but you have to pick your spots right or you won't make money.

That's why it's increasingly important to really drill down and understand the portfolio moves of top funds. Ignore Goldman Sachs' top fifty stocks hedge funds are shorting like crazy or the top fifty hedge funds love the most. Most of the time, you're better off taking the opposite side of these trades, and the Goldman boys don't tell you the top fifty stocks hedge funds should be buying going forward (like Twitter!).

There is a lot of garbage out there, stock market porn, and it's no wonder very few retail and institutional investors make money actively managing their portfolios. And it's not just about picking stocks right, you got to get the macro calls right, which very few people seem to be doing.

Just yesterday, I watched and interesting interview with Ambrose Evans-Pritchard posted on Zero Hedge (see below). I agreed with him that the U.S. will remain the economic superpower over the next century but was baffled by his call that rates will rise because "wage pressures" will pick up significantly.

I've said it before and I'll say it again, after we get a huge liquidity driven spike in stocks, we'll see asset prices across public and private markets deflate and a long period of deflation will settle in. There is simply too much debt out there and it won't end well (listen below to Chris Martenson's interview with Hoisington's Lacy Hunt to understand why).

But remember the wise words of John Maynard Keynes, "markets can stay irrational longer than you can stay solvent." The events I'm describing above won't happen in the next year or even five years. So while the Zero Hedge bears keep posting scary clips, relax and mark my words, the real risk in the stock market is a melt-up, not a meltdown, and institutions betting on another crash will get clobbered.


Tuesday, August 26, 2014

The Myths of Shared-Risk Plans?

Hassan Yussuff, President of the Canadian Labour Congress, wrote a special for the Financial Post, Why there’s no benefit in target benefit pensions:
So-called ‘shared risk’ plans have nothing to do with sharing

Every child grows up learning the importance of sharing. It’s also fundamental to the labour movement. Unions bargain with employers to ensure that workers share in the fruits of their labour. This makes for a stronger, stable economy and a fairer society.

Sharing is also at the heart of workplace pensions. Part of the wages and salaries that unions bargain get deferred until retirement, in the form of pensions. When our negotiated pension plans experience funding shortfalls, as they have in the last six years, unions have stepped up and agreed to pay more into the pension fund, even temporarily cutting back on benefit levels. In return, unions expect that employers will live up to their commitments and pay retirees the pensions they’ve earned over a working lifetime – the essence of the defined-benefit (DB) pension deal.

Even as our pensions return to health, however, employers are looking for ways to rid themselves of the cost and headache of pension plans altogether. And the federal government is lending a hand. In April, the federal government announced that it is proposing target-benefit plans or so-called “shared risk” pension plans in the federal private sector, and for Crown corporations.

In fact, so-called “shared risk” plans have nothing to do with sharing. Let’s look at some of the myths around these plans:

Myth 1: “Shared-risk” plans split the risk and rewards between employers and employees.

These plans don’t “share” risk; they dramatically reduce employers’ risk by shifting it onto plan members and pensioners. Employers would enjoy cost-certainty and strict limits on future risk, while plan members face an open-ended risk of benefit cuts, even when retired. Employers converting their existing DB plans would be able to turn promised pension commitments (once a legal obligation that could not be revoked) into fully reducible “target benefits” that may or may not be delivered.

Myth 2: “Shared-risk” plans strike a balance between worker-friendly DB plans and the defined-contribution (DC) plans that employers prefer.

For employers, switching to a “shared-risk” plan brings significant advantages: Employer contributions are capped, no pension guarantees of any kind are made to employees, and no pension liabilities appear on the employer’s financial statements. Plan members, however, experience a massive loss of security: The legal protection for already-earned benefits is taken away, and everything can be reduced, including pension cheques being mailed to retirees.

Myth 3: If benefits are reduced in a “shared-risk” plan, they will only be temporary reductions.

In fact, there is no requirement in a “shared risk” plan that benefit reductions only be temporary. Permanent benefit reductions are indeed a possibility in this model. This means, absurdly, that temporary shortfalls in the plan could lead to permanent reductions in benefits.

Myth 4: The “shared-risk” plan is a hybrid, in which some benefits are guaranteed and some (like inflation protection) are conditional.

Not true. There are no legal benefit guarantees of any kind in “shared risk” plans. All benefits (whether basic pension benefits, or additional benefits like inflation indexing) can be legally reduced without limit.

Myth 5: Unions have embraced the “shared-risk” model.

The vast majority of unions do not support the conversion of DB plans into “shared-risk” plans. Faced with the distinct possibility that their pension plan would be wound up, a small number of New Brunswick bargaining units supported “shared risk” plan conversions for a few severely-underfunded pension plans. By contrast, “shared risk” conversions are now being proposed for healthy and sustainable pension plans, across the country.

The fact of the matter is that the “shared-risk” approach is about one thing: reducing employers’ risk and cost. But Canadians cannot allow the conversation to be restricted to just employers’ costs. We have to talk about adequacy and security of retirement income, and in that respect, we’re not making progress. Access to pensions at work continues to dwindle as a share of the working population, and a growing number of families face a retirement plagued by financial insecurity.

Over 60% of working Canadians have just one pension plan at work: the Canada Pension Plan or the Quebec Pension Plan. These plans are truly shared, paid for equally by employers and employees. The Canadian Labour Congress calls on the federal government to expand the Canada Pension Plan and Quebec Pension Plan. The government’s misguided shared-risk initiative will only further undermine the retirement security of Canadians.
In my last comment on whether Quebec is pulling a Detroit on pensions, I argued that it's about time Quebec tackles its pension deficits and introduces real risk-sharing in their municipal and other public pension plans.

In his comment above, Mr. Yussuff argues that shared-risk plans have nothing to do with sharing and only benefit employers, while severely undermining the retirement security of employees who could potentially face "permanent" cuts to their retirement benefits which they are legally entitled to.

Is Mr. Yussuff right? Yes and no and let me explain why. I went over New Brunswick's pension reforms and followed up in another comment where I revisited these reforms, discussing why Bernard Dussault, the former Chief Actuary of Canada working for the Common Front, thought New Brunswick's shared-risk was nothing more than risk-dumping:
  • although not properly identified and designed in Bill C-11, the proposed increase in PSPP members’ contribution rates and the proposed increase from 60 to 65 in the age at which PSPP members become entitled to a normal (unreduced) retirement pension, respectively, are the only areas of remedies that are relevant to the unfavourable financial findings identified in the April 1, 2012 actuarial report on the PSPP;
  • it is unfair, as it does make pension indexation, both active and pensioned members, dependent upon the ongoing financial experience of the PSSA through the use of inappropriate actuarial and accounting mechanisms that properly account for indexation in the contributions and assets of the PSPP but not at all in its liabilities;
  • it fails to show the proportion of the PSPP cost that will be shared by active PSSA members; and
  • it is too complex, which was publicly acknowledged by the Minister of Finance, as he did himself publicly stated that he does not fully understand it, and as its implementation, management and day to day administration would be an overly expensive and intricate endeavour.
In this case, I agreed with Bernard, there were irregularities in the terms for pension indexation and what proportion of the PSPP cost will be shared by active PSSA members.

But that doesn't mean that shared-risk plans should be scrapped because they are inherently unfair to employees. This is pure rubbish and I have a bone to pick with Mr. Yussuff and the Canadian Labour Congress for spreading some blatant lies and falsehoods in the comment above.

A perfect example of a defined-benefit plan that is fully-funded and has implemented a shared-risk model is the Healthcare of Ontario Pension Plan (HOOPP). In fact, HOOPP is now overfunded and looking at ways to increase benefits to its members, which can include cuts in contributions or better indexation. In this case, shared-risk doesn't mean risk-dumping on employees; it goes both ways.

Another example is the Ontario Teachers' Pension Plan (OTPP), which has also adopted a shared-risk model with its members. For all effective purposes, OTPP is fully-funded, which is quite remarkable given the Oracle of Ontario uses the lowest discount rate in the world among public pension plans to discount its future liabilities.

But both these plans did implement some forms of risk-sharing in the past to temporarily deal with their shortfalls when times were tough. In particular, they temporarily cut the cost of living adjustments to members for a period of time until their plan became fully-funded again.

In doing so, both employers and employees benefited because the contribution rates stayed the same. Pensioners temporarily suffered a marginal cut in cost of living adjustments but it wasn't a huge or permanent hit to their benefits.

There is another problem with Mr. Yussuff's comment, one that really irks me. Sometimes I feel like these unions live in a bubble, completely and utterly oblivious to what is going on in the private sector and completely clueless about how unfunded liabilities are a debt and can severely impact a country's debt rating. And he completely ignores the demographic shift and the rising challenge of measuring and managing longevity risk.

Once again, let me go back to what happened in Greece. In order to avert a full default, which would have been catastrophic to Greece and spelled the end of the eurozone, Greece had to accept savage cuts in wages and pensions forced upon them by troika which represented bondholders.

And in Greece, public employee unions were living in a bubble, completely oblivious to the plight of the private sector and the economic realities of a country living way beyond its means. What happened? The private sector in Greece had to borne the brunt of the savage cuts and only later did public employee unions succumb and accept cuts to pensions and wages.

But till this day, hardly any public sector employee in Greece lost their job. Sure, their wages and pensions were cut in half or by two-thirds, but the massive unemployment that Greece experienced in the last few years was all in the private sector. This is where troika and the bondholders really screwed things up with their myopic and idiotic austerity measures. When 50% of the Greek working population has a public sector job with the benefits that go along with these jobs, there is a serious problem. The cuts should have been in the public sector, not the private sector.

Anyways, don't get me started on Greece and troika, my blood boils. Let me get back to Canada and Mr. Yussuff's comment above. I think he's intentionally exaggerating his points and spreading lies and falsehoods to make public sector employees be the victims of shared-risk plans, but this is pure rubbish.

One area where I do agree with Mr. Yussuff and the Canadian Labour Congress is that it is high time the boneheads in Ottawa enhance the CPP for all Canadians, regardless of whether they work in the public or private sector.

I have a vision for Canada's retirement security. In my ideal world, OTPP, HOOPP, AIMCo, OMERS, Caisse, bcIMC, and other large public and private defined-benefit pensions will be working for all Canadians, just like CPPIB is doing right now. It's akin to what they have in Sweden where you have a series of large, well-governed state plans serving all Swedes but even better because the Swedes didn't get everything right.

In my ideal world, you'll have true shared-risk among all Canadians and the benefits that go along with that. There will be pushback by some banks, mutual funds and insurance companies but in time, even they will see the benefits of this approach which brings true retirement security and pension portability to all Canadians.

Below, Angela Mazerolle, Superintendent of Pensions and Superintendent of Insurance at New Brunswick's Financial and Consumer Services Commission, shares insights from her session "Shared-Risk Pension Plans" while at the International Foundation's 46th Annual Canadian Employee Benefits Conference in San Francisco. Listen to her comments and keep an open mind on share-risk plans, they aren't as bad as Mr. Yussuff claims.

Monday, August 25, 2014

Quebec Pulling a Detroit on Pensions?

Don Pittis of CBC reports, Workers not to blame for Quebec pension problem:
A deal's a deal, right? Well, not when it comes to the province of Quebec and the pensions of its municipal employees.

And if Quebec gets away with cutting municipal worker pensions, which have been eaten away through mismanagement by the very people doing the cutting, then watch this phenomenon spread.

Quebec is pulling a Detroit. About a year ago, I pointed out that the shattered dreams of Detroit pensioners should be a warning to the rest of us. But unlike Detroit, Quebec is trying to snatch back promised pension money by fiat through its proposed Bill 3 pension reform legislation, without the inconvenient legal process of bankruptcy.

To read many of the stories about these Quebec pension cuts you would think that it was the pensioners' fault. The same kind of thing happened in Detroit. Outraged taxpayers inveigh against government employees for sucking money out of the public purse for a cushy retirement. It's as if by choosing a job with a pension and keeping to their side of the contract, the workers are taking advantage.

"Right now, municipalities are taking all of the risk on the payouts and employees are taking relatively none of the risk," said economist and McGill Professor Brett House on CBC's Montreal's radio morning show.

Such comments anger Bernard Dussault, the architect of the Canada Pension Plan and former Chief Actuary for the Government of Canada. The CPP is well known around the world because, unlike many government plans, it is properly funded and can pay out forever (as I've mentioned before, the flaw with the CPP is the actual payout is too small, barely covering rent in many Canadian cities). In fact, this week the chief executive of Hong Kong's social services said he is studying CPP as a model for the reform of the territory's pension system.

As an actuary, Dussault is a sort of super statistician who studies lifespans, average investment yields and the cost of risk. He says that if you do your calculations right, update them frequently and set enough money aside, there is almost no risk involved with pensions.

He says "risk" is not the reason Canadian pension plans are facing problems, and he points out that Quebec is not an exceptional case.

"There are plans with problems all across Canada," says Dussault.

In every case, he says, the problem is a simple failure to set enough money aside.

Many blame the market crash of 2008 for shortfalls in pension plan investment returns. Dussault agrees that was a setback, but adds that it's a weak excuse, because as I write this the Toronto stock exchange has just hit another all-time record high. Yes, it's higher than the peak before the crash. And any pension contributions invested since the crash have seen extraordinary gains.

That assumes, of course, that the pension plans have collected enough money in contributions from both employer and employees, and have actually invested it. And therein lies the flaw.

In Quebec's case, the pension deficit can be traced back, in part, to a previous attempt to balance the province's books. Back in the nineties, Quebec downloaded hundreds of millions in costs to the municipalities. To help them deal with those expenses, since pension plan investment returns were strong at the time, municipalities were permitted to take a pension-contribution holiday.

Brett House agrees that pension holidays were a mistake, and regular contributions should have continued. "By any historical measure, those were exceptional surpluses that should have been saved rather than disbursed."

Actuaries know that even if things look really good one year, that only makes up for other years when things look really bad.
In the dark

And unless they did some serious homework, the workers wouldn't even know the pension pot wasn't full.

Their monthly contributions would come off their paycheques. They would get periodic pension statements showing their accrued benefits based on the promises in their contract, but the accounting in those documents was imaginary. By this year the province, which is ultimately responsible for municipal debts, was in the hole by almost $4 billion for municipal pension deficits.

Just like Detroit, just like the car companies, Quebec and its cities negotiated these pension contracts with their unions with their eyes wide open. Now they are planning to walk away from those deals. Years after you've signed a deal with the bank you can't go and say, "You charged me too much for my mortgage; I'm taking it back." Try it and see what happens. But that is what the province is saying to city workers.

And in their negotiations for improved pensions, the workers traded away other benefits, like better pay. "We’d rather have taken our salary raises," says the head of the Gatineau police union.

"It is terrible because it is stealing money that has already been accrued," says Dussault.

He adds that Canada has a good financial reputation because it regulates banks, insurance companies and pension funds.

"So now we allow pension plans to renege on their obligations," he says. "We will next allow banks and insurance companies to renege on their obligations?"

Dussault points out that Quebec is not the first to take away pensioners' accrued benefits. New Brunswick did the same thing and pensioners are still not happy about it. And he says if Quebec succeeds, it won't likely be the last.

Perhaps the most underfunded pension plan in the country belongs to the federal government. Federal employees have pension contributions deducted and they go into a "fund," but that fund is based on what Dussault calls "notional bonds." Essentially, the contributions are on the government's books, but they go into general revenue and no outside assets are purchased to cover them — ultimately the payment to the pensioner will come out of future general tax revenue.

"All this accounting is theoretical. It is not real money," says Dussault. "I don't see the federal government reneging on its obligations, but there are more and more pressures. And that frightens me."

Despite the theoretical accounting, Canada's federal government more or less has its financial house in order. But as we saw in Detroit, other governments — and many companies — have shown a willingness to hide disturbing amounts of financial trouble by sweeping it under the carpet of pension deficits.

It may be a painful process, but it appears that Quebec workers will be forced to negotiate a new pension deal. As they do so they should study other arrangements, such as the Ontario municipal pension fund OMERS and the Ontario Teachers Pension Plan. Those pension plans are fully funded and about as well managed as any pensions anywhere.

The difference? It's certainly not risk. They were exposed to the same market crash as everyone else.

What is different is where the money goes and who manages it. Contributions from both the employees and employer go straight into a fund. No notional bonds. No deficits. No promises to pay later.

And the fund is invested and controlled by the employees. The only way the government will get that money back is in the income tax those pensioners pay as they live out a comfortable retirement.
In her article, Ingrid Peretz of the Globe and Mail reports, Quebec pension status quo ‘no longer option’ says Montreal mayor Coderre:
Montreal Mayor Denis Coderre said he would “never give in to thugs” as the province’s political leaders appeared ready to take on restive public-employee unions over Quebec’s controversial pension-reform plans.

Hearings into the Liberal government’s pension legislation opened in Quebec City against a backdrop of heightened security and noisy street protests by municipal workers furious about the bill.

As employees protested outside, Mr. Coderre and the mayor of Quebec City, Régis Labeaume, both outspoken proponents of the pension changes, said taxpayers couldn’t keep sustaining the current pension regime.

“The status quo is no longer an option,” Mr. Coderre said. “We’re now confronted with a financial reality we can no longer ignore.”

Pension costs in Montreal have more than quadrupled since 2002 and now eat up 12 per cent of the municipal budget, the mayor said. Mr. Coderre said he was open to compromise with the unions but wouldn’t countenance the rowdy spectacle that unfurled at City Hall Monday night, when protesting firefighters and other municipal employees surged into the historic building and littered it with papers and other debris.

“The last few weeks have been hectic and even emotional for many people,” Mr. Coderre said. “But now, time has come to work together.”

The pension legislation, Bill 3, seeks to have municipal employees in Quebec assume a larger share of their pensions by requiring workers and cities to split the cost of covering their plans’ $4-billion deficit.

The proposal has morphed into the first major test for Premier Philippe Couillard, who has made belt-tightening a byword of his four-month-old government. He has vowed to stand firm on pension reform.

As expected, unions are up in arms over the proposals. Serge Cadieux, secretary-general of the Fédération des travailleurs du Québec, told the hearings Wednesday the bill was inequitable, set a bad precedent and was probably unconstitutional.

City unions in Montreal have never shied from a forceful fight with their bosses. Blue-collar workers have a track record of militancy: A former, high-profile union leader, Jean Lapierre, appeared at a demonstration in Montreal on Wednesday to announce that protest actions would get more “radical” and this was “only the beginning of hostilities.” Police officers in camouflage pants and fire trucks plastered with stickers have become routine in labor conflicts.

But it’s unclear whether the public will side with the unions this time. Several observers say Monday’s vandalism at City Hall may have cost the unions some public sympathy; police officers were seen on site standing by without reining in the rowdy demonstrators.

The head of Montreal’s police union, Yves Francoeur, defended his members on Wednesday, saying they never got the green light from senior officers to step in and carry out crowd control. Even after the boisterous mob had entered City Hall, police sought the go-ahead from their superiors to do their job, Mr. Francoeur said. But the rank-and-file officers were told no, because city hall had not requested police intervention. Mr. Francoeur referred to the incident as a “comedy of errors.”

Hearings into Bill 3 continue on Thursday.
There is a lot to cover in these articles. First, let me agree with Bernard Dussault, Canada's former Chief Actuary, Quebec's pension deficits were exacerbated by the 2008 crisis, but the real problem can be traced back to balancing the books by neglecting to top up pensions. These "contribution holidays" sounded good at the time because markets were roaring and interest rates were much higher, so many pension plans had surpluses instead of deficits.

However, contribution holidays ended up being a disaster for many Quebec, Canadian and U.S. plans. In fact, fast forward to 2014. While stocks and other risk assets pensions invest in (like corporate bonds) have soared to record highs in the last five years, interest rates keep declining to historic lows, and that spells trouble for pension plans.

Why? Because the decline in interest rates is a much more important factor in terms of impact on pension deficits than soaring asset prices. And if rates keep falling because global deflation takes hold, watch out, asset prices and interest rates will tumble, and pension deficits will explode throughout the world (like 2008 only much worse because it will last a lot longer).

Why is the decline in interest rates a bigger factor on pension shortfalls than soaring asset prices? Because future liabilities on pensions are typically discounted using market rates and if interest rates decline, pension deficits widen even if stocks and corporate bonds are doing well. In finance parlance, the duration of pension liabilities is a lot longer than the duration of pension assets, so a decline in interests rates will disproportionately impact liabilities a lot more than a rise in asset values. 

This is where I part ways (somewhat) with my good friend, Bernard Dussault. Given where we are now in 2014, and given the immense risks of global deflation that I see ahead, I'm not at all comfortable with the current risk-sharing aspects of Quebec's pension plans and have expressed my concerns here and here.

In my opinion, if Quebec doesn't slay its pension dragon once and for all, it will head the way of Greece where bond vigilantes rammed through savage cuts on public (and private) pensions and wages.

This is very important and I want people to fully comprehend the point I'm trying to convey here. Quebec is a lot richer than Greece but there are eery parallels in the way public finances have been mismanaged between the two and the insane power that public employee unions hold. In fact, one of my friends is dead serious when he warns me: "Mark my words, when the shit hits the fan, Quebec is the next Greece."

This might sound crazy but to those of us who know Greece and Quebec very well, there were a lot of promises made over the last three decades to buy votes from public employee unions, and everyone knew these promises cannot be kept in the future. But politicians being politicians were only thinking of gaining political power, not the powder keg they were creating in the future.

It's nice to retire at 55 or 60 after 30 years of working with a guaranteed pension till you die but is it affordable and realistic? These promises were made at a time when the demographics were favorable to pension plans, ie. when you had more active workers relative to pensioners and people weren't living as long as they do now. This is no longer the case. As the baby boomers retire, we will see a lot more pensioners relative to active workers and these pensioners are living longer. The ongoing jobs crisis plaguing the developed world will only exacerbate this trend.

Of course, it's not all driven by demographics because the reality is that investment gains in well governed defined-benefit plans account for 2/3 of most pension pots, and only 1/3 comes from employee and employer contributions. 

So what do we need to do now? We need to consolidate many municipal and city plans in Quebec to create a new municipal employee retirement system akin to OMERS in Ontario.Then we need to implement world class governance, adopting best practices from around the world, not just Canada.  Lastly and most importantly, we need to implement real risk-sharing so employees and employers share the risks of these plans equally so taxpayers don't foot the bill if pension deficits explode.

If you look at most fully-funded pension plans in Canada, whether it's HOOPP, Ontario Teachers or CAATT, the employees and employers share the risk of their plan. This means, if markets go sour, they implement measures to reduce the pension deficit by increasing contributions or decreasing pension benefits (like cost-of-living adjustments).

This is where a funding policy is critically important. I recently discussed PSP"s funding policy, going over some of the problems mentioned above with the federal government's pension plans. It's not yet clear what the federal government will do but my advice would be to have PSP manage the assets and liabilities accrued before 2000 of these federal plans and adopt risk-sharing measures. If that happens, the funding policy will be even more critical.

I know this is a long comment and pensions are an emotional subject for many people who have contributed to their pension plan over many years and expect the pension promise to be delivered. But the pension chicken has come home to roost, not only in Quebec but all around the world. 

I agree with Denis Coderre and Philippe Couillard, pension reforms cannot wait. If public employee unions don't sit and negotiate some form of risk-sharing in good faith, there will be a day of reckoning for pensions, and when it comes it will be too late. The bond vigilantes will impose savage cuts on public pensions and wages just like they did in Greece.

I'm not being a scaremonger here. I'm being brutally honest. While I agree with many of the comments of Bernard Dussault, the economic and political reality is that pension reforms cannot wait any longer. I'm all for defined-benefit plans but you have to get the governance and risk-sharing right or else they are doomed to fail spectacularly.

If you have any comments, feel free to email me at LKolivakis@gmail.com. Please remember to contribute to this blog via PayPal at the top right-hand side. I thank the institutions that have contributed and ask many more to do so.

Below, as Quebec workers vow to keep up the pressure over a proposed increase in their pension costs, I embedded an older clip where thousands of Greek pensioners have taken to the streets of the capital Athens to protest against government cuts to their income.

If you think this will never happen in Quebec or Canada, you're dreaming.  When the money runs out, Quebec and the rest of the world will head the way of  Detroit and worse still, Greece where savage austerity measures have been imposed by the bond vigilantes.

Of course, I agree with France's economy minister, German austerity is not the answer and it will only exacerbate the euro deflation crisis. It's time for Quebec, Canada and the U.S. to implement real pension reforms before we reach a critical point of no return, leaving the decision up to bondholders.

Wednesday, August 20, 2014

Leverage Spells Headline Risk for SDCERA?

Dan McSwain of U-T San Diego reports, Leverage spells headline risk for pension fund:
By tradition, a public pension fund is safe and boring.

If you run one of these multibillion-dollar funds, replacing a lost benefit check should be your biggest problem on any given day. Same goes for taxpayers who support the pension system, and retirees who depend on it.

Here’s what you don't want: A front-page article about your fund in The Wall Street Journal.

Yet that’s precisely where San Diego County’s fund landed Thursday morning, as it has on many U-T San Diego covers in recent years.

Here’s how Journal reporter Dan Fitzpatrick described the situation: “A large California pension manager is using complex derivatives to supercharge its bets as it looks to cover a funding shortfall and diversify its holdings.”

That sounds neither safe nor boring.

Until the 1980s, when pension managers began adding stocks to portfolios, most funds were restricted to ultrasafe government bonds. But by the 2000s, many had added hedge funds, commodities, private equity and other alternative investments.

Now fund managers are reconsidering whether the returns have justified the additional risk. On Monday, The Wall Street Journal reported that managers of CalPERS, the nation’s largest fund, are considering a move away from alternatives.

The trend leaves San Diego County increasingly alone at the cutting edge of complexity.

And this story isn't over, because members of the fund’s governing board face important decisions about how their manager will make highly leveraged bets.

In April, the fund’s governing board voted unanimously for a new investment strategy.

Under the previous strategy, the county fund was among the nation’s most aggressive in its use of leverage. The board allowed investment strategist Lee Partridge of Houston to effectively borrow 35 percent of the fund’s assets for bets on Treasury prices.

But now, as of July 1, Partridge has a green light for 100 percent leverage, according to Brian White, the fund’s chief executive.

Put another way, Partridge can leverage the county’s $10 billion retirement fund, using derivatives, to place at least $20 billion at risk in stock, bond and commodities markets.

I use the term “at least” advisedly, because board member Richard Vortmann estimated at a July 17 board meeting that the actual leverage could easily approach 150 percent.

Partridge didn't correct him. Nor did officials with Wurts Associates, the independent consultant hired to monitor the fund’s risk management.

Given the history of spectacular collapses of leveraged investment funds, why does the county use such complex financial tools?

Because it needs money.

Partridge and Wurts have forecast average annual returns of about 6 percent over the next decade, using a traditional investment portfolio of 60 percent stocks and 40 percent bonds.

This would be very bad news for the county’s fund, which assumes it will earn at least 7.75 percent a year to meet retirement obligations.

For perspective, the fund’s actuarial debt to its members increased 4.7 percent last year to $2.45 billion — mostly because its portfolio earned 7.73 percent. Cutting returns to 6 percent could add billions to its liability.

So the fund’s board, in the clearest terms possible, has instructed Partridge to boost those returns. His strategy, stated explicitly in public meetings, is increasing risks to the pension fund — using leverage — to raise returns.

“We’re trying to bring up the risk, not keep the return and dial down the risk,” he said in April.

To be clear, Partridge and Wurts officials say there are plenty of circuit breakers built into the strategy to prevent the entire fund from disappearing.

However, large “downdrafts” are possible, Partridge said. Such losses could very well equal those of a traditional pension fund, which holds 60 percent in stocks and 40 percent in bonds, he said.

At its Sept. 18 meeting, the board could approve an “investment policy statement,” a document following the April decision that is supposed to define the fund’s complex strategy.

The effort has not gone well. In July, the board rejected the 18th draft of this key document.

What’s been missing is much discussion of the fund’s headline-grabbing history with leverage.

In 2001, the San Diego County Board of Supervisors approved a 50 percent increase in lifetime benefits to retirees, instantly creating $1.4 billion in debt for the pension fund, which was worth $3.7 billion at the time. The board then borrowed $900 million.

In 2006, an $87 million county investment collapsed after a young trader at a “multistrategy” hedge fund lost $6 billion in a week. Then, in 2008, the county’s portfolio lost 25 percent of its value, much of it on leveraged equity hedge funds.

Like most funds, the county’s has bounced back, earning an average 9.7 percent a year since 2009.

But the board's fondness for risk is still earning it headlines.
Last year the fund sent three board members to a training session in Hawaii, where one of the sessions was called “Avoiding a Front Page Scandal at Your Pension Fund.”

Perhaps they weren't taking notes.
Brian White, SDCERA's CEO, responded to these claims in a comment published in U-T San Diego,  SDCERA uses smart investment strategy for pension fund:
Recent media coverage of the San Diego County Employees Retirement Association (SDCERA) has suggested its retirement fund’s portfolio managers have recklessly pursued riskier investments in pursuit of higher returns to close the pension funding gap. In fact, nothing could be further from the truth. SDCERA is answering the real concern impacting public pensions by using tried and true principles of asset liability management and diversification, and not relying heavily on more volatile equities to close this gap.

The fund is responsible for paying the retirement benefits for thousands of individuals, and has done so consistently since 1939. SDCERA’s administration of the retirement contributions and the fund’s investment earnings have pre-funded 80 percent of the assets necessary to pay for members’ promised future benefits. SDCERA’s Board of Retirement, which includes county representatives, active employees, and retirees, monitors the risk in the portfolio and periodically adjusts the strategy to account for changing macroeconomic and market conditions.

For the past decade, San Diego County and its employees paid 100 percent or more of their annually required contribution to the SDCERA retirement fund. Consistent employee and employer contributions over the years have laid a foundation for investment gains and asset growth. SDCERA’s investment strategy helps the employer’s budgeting process and stabilizes employer costs by reducing the volatility of returns and steadily achieving the rate of return needed to fund the benefit.

At $10 billion, the SDCERA fund is able to pursue certain investment strategies that larger plans like CalPERS cannot access and smaller plans do not have the resources to deploy. SDCERA’s investment strategy is purposely designed to be no riskier than traditional pension fund asset allocation strategies. Risk-parity and trend strategies, which utilize leverage, are limited to 25 percent of the SDCERA portfolio, not the entire set of portfolio assets. The other 75 percent of the portfolio is managed using traditional asset allocation and rebalancing approaches.

SDCERA focuses on controlling the volatility of the investment portfolio and diversifying across a range of investments suited for a variety of economic environments. The use of leverage is a useful and effective tool that allows us to increase exposure to diversifying assets while reducing exposure to more volatile assets like equities. Different portions of the portfolio have different levels of risk, all of which together contribute to a diversified fund designed to moderate risk over the long term across different economic conditions.

SDCERA utilizes leverage in an attempt to obtain superior risk-adjusted returns and long-term, prudent growth through diversification, not to achieve higher returns or reduce funding shortfalls. This point has been discussed in public at many SDCERA board meetings since before the initial adoption of the strategy in October 2009. At that time, SDCERA adopted an investment strategy with the objectives of diversifying the portfolio across a wide range of economic scenarios; managing exposure levels to various asset classes more dynamically to maintain predetermined risk and diversification targets; and adopting a more conservative approach, as measured both by the variability of returns and by the reduced likelihood and potential magnitude of a significant loss of capital. With this investment strategy in place, SDCERA’s portfolio has performed as expected — preserving capital in difficult markets and generating strong returns in up markets.

Of course, no investment program offers guaranteed success, and as shown throughout history, drawdowns can have an enormously negative impact on the overall financial health of an investment program. With these important considerations in mind, SDCERA’s board adopted an asset allocation designed to serve the dual objectives of maximizing the fund’s likelihood of meeting its return objective while minimizing the risk of significant loss. This is clearly much different from using leverage to increase risk in an ill-conceived pursuit of higher returns. This change was adopted by a unanimous vote of SDCERA’s board after months of public discussion, consideration of a wide range of options, and stress-testing in various economic conditions.

SDCERA’s meticulous risk management is the opposite of “gambling” — it is prudent governance. Managing risk exposure has been a long-standing practice at SDCERA, and one that continues in the fund’s current investment strategy. This context is crucial to fully understanding SDCERA’s approach to portfolio management.
Last week, I posted a comment on how some pensions are using more leverage to combat pension shortfalls, discussing SDCERA's use of leverage. Following my comment, Doug Rose, a former trustee at SDCERA (served from 2002- June, 2014) and a long time reader of my blog, shared these comments with me:
It’s unfortunate that the Wall Street Journal relied on the report of a local business columnist in writing about the SDCERA portfolio, as what that columnist wrote and what the facts are happen to be exactly opposite. For example, the leverage is not across the entire portfolio. I won’t go point by point--- I have attached below the SDCERA response printed today in the local newspaper.

I noted you poked around the SDCERA website. I am proud to say that SDCERA is one of the most transparent pension funds in the country. Since 2010, every meeting is broadcast live over the internet, with all supporting documents the trustees use posted on the broadcasts as well. In addition, those meetings are then archived so that anybody can review the meeting and the documents at a later time. The link is found at the “meetings online” section of the website, where you can scroll through to any meeting you want. The discussions of the trustees and staff, and the documents that we relied on are publicly available—see the “investment meetings” dating back through last year when discussion of the structure of the current portfolio first began, and investment meetings going back to 2010 where the prior portfolio with similar objectives was first constructed.

As far as Chris Tobe goes, let me be blunt----he’s full of crap. The “whistleblower” he refers to is an investment analyst who was fired for repeatedly disclosing confidential documents to the press. That firing was upheld by a Civil Service Commission following a three day hearing, and his federal lawsuit against SDCERA for his firing was dismissed by the judge. There aren’t shady dealings at SDCERA, nor dozens of articles about the shady dealing at SDCERA.

Short term performance is meaningless to draw conclusions about a portfolio, but while we are on the topic—the SDCERA portfolio, designed to minimize volatility and guard against downside risk, returned 6.5% in fiscal year 2012, vs equity heavy peers that were negative or returned 1-2%. As expected, last year SDCERA returns lagged more equity heavy peers, and in every year where equity markets soar, SDCERA will lag but still beat its assumed rate of return.
I thank Mr. Rose for sharing these comments with my readers and I am glad SDCERA is very open and transparent about their board meetings (other public funds should follow this level of openness).

I think the intelligent use of leverage can actually increase risk-adjusted returns, but SDCERA needs to be very careful in implementing this "risk-parity" strategy at this point in time. Go read my previous comment on Leo de Bever discussing the long, long view. Listen carefully to his presentation and the follow-up discussion where he discusses how the intelligent use of leverage can decrease risk of the overall fund, as well as the risks of implementing risk-parity and the LDI approach at this time.

But Leo is outspoken on the terrible returns for bonds he sees over the next decade and he discusses the perils of implementing risk-parity strategies and liability-driven investment approach (LDI) at this time (roughly 45 minutes into the clip).

However, I received this comment from an astute investor who agreed with me and disagreed with Leo on where rates are heading:
The advice to stay short duration in fixed income was pretty much good advice from about a year post credit crisis, more or less til this year. Short and long rates have since been falling, and the yield curve is flattening. Despite all central bank efforts, I tend to see a mild deflation scenario playing out, something you have commented on. With that in mind, I think fixed income holders are best served to be diversified in credit and interest rate duration, and currency, definitely avoid an all in directional bet on rates.
Go back to read my comment on the Caisse warning of headwinds ahead. I discuss my views on why I think deflation is the ultimate endgame and why rates aren't going to rise anytime soon.

I have a question for all of you who see "terrible" or "disastrous"returns on bonds over the next decade. Where are the jobs going to come from? Where is wage pressure? Where is inflation except for risk assets which can collapse at any time?

I'm trying to be optimistic but the global economy isn't exactly firing on all cylinders. Employment growth is picking up in the U.S. but too many consumers are just getting by, saddled with unprecedented debt. The euro deflation crisis will drag Euroland into a protracted period of subpar growth. Japan is pulling out all the stops to lift inflation expectations but that country is not out of deflation yet. And if Abenomics fails, watch out, it's headed for an even worse bout of deflation.

What about emerging markets? They have staged a comeback in recent months, but growth prospects remain tempered and uneven in various countries and the threat of geopolitical turmoil, Fed tapering and lower oil and commodity prices can wreak havoc in these markets. And despite the secular trend of growth, it's still unclear how this growth will develop and what pitfalls investors will endure along the way.

All this to say that the biggest risk out there, in my humble opinion, remains deflation, not inflation. If that's the case, pension funds should still be adopting an LDI approach despite historically low rates (see Jim Keohane's comments here) and/or increase leverage to implement a risk-parity framework despite the dangers of fighting the last investment war.

The most important question for any pension fund or asset manager going forward is who will win the titanic battle over deflation? I've repeatedly warned you that deflation is coming and it will expose naked swimmers. That's why bond yields are falling even though the Fed is tapering. And despite unprecedented monetary stimulus, there is a jobs crisis and private debt crisis going on all over the world and the risks of deflation remain high.

The only place where I see inflation is in risk assets like stocks and high yield bonds. But you have to pick your spots right and deal with huge volatility or else you'll get crushed. This is one reason why I think the Caisse has opted to invest $25 billion in a global portfolio made up of major companies positioned for growth in emerging markets, including Procter & Gamble Inc., Unilever Group and Nestlé SA. In a deflationary world, they're opting to focus on big, safe companies with pricing power.

That is one approach but another one which I recommended is to co-invest with top hedge funds they're investing with or just track my quarterly comments on top funds' activity and take smarter risks in public equities as opportunities arise.

For example, when Twitter (TWTR) fell below $30, I would have been pounding the table at the Caisse or PSP to pounce and take an overweight position. Admittedly, I'm getting a little ahead of myself but there are some dips on specific stocks pension funds have to buy -- and buy big. Why should they pay some hedge fund 2 & 20 when they can do it themselves?

The same thing goes for the biotech companies I recommended. It's still early in the game but when I tell you there is a biotech revolution going on, I know what I'm talking about. I'm not just looking at the Baker Brothers' portfolio, I've got real skin in the game. I was diagnosed with MS almost 20 years ago and have tracked unbelievable advances in drug therapies and other treatments which include stem cells and advances in genomics. I see the future now and taking part in drug trials that are revolutionary!

Too many pension funds are not thinking long term. They're working in silos, worried about ramping up a specific asset class, listening to recommendations from their useless investment consultants. They are not thinking about investing through the cracks or taking risks where others refuse to take risks.

Anyways, everyone has their views on how to manage pension assets. I happen to think that far too many pension funds are worried about headline risk and not rocking the boat with their board of directors. They're not thinking about using their long, long investment horizon to take intelligent risks across all asset classes, in between asset classes and in under-invested sectors (like biotech, renewable energy, big data, etc.).

I know, it doesn't pay to be a hero, you risk getting your head handed to you, especially if your timing is off by several years. I know the Fed is tapering but I'm warning all of you, there is plenty of liquidity to drive risk assets much, much higher. And all the sectors Fed Chair Yellen warned about (biotech,  social media, etc.) are where the biggest moves will happen and short sellers focusing their attention in these sectors are going to get killed. I stick by this call even if we get a mild or severe correction this Fall.

Below, Bob Rice, general managing partner with Tangent Capital Partners LLC, explains "Risk Parity" in an older Bloomberg clip (June, 2013). And Bloomberg's Scarlet Fu displays the current valuations of biotech and internet stocks compared to the bubble of 1999. She speaks on "Bloomberg Surveillance."

The second clip is almost a month old and since then, both these sectors have continued rising on growth prospects. And just wait, it's far from over which is why the Fidelities and Blackrocks of this world continue to ramp up their exposure to these sectors.

Finally, take the time to listen to Janet Tavakoli on the return of the complex financial instruments that fuelled the 2007 credit bubble. Great interview with a very sharp lady who really knows her stuff.