Friday, July 13, 2018

Time To Get Defensive?

April Joyner of Reuters reports, Trade Policy Uncertainty Could Bolster U.S. Defensive Stock Sectors:
As the United States ramps up import tariffs and long-date U.S Treasury debt yields remain low, stocks in so-called defensive sectors may have room to run higher in price, even though expectations for the currently quarterly earnings seasons are high.

Stocks in defensive sectors, which generally pay steady dividends and have steady earnings, languished for the first months of 2018. Utilities, real estate, telecommunications and consumer staples all saw their stocks fall into early June even as the U.S. benchmark S&P 500 index rose more than 4 percent.

But over the past 30 days, two of those sectors have led the S&P 500 in percentage gains as geopolitical risk has risen.

Utilities have jumped 7.7 percent, and real estate has gained 3 percent. Not far behind, consumer staples have risen 2.5 percent. All have outperformed the S&P's 0.4 percent advance.

By contrast, shares in several cyclical sectors, which tend to rise as the economy grows and are often favored by investors in the late stage of a bull market, have dropped over the same period. Industrials have slumped 3.9 percent, while materials have slid 3.6 percent and financials have fallen 2.7 percent.

Several conditions have supported a rotation into defensive stocks, investors said.

They tend to perform better when interest rates are low, and they have risen as yields on the 10-year Treasury note have retreated from the 3.0 percent mark since early June.

A burgeoning U.S. trade war with China and the European Union has also led investors to seek stability. On Tuesday, the White House proposed 10 percent tariffs on an additional $200 billion worth of Chinese goods.

Consumer staples stocks also got a boost on Monday after PepsiCo Inc reported better-than-expected quarterly results.

Seven out of 25 of the S&P 500 consumer staples companies have reported so far, and of those, 86 percent have beaten analyst estimates for revenue and profit. Generally, staples and other defensive areas lag the other S&P 500 sectors in revenue and earnings growth.

Some market watchers have begun to recommend portfolio adjustments in anticipation of a downturn in U.S. stocks.

On Monday, Morgan Stanley's U.S. equities strategists upgraded consumer staples and telecom stocks to an "equal weight" rating, after raising utilities to "overweight" in June. They downgraded the technology sector, which accounts for more than a quarter of the weight of the S&P 500, to "underweight."

"We expect the path to be bumpy for the next few months," said Keith Lerner, chief market strategist at SunTrust Advisory Services in Atlanta, which in May added exposure to real estate stocks in one of its portfolios. "Having some dividend strategies is likely to be a nice ballast."

Few investors believe the end of the bull market is imminent though.

Some said the gains in defensive sectors are bound to be short-lived as strong corporate earnings and continued economic strength boost market sentiment. Others believe recent tensions between the U.S. and China over trade policy will be resolved by the autumn as the U.S. midterm Congressional elections approach.

"We have solid earnings growth, and we have an economy that continues to march down the path of acceleration," said Emily Roland, head of capital markets research at John Hancock Investments in Boston. "Those (defensive) sectors are not attractive to us."

Even so, defensive sectors could draw investors' attention in the next few months if stock markets remain choppy. As they have languished in the past few years, stocks in those sectors could offer value, especially if the companies raise dividends, said Kate Warne, investment strategist at Edward Jones in St. Louis.

The improving performance of stocks in defensive sectors may ultimately be beneficial for the market, some investors said.

The lion's share of growth in the S&P 500 index has come from technology and consumer discretionary stocks: most notably, Facebook Inc, Inc, Netflix Inc and Google parent company Alphabet Inc, collectively known as FANG.

If other sectors can contribute more to the index's gains, investors may have more confidence in diversifying their portfolios.

"With a very narrow market like you've had most of this year, it's great for stock pickers, but it's hard for indexes to make money," said Robert Phipps, a director at Per Sterling Capital Management in Austin, Texas. "What you're seeing is a broadening out of the market, which is extraordinarily helpful."
Since the beginning of the year, I've been telling investors the theme this year will be the return to stability, borrowing off the wise insights of François Trahan at Cornerstone Macro.

So far, tech stocks (XLK) are on fire and while some fear another dangerous tech mania is upon us, François Trahan correctly predicted the surge in tech shares is all part of a much bigger Risk-Off defensive trade.

Nevertheless, while the environment is Risk-Off, many safe dividend sectors like healthcare (XLV), utilities (XLU), consumer staples (XLP), REITs (IYR) and telecoms (IYZ) got hit earlier this year as long bond yields rose and investors got all nervous about the bond teddy bear market.

As of June, however, long bond yields have declined and these defensive sectors are coming back and the media thinks it's mostly due to rising trade tensions. 

It's not. Don't get me wrong, mounting trade tensions aren't bullish and they will exacerbate the global downturn but the downturn began long before Trump started slapping tariffs on America's allies and China. 

The downturn is part of the cumulative effect of Fed rate hikes which is why I keep warning my readers not to ignore the yield curve

I know, the media will tell you not to fear the flat yield curve and financial websites will tell you the yield curve panic is overdone, but I'm telling you the US and global slowdown is already here and you need to pay very close attention to the yield curve and ignore those who tell you otherwise.

It doesn't mean that markets are going to tank the minute the yield curve inverts, it means risks are rising and allocating risk wisely is going to become harder and harder in an already brutal environment. 

Sure, you can buy Netflix (NFLX) before the company announces earnings on Monday and who knows, you might make a killing if the company reports blowout numbers again, as any good news will drive shares higher to a new 52-week high (click on image):

If it disappoints, however, it will get crushed, especially after a huge run-up this year. 

This is becoming a stock picker's market, which is a good thing. Tracking top funds' activity every quarter, I can tell you many interesting tidbits like who's buying what stocks, who's making money, who's losing money and on what specific trades.

And it's not always high-profile stocks you should be looking at. Warren Buffett, Bill Miller, John Paulson, Steve Cohen may not have much in common but they and others have made decent money playing generic drug stocks and big pharmaceuticals like Teva Pharmaceuticals (TEVA), Mallinckrodt (MNK), Endo International (ENDP) and Novartis (NVS).

Unfortunately, Buffett is getting killed on Kraft Heinz (KHC) this year, one of his biggest holdings in consumer staple stocks but that stock has done well recently (click on image):

What else has done well recently? US long bonds (TLT) which tells me investors are starting to worry about the sell-off in emerging markets (EEM) and whether global weakness will spread throughout the world (click on images):

After the yuan's recent sharp decline, markets are nervous that China intends to wield its currency as a weapon in its trade tussle with the US but some say while the worries are understandable, they're overblown as Beijing stands to lose more than it would gain by devaluing the yuan.

Right now, if I were recommending where to allocate risk, it would be in defensive sectors like healthcare (XLV), utilities (XLU), consumer staples (XLP), REITs (IYR) and telecoms (IYZ). And I would hedge that stock exposure with good old US long bonds (TLT).

Who knows, we shall see, I'm defensive in my recommendations but still see a lot of risk-taking activity in biotech and other names I track and trade. These were some of the stocks on my watch list which popped big on Thursday (click on image):


Some of them like Galmed Pharmaceuticals (GLMD) and Zogenix (ZGNX) surged this week and are having an outstanding year

I'm sharing this with you because I track stocks every day, lots of stocks, and it's hard for me to be ultra bearish when I see many risky stocks making huge gains.

Below, the S&P 500 posted on Friday its best closing level since early February as shares from some of the largest tech companies hit record highs. UBS's Art Cashin and CNBC's Bob Pisani discuss factors impacting the markets today.

And Scott Minerd, Guggenheim chief investment officer, discusses the economic impact of a potential trade war. Marc Mobius also appeared on Bloomberg this week stating the trade war is just a warm-up to the financial crisis.

Take all the gloom & doom talk about trade wars with a grain of salt. The global economy is slowing, it's a good time to get defensive but it's not time to panic, at least not yet.

Thursday, July 12, 2018

The Case For Change at OMERS?

A reader of my blog an member of OMERS sent me an email he received from OMERS Sponsors Corporation announcing proposed Plan options for consultation:
Last month, we sent a special bulletin to members announcing important updates on the Comprehensive Plan Review, including revised timelines. In this latest edition, we’re sharing the results of the June Sponsors Corporation (SC) Board meeting, including the Plan change proposals and next steps.

  • Despite recent gains, the OMERS Plan remains financially vulnerable to longer-term pressures beyond our immediate control
  • Extensive modelling shows that the cost of the Plan will continue to increase over time – substantially under some circumstances
  • Possible Plan options are being considered to help stabilize Plan costs, reduce long-term funding risk, and introduce an important level of equity across generations
  • Changes (if any) are unlikely to take effect before January 1, 2021
  • No impact on pension benefits accrued (earned) before the effective date of any change
  • No impact on current retirees or members who retire before the effective date
  • SAVE THE DATE: Member webcasts starting next month on August 14 and 16
  • New e-alerts: Sign up to get notifications on all the latest updates
  • New SC Facebook page – coming soon
The case for change

Change is seldom easy, but it is often necessary – in the best interests of our members. Despite recent investment success, the OMERS Plan remains financially vulnerable to longer-term pressures. Consider the facts:
  • The Plan has not yet recovered fully from the 2008 financial crisis. As at December 31, 2017, the Plan was 94% funded and had a deficit of more than $5 billion on a smoothed basis.
  • We have the highest discount rate among our peer plans, which means that we are allocating more risk to future generations.
  • Investment markets are challenging in 2018, and OMERS is not immune to investment market pressures. The Plan needs to generate about $6 billion in investment earnings each year just to maintain its funding at current levels.
  • In 2017, the Plan collected $4 billion in contributions from members and employers, and paid out $4 billion in pensions. Going forward, the Plan will pay out more than it collects, creating a negative cash flow.
  • Enhancements to the Canada Pension Plan (CPP) will increase both benefit and contribution levels for OMERS members and employers, beginning in 2019.
  • Like all major pension plans, we also face a number of financial realities that are beyond our immediate control. These include a steadily maturing plan, longer life expectancy, changing demographic and workplace trends, and an increasingly uncertain economic environment.
Collectively, these factors will increase the cost of the Plan over time – substantially under some circumstances. This means higher contributions for members and employers, reduced benefits, or some combination of the two.

That’s where the Comprehensive Plan Review comes in. The primary objective is simply to ensure that the OMERS Plan remains sustainable, meaningful and affordable for generations to come. It’s about protecting the Plan’s long-term future – and the essential benefits it provides.

Summary of proposed Plan options

Following an intense eight-month review – including regular discussions with sponsors and other stakeholders – the SC Board has identified the following potential Plan options for further consideration and consultation:

  1. Replace guaranteed indexing with conditional indexing for future pensions
  2. Integrate the pension formula with the new “Year’s Additional Maximum Pensionable Earnings” (YAMPE), introduced as part of the enhanced Canada Pension Plan (CPP)
  3. Update the criteria for early retirement subsidies
  4. Eliminate the current 35-year cap for credited service
  5. Make participation for non-full-time employees mandatory, with possible opt-out
  6. Allow paramedics to negotiate NRA 60 participation

Click any of the links above to learn more about each of the proposed Plan options.

Key things to consider

As you consider the options, there are a few essential things to keep in mind:
  • No changes have been confirmed at this point. The SC Board will vote on final changes in November, following broader consultation. As always, Plan changes require a two-thirds affirmative vote by the SC Board, and are unlikely to take effect before January 1, 2021.
  • If the SC Board approves any of the proposed options in November, the approved changes will apply only to benefits accrued (earned) after the effective date of the change. The current rules will apply to all benefits earned before the effective date.
  • Any changes will have no impact on current retirees or members who retire before the effective date. In no case will benefits earned before the effective date be reduced.
As always, we encourage you to review these materials carefully. If you have any questions, check out our Frequently Asked Questions. If you have a question you can’t find an answer to, send an email to

SAVE THE DATE: Upcoming webcasts

Between now and the SC Board meeting in November, we will be hosting a series of informational webcasts on the proposed Plan options. The first two sessions will be on August 14 and 16.

This is your opportunity to hear about the Comprehensive Plan Review first-hand. Sign-up details will be posted on our website later this month.

While registration may be limited, there will be a number of webcasts happening over the next few months, and more opportunities to sign up for a future session. As always, you can continue to share your thoughts and questions by sending an email to

Keeping you informed

The SC website is your central information source for regular updates on the Comprehensive Plan Review. This site will be updated with our latest resources, including videos, newsletters and answers to member questions. Please visit and check back from time to time for the latest news.

*New* Sign up for e-alerts

If you’d like to get an email notification on updates we post on the site, sign up for e-alerts by clicking here.

Let me begin this comment by thanking the member of OMERS who forwarded this email to me.

Second, I think it's important everyone reads about the Comprehensive Plan Review here.

It was almost a month ago where I discussed why OMERS is reviewing its indexing policy, noting the following:
So who is right, the Canadian Union of Public Employees union or the CEO of OMERS's Sponsors Corporation when it comes to conditional inflation protection?

Let me unequivocally, emphatically state that Paul Harrietha is spot on and it's about time CUPE stop demanding guaranteed inflation protection and allow OMERS to adopt conditional inflation protection.

The two best pension plans in the country, Ontario Teachers' and HOOPP, both adopted conditional inflation protection.

Go read my comment on making OTPP young again where I stated:

What's crucially important to understand is that not only does conditional inflation protection (CIP) address intergenerational risk sharing, it also allows the plan to breathe a little easier if they do experience a severe loss and run into problems in the future.

In effect, as more teachers retire, if the plan runs into trouble and experiences a deficit, CIP allows them to slightly adjust benefits (remove full indexation for a period) until the plan's funded status is fully restored again.

Because there will be more retired relative to active teachers, they will be able to easily shoulder small adjustments to their benefits for a period to restore the plan back to fully funded status.

This isn't rocket science. The Healthcare of Ontario Pension Plan does the same thing and so do other Ontario pension plans like the Ontario Pension Board and CAAT Pension Plan which recently hit 118% funded status, putting it right behind HOOPP in terms of the best funded Canadian plan.

Importantly, while all these plans have different maturities and demographics, they've all adopted a sensible shared-risk model which is fair to all members of their plan, active and retired members, and it ensures the sustainability of their plan for many more years.
As of now, only two large Canadian pension plans offer guaranteed as opposed to conditional inflation protection, OMERS and OPTrust.

OPTrust is fully funded but to address the challenges it has ahead to maintain guaranteed inflation protection without burdening current workers, it's looking at an innovative new pension initiative which will launch a new defined benefit plan for employers in the broader public sector, charitable and not-for-profit industries.

In other words, it's looking to increase assets under management to maintain guaranteed inflation protection for retired members of the plan.

The problem with this approach is they have to sell it to new members, which isn't easy, and even if they're successful, it might not be the most efficient way to address the problem of intergenerational equity.

A much simpler approach is just to adopt conditional inflation protection and explain to plan members because the ratio of active to retired members has shifted to almost one for one, it only makes sense that when the plan runs into problems, retired members bear some of the risk too and accept their cost-of-living adjustments (indexing) will be adjusted lower in periods where the plan runs into deficits.

This cut in benefits won't be material, it won't be felt, and it will only last until the plan's funded status is restored to fully funded status.

Unions hate conditional inflation protection but I really don't understand why. Yes, OMERS is doing well, had an exceptional year last year and posted solid gains over the last four years but so what?

You cannot expect a plan's funded status to rely solely on its investment gains. You absolutely need to adopt a shared-risk model to ensure the plan's long-term sustainability.

I've said it before and I will say it again, the key to a successful pension plan is great governance and adopting a shared-risk model which spreads the risk across active and retired members.

Hiking the contribution rate puts pressure on active members but as more and more people retire, shouldn't they too bear some of the risk if the plan runs into trouble?
Shortly after writing that comment, I saw OPSEU President Warren (Smokey) Thomas saying the executive of the OMERS Pension Plan can expect a fight if they try to rush through unnecessary pension plan changes that will leave members paying more for less:
"The OMERS pension plan is in good shape financially and will ensure a dignified retirement for the hundreds of thousands of Ontarians who've paid into it throughout their working careers," said Thomas. "We don't see any good reason to scale back the size of peoples' pensions or to increase the amount that people pay in. We'll fight any proposal to do either."
I suggest Smokey reads my previous comment and this comment carefully because he's dead wrong to oppose these proposed changes and if the union does fight OMERS on these proposed changes, it will only weaken the Plan considerably and might jeopardize benefits in the future if deficits pass a point of no return.

Now, I don't want to be an alarmist, OMERS is doing great, its 94% funded status is a great achievement which has happened over the last few years and for all intensive purposes, it's a fully-funded plan which is quite remarkable given it guarantees inflation protection (OPTrust is the other major Canadian plan which is fully funded and guarantees inflation protection, most don't).

The big problem is what's going to happen the next time markets tank because of a major global financial crisis and all pensions, including Canada's mighty pensions, will be tested as their funded status deteriorates.

Let me even give you a scenario. What if global stocks don't go down 30% like 2008 and come roaring back? What if we get a protracted bear market like 1974-75 or worse where stocks decline and go nowhere for many years as interest rates stay at ultra-low levels or make new secular lows?

Well, in this scenario, even Canada's fully funded pensions are going to feel the sting, but some are much better equipped to deal with this scenario than others.

Importantly, and I really need to stress this, mature plans like Ontario Teachers', HOOPP and CAAT Pension Plan which have adopted conditional inflation protection and a shared risk model will be able to weather the storm ahead much better than an OMERS or OPTrust who are guaranteeing inflation protection.

Again, if the name of the game is to ensure the long-term sustainability of a plan, why not incorporate elements which will ensure this long-term sustainability and also ensure intergenerational equity as demographic pressures put more pressure on current members over retired members.

Too much of a big deal is being made about conditional inflation protection. The unions will huff and puff "oh, they are taking away our benefits" but my answer to that nonsense is "no they're not, they're ensuring the long-term sustainability of your Plan and the partial or even full removal of inflation protection over a brief time until the Plan's fully funded status is restored is painless to retired members."

Unions need to stop being oppositional and get on board with all these proposals, especially adopting conditional inflation protection.

In fact, I would demand conditional inflation protection for all public pension plans in the world no matter what as I consider this a critical element of sustainability.

We live in a new world folks. Low rates and low returns are here to stay and pension plans that don't adapt and implement sensible changes to ensure the long-term sustainability of their plan are going to be in big, big trouble.

Again, I'm not being alarmist, I'm being a realist.

Below, Paul Harrietha, CEO of OMERS Sponsors Corporation, discusses the proposed changes to the OMERS Plan to ensure sustainable, meaningful and affordable pensions for generations to come. Take the time to watch this, it's excellent.

Update: After reading this comment, Claire Prashaw, Manager, Public Affairs at OPTrust, shared this with me as Hugh O'Reilly wanted to clarify something:
Hugh strongly believes in Pension Citizenship- we want others to enjoy what we have, the establishment of OPTrust Select is part of our strategy to ensure more Ontarians have access to a secure, defined benefit retirement plan. We believe OPTrust Select will also benefit the OPSEU Pension Plan by creating greater sustainability over the long term through the allocation of risk and operational costs over a broader membership base. We see the value of sharing investment risk over a larger membership body, this is the risk we refer to rather than offsetting COLA. OPTrust Select is targeted to modest-income earners working for Ontario Charities, Not-For-Profits and the Broader Public Sector – a group that has been long underserviced from a retirement standpoint. We believe that OPTrust Select can be the solution these organizations have been looking for to not only provide a better retirement for employees but also help address talent attraction and retention.
I thank Claire and Hugh for their input on this matter and wish OPTrust success in this innovative new pension initiative which will allow more workers to enjoy the benefits of a defined benefit plan.

Wednesday, July 11, 2018

Bank of Canada Preparing For Next Crisis?

Theophilos Argitis of Bloomberg reports, Bank of Canada Raises Rates, Keeps Hiking Path Amid Trade Rows:
Bank of Canada Governor Stephen Poloz brushed aside concerns about trade wars and pressed ahead with a fresh interest rate increase as inflation hovers at its highest in seven years.

The Ottawa-based central bank raised its overnight benchmark rate by a quarter point to 1.5 percent on Wednesday, the second hike this year and fourth over the past 12 months. The statement didn’t introduce any new “dovish” language, with officials only reiterating that rates will need to rise further, albeit gradually, to keep price pressures in check.

The move signals policy makers are determined to bring rates back to normal levels, and are confident in the Canadian economy’s ability to cope with both higher borrowing costs and the mounting trade tensions. It also suggests the benefits to Canada of strong U.S. growth -- by fueling exports and business investment -- are outweighing the costs and uncertainty imposed by Donald Trump’s trade policies.

“The Bank of Canada decided today that the things we know look bright, and this outweighs the concern we have over the potentially bad outcomes of the things we do not. In other words, the known knowns outweigh the known unknowns,” said Jeremy Kronick, associate director of research at C.D. Howe Institute.

Wednesday’s move was fully priced in by markets. Investors have also been anticipating additional hikes every six months or so until the benchmark rate settles around 2 or 2.25 percent by the end of 2019 -- in line with the central bank’s gradualist guidance.

‘Hypothetical Scenarios’

The Canadian dollar advanced immediately after the statement was released, gaining as much as 0.4 percent, before easing back and trading down 0.2 percent at C$1.31389 per U.S. dollar at 11:41 a.m. in Toronto trading. The currency is down 1.8 percent over the past year, despite rising oil prices.

In his opening statement at a press conference after the decision, Poloz said he understands there is concern about escalation of trade tensions and acknowledged there was speculation he would hold as a result. But the governor said policy can’t be made “on the basis of hypothetical scenarios.”

Monetary policy, meanwhile, is not suited to counter all the negative effects of protectionist measures, and the effect on inflation is “two-sided,” he said. For example, a slowing economy, higher tariffs and a weakening currency could add price pressures.

“The implications for interest rates of an escalation in trade actions would depend on the circumstances,” Poloz said.

In its statement and accompanying monetary policy report, the central bank described an economy running close to capacity where higher oil prices, a weaker Canadian dollar and stronger-than- expected business investment is fully offsetting the negative effect of trade uncertainty. Exporters, meanwhile, are doing even better than previously estimated because of buoyant foreign demand.

The Bank of Canada forecast growth will average 2 percent over the next three years, unchanged from its last estimate in April and still slightly higher than what officials believe is the economy’s long-term sustainable pace. The latest growth forecasts incorporate negative adjustments that capture greater trade uncertainty.

The central bank also raised its estimates for inflation, but expressed confidence it would settle back to 2 percent after temporary factors drove the rate above target.

“Governing Council expects that higher interest rates will be warranted to keep inflation near target and will continue to take a gradual approach, guided by incoming data,” the bank said.

Exports, Investment

In another positive development, officials highlighted that the composition of growth is shifting away from consumption to exports and business investment -- implying they believe the expansion is more sustainable.

The increase in borrowing costs also puts the Bank Canada more in sync with the Federal Reserve and investors are now expecting the northern nation to keep track with rate hikes south of the border over the next year. The Bank of Canada has been lagging the Fed’s rate increases since oil prices collapsed in 2015 -- marking a rare divergence given how closely Canada’s economy is linked to the U.S.

Rate normalization is a delicate task for Poloz. With inflation already above the central bank’s 2 percent target and heading higher, and with financial conditions still very loose, the central bank chief needs to keep wage and price pressures in check. At the same time, moving too soon and too fast could inadvertently trigger a downturn at a time when the economy is awash in risk. And the Bank of Canada would be wary of getting ahead of the Federal Reserve should slowing global growth impact the hiking path in the U.S.

Gradualism remains the order of the day however, and the Bank of Canada repeated most of the list of concerns and unknowns it has said is keeping it from an even faster normalization -- in addition to trade. Officials reiterated, for example, how the economy has become more sensitive to higher interest rates given high debt levels, which would mitigate any impulses to hike. They also believe there remains excess capacity in the labor market, with the Bank of Canada estimating that underlying wage pressures are at 2.3 percent, less than what would be expected in a jobs market that had no slack.

Policy makers are also anticipating that higher business investment will generate new capacity as companies invest to meet sales, a process the central bank has said it has an “obligation” to nurture with stimulative borrowing costs. Because business investment in the first quarter was more robust than expected, the central bank slightly increased its estimate for potential output growth in 2019 and 2020.
Pete Evans of CBC News also reports, Bank of Canada raises benchmark interest rate to 1.5%, noting trade tensions:
The Bank of Canada has decided to raise its benchmark interest rate to 1.5 per cent.

The bank's rate, known as the overnight rate, is the interest that retail banks have to pay for short term loans, but it affects what that consumers pay to those banks for things like mortgages, lines of credit and savings accounts.

Every six weeks, the bank meets to decide on what its interest rate will be, based on what it sees happening in the economy. This time, the bank has decided to raise its rate by 25 basis points — 0.25 percentage points — to 1.5 per cent. It's the fourth time the central bank has raised its rate since last summer.

The bank's next decision on interest rates is expected on Sept. 5.

The central bank tends to cut its rate when it wants to stimulate the economy and raise it when it wants to keep a lid on inflation.

The move was exactly what economists who monitor the bank were expecting, as a recent slate of numbers from Statistics Canada suggest the economy is expanding, the job market is doing well, and inflation is inching higher.

In its decision to hike, the bank noted in a statement that the housing market is stabilizing, commodities such as oil are starting to rally, and businesses are starting to spend again. From the bank's point of view, those are all good signs for the economy.

But the bank also said it is keeping an eye on tariff disputes, specifically those on Canadian steel and aluminum. On the whole, the bank doesn't think the impact will be too harsh.

"Although there will be difficult adjustments for some industries and their workers, the effect of these measures on Canadian growth and inflation is expected to be modest," the bank said.

But that's not to suggest the bank isn't concerned by what's happening on the trade front.

In the statement, the bank said the mere possibility of increased protectionism is "the most important threat to global prospects," and in his comments accompanying the decision on Wednesday, Bank governor Stephen Poloz said trade tensions were "the biggest issue" on the minds of policymakers in recent weeks.

In its accompanying monetary policy report, the bank gauged the impact of those tariffs and concluded that it expects Canadian exports to shrink by 0.6 per cent at the end of 2018 because of them. Imports will take a similar hit. In real terms, that's $3.6 billion less going out, and $3.9 billion less coming in, and it will nudge up consumer prices in the process.

Poloz was quick to add that those projections are only based on trade developments that have already happened. They don't factor in the possibility of worse ones, such as U.S. President Donald Trump's threat to put a 25 per cent tariff on Canadian made cars.

"We felt it appropriate to set aside this risk and make policy on the basis of what has been announced," Poloz said.

Toronto Dominion Bank economist Brian DePratto was among those expecting a hike, given the underlying strength in the job market.

"We're in exactly the sort of situation that traditionally warrants rising borrowing costs. Of course, beyond the fundamentals, the current economic environment is hardly normal," he said.

He expects the bank to keep moving cautiously, hiking its benchmark rate any time it can without harming the economy too much, while keeping a close eye on trade issues.

"We still look for more hikes, but think a gradual pace of one hike roughly every two quarters still makes the most sense," he said. "NAFTA resolution and/or receding trade threats would certainly lay the ground work for an additional hike this year, but we won't hold our breath."
Kevin Carmichael of the National Post also reports, Bank of Canada raises rates as Poloz’s tale of recovery from Great Recession finally starts coming true:
The Bank of Canada raised interest rates July 11 because Stephen Poloz’s tale about how the economy would recover from the Great Recession finally is coming true.

Most everyone assumed the central bank would lift the benchmark rate a quarter point to 1.50 per cent. The few who didn’t thought policy makers would be spooked by what President Donald Trump has in store for global trade. On the eve of the interest-rate announcement, the U.S. escalated its trade war with China, scheduling tens of billions in additional tariffs.

Canada also is on Trump’s hit list. The central bank now reckons the combination of U.S. duties on Canadian lumber, newsprint, aluminum, and steel — and the chilling effect of trade uncertainty on investment — will subtract two thirds of a per cent from gross domestic product by 2020, an increase from its previous estimate in April.

That’s the equivalent of about $12 billion, so it’s not nothing.

But the bigger story in the Bank of Canada’s new Monetary Policy Report is that most companies are responding to their order books rather than the headlines in the business pages. Policy makers significantly upgraded their outlooks for business investment and exports, offsetting weaker household consumption.

“Canada’s economy continues to operate close to its capacity and the composition of growth is shifting,” the Bank of Canada said in its policy statement. “Exports are being buoyed by strong global demand and higher commodity prices. Business investment is growing in response to solid demand growth and capacity pressures, although trade tensions are weighing on investment in some sectors.”

That shift has been a long time coming. Poloz predicted it would happen soon after he became governor in 2013. But exports and investment faltered, forcing the central bank to keep interest rates low. That encouraged households to keep spending — and adding to their debts.

It’s somewhat surprising that the long-awaited rotation to exports and business investment is happening amid a trade war. The reason also relates to Trump: his tax cuts are stoking a surge in U.S. demand that is proving a magnet for Canadian exports.

The improvement in investment and exports was so strong that the Bank of Canada was forced to raise the pace at which it thinks the economy can grow without triggering inflation. The new potential growth rate for 2018 is 1.8 per cent; the figure for 2019 and 2020 is 1.9 per cent.

All things equal, the revision suggests the central bank will be less pressed to raise interest rates in the future. The central bank aims to keep inflation advancing at an annual rate of about 2 per cent, which it thinks it is on track to achieve over the next couple of years, although it said inflation may jump temporarily due to a combination of higher gasoline prices, increased minimum wages, tariffs and a weaker currency.

Stronger exports and investment also will offset weaker spending by Canada’s debt-saddled households.

The Bank of Canada predicted GDP will increase 2 per cent this year.

That’s the same as its last estimate, but that growth now is being driven by different engines. Consumption will account for 1.3 percentage points of that growth, less than expected earlier this year. Business investment will account for 0.7 percentage point of the GDP increase, and exports 0.5 percentage point, the central bank estimates. Both are big increases from the April outlook.

The threat of increased protectionism means it would be folly to predict a fairy-tale ending. Still, the story being written on the ground in the Canadian economy appears to be different than than the one you’ve been reading about in recent months.
It was last September when I wrote a comment warning the Bank of Canada is flirting with disaster. At the time, I was worried about deflation hitting the US and stated the following:
Canada most certainly isn't Greece but we are are very similar in terms of troubling debt trends going on here and people who think they are entitled to live in a nice house, drive not one but two expensive cars, buy expensive furniture and take great trips twice a year.

It's surreal and nothing but a big, fat chimera. When it implodes, it will destroy many Canadian households for years.

Now, the key here is not what is going on in Canada, the key is what is going on in the rest of the world. The US economy is slowing at a time when the deflation hurricane is about to hit our most important trading partner.

My last comment on deflation headed straight for the US is probably one of the most important macro comments I've written and it has serious implications for the global economy and Canada in particular.

Importantly, when the global deflationary shock hits the US, Canada is literally toast. Finito, caputo, thank you for playing this game Mr. Trudeau, you will be ushered out of office so fast, your head will be spinning.
But there was no global deflationary shock. Instead, the US tax cuts kicked in and the US economy took off, allowing the Fed to continue raising rates, and the Bank of Canada is following suit.

Does this mean I was way off? Not exactly. It means my timing was way off but let me be clear here, the Bank of Canada is chasing the Fed, doing the exact same thing, namely, raising rates to prepare for the next big financial crisis.

The Fed and other central banks are gearing up for what might be a protracted global slowdown and trade tensions will only exacerbate this slowdown which is already in the making.

Let me be very clear here because this is very important, the global economy is slowing and the US economy is rolling over, and central banks are keenly aware of this.

You don't believe me? Check out the action in emerging market stocks (EEM) which have been pummelled this year and this started before trade tensions started mounting (click on chart):

What's driving this sell-off in emerging markets? The Fed's rate hikes and the surge in the US dollar (UUP) which is pushing dollar-denominated debt higher (click on image):

Now, I've been short emerging markets and thought we would see some rally this summer so I can short it some more but so far, the downtrend is intact which isn't good for the global economy.

Interestingly, the Bank of Canada's rate hike was priced into the market which explains why the Canadian dollar (FXC) sold off today after the announcement and initial knee-jerk reaction of appreciating (traders sold the news, the big drop in oil prices and trade tensions also didn’t help).

Still, the weaker Canadian dollar (FXC) this year loosened financial conditions which allowed the Bank of Canada to easily raise the overnight rate by 25 basis points (click on image):

What I find interesting is the Canadian dollar is down almost 2% this year despite the rise in oil prices which tells me either the algos are having fun destroying long CAD positions or the NAFTA trade negotiations are really what's scaring investors away from the loonie.

But foreigners who want to buy homes in Vancouver, Toronto or Montreal which is the current hot market are loving the weakness in the loonie, not that this makes a huge difference for many foreigners who are laundering millions to buy houses in Canada (yes, Canada is a global haven for money launderers, our big banks will accept your money with NO questions asked, trust me).

Apart from foreign money, non-bank entities have increased their lending activities to Canadians who cannot afford a mortgage from banks (and are paying higher rates with subprime mortgage brokers). These people are one job loss away from ruin, and there are tens of thousands of them all over Canada.

When will all this folly with Canadian real estate stop? Well, if you listen to Garth Turner over at Greater Fool blog, it will stop because rates are headed higher as inflation kicks in.

The problem is Garth has been wrong forever and he still doesn't get it.

The single biggest threat to the global economy is deflation, not inflation, and the transmission mechanism for lower housing prices won't come from higher rates and inflation but a deflationary shock the likes of which we haven't seen in a very long time.

I've tried to explain this to Garth on his blog but he deletes my comments and gets all pissy with me if I question him about higher sustainable rates and inflation.

Again, let me repeat what I said last year, we are one deflationary global crisis away from a major recession in Canada. Stop looking at the jobs data, stop looking at housing prices, stop looking at oil prices, stop looking at the TSX making record highs and stop listening to the Bank of Canada, overanalyzing its decisions.

I worked with Steve Poloz at BCA Research. He's not an idiot, far from it, and knows exactly what I'm worried about because that's what keeps him up at night. He will never admit this publicly for obvious reasons, but we are in deep trouble in this country.

The Bank of Canada is doing exactly what the Fed is doing, raising rates so it can have bullets to lower them when the next big one hits us. That's it, that's all, don't bother reading too much into this rate hike or any subsequent rate hike from the Fed or Bank of Canada.

Below, Governor Stephen S. Poloz and Senior Deputy Governor Carolyn A. Wilkins answer reporters’ questions following the policy rate decision and the release of the Monetary Policy Report.

Tuesday, July 10, 2018

Japanese Pensions Rushing Into Alternatives?

Julie Segal of Institutional Investor reports, Japanese Pensions Push Hard Into Alternatives:
In a major shift, historically conservative Japanese institutions are significantly increasing their investments in hedge funds, private equity, private debt, infrastructure, and other unlisted asset classes.

The average Japanese corporate pension fund now has a 17 percent allocation to alternative investments, up from 11 percent in 2013, according to J.P. Morgan Asset Management’s annual survey.

Furthermore, six in ten pension funds said they plan to increase their alternative investments next year. The asset manager interviewed staff members at 120 corporate defined benefit pensions between March and mid-June 2018 for its 11th annual survey. The study covers fiscal years 2016 and 2017 as well as allocators’ plans for the future.

Domestic bond allocations fell to 21.7 percent on average, the lowest level since JPMAM began been tracking the market. The move out of bonds coincides with the Bank of Japan’s policy of keeping interest rates negative to spur economic growth. The policy has hurt its institutional investors who tended to invest heavily in sovereign bonds. To offset disappearing bond yield, pension investors are hoping alternatives such as infrastructure and real estate can help them meet their return targets.

“Japanese corporate defined benefit pension plans remain under pressure to generate returns sufficient to fund their obligations and are gradually unshackling themselves from a long tradition of highly conservative investing,” institutional sales head Yoichiro Nitta said in a statement.

“The challenge will continue as anticipated bond and equity returns remain subdued, the Bank of Japan sticks with ultra-loose monetary policy to coax inflation, the U.S. economy is late cycle, and Japan’s GDP forecast is unclear,” he continued.

JPMAM also found that Japanese institutional investors are using absolute return/unconstrained fixed income, multi-asset strategies, and private debt funds to help manage volatility.

Twenty percent of Japanese institutions have nixed domestic bond and equity buckets and instead now use global versions of each as they continue to diversify outside their home market of Japan. “Within these newly condensed buckets, exposure to domestic assets is generally falling at the expense of greater allocation to foreign assets,” the announcement said.

Although Japanese pensions are moving further into alternatives, many of them still have concerns. Common hurdles include communicating how the investments work to boards and other stakeholders; whether low liquidity assets have been flooded with capital and are in a bubble; and understanding where risk lies.

“Defined benefit pension fund managers are racking their brains to explain complicated instruments and upgrade their portfolio management,” the JPMAM report stated.
Chris Flood and Attracta Mooney of the Financial Times also report, Japanese pension funds embrace alternative investments:
Appetite among Japanese pension funds for alternative investments has hit a new peak at the same time as bond allocations have sunk to a record low, according to a survey by JPMorgan Asset Management.

Pension funds in Japan, historically regarded as some of the world’s most conservative investors, have been forced to make radical changes to boost returns as a result of the extreme measures taken by the Japanese government to stimulate economic growth and inflation.

JPMorgan surveyed 123 Japanese corporate pension funds and found that the average allocation to alternative investments reached a record 17.1 per cent in March, up from 11.4 per cent over the past five years.

Exposure to Japanese government bonds dropped to 21.7 per cent, the lowest in the 11-year history of JPMorgan’s survey.

Japanese policymakers have deliberately held interest rates at ultra-low levels since 1999 in an effort to boost economic activity. The benchmark 10-year government bond yields just 2 basis points.

Expected returns among corporate pension funds have fallen over the past decade from about 3.5 to 2.6 per cent, reflecting the downward pressure on domestic interest rates.

“Japanese corporate pension funds remain under significant pressure to generate sufficient returns to fund their obligations and are gradually unshackling themselves from their long tradition of highly conservative investing. Alternatives have now truly become a mainstream asset class for Japanese pension funds,” said Akira Kunikyo, an investment specialist in JPMorgan AM’s Japan institutional business.

Katsunori Kitakura, lead strategist at SuMi Trust, the $475bn Tokyo-based asset manager, said that difficulties in forecasting the future performance of alternative investments raised concerns over whether these illiquid assets would deliver the returns required.

“It may be too late to take any countermeasures if a pension fund realises that its illiquid alternatives may not achieve their expected returns,” said Mr Kitakura, adding that risk monitoring and governance were vital considerations. “We have seen pension funds invest in alternative products in the past without conducting the appropriate due diligence and setting up risk monitoring facilities.”

JPMorgan’s survey showed that just under 60 per cent of corporate pension funds intended to raise their exposure to alternatives over the next year.

“We expect to see investors continue to ‘push the envelope’ on alternatives to boost returns and increase portfolio resilience,” said Mr Kunikyo.

In April 2017, Japan’s Government Pension Investment Fund invited proposals from alternative investment managers to handle private equity, infrastructure and real estate allocations via funds of funds. The number and size of new mandates has not been disclosed by the GPIF, which holds a fraction of its assets in alternatives.
GPIF, the world's biggest pension fund, reported a 6.9% gain for its fiscal year that ended March 31st, its best gain in three years buoyed by gains in domestic and overseas stocks:
Japan’s Government Pension Investment Fund returned 6.9 percent, or 10.1 trillion yen ($91 billion), in the year ended March 31, with assets totaling 156.4 trillion yen, it said in Tokyo on Friday. Domestic stocks were the fund’s best-performing investment, adding 5.5 trillion yen, followed by a 3.5 trillion yen increase in overseas shares. Domestic bonds gained 362 billion yen, while overseas debt rose 674 billion yen.

Six quarters of gains boosted assets to a record at the end of 2017. The GPIF incurred losses during the first three months of this year as investor sentiment turned from optimism over U.S. tax cuts to fears of a trade war. A global equity rout and plunge in Treasuries in its final fiscal quarter kept the fund from beating a record 12 percent annual gain set three years ago.

“The environment is favorable for stock investments for the time being as the global economy remains solid and inflation is benign,” said Naoki Fujiwara, chief fund manager for Shinkin Asset Management Co. in Tokyo. “Yet, from a long-term perspective, the ratio of risk assets in its portfolio may be too much.”

The GPIF doubled stock holdings and cut bonds as part of a strategy revamp in 2014 with the assumption that rising prices would erode the spending power of Japan’s low-yielding debt. Since then, the shift has helped the fund generate a positive return for three out the past four fiscal years.

“Domestic and overseas stocks rose largely supported by a robust economic environment and solid corporate earnings, in addition to” political stabilization in Europe and expectations over an economic boost from a U.S. tax cut, GPIF President Norihiro Takahashi said in a statement Friday. “However, toward the end of the fiscal year, domestic and overseas stocks narrowed their gains on uncertainties over U.S. trade policy, while the yen strengthened against the dollar.”

Trade friction between the U.S. and China has become a big issue when assessing the investment environment, Takahashi said at a press conference in Tokyo. In addition, he said the fund is cautious about investing in Japanese bonds with a maturity less than 10 years because of negative yields.
Did you catch that last part? When people ask me about the US bond market, I tell them to forget articles in the Wall Street Journal claiming US corporations are behind the rally in Treasurys and look at what is happening overseas where there is a record amount of sovereign debt trading at negative yields.

So it's not surprising that Japanese pensions, insurance companies and other foreign investors stuck with the same dilemma are going to look for yield in the US bond market, investing in corporate bonds and US Treasurys.

Why don't they only invest in US bonds? Because their liabilities are in local currency (like yen in this case) and there are F/X hedging costs involved which come back to bite them when the US dollar underperforms like it did last year before reversing course this year.

All this to say, even with negative yields, global pensions will still invest in their own bond market when it makes sense.

The obvious problem is that negative yields don't pay pension benefits. These Japanese pensions need to generate returns to match assets with their long-dated liabilities. And negative rates means these liabilities have mushroomed since the financial crisis but their asset allocation is still way too conservative so they are not able to generate the required rate of return.

It's pretty much the same problem every pension has all over the world. Historic low rates are forcing everyone to take more risk in risk assets like stocks and corporate bonds but these risk assets are very volatile, so here comes JPMorgan recommending everyone shifts more assets out of bonds and into alternatives.

Great for JPMorgan, they can recommend alternatives to all their clients all over the world and generate huge advisory, underwriting and trading fees but is it the best course of action for pensions and their members over the long run?

I just finished a comment going over Pennsylvania's pension fury where I discussed why simply shifting assets into alternatives without a plan and strategy is a recipe for disaster.

The big squeeze is a real issue for many underfunded US pensions which have been paying hundreds of millions in fees to alternative investment managers and receiving mediocre returns over the long run.

But the problem isn't fees. The problem is governance and no strategy when it comes to alternatives.

Today, I had lunch with a representative from Partners Group, a global powerhouse in private market investments. This fellow was super nice and very sharp. He invited me to lunch after reading my comment on PSP ramping up its direct investments.

Anyway, we talked about the Caisse going direct in private equity and PSP upping the dosage too and we noted that Stephane Etroy (Caisse) and Simon Marc (PSP) are doing a great job executing their strategy in private equity, ramping up co-investments to scale into the asset class and lower overall fees.

He told me that they view both these gentlemen and their team members as highly sophisticated investors "who bring a lot more than capital to the table". "It's the same with folks from AIMCo, CPPIB, OMERS, and OTPP."

He told me that Partners Group is focusing more on bespoke investing and there is a gamut between fund investments and co-investments. They are also focusing more on long-term investing keeping some portfolio companies much longer than the typical 3 to 5 years.

He also told me that in the US, their best-performing LP is one that doesn't press them on fee conscessions but one that is able to quickly evaluate opportunities as they arise and partner up with them on deals.

He even gave me the example of a recent deal where the LP's employees were on vacation but over the weekend, they managed to go to their board and come back quickly on a co-investment deal.

That is unheard of. A process like that takes great governance, a great team to evaluate co-investments quickly, and a quick turnaround.

That's not something you'll find at US public pensions which are often weighed down by politics. There are good people working at US public pensions but the process is highly bureaucratic and the governance is weakened by political interference.

Why am I bringing this up here? What does this have to do with Japanese pensions?

Because Japan's GPIF has a giant beta problem, just like Norway's monster pension fund which has gained very nicely since March 2009 when global stocks bottomed and rallied hard ever since.

But what happens when beta works against these funds like in a long, protracted bear market? Unlike Canada's large pensions which are well diversified across global public and private markets and have executed their strategy nicely focusing on hiring top talent to lower fees by doing more co-investments, many global pensions are very vulnerable if another downturn strikes.

But blindly shifting ever more assets into alternatives at this stage of the cycle is a recipe for disaster. You need a strategy, long-term focus and discipline or else forget alternatives, it's not worth it.

It is worth noting, however, that GPIF is moving as fast as possible into alternatives and its infrastructure portfolio which is still relatively small in terms of overall assets, generated a 5.25% return in fiscal 2018 and is looking great:
Japan’s Government Pension Investment Fund (GPIF) has recorded a return of 5.25% (in US dollars) on its ¥196.8bn (€1.51bn) core infrastructure portfolio in the 12 months ending 31 March 2018.

It is the first time that the ¥156.4trn pension fund has disclosed details about its alternative investments in its annual investment report.

According to the report, the infrastructure portfolio includes investments in the Port of Melbourne in Australia, and Birmingham Airport, Bristol Airport and Thames Water in the UK.

GPIF said its infrastructure investments were located mostly in the UK (57%), Australia and Sweden (both 15%), Spain (10%) and Finland (3%).

The pension fund first invested in infrastructure in 2014 when it become a co-investor in the Global Strategic Investment Alliance (GSIA) with Canadian pension fund OMERS and the Development Bank of Japan (DBJ).

It also invests globally in infrastructure funds through multi-managers DBJ Asset ManagementStepStone Infrastructure & Real Assets and Pantheon.

GPIF’s real estate exposure is smaller at ¥8.1bn, according to the report. The pension fund plans to increase this through domestic and global multi-manager mandates.

Late last year it appointed Mitsubishi UFJ Trust as its domestic real estate multi-manager, and has yet to announce its global real estate multi-manager.

GPIF’s plans to invest in core real estate to generate long-term, stable income.

Norihiro Takahashi, GPIF’s president, said the pension fund’s overall portfolio returned 6.9% for the fiscal year.

He attributed the performance to a strong global economy, which had buoyed global stock markets, but warned of uncertainties now created by trade tensions between the world’s largest trading nations.
On private equity, GPIF's CIO rightly notes it's fast becoming more mainstream but if I were to consult GPIF and Japan's corporate pensions, I'd tell them to contact Partners Group, Blackstone, KKR, TPG and a list of top funds but also talk to guys like Mark Wiseman and André Bourbonnais who are now working at BlackRock.

You need to get the right team in place for alternatives especially when you're the size of a GPIF or some of these monster Japanese corporate pensions but more importantly, you need to get the strategy right or else you will regret getting into alternatives.

Many US public pensions didn't get the strategy right and now they're coming to the realization that more alternative investments haven't helped in terms of their long-term performance and improving their funded status. It's been a boon for alternative investment managers but not so much for public pensions and their members.

All this to say, Japanese and other global pensions looking to embrace alternatives need to first and foremost get the strategy right and develop a long-term plan to slowly but surely build out co-investments to scale into private equity and lower overall fees. Using funds of funds is fine initially but that's not a long-term strategy.

Fund investments and co-investments is the long-term strategy which has led to the success of Canada's large public pensions but before you get the strategy right, you need to get the governance right and I'm not sure that's easy in Japan or elsewhere.

So when I read articles like the one above on Japan's pensions embracing alternatives, I'm very cautious. This is great news for JPMorgan, Goldman, and their top-paying clients which are top alternative investment managers, but it remains to be seen as to how this will help Japanese pensions over the long run.

I'm also very concerned as to what all this money chasing alternative investments globally will do to dilute returns in the long run. What did Tom Barrack once say about "too much money with too few brains chasing too few deals"?

Below, an interview with Hiromichi Mizuno, GPIF's CIO. You can also read this recent SWFI interview with 'Hiro' who rightly introduced performance fees for active managers back in April.

And Alvin Liew of UOB says a change in consumer "mindset" is likely required for Japan's inflation outlook to improve.

Unfortunately, I see no such change on the horizon and fear Japan's deflation demon is spreading throughout the world, ensuring historic low rates are here to stay.

Monday, July 9, 2018

Pennsylvania's Pension Fury?

Chris Flood of the Financial Times reports, Pennsylvania state treasurer condemns $5.5bn pension fee ‘waste’:
Fury has erupted in Pennsylvania over huge fees paid by the Quaker state’s two largest public pension funds to investment managers on Wall Street.

Joseph Torsella, state treasurer, has accused Pennsylvania Public School Employees’ Retirement System (PSERS) and Pennsylvania State Employees’ Retirement System (SERS) of wasting $5.5bn paid as fees to Wall Street investment managers whose funds performed poorly.

The dispute follows similar rows in Maryland and California, where pension officials were forced to admit their failure over decades to disclose multimillion-dollar payments to private equity managers.

Unfunded pension liabilities across US state and local governments now exceed $6tn.

“The pension crisis is national,” said Jeff Hooke, a senior finance lecturer at Johns Hopkins University’s Carey business school.

Mr Torsella’s claim brings into question the secrecy surrounding private equity contracts. It also highlights the issue of whether it is appropriate for public pension schemes to use costly investment managers when the outlook for returns is deteriorating.

He said both PSERS and SERS would have achieved better returns at a lower cost by following a simple passive index-tracking strategy.

“We have paid Wall Street handsomely for mediocre returns. Lavish fees [ . . .] represent not just a waste of money but an abuse of the trust of the people,” said Mr Torsella.

A review has begun into the management of the funds, which also aims to find $3bn savings over 30 years. It will also examine investment performance and fees paid.

Mr Torsella estimated that PSERS could have avoided $3.9bn in fees if it had followed a simple equity-bond global index strategy. It would also have delivered better returns in seven of the past 10 years.

The smaller SERS could have saved $1.6bn in fees. An index-tracking strategy would have outperformed the pension fund’s investment portfolio in six of the past 10 years.

“The numbers clearly show that one simple low-cost passive strategy would have performed far better and saved a fortune,” said Mr Torsella. The treasurer has also called for both pension funds to abandon the use of placement agents — middlemen who facilitate introductions to investment managers in return for a fee.

The review body will present its findings to the state governor before the end of the year.

PSERS oversees assets of $53.5bn on behalf of more than 600,000 members. It says in its annual report that it paid $474m in “investment expenses” in the year to June 2017.

Alternative investments, including private equity, private debt and venture capital, account for 15.2 per cent of the system’s assets but 21.7 per cent of fees paid.

PSERS said it was “one of the most transparent” of the large US public pension funds because it disclosed data on management fees paid to private equity managers. Its annual report makes no mention, however, of performance fees, known as carried interest, paid to private equity managers.

The pension fund said: “PSERS has recently begun to collect performance-fee data for private markets (private equity, private debt and real estate) but it is not available yet.”

SERS oversees assets of more than $29bn on behalf of 239,000 members. It paid out $135m in 2017 in investment expenses, including fees to managers. About $70m in fees was paid to 147 private equity managers in 2016, the latest year for which data are available. Private equity accounts for 16 per cent of SERS’ assets but more than 40 per cent of the fees paid to investment managers.

SERS also does not disclose performance fees paid to private equity managers. It said the fund continually looked for savings. “We look forward to any new viable ideas that the Review Commission may bring forward,” said a spokesman.

The tension in Pennsylvania echoes issues in California, home to the two largest US public pension plans.

In 2015 these were forced to admit that they had no record of $7.5bn performance fees paid to private equity managers over more than 20 years.

After investing in a new reporting system, the California Public Employees’ Retirement System (Calpers), revealed in 2015 that it had paid $3.4bn in carried interest to private equity managers over 25 years. Calpers also admitted that the estimate was incomplete. Nine managers refused to provide historical data and Calpers was also unable to recover details of carried interest paid to private equity funds that had already matured.

The revelations prompted John Chiang, California state treasurer, to sponsor legislation requiring public pension funds to disclose management fees, fee offsets, fund expenses and carried interest paid to private equity and hedge fund managers.

The California State Teachers’ Retirement System (Calstrs), the second-largest public pension scheme, is yet to disclose the information on fees demanded by Mr Chiang.

Officials such as Mr Chiang and Mr Torsella have led efforts to improve transparency.

The National Association of State Treasurers, a body representing officials from 47 US states, made a call in 2016 for pension funds to report all private equity fees and expenses so that scheme members could fully understand the cost of investments.

Maryland’s $49bn state pension scheme was forced to admit in May that it had paid $87.4m in previously undisclosed performance fees to its private equity managers for the year to December 2016.

The Maryland Public Policy Institute, a think-tank, estimated that the state pension lost nearly $9bn income over 10 years after paying higher-than-average investment fees to Wall Street managers and in exchange for lower-than-average returns.

Mr Hooke, said pension fund executives were too easily seduced by the active management promises sold by Wall Street professionals.

Closing the $6tn funding gap could require tax increases or cuts in pension benefits unless improvements are made in the performance of public pension funds.

“It is time to fix America’s broken state and municipal pension system so workers and taxpayers receive a fair deal,” said Mr Hooke.
It looks like all hell is breaking loose in Pennsylvania and I will be the first to admit that I was aware something was cooking here as I was approached months ago by a lady consulting the state treasurer telling me they're looking closely at fees being paid out to alternative investment managers at SERS and PSERS.

I put her in touch with a bunch of people I knew in Canada and never heard back from her. I also carefully explained the Canadian pension model to her so she understands that the success is built on two principles:
  1. World-class governance: Allows Canada's pensions to hire top talent across public and private markets and pay them properly. This is why over 70% of the assets are typically managed internally, lowering fees and costs, adding meaningful alpha over benchmark index returns over the long run.
  2. A shared-risk model: This means when pensions run into trouble and there is a deficit, the risk of the plan is shared which in turn means higher contributions, lower benefits or both. Pension plans in Canada with a shared-risk model have adopted conditional inflation protection to partially of fully remove cost-of-living-adjustments for a period until the plan's funded status is fully restored again.
I also explained to her that Canada's large pensions also pay big fees to private equity and real estate funds but they are doing more co-investments to lower overall fees (see my recent comment on PSP upping the dosage of private equity).

But to develop a solid, long-term co-investment program where pensions can invest alongside a GP on larger transactions where they pay no fees, they first have to invest in the traditional funds where they pay big fees and they need to hire qualified people to evaluate co-investment opportunities as they arise.

Still, if done properly, a good co-investment program allows pensions to scale into private equity and maintain target allocations without paying a bundle on fees.

I mention this because I guarantee you very few US public pensions have developed their co-investment program to rival that of Canada's large public pensions which is why they're paying insane fees to their private equity managers per dollars invested in their PE portfolio.

The other thing I'd look into is whether the performance of these funds is worth the fees they've been paying into them.

Importantly, is the private equity portfolio too diversified and offering mediocre returns once you factor in leverage and illiquidity?

I recently wrote a comment on pensions taking aim at private equity funds for  increasing their use of credit lines to leverage up their returns. Someone emailed me afterward asking me "whether funds get paid their carry on the IRR including the effect of leverage or excuding it"?

I told him I have no clue but my guess is they get paid the carry including the use of leverage much like hedge funds do.

On the issue of management fees and carry (performance fees), it's simply indefensible for any public pension fund not to report these fees in detail in every annual report.

I have nothing against paying fees, especially if a manager is delivering good solid returns over a long period, but for Pete's sake, report what you pay in carry and management fees, and other related costs.

Where I disagree with Joseph Torsella, the state treasurer, is when he compares the performance of SERS' and PSERS’ total portfolio with alternative investments to a simple global bond-equity index portfolio over the last ten years.

This is pure data mining. Since bottoming out in March 2009, we have had one of the greatest bull markets in stocks and bonds so it's stupid to compare alternatives to an index portfolio during a roaring bull market.

I'll go a step further. The big party in equities and passive index allocation is coming to an abrupt end sooner than most are prepared for. The next bear market will be long and painful.

This is why now is the time to invest in alternatives including hedge funds but make sure you're doing so intelligently reducing fees and aligning interests properly.

You need to compare an alternatives portfolio over a very long period that includes bear markets because that is when these investments should kick in to lower downside risks.

I'm not saying there aren't problems at SERS and PSERS in regards to their approach to alternatives but switching over to index funds is the dumbest thing you can do at this time of the cycle.

That's why I keep telling US pensions to focus on governance and a shared-risk model but nothing seems to be changing down south, it's business as usual which guarantees mediocre long-term results.

Below, Jay Bowen, Bowen, Hanes & Company chief investment officer, discusses pension reform and the unfunded public pension liability crisis in the United States.

Now, I'm on record being very suspicious about Tampa's hot pension fund and have openly questioned its use of one sole asset manager, Bowen, Hanes & Co (see their portfolio of stocks here, it's over 145, not 60, and it's a pretty standard portfolio of well-known names so I find it hard they delivered the returns they claim below).

I am definitely not promoting Tampa's firefighter pension approach especially for a large state plan. That's simply nuts but listen to some of the points he raises below which are interesting. Still, I don't agree with him on adopting an indexing aproach at this time, I find that irresponsible and dangerous.

The time for alternatives is now but choose more liquid alternatives (hedge funds) and do your due diligence right. If you're going to invest in private equity, make sure you're also co-investing with your GPs on larger transactions to scale into the asset class and lower overall fees, but in order to do this properly, you need to hire and pay talented people to come work at your pension.