Friday, October 21, 2016

The Elusive Search For Alpha?

Svea Herbst-Bayliss and Lawrence Delevingne of Reuters report, Some hedge funds post mega-gains, brighten industry gloom:
Hedge funds have suffered a steady drumbeat of bad news this year: poor performance, withdrawals, prominent closures, bribery and insider trading charges, and accusations from a state regulator that the whole sector is a "rip-off."

Yet amid the gloom there are still a few managers posting the double-digit percentage gains that turned hedge funds into an elite asset class more than a decade ago, according to performance data provided by fund investors.

For instance, Eric Knight's activist-oriented Knight Vinke Institutional Partners is up nearly 50 percent before fees this year, while the Russian Prosperity Fund, which picks stocks in the former Soviet Union and is led by Alexander Branis, has climbed 43 percent (click on image below).

Then there are Jason Mudrick's Mudrick Distressed Opportunity Fund and Phoenix Investment Adviser's JLP Credit Opportunity Fund, which are both up 38 percent. Energy-oriented Zimmer Partners' ZP Energy Fund is up 27 percent, while Gates Capital Management's ECF Value Fund has risen 26 percent and Michael Hintze's CQS Directional Opportunities Fund has climbed 20 percent.

By contrast, the average hedge fund returned a little more than 4 percent over the first nine months of the year, according to data from Hedge Fund Research. That is about half of what the S&P 500 Index has returned over the same period, including dividends, and compares to a 7 percent increase for the Barclays Capital U.S. Government/Credit Bond Index, a common measure of the credit markets.

"In general there is no doubt this has been a tough year in terms of performance, but there are still winners out there," said Mark Doherty, a managing principal at PivotalPath, an investment consultant.


The winners are harder to find. They tend not to be multi-billion-dollar household names whose managers appear on television and at industry conferences, attracting money to invest from the largest pension funds.

Although they pursue a variety of strategies, they are united in their relatively small size, investors said.

Gates Capital manages $1.8 billion, while Mudrick Capital oversees $1.5 billion and Phoenix's JLP Credit Opportunity and Zimmer Partner's ZP Energy Fund are smaller, with about $1 billion in assets, investors in the funds said. Representatives for the firms declined to comment.

There are a number of even smaller firms delivering blockbuster returns. Former Paulson & Co partner Dan Kamensky's $125 million Marble Ridge, which started trading in January, is up 23 percent. Svetlana Lee's Varna Capital, which invests less than $100 million, is up 20 percent. Halcyon Capital's $200 million Halcyon Solutions Fund, managed by Jason Dillow, is up 22 percent.

"These funds may be able to capitalize on smaller and more inefficient securities that are too small for the larger funds," said Michael Weinberg, chief investment strategist at New York-based Protégé Partners, which invests in smaller funds.


Knight Vinke's gains were largely driven by the merger of French electronics company Fnac with electrical retailer Darty, which the hedge fund pushed for, its most recent letter said.

Bets on steelmaker Evraz, Russian airline Aeroflot and Federal Grid Company, which manages Russia's unified electricity transmission grid system, helped the Russian Prosperity fund, its investment chief Branis said.

Some of the winners, including Dallas-based Brenham Capital, which manages $1.3 billion and is up 19 percent this year, also scored big by betting on the beaten-down energy sector as it recovers. Mudrick Capital won with bets on Alpha Natural Resources as the coal miner exits bankruptcy and closely held driller Fieldwood Energy, a fund investor said.

To be sure, this year's strong returns were preceded by big losses in 2015 and early in 2016 at some firms. Mudrick Capital, which made early bets on distressed energy and commodity companies, lost 26 percent last year, and Gates' ECF Value Fund lost 19 percent.

Some clients have not had the patience to stick around. Last month Rhode Island's pension fund voted to cut its hedge fund allocation in half following in the footsteps of New Jersey, which voted for a similar reduction in August. This week New York's financial regulator called hedge funds a "rip-off" in a report that said the state pension fund lost $3.8 billion on them in the last eight years.

Investors pulled an estimated $23.3 billion from hedge funds over the first half of the year, according to Hedge Fund Research, less than 1 percent of the industry's $2.9 trillion overall assets.
While a handful of less well-known hedge funds are delivering great returns, the majority are struggling to master their miserable new world where their compensation is getting sliced as big investors pull out, fed up of paying hefty fees for mediocre returns.

A couple of weeks ago, I discussed why Rhode Island met Warren Buffett, stating that while I don't buy Buffett and Munger's biased views on hedge funds, I agree with them that most US public pensions have no business whatsoever investing in hedge funds or even private equity funds which are raking them on fees and delivering paltry returns.

[Note: Interestingly, Business Insider ran an article on how private equity giants are emulating Warren Buffett, trying to lock up more assets for a longer period, which is something I discussed last year. The problem is that these are treacherous times for private equity and many experts are openly questioning the industry's alignment of interests.]

This week I went over why CalSTRS cut $20 billion from external managers and why New York's Department of Financial Services (DFS) issued a report finding that the New York State Common Retirement Fund (CRF) for years has invested pension system funds in high-cost underperforming hedge funds, costing the system $3.8 billion over the last eight years.

I ended that comment by stating the following:
Is this the beginning of something far more widespread, a mass exodus out of external managers? I don't know but clearly there are some big pensions and sovereign wealth funds that are tired of paying hefty fees to external managers for lousy absolute and risk-adjusted returns.

The diversification argument can only take them so far, at one point funds need to deliver the goods or they will face the wrath of angry investors who will move assets internally and never look back.
This week we find out that hedge fund investors withdrew $28.2 billion in third quarter but I take these figures with a grain of salt. Matthias Knab of Opalesque sent this out in an email this morning (click on image):

Clearly there is no mass exodus out of hedge funds (or private equity funds) and the reason is simple, many US public pensions cannot manage assets internally because they lack the size or don't have the governance and compensation system to attract talented investment officers to manage assets across public and private markets internally.

Instead, they hire useless investment consultants which shove them in large brand name hedge funds they typically should be avoiding (because many have become large asset gatherers who focus more on the 2% management fee and less on delivering stellar performance).

If you don't believe me, ask Mark Rzepczynski, Founding Partner, Chief Investment Officer AMPHI Research and Trading, who wrote this on Harvest Exchange:
Investment consultants are a force to the reckoned with in the pension world. They advise and drive many pension decisions around the globe. Consultants literally control trillions of dollars of allocations to managers through their recommendations, yet there have been no studies on the effectiveness of their choices. There may be limited argument that they provide useful information and education for pension managers, but they also give specific advice on managers, so an analysis of their picks is extremely valuable. The result may surprise you. Their investment manager picks do not outperform some simple benchmarks.

The recently published study in the Journal of Finance, "Picking Winners? Investment Consultants’ Recommendations of Fund Managers", makes a carefully researched assertion that consultant recommendations have little value. Worthless may be too strong, but that is close to what most would conclude when they read the paper. Given all of the work on trader skill and market efficiency, this should not be surprising. But, given that consultants supply their work to leading pensions, it is should be surprising that no one has called them on their recommendations.

The authors do a very careful job of researching this topic through analyzing what drives recommendations. Recommendations are driven by more than past performance but by soft factors such as philosophy, service, fees, and size. Consultants are not return chasers but are slaves to size which is a key driver for this results. The soft factors also seem to be key drivers for recommendations. The due diligence process identifies managers that have a well-defined process and can explain well. Given their client base and job, consultants have to be size sensitive. Perhaps in an imperfect world, the best they can do is conduct due diligence and make the best recommendations given size constraints.

Nevertheless, it may be too easy to let them off the hook based on the size argument. First, there is no evidence of outperformance and equal weighted portfolios of recommendations underperform. Second, these performance results hold for a number of different factor models. Third, the size or scale effect can explain the underperformance, but it cannot explain why the recommendations do not outperform alternatives.

Use your consultants carefully. If you want them to sift through managers and find those that meet size criteria and have well-defined processes, you are in safe ground. If you are asking them to pick future winners, beware.
You can read the full article with all charts and tables on Harvest Exchange here.

I agree with Mark Rzepczynski, use your consultants carefully and you should spend a lot more time understanding and vetting your consultants, their business model and any potential conflicts of interest.

In my experience, most consultant are backward looking and they definitely have a size bias. It's not their fault, of course, as their clients are big pension or sovereign wealth funds that are looking to write huge cheques to a few brand name funds but in many cases, there are gross conflicts of interest where consultants recommend funds they themselves invest in or trade with.

I discussed some of this when I went over the Montreal emerging managers conference a few weeks ago and was perplexed as to why some LPs think there are conflicts of interest in bfinance's approach where they put out the RFP, the LPs choose the managers that best suits their needs, and then the GPs have to pay a one time fee to bfinance based on the assets they receive if they are selected by the LP for the mandate.

[Note: I am not just plugging bfinance, on my blog you will find links to a list of advisors and consultants on the right-hand side, many of which are well known but others that are less well-known, small, excellent, independent and conflict-free, like my buddies over at Phocion Investment Services (and I have no monetary arrangement with them).]

Anyways, I am rambling on a bit too much and want to get to the article above. Be very careful when you read articles like this, extremely careful not too get overly excited about any hedge fund manager shooting the lights out on any given year.

Four years ago, I wrote a very popular comment on the rise and fall of hedge fund titans. Investors get so enamored when some hedge fund "superstar" (or no-name) hits a home run in any given year but I'm speaking from experience, one or even two years of stellar results guarantees nothing in terms of future performance and if you chase hot hedge funds, no matter how big or small they are, you will more than likely get your head handed to you.

Does anyone remember Vega Asset Management which was based in Madrid, Spain? I visited them with Mario Therrien of the Caisse back in 2003. Vega was a global macro fund run by Ravi and Jesus, two very experienced traders formerly of Santander. Great macro fund, tight risk management, a marketing machine, assets mushroomed from $2 billion to well over $12 billion in a few short years and after doing well, it sustained heavy losses in 2005-2006 and eventually closed.

In 2003, before all this happened, I recommended an allocation to this fund but also recommended to cut the initial allocation in half. My biggest concern was that I totally disagreed with their main thesis, which was to short US bonds, but I also had issues with how the fund was aggressively marketing to prospective clients.

Still, they had a great operational setup, knew their stuff, were seasoned traders and who was I to question their thesis? And to be fair, they were making excellent risk-adjusted returns even after I left the Caisse later that year (2003) to join PSP.

Sometimes you pick managers who have it all, experience, skills, a great team, great operational setup, tight and first rate risk management, and they still can run into big problems.

Can this even happen to Citadel or Bridgewater? Absolutely, it can happen to any fund and that's why I agree with Jacques Lussier, President and CEO of Ipsol Capital, Return = Alpha + Beta + Luck!!!!!!

[Note: Jacques's second book which he co-authored with Hugues Langlois, Rational Investing: The Subtleties of Asset Management, will be out in March 2017 and you can pre-order and read about it here.]

A lot of novice hedge fund investors need to read When Genius Failed just to get a reality check. I've said this before and I will repeat it, stop pandering to glorified hedge fund gurus and treat everyone the same and start grilling them hard no matter how poorly or well their fund is performing.

"But Leo, I'm very intimidated when sitting in front of a Ray Dalio, his top lieutenants or any other hedge fund guru. I just can't grill them like you used to do." Then investing in hedge funds is not for you, it's that simple.

When you sit in front of a Dalio, a Tepper, or anyone else and start asking them tough questions, you need to be very well prepared and be ready to get jabbed a couple of times (comes with the territory, you're dealing with egos the size of Trump's or worse in some cases).

[Note: Nowadays, even if you're a big investor, you have a better chance of winning the lottery than getting to sit in front of any hedge fund guru to ask them tough questions. Instead, you will deal with some investor relations person which is far from optimal.]

And that brings me to the point I want to make about why you need to be careful reading too much into the performance of any hedge fund manager. Do you understand the process? The sources of returns? The risks of the strategy? Are they benchmarking their performance properly or trying to pull wool over your eyes? Are their operations solid? Is their risk management rigorous or all smoke and mirrors? Are the managers simply lucky, riding a big beta wave up?

That last question might seem easy to answer, after all, if you get the beta benchmark right, it should be easy to determine whether there is any real alpha there, but there is an element of luck that is very underappreciated in all investment strategies.

I mention this because while there is a crisis in active management, we are living in extraordinary times where the alpha bubble has shifted to a giant beta bubble spurred by record low rates, a buyback bubble which is reaching its limits, robo-advisors shoving billions into "low volatility" and other ETFs, etc.

All this to say while it's tough finding elusive alpha, especially for the big giant funds, everyone needs to take a step back and really understand the market environment and what is driving returns in various long-only, hedge fund and private equity strategies.

And yes, on any given year, you will find exceptional outperforming hedge funds and long-only mutual funds, but try to understand their process and source of returns before chasing them (actually, you should never chase after any fund, period).

Hope you enjoyed this comment, if you have anything to add, feel free to email me at As always, please remember to subscribe or donate to the blog via PayPal on the top right-hand side under my picture (need to view web version on your cell phone).

Below, hedge fund billionaire David Tepper is pretty cautious on the market. Remember what I keep telling you, "beware of gurus with dire warnings!", and read my comment on bracing for a violent shift in markets.

More interestingly, Barry Rosenstein, JANA Partners founder, shares his take on why stock picking isn't dead (once the ETF bubble bursts). Richard Pzena, Pzena Investment Management, also weighed in on active vs. passive fund management, as well as market volatility.

Lastly, I embedded the full Al Smith dinner from Thursday night where Donald Trump and Hillary Clinton were supposed to be relaxed and look at the lighter side of things, all in the name of charity.

Trump started off well but then he really "trumped up" and you could feel the tension in the room (thought the good cardinal was going to fall off his chair but apparently they played nice behind the scenes). Have a great weekend and enjoy watching the elusive search for political humor.

Thursday, October 20, 2016

What's Worrying the Bank of Canada?

Barrie McKenna of the Globe and Mail reports, Bank of Canada weighs further interest-rate cut amid sluggish exports:
The Bank of Canada flirted with the possibility of another interest-rate cut this month in the face of a gloomier forecast for the country’s export-led economy.

Governor Stephen Poloz and his top deputies “actively discussed” the merits of what would have been a third cut since the beginning of last year in the lead-up to Wednesday’s rate decision, he acknowledged to reporters in Ottawa.

In the end, the central bank opted to leave its benchmark rate at a still-low 0.5 per cent, because of the “significant uncertainties” clouding the bank’s economic outlook, including the tumultuous U.S. election and new mortgage insurance rules in Canada.

The central bank said it is closely monitoring the effect of the federal government’s move this month to tighten lending standards and limit access to mortgage insurance for riskier borrowers. The new rules should cool resale activity in the housing market and push developers to focus on building smaller units, the bank said.

The housing measures will slice as much as 0.3 per cent a year off economic growth by 2018 as resale activity and home construction take a hit, but they’ll also lead to “higher quality” borrowing patterns over the longer term, according to Mr. Poloz.

“While household debt levels have continued to increase, these measures should, over time, help ease the growth of economic vulnerabilities related to household debt and housing,” he later told members of the Senate banking, trade and commerce committee.

Earlier Wednesday, Mr. Poloz told reporters he wants to be “dead certain” that the bank’s downgraded projection for exports is permanent. He suggested that many businesses in the all-important U.S. market may be holding off on making investments until after the election, and that affects the U.S. appetite for Canadian goods and services.

“It’s worth having a little more time to examine some of these things,” Mr. Poloz explained.

Not cutting rates was the right thing to do, Toronto-Dominion Bank economist Brian DePratto said.

“An interest rate cut would likely do little to spur exports, while potentially undoing much of the impact of recent housing market rule changes,” he argued.

The central bank now expects the economy to grow 1.1 per cent this year and 2 per cent in 2017, down from its July projection of 1.3 per cent and 2.2 per cent respectively, according to its latest monetary policy report, released Wednesday. As well, the bank said the economy won’t get back to full capacity until “around mid-2018” – at least half a year later than it predicted just three months ago.

This expected delay suggests it could be another two years before the bank starts trying to push up interest rates – a timetable that now puts it well behind the U.S. Federal Reserve and could keep a lid on the value of the Canadian dollar, now trading at about 76 cents (U.S.) for the foreseeable future.

“This is a bank that has precisely zero appetite for rate hikes, and seems to be keeping a flame alive for the possibility of rate cuts, should the need arise,” Bank of Montreal chief economist Douglas Porter said in a research note.

On the positive side, the bank said the worst may be over for the resource sector, where economic activity appears to be “bottoming out.” And the bank expects the global economy will “regain momentum” over the next two years.

Still, the bleaker forecast is the latest in a series of disappointments for Mr. Poloz, who has repeatedly predicted that a rebound in non-resource exports would lift the country out of its economic funk. The bank’s latest forecast slashes expected export growth by a full percentage-point in 2017 and 2018, shaving roughly 0.5 per cent off economic growth – and some of the loss may be permanent, rather than cyclical, according to Mr. Poloz.

“The level of exports is well below where we thought it would be by now,” Mr. Poloz told reporters. He suggested that rising protectionism, the unknown status of various free-trade deals, high electricity costs and poor infrastructure may be inhibiting investment and exports.

Wednesday’s report from the bank provides an extensive explanation for why Canada’s exports haven’t hitched themselves to the recovery in the U.S. – the destination for nearly three-quarters of Canadian goods exports. The main culprits are weaker-than-expected U.S. business investment and more pronounced competitive challenges for Canadian exporters. While a cheaper Canadian dollar has made exports more affordable to foreign buyers, the currencies of major trading rivals have declined even more against the U.S. dollar, giving them an edge in the U.S. market, the bank pointed out in its report. The Mexican peso, for example, has fallen by more than 30 per cent since mid-2014, compared with a 20-per-cent drop for the loonie.

The central bank now expects U.S. business investment to grow just 3 per cent over the next two years, down from a previous estimate of 4 per cent, due to greater uncertainty.
Greg Quinn and Maciej Onoszko of Bloomberg also report, Poloz’s Deepest Thoughts on Rates Now Saved for Press Conference:
Investors seeking insight into Bank of Canada Governor Stephen Poloz’s thinking on monetary policy need to look beyond the main rates statement for clues.

For the second time in seven months, Poloz whipsawed markets with prepared comments to reporters after the rate decision was released Wednesday, saying that the central bank “actively” considered adding stimulus to prop up a sluggish economy.

The Canadian dollar, which had rallied on the rates announcement at 10 a.m., erased gains after Poloz read from a separate statement 75 minutes later. Canada’s 2- and 10-year bond yields reacted in the same way, rising and then falling.
“It was interesting that he waited until the press conference to deliver the real message, which in the end was a pretty dovish one,” Alvise Marino, a foreign-exchange strategist at Credit Suisse in New York, said by phone Wednesday. “He just conveyed in a more strong way that easing is still on the table, which was something the market isn’t pricing at all.”

The moves reflect a shift under Poloz, who said in 2014 he was starting to offer more color on the bank’s deliberations in his preamble to the press conference after each quarterly release of the bank’s Monetary Policy Report. Other changes under Poloz include abandoning so-called forward guidance that gives a direct hint on the next move in borrowing costs, and adding new language to forecasts about inflation risks.

The opening statement at the press conference “fills the gap between the MPR and the press release, offering insight into which issues were really on the table during the deliberations and how those issues influenced the decision,” Bank of Canada spokeswoman Jill Vardy said in an e-mailed message. “We think this helps people understand better the thinking behind the decision and provides useful information to market participants about our risk management approach to monetary policy.”
Loonie Declines

The currency initially gained and bonds dropped after the central bank held its benchmark interest rate at 0.5 percent and the policy statement dropped a reference to downside inflation risks that featured in its previous stance from September. The markets then did an abrupt u-turn after Poloz said policy makers discussed monetary easing “in order to speed up the return of the economy to full capacity.”

The currency weakened 0.1 percent to C$1.3128 against the U.S. dollar as of 4 p.m. in Toronto, reversing a rally of as much as 0.8 percent. The rate on Canada’s bond due in November 2018 fell two basis points to 0.57 percent, after an earlier gain of two basis points (click on image).

“I was a little bit surprised how the statement and Poloz didn’t seem to line up too cleanly,” Tom Nakamura, Toronto-based vice president and portfolio manager at AGF Investments Inc. that has C$34 billion ($26 billion) under management. Some of the market reaction to the statement may have gone too far since it wasn’t out of line with Poloz’s overall worldview, he said. “What I think happens is that the market doesn’t think through the big picture sometimes.”
April Move

Investors went through a similar ride in April. Poloz held borrowing costs unchanged in the official rate decision, adding in his opening statement to reporters that the bank “entered deliberations” about easing monetary policy further. The dollar initially reversed losses after the rate announcement, only to resume declines during that press conference.

For a central bank that doesn’t offer minutes of their meetings, the context is helpful, said Marino at Credit Suisse.

“It was totally appropriate for them to say that in the press conference and not the statement,” he said. “It’s not different from what everybody else is doing.”

Investors will hear from Poloz again Wednesday, as he testifies at the Senate Banking Committee beginning at about 4:15 p.m. Another opening statement is expected.
You can view the Bank of Canada's latest Monetary Policy Report here and I embedded the press conference below (it is also available here).

Let me give you my quick thoughts on the latest decision, the press conference, the loonie and other currencies:
  • There was no surprise that the Bank of Canada decided to leave rates unchanged since oil prices have been hovering near $50 a barrel, bolstering the loonie and tightening financial conditions (remember, the loonie is a petro currency, as oil rises, it follows, lifting the pressure on the BoC to raise rates as financial conditions tighten).
  • The big surprise came after during the press release when Steve Poloz said he and his top deputies "actively discussed" the merits of another rate cut. Why were they actively discussing this? No doubt, the Bank is worried about weakness in real estate and exports but I also think there was an active discussion on whether global deflation risks are really fading and more importantly, whether Janet Yellen's speech last Friday was a real game changer
  • By all accounts, the Fed is set to raise rates by 25 basis points in December but during her speech last Friday, Fed ChairYellen dropped a bomb stating the Fed might need to stay accommodative for longer and risk overshooting its 2% inflation target. 
  • I interpreted these remarks as the Fed is still worried about global deflation and might even fear it's behind the deflation curve, so there is no rush to raise rates and it might be smarter to stay accommodative for longer, even if that means risking inflation down the road (they won't publicly admit this but they'd much prefer inflation than deflation even if it will take a miracle to achieve this outcome by inflating risks assets which only exacerbates rising inequality and the retirement crisis which ironically exacerbates deflation!!).
  • What signal is the Fed sending to the Bank of Canada and other central banks? Basically, have no fear, the Fed is in no hurry to raise rates and even if it does raise in December, it will be a one and done deal. 
  • On Thursday, the US dollar hit seven-month high after ECB meeting, pressuring oil and US stocks. I had warned my readers to ignore Morgan Stanley's call at the beginning of August on the greenback being set to tumble, and turned out to be right. The US Dollar Index (DXY) has rallied sharply since then and is now closing in on 100. 
  • I spoke to my buddy in Toronto this morning. He runs a one-man currency hedge fund machine and he was telling me that he thinks now is the the time to take profits on the long USD position and if the DXY goes over 99, start shorting the greenback. He also told me to he's long the British pound (especially versus the euro) but thinks the Canadian dollar could fall as low as 73 cents (oil prices between $50 and $60 will help Alberta and bolster the loonie but slowdown in real estate and exports and divergence in monetary policy will weigh on the Canadian currency).
  • Obviously my buddy who has been trading currencies for over 25 years knows what he's doing and I agree with him on a cyclical basis, especially after Yellen's speech, but structurally, I remain short currencies in regions where deflation is wreaking havoc on the economy and if a financial crisis erupts anywhere, King Dollar will surge much higher. 
  • My buddy also told me that the pickup in China's PPI last week was all due to the devaluation in the Chinese currency, allowing them to import inflation but he too doesn't see this as a sustainable strategy. 
That brings me back to the Bank of Canada's decision and press conference. Steve Poloz was the head of Export Development Canada prior to being nominated Governor of the Bank of Canada. I worked with him in the late nineties at BCA Research when he was a Managing Editor covering G7 economies. He's extremely smart, knows his stuff and is very nice. I have nothing but praise for him even if he pisses off market participants at times (who cares, maybe they aren't reading him right or listening carefully to his message).

I trust Steve's judgment but I also worry that Canadian exports will lag in an environment where US protectionism is on the rise (regardless if Trump loses) and other countries like Mexico keep devaluing their currency to gain US market share.

In other words, if oil keeps rising or hovering above $50 but Canadian exports don't pick up, or worse still, the housing market craters, don't be surprised if the Bank of Canada cuts rates or even starts engaging in QE. We are far from there but I'm very worried that Canada's days are numbered and have been short the loonie since December 2013 (and remain short).
    Speaking of BCA Research, I see Gerard MacDonell is back from vacation and posting all sorts of comments on his blog. I ignore his political rants/ jibberish but love reading his market insights like his latest on the core PCE deflator looking firm in September. I will let you read it.

    Below, the press conference where Bank of Canada Governor Stephen S. Poloz and Senior Deputy Governor Carolyn Wilkins discuss the October Monetary Policy Report. I also embedded the press conference where ECB President Mario Draghi explains the decision to keep rates on hold and once again reaffirmed plans to maintain the quantitative easing program at €80 billion to March 2017 or beyond if needed. The ECB left the door open to more stimulus, pointing to the December meeting.

    Part of me misses those Friday afternoon sessions at BCA Research back in the day when Steve Poloz and other smart Managing Editors like Gerard, Francis Scotland, Chen Zhao, Warren Smith, Martin Barnes and Dave Abramson would all get into it and "actively discuss" their market views (sometimes it was warfare!).

    I got to hand it to Tony Boeckh, he knew how to recruit them and pit them against each other, which made for a lousy work environment but great for his bottom line. Tony's business model was simple, recruit a few top guns from industry and the government, hire a bunch of hungry and smart university students and pay them in Canadian dollars, and deliver great investment research which is sold to clients all over the world charging them US dollars (pure genius which is why he made a fortune when he sold BCA several years ago to manage his money and write his investment letter).

    Unfortunately, I don't have Tony Boeckh's business savvy so I will remind all of you to kindly subscribe and/ or donate to this blog on the top right-hand side under my picture. I thank those of you who support my efforts, I truly appreciate it.

    Wednesday, October 19, 2016

    Norway's GPFG to Crank Up Equity Risk?

    Richard Milne and Thomas Hale of the Financial Times report, Norway’s oil fund urged to invest billions more in equities (h/t, Denis Parisien):
    Norway’s $880bn oil fund is being urged to invest billions of dollars more in equities and take on more risk in what would be a big shift in its asset allocation away from bonds.

    The world’s largest sovereign wealth fund should invest 70 per cent of its assets in shares, up from today’s 60 per cent, at the expense of bonds, according to a government-commissioned report on Tuesday.

    The move is highly significant for global markets as the oil fund owns on average 1.3 per cent of every single listed company in the world and 2.5 per cent in Europe.

    The report is the latest salvo in a debate on how much risk the long-term investor should take and comes amid growing warnings of dwindling returns for government bonds in particular. The allocation to equities was increased from 40 per cent to 60 per cent in 2007.

    “With a higher share of equities the expected return will increase as will the income to the government budget. Yes, it comes with higher risk but we think we are well equipped to handle this risk,” Hilde Bjornland, an economics professor behind the recommendation, told the Financial Times.

    The centre-right government will evaluate the recommendations before setting out its own position in the spring. Senior insiders said they expected the allocation change to go through as the report was co-authored by two former finance ministers.

    Siv Jensen, the finance minister, told the Financial Times: “We are always thoroughly evaluating how we are running the fund … We know now that we have a very low interest rate regime globally. We have 40 per cent in bonds, and that will affect the return over time.”

    Saker Nusseibeh, chief executive of Hermes Investment Management, a UK asset manager, said there was a broader trend of investors looking to increase their equity exposure. “This is about the realisation that you cannot make returns of the same amount that you used to make in the past,” he said.

    He added: “If you are a sovereign wealth fund … you will question why you would have so much in fixed income at all.”

    The latest survey of fund managers from Bank of America Merrill Lynch shows a rise in cash holdings, which in part reflects “scepticism or outright fear of bond markets”, according to Jared Woodard, an investment strategist at the bank.

    In a sign of how the Norwegian debate might unfold, the chairman of the report, Knut Mork, voted against the other eight members and argued the allocation to equities should be cut to 50 per cent. This would give the government a more predictable income stream from the fund, he said.

    The Norwegian government is permitted to take out up to 4 per cent of the value of the fund each year to use in the budget. But it is using only about 3 per cent this year.

    The report estimated that the fund’s real rate of return was expected to be 2.3 per cent over the next 30 years. A majority of the commission suggested “one potential margin of safety” could be to restrict the government’s ability to take money out of the fund to the level of the expected real return.
    Mikael Holter and Jonas Cho Walsgard of Bloomberg also report, Norway Sovereign Wealth Fund Urged to Add $87 Billion in Stocks:
    Norway’s $874 billion wealth fund needs to add more stocks as record low interest rates and a weak global economy will otherwise lower returns to just above 2 percent a year over the next three decades, a government-appointed commission recommended.

    The Finance Ministry should raise the fund’s stock mandate to 70 percent from 60 percent, the committee, comprised of academics, investors and two former finance ministers, urged on Tuesday. A decision on increasing its stock investments will be made by the ministry, which hasn’t always agreed with the conclusions of similar reviews on the fund’s holdings.

    “A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the Fund and a higher risk of a decline in its long-run value,” the group said. “The majority is of the view that the this risk is acceptable, provided that there is political will and ability to adapt economic policy to the accompanying increase in risk, in both the short and long run.”

    Norway is looking for ways to boost returns that have missed a real return goal of 4 percent as interest rates have plunged globally in the aftermath of the financial crisis. The government is this year withdrawing money from the fund for the first time to make up for lost oil income after crude prices collapsed over the past two years.

    “The 60 percent equity share has over time been very good for us because it has given us considerable income from the fund,” Finance Minister Siv Jensen said in an interview after a press conference. “But we have also experienced that there can be swings from one year to another because the stock market moves over time.”

    ‘Considerably Less’

    After getting its first capital infusion 20 years ago, the fund has steadily added risk, expanding into stocks in 1998, emerging markets in 2000 and real estate in 2011 to safeguard the wealth of western Europe’s largest oil exporter.

    It’s currently mandated to hold 60 percent in stocks, 35 percent in bonds and 5 percent in real estate. After inflation and management costs, it has returned 3.43 percent over the past 10 years.

    The committee said that the expected returns from the fund are now “considerably less” than 4 percent. With the current equity share, the commission predicts an annual real return of just 2.3 percent over the next 30 years.

    Still, that didn’t stop the chairman of the commission, Knut Anton Mork, from disagreeing with the majority’s conclusion. The former chief economist at Svenska Handelsbanken in Oslo instead recommended cutting the stock holdings to 50 percent.

    “The minority recognizes that the reduction in the oil and gas remaining in the ground over the last decade is an argument in favor of a higher equity share, but considers this less important than the predictability of budget contributions from the fund,” he said.
    Lastly, Will Martin of the UK Business Insider reports, The world's biggest sovereign wealth fund is about to start taking more risks:
    Norway's Global Government Pension Fund, the biggest sovereign wealth fund in the world by assets under management, could be about to start taking a lot more risks if it follows the advice of a government-commissioned report into the way it allocates its assets.

    The new report, released on Tuesday, argues that the £716 billion ($880 billion) fund should increase its holdings of shares, and move around £71 billion ($87 billion) of its assets into riskier equity holdings.

    This would mean that roughly 70% of the fund's assets are held in stocks, up from just less than 60% right now. As a result, the fund's government bond portfolio would shrink substantially

    "A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the Fund and a higher risk of a decline in its long-run value," the report noted.

    "The majority is of the view that this risk is acceptable, provided that there is political will and ability to adapt economic policy to the accompanying increase in risk, in both the short and long run."

    Previously, the fund held around 40% in equities before increasing its allocation to 60% in 2007, just before the global financial crisis hit.

    Norway's sovereign wealth fund is looking for new ways to make money given the rock-bottom yields most developed-market government debt has right now, and following the crash in oil that has seen prices for the world's most important commodity crash from more than $100 per barrel to just more than $50 now, having briefly dropped below $30 early in the year.

    The crash has impacted Norway's economy so much that in 2016 — for the first time in nearly two decades — the fund is expected to  see net outflows, with the Bloomberg reporting February that the government will withdraw as much as 80 billion kroner (£7.99 billion; $9.8 billion) this year to support the economy.

    Rock-bottom global bond yields are making things even more tricky, as interest rates close to zero all around the world continue to bite. The eurozone, Switzerland, Sweden, Denmark, and Japan all already have negative interest rates, and rates in most other developed markets are pretty close to zero. In the UK, the rate is 0.25%, while in the USA it is 0.5%.

    Low interest rates mean low yields on bonds, meaning that the fixed-income market is not one where there is much money to be made right now, and that has helped drive the recommendation to move more money into stocks.

    "With a higher share of equities the expected return will increase as will the income to the government budget. Yes, it comes with higher risk but we think we are well equipped to handle this risk," Hilde Bjornland, an economist who was part of the team that compiled the report, told the Financial Times.

    Should the fund take up the report's recommendations, it could have a substantial impact on European, and even global markets. The fund's stock holdings are already so large that if averaged out, it would hold 2.5% of every single listed company in Europe. In the UK for example, the fund has invested almost £50 billion in stocks, spread across 457 different companies.
    There are two huge global whales that everyone looks at, Japan's Government Pension Investment Fund (GPIF) and Norway's Government Pension Fund Global (GPFG). The latter was created for the following reason:
    The Government Pension Fund Global is saving for future generations in Norway. One day the oil will run out, but the return on the fund will continue to benefit the Norwegian population
    As you can imagine, it's a big deal for Norwegians and global markets what decisions are taken in regards to the Fund's asset allocation and its investments which are managed by Norges Bank Investment Management.

    I am very well aware of Norway's Government Pension Fund Global because when I wrote my report on the governance of the federal public service pension plan for the Government of Canada (Treasury Board) back in 2007, I used the governance of Norway's pension as an example on how to improve transparency and oversight.

    What I like about Norway's pension fund is that it's clear about its investments, takes responsible investing very seriously and is extremely transparent, providing great insights in its reports, discussion notes, asset manager perspectives and of course, in its submissions to the Ministry of Finance.

    For example, in its latest publicly available submission to the Ministry on October 14, there is an excellent discussion on how the Fund can properly benchmark unlisted real estate investments, going over three methods:
    The first uses data from IPD for unlisted real estate investments, adjusted for autocorrelation. The return series from IPD can be broken down into the countries and sectors in which the fund is invested. The greatest challenge when using IPD data for calculating tracking error is that the time series are updated only quarterly or annually. The relative volatility of equities and bonds is currently calculated using weekly data, equally weighted, over a three-year period. Even an extension of the estimation period to ten years, for example, will yield relatively few observations if the calculations have to be performed on quarterly or annual data.

    The second method uses data for shares in listed REITs, adjusted for leverage. The main benefit of using REITs over IPD data is the availability of observable daily prices. To be able to represent the fund’s unlisted real estate investments meaningfully, we need to select individual funds in the markets in which the fund is invested. Their leverage must also be adjusted to the same level as the “equivalent” investment in the fund. This selection process and adjustments to take account of differences in risk profile will to some extent need to be based on criteria that will be difficult for experts outside the bank to verify.

    The third method is based on an external risk model developed by MSCI. The Bank has commissioned MSCI to compute a return series for an unlisted real estate portfolio that resembles the GPFG’s portfolio of unlisted real estate investments. An external risk model gives the Bank less insight into, and less control over, the parameters that influence the return series, but has the advantage of being calculated by an independent party.
    I will let you read the entire submission to the Ministry of Finance as it is extremely interesting and well worth considering for large pensions that invest in global unlisted real estate and are not properly benchmarking these investments (and I include some of Canada's large venerable pensions with "stellar governance" in this group).

    Now, the latest submission recommending to increase the allocation of global public equities to 70% from 60% and reducing the allocation of global fixed income to 25% from 35% is not yet available on its website in the news section.

    It will be posted on the website but I am not very interested in reading their arguments as I don't agree with this recommendation at all and side with Knut Anton Mork who thinks the allocation should be cut to 50%.

    But I also think the allocation to global fixed income should be cut by 10% so that the Fund can invest more in unlisted real estate and infrastructure all over the world (see below). 

    My reasoning is that over the short, intermediate and even long run, the return on stocks and bonds will be very low and very volatile so now is definitely not the time to crank up the risk in global equities.

    Look, Norway's pension fund can put out all the academic discussion notes it wants on the equity risk premium but when making big shifts in asset allocation, the folks at NBIM really need to think things through a lot more carefully because cranking up the allocation in stocks at this point exposes the Fund to a serious drawdown, one that might take years to recover from, especially if the world falls into a long deflationary cycle (my biggest fear).

    Bill Gross rightly noted last month now is not the time to worry about return on capital but return of capital. In his latest comment, he notes that the doubling down strategy of central bankers significantly increases the risk in risk assets.

    All this to say that I am surprised Norway's mammoth pension fund is seriously considering increasing risk by increasing its allocation to global equities at this time.

    True, global bonds have entered the Twilight Zone and there are cracks in the bond market, which is why delivering alpha gurus are pounding the table that bonds are dead meat, as are other bond bubble clowns.

    But unless someone convinces me that the fading risks of global deflation are credible and sustainable, I still see bonds as the ultimate diversifier in a deflationary world.

    One thing is for sure, Fed Chair Janet Yellen isn't convinced that global deflation is dead which is why her speech last Friday on staying accommodative for longer, overshooting the Fed's 2% inflation target, was a real game changer for me.

    More worrisome, Yellen's speech was a stark admission the Fed may be behind the deflation curve (or unable to mitigate the coming deflation tsunami) and investors may need to brace for a violent shift in markets, one which could spell doom for equities for a very long time.

    And if that is the case, you have to wonder why in the world would Norway risk its savings from oil revenues and flush them down the global stock toilet?

    I'm not being cynical doomsayer here, more of a realist. I've actually recommended selectively plunging into stocks right now, but that advice carries huge risks and it won't help a mega fund like Norway's GPFG.

    Admittedly, it's a mathematical certainty that global bonds are not going deliver great returns over the next ten years, but it might be a lot worse in global stocks, especially when you adjust returns for risk.

    So what advice do I have for Norway's GPFG? Take the time to read my conversation with HOOPP's Jim Keohane where he admitted HOOPP will never invest in negative yielding bonds, preferring real estate instead.

    I personally recommend GPFG follows Canada's large pensions and ramp up its infrastructure investments which it just introduced into its asset allocation. Generally speaking, there is a growing appetite for infrastructure as large institutional investors are looking for scalable investments that can deliver steady cash flows over a long period.

    [Note: Norway’s sovereign wealth fund has bemoaned the smaller scale of infrastructure projects in developing nations after a report to the government called for it be allowed to invest in the asset class, but in my opinion it should exclusively focus on developed nations initially.]

    Still, I'm not going to lie to you, infrastructure investments are frothy and they carry their own set of unique risks (illiquidity, regulatory, political and currency risks like what happened to British infrastructure investments post Brexit).

    But Norway's pension has to stop being so excessively reliant on global public markets and start considering the benefits of global private markets. There is a reason why the Canada Pension Plan Investment Board and other large Canadian pensions are scouring the globe for opportunities across public and private markets, delivering excellent long-term results, and I think Norway's GPFG and Japan's GPIF need to follow suit, provided they get the governance right (not worried about Norway's governance even if it's not perfect, it is excellent).

    To be sure, Norway's GPFG is an excellent fund that is run very well but it's essentially at the mercy of public markets and far more vulnerable to abrupt shifts in global stocks than large Canadian pensions.

    No matter how much risk management it has implemented, at the end of the day, Norway's GPFG is a giant beta fund and that means it will outperform Canada's large pensions during bull markets but grossly underperform them during bear markets.

    On that note, let me remind all of you once again that it takes a lot of time and effort to research and write these comments. Please kindly show your appreciation by donating or subscribing on the right-hand side under my picture (you need to view web version on your cell to view the PayPal options on the right-hand side under my picture).

    Below, a CNBC clip which discussed why Norway tapped its oil fund for the first time back in March. I hope this doesn't become a regular occurrence in the future which is why I'm openly questioning the recommendation to crank up the risk in global equities at this time.

    There is a much better option, like following the asset allocation of Canada's large pensions which invest proportionally more in private markets and are delivering stellar long-term returns.

    Tuesday, October 18, 2016

    CalSTRS Cuts External Managers?

    Aliya Ram of the Financial Times reports, Calstrs to pull $20bn from external fund managers:
    The California State Teachers’ Retirement System plans to pull $20bn from its external fund managers. The third-largest US pension scheme is blaming the withdrawal on high fees and disappointing returns across the investment industry.

    Sacramento-based Calstrs, which oversees $193bn of assets, currently allocates half of its assets to external fund companies.

    Jack Ehnes, the chief executive of Calstrs, told FTfm the scheme will reduce the level of money run by external companies to 40 per cent because it “costs pennies” to run the money internally versus paying fees to external investment managers.

    “The best way to get better returns is not finding better managers,” he said. “For every $10 we pay an outside manager, we would pay $1 inside. That is a pretty daunting ratio.”

    According to its latest annual report, the pension scheme’s largest external mandates are with Generation Investment Management, the London-based company that was co-founded by Al Gore, the former US vice-president, New York-based Lazard Asset Management and CBRE Global Investors, the property investment specialist.

    As pension deficits grow due to rising life expectancy and poor returns, other schemes have also pulled mandates from external fund companies that are already under pressure from market volatility and the popularity of cheaper, passive portfolios.

    Alaska Permanent Fund, which manages $55bn, said last week it will retrieve up to half its assets from external managers, while ATP, Denmark’s largest pension provider, and AP2, the Swedish pension scheme, both dropped mandates from external managers earlier this year.

    Calstrs has already shifted $13bn of its assets in-house over the past year, according to Mr Ehnes. The number of investment staff employed by the pension fund has risen 15 per cent, to 155, over the past two years to deal with the increase in capital managed internally.

    Calstrs’ latest annual report showed it paid $155.7m in investment fees in the year to the end of June 2015, nearly a 10th less than it paid in fees the previous year.

    The fee intake of investment managers Morgan Stanley, T Rowe Price and Aberdeen Asset Management fell significantly, by 61 per cent, 24 per cent and 15 per cent respectively.

    Mr Ehnes said the proportion of assets managed in-house at Calstrs could increase beyond 60 per cent as its expertise develops.
    Glad to read that CalSTRS finally woke up and discovered the secret sauce of the Ontario Teachers' Pension Plan (OTPP), the Healthcare of Ontario Pension Plan (HOOPP) and the rest of Canada's Top Ten pensions which manage most their assets internally.

    Of course, CalSTRS still has to work on improving its governance structure to get politics out of its investment decisions and hopefully they're starting to pay their investment staff properly as they cut external mandates and bring assets internally (maybe not Canadian compensation standards but much better as responsibilities shift to internal management).

    Why did CalSTRS decide to cut a big chunk of its external fund managers? There are a lot of reasons. First, the performance at CalSTRS during fiscal 2015-16 was far from great, likely prompting a lively internal discussion where they asked themselves the following question: "Why are we paying external fund managers excessive fees if they keep delivering mediocre returns?"

    By the way, it's not just CalSTRS asking this question. CalPERS nuked its hedge fund program exactly two years ago and its senior officers have gotten grilled on private equity fund fees (so have the ones  at CalSTRS and rightfully so as private equity's misalignment of interests is the worst kept industry secret).

    Even Ontario Teachers' which is by far one of the biggest and best investors in external hedge funds, cut allocations to some computer-run hedge funds that weren't delivering the goods.

    And many other pensions and endowments are asking tough questions on their external managers and whether they are worth the fees. On Monday, Simone Foxman and John Gittelsohn of Bloomberg reported, Hedge Funds Cost N.Y. Pension Plan $3.8 Billion, Report Says:
    The New York state comptroller’s decision to stick with hedge funds despite their poor returns has cost the Common Retirement Fund $3.8 billion in fees and underperformance, according to a critical report by the Department of Financial Services.

    The state comptroller, who invests $181 billion for two systems covering local employees, police and fire personnel, "has over relied on so-called ‘active’ management by outside hedge fund managers," the department said Monday in the 20-page report. "For years the State Comptroller has been frozen in place, letting outside managers rake in millions of dollars in fees regardless of hedge fund performance."

    Spokeswoman Jennifer Freeman defended the office of comptroller Thomas DiNapoli, accusing the department of harboring political motives.

    "It’s disappointing and shocking that a regulator would issue such an uninformed and unprofessional report," Freeman said in a statement. "Unfortunately, the Department of Financial Services seems more interested in playing political games, so remains unaware of actions taken by what is one of the best managed and best funded public pension funds in the country."

    Hedge funds, which charge some of the highest fees in the money-management business, have faced mounting criticism from clients over steep costs and performance that mostly hasn’t kept pace with stock markets since the financial crisis. The California Public Employees’ Retirement System, the largest U.S. pension plan, voted to divest of hedge funds in 2014 because they were too complicated and expensive. On Friday, the investment committee for the Kentucky Retirement Systems voted to exit its $1.5 billion in hedge fund holdings over three years.
    Opening Round

    The DFS report appears to be the opening round in an broader investigation into the management of New York’s retirement system, the third largest state fund at the end of 2015. Led by Superintendent Maria Vullo, the department said it was considering potential regulations on fees and profit-sharing "as well as pre-approval of contracts that provide for fees or profit sharing in excess of a certain rate."

    The topic is of interest to Governor Andrew Cuomo, who oversaw a three-year investigation of the comptroller’s office when he was New York Attorney General. By the end of that probe, former Comptroller Alan Hevesi pleaded guilty to one felony count stemming from a pay-to-play kickback scheme.

    Categorized under New York system’s “absolute return strategy,” hedge fund investments lost 4.8 percent in the fiscal year that ended March 31, according to the system’s annual report. The average hedge fund lost 3.8 percent in the same period, according to data compiled by Hedge Fund Research Inc. New York’s hedge fund investments have returned an average of 3.2 percent each year over the past 10 years, compared with 5.7 percent for the total fund.

    The DFS’s report said the state had paid almost $1.1 billion in fees to its absolute return managers, a category that includes hedge funds, since 2009. Had the system allocated that money to global equities managers instead, their performance would have netted the fund $2.7 billion more in gains.
    Doubling Down

    In the face of three years of “massive hedge fund underperformance,” the report added, the comptroller continued the gamble by almost doubling -- increasing by 86 percent -- the assets poured into the managers between 2009 and 2011.

    Freeman said DiNapoli and Chief Investment Officer Vicki Fuller have taken "aggressive steps" to reduce hedge fund investments and limit fees, and that the system hasn’t put money into a hedge fund in well over a year.

    The report also criticized the lack of transparency related to the system’s private equity investments, saying the comptroller hadn’t taken sufficient action to make sure funds were disclosing all their fees and expenses.

    The pension system "has only recently discovered what should have been clear long ago -- that making a commitment to alternative investments places a much greater monitoring burden on the investor," the report said. "Taking on asset allocations that are complex to monitor and oversee and only belatedly understanding the challenges reflects poor planning."
    I don't know what all the fuss is about but I actually read the full DFS report and completely disagree with that spokeswoman who defended the office of comptroller Thomas DiNapoli, claiming the report is "uninformed and unprofessional" and politically motivated.

    In fact, DFS Superintendent Maria T. Vullo put out a press release following the release of this report:
    Yesterday the Department of Financial Services (DFS) issued a report finding that the New York State Common Retirement Fund (CRF), managed by the New York State Comptroller as sole trustee, for years has invested pension system funds in high-cost underperforming hedge funds, costing the system $3.8 billion over the last eight years. Contrary to the statement by the Comptroller’s communications director, and despite the fact that DFS, as regulator, had no obligation to inform them, the Comptroller’s office was well aware of this review. In a letter sent on September 9, 2016, DFS raised specific questions about the management and investment allocations of the CRF. None of the information provided to DFS in response to the September letter validates the claims being made now. And putting aside all of the bluster, the Comptroller has not contested, because he cannot contest, the fact that he took 8 years to address these significant issues while pension fund managers nationwide have significantly cut or entirely eliminated their hedge fund investments. Prior to the release of our report, I personally called the Comptroller but he has yet to return my call. DFS stands by its report and will continue to exercise its oversight of the pension systems and maintain its obligation to the public to report on these important issues.
    Kudos to Superintendent Vullo and the Department of Financial Services for having the chutzpah and foresight to issue this report and spell out in clear terms the actual and opportunity cost of investing in hedge funds and private equity funds as well as other issues investing in these funds.

    Moreover, I recommend all US, Canadian and European public pensions follow New York State's lead and commission similar reports from independent and qualified professionals who can perform a serious and in-depth operational, investment and risk management audit of their public plans.

    New York's Common Retirement Fund should follow CalPERS, CalSTRS and others and nuke their hedge fund program and even cut a lot of their private equity funds which are delivering equally mediocre returns and charging it a bundle in fees ($1.1 billion in fees pays a lot of excellent salaries to bring assets internally provided they get the governance and compensation right).

    Importantly, in a deflationary, ZIRP and NIRP world where ultra low or negative rates are here to stay, it's simply indefensible to pay external managers huge fees for mediocre or even solid returns.

    Yes, let me repeat that so the Ray Dalios, Ken Griffins, David Teppers of this world can understand in plain English: no matter how much alpha you are reportedly delivering, it's simply ludicrous and indefensible to justify 2 & 20 (or even 1 & 10 in some cases) to your big pension and sovereign wealth fund clients.

    I don't care if it's mathematical geniuses like Jim Simons and the folks at Renaissance Technologies or up and coming hedge fund gurus trying to one up Soros, the glory days of charging customers 2 & 20 or more on multibillions are over and they're never coming back.

    What about Steve Cohen, the perfect hedge fund predator? Will he be able to charge clients 5 & 50 for his new fund like he used to in the good old days at SAC Capital? No, there's not a chance in hell he will be charging large institutional global clients anywhere close to that amount, provided of course that he first manages to lure them back to invest with him (a lot of big institutions are going to be reluctant or pass given his sketchy background but plenty of others won't care as long as his new fund keeps delivering outsize returns of SAC and his family office).

    And it's not just hedge funds that need to cut fees. These are treacherous times for private equity funds and they need to cut fees too and reexamine their alignment of interests and whether they're truly in the best interests of their large institutional clients and their members.

    The same goes for long-only active management where there's been a crisis going on for years. Why do institutional and retail investors keep forking over fees to sub-beta performers who obviously can't pick stocks properly? It's the very definition of insanity.

    This is all part of the malaise of modern pensions and in a deflationary world where fees and costs add up fast, many other US public pensions will follow CalPERS, CalSTRS, and others who cut or are cutting allocations to external managers charging them hefty fees for mediocre returns or risk being the next Rhode Island meeting Warren Buffet.

    Is this the beginning of something far more widespread, a mass exodus out of external managers? I don't know but clearly there are some big pensions and sovereign wealth funds that are tired of paying hefty fees to external managers for lousy absolute and risk-adjusted returns.

    The diversification argument can only take them so far, at one point funds need to deliver the goods or they will face the wrath of angry investors who will move assets internally and never look back.

    Below, I embedded CalSTRS's September 2016 Investment Committee. The committee began with public statements from California teachers and Chris Ailman, the CIO, starts discussing performance around minute 24. Take the time to watch the entire committee and listen to the discussion on fees (of course, most of the interesting discussions take place in closed camera sessions).

    Monday, October 17, 2016

    The Fed's Game Changer?

    Howard Schneider and Svea Herbst-Bayliss of Reuters report, Fed's Yellen says 'high-pressure' policy may be only way back from crisis:
    The Federal Reserve may need to run a "high-pressure economy" to reverse damage from the 2008-2009 crisis that depressed output, sidelined workers, and risks becoming a permanent scar, Fed Chair Janet Yellen said on Friday in a broad review of where the recovery may still fall short.

    Though not addressing interest rates or immediate policy concerns directly, Yellen laid out the deepening concern at the Fed that U.S. economic potential is slipping and aggressive steps may be needed to rebuild it.

    Yellen, in a lunch address to a conference of policymakers and top academics in Boston, said the question was whether that damage can be undone "by temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market."

    "One can certainly identify plausible ways in which this might occur," she said.

    Looking for policies that would lower unemployment further and boost consumption, even at the risk of higher inflation, could convince businesses to invest, improve confidence, and bring even more workers into the economy.

    Yellen's comments, while posed as questions that need more research, still add an important voice to an intensifying debate within the Fed over whether economic growth is close enough to normal to need steady interest rate increases, or whether it remains subpar and scarred, a theory pressed by Harvard economist and former U.S. Treasury Secretary, Lawrence Summers, among others.

    Her remarks jarred the U.S. bond market on Friday afternoon, where they were interpreted as perhaps a willingness to allow inflation to run beyond the Fed's 2.0 percent target. Prices on longer dated U.S. Treasuries, which are most sensitive to inflation expectations, fell sharply and their yields shot higher.

    The yields on both 30-year bonds and 10-year notes ended the day at their highest levels since early June, and their spread over shorter-dated 2-year note yields widened by the most in seven months.

    Jeffrey Gundlach, chief executive of DoubleLine Capital, said he read Yellen as saying, "'You don't have to tighten policy just because inflation goes to over 2 percent.'

    "Inflation can go to 3 percent, if the Fed thinks this is temporary," said Gundlach, who agreed Yellen was striking a chord similar to Summer's "secular stagnation" thesis. "Yellen is thinking independently and willing to act on what she thinks."

    While investors by and large think the Fed is likely to raise interest rates in December this year, in a nod to the country's 5.0 percent unemployment rate and expectations that inflation will rise, they do not see the Fed moving aggressively thereafter.

    "This is a clear rebuttal of the hawkish arguments," to raise rates soon, a line of argument pitched by some of the Fed's regional bank presidents, said Christopher Low, chief economist at FTN Financial.

    Boston Federal Reserve Bank president Eric Rosengren, who is hosting the conference at which Yellen spoke, was one of three policymakers who dissented at the Fed's September policy meeting and argued for an immediate increase in interest rates. He feels a slight increase now will keep job growth on track and prevent a faster round of rate increases later.

    But in a speech earlier on Friday Rosengren also referred to the economy as "nonconformist" because of its slow growth, and the general mood at the conference was that the sluggishness is largely the result of forces like aging and demographics that are unlikely to change.

    "We may have to accept the reality of low growth," said John Fernald, a senior research at the San Franciso Fed. "Potential is really low."

    That sort of assessment could figure importantly in coming debates over rate policy, and over whether support is building at the Fed to risk letting inflation move above its 2.0 percent target in order to employ more workers and perhaps encourage more investment. It could even impact the central bank's willingness to put more aggressive monetary policies back into play if the economy slows.

    "If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand," Yellen said. It would "make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn."

    From low inflation to the effect of low interest rates on spending, Yellen's remarks demonstrated how little in the economy has been acting as the Fed expected.

    With public expectations about inflation so hard to budge, Yellen said tools like forward guidance, "may be needed again in the future, given the likelihood that the global economy may continue to experience historically low interest rates, thereby making it unlikely that reductions in short-term interest rates alone would be an adequate response to a future recession."
    On Friday, I examined whether risks of global deflation are fading, noting the following:
    You will recall I openly questioned Morgan Stanley's call that the greenback was set to tumble at the beginning of August (they blew that call).

    I've always maintained that global macro traders should short currencies where deflation is prevalent (like Europe and Japan) and go long currencies where deflation has yet to strike (like the United States). I also warned my readers to keep an eye on the surging yen as it could trigger a crisis, especially another Asian financial crisis.

    The way to think about currency moves is simple. A rising currency lowers import prices and exacerbates disinflation and/ or deflation. In a country like Japan which imports and exports a lot of goods, a rising currency will wreak havoc on its exports and attempts to reflate inflation expectations. And more deflation in Japan puts more pressure on other Asian economies to lower prices, exporting deflation to the rest of the world.

    This is why it's a big deal if China can escape deflation. The thing you need to ask yourself is whether the pickup in inflation in China is sustainable and credible or doomed to dissipate quickly depending on what is going on in Japan and the Eurozone. Because if Japan and the Eurozone can't escape deflation, it's hard to envision China escaping deflation (there is a reason why China's exports were down sharply, and it has to do with weak demand from Europe and elsewhere).

    And if the US dollar keeps rising, and global deflation comes back with a vengeance, it's going to be hard for the US to escape deflation too.

    One thing I can guarantee you, if the US dollar keeps rising, the Fed will proceed very gradually in terms of rate hikes. It might hike rates 25 basis points in December (not convinced it will) and wait to see the effects on emerging markets and China.

    A rising US dollar will also effectively cap commodity prices (lower oil, gold, energy prices) and even long bond yields (lower import prices mean lower inflation expectations going forward). It will also alleviate pressure on the Fed to raise rates as a rising dollar tightens financial conditions.
    My thinking is that the pickup in PPI inflation in China might allow the Fed to proceed with one more rate hike in December but I am far from convinced it will hike rates this year. In fact, I'm on record stating the Fed should not raise rates now.

    And after reading Fed Chair Janet Yellen's speech on The Elusive Great Recovery, I interpret it the same way Jeffrey Gundlach does, the Fed is willing to stay accommodative for longer:
    Federal Reserve Chair Janet Yellen's speech on Friday on running a "high pressure" economy with a tight labor market to reverse some of the negative effects of the Great Recession of 2008 suggests the U.S. central bank will stay accommodative for longer, said Jeffrey Gundlach, chief executive of DoubleLine Capital.

    "I didn't hear, 'We are going to tighten in December,'" Gundlach said in a telephone interview. "I think she is concerned about the trend of economic growth. GDP is not doing what they want."

    Gundlach said the GDP Now indicator from the Atlanta Federal Reserve has been cut in half to only 1.9 percent for the third quarter after only 1.1 percent actual for the first half of this year. "GDP Now keeps fading away. If we get only 1.9 percent GDP for third — and fourth quarters — we are looking at only 1.5 percent GDP this year," he said.

    Gundlach, who oversees more than $106 billion at Los Angeles-based DoubleLine, said Yellen's remarks suggest that she embraces the hypothesis introduced by former U.S. Treasury Secretary Larry Summers, who said that secular stagnation, or a lack of demand, is pushing down global growth.

    "I think Yellen is saying, "You don't have to tighten policy just because inflation goes to over 2 percent. Inflation can go to 3 percent, if the Fed thinks this is temporary," Gundlach said. "Yellen is thinking independently and willing to act on what she thinks."
    Has Janet Yellen lost her marbles? Isn't she worried about cracks in the bond market and the bursting of the so-called bond bubble?

    I believe Friday's speech was a game changer at the Fed because it's openly admitting what I've long been warning of, namely, the deflation tsunami is coming, the bond market is worried, and there is a sea change at the Fed to try to stave off the rising risks of global deflation.

    I've long maintained the Fed would be nuts to raise rates in a world where global deflation is the clear and present danger. All this will do is reinforce deflationary headwinds around the world and risk another emerging markets crisis and a prolonged deflationary episode, one that might hit the US economy.

    I also warned no matter what the Fed and other central banks do, all they're doing is buying time. Inevitably, the deflation tsunami will strike the developed and emerging world, and this will likely bring about a massive fiscal policy response, but by then, it will be way too late.

    Of course, there is a risk of staying accommodative for longer, namely, that all it will do is exacerbate rising inequality and the ongoing retirement crisis, which are two structural factors I keep harping on when I discuss the lack of aggregate demand in the United States and elsewhere.

    Importantly, while staying accommodative for longer buys the Fed time, if it doesn't succeed in overshooting its inflation target, then get ready because ZIRP and NIRP will be with us for the next decade(s). 

    On that last point, I want you to read a recent comment by Brian Romanchuk of the Bond Economics blog where he examines whether Treasury yields will escape their low yield trap. Brian also has his doubts on fiscal policy and rightly notes while a cyclical bond bear market can happen, wiping out risk parity funds and big obscure hedge funds loading up on Treasuries, a structural bond bear market is highly unlikely until policymakers address structural factors behind persistently weak growth (like rising inequality and lack of aggregate demand).

    Below, the Boston Fed’s 60th Economic Conference, “The Elusive 'Great' Recovery: Causes and Implications for Future Business Cycle Dynamics” Bank President Eric Rosengren offered opening remarks and Federal Reserve Chair Janet Yellen delivered the keynote address.

    Later on Monday, Fed Vice Chairman Stanley Fischer will deliver a speech which I will embed if it becomes available.

    But in my opinion, the key speech was delivered by the Fed Chair on Friday and it's a game changer because it signals the Fed is losing its fight on deflation and it needs to remain accommodative for longer and investors might need to brace for a violent shift in markets.

    Update: In a speech at the Economic Club of New York, Why Are Interest Rates So Low?, Federal Reserve Vice Chairman Stanley Fischer suggested that low rates can lead to longer and deeper recessions, making the economy more vulnerable. He added they can also threaten financial stability, although the evidence so far doesn't show a heightened threat of instability.

    I would focus more on Fed Chair Yellen's speech than the one given by Stanley Fischer. Fischer has been warning of the dangers of low rates for a long time and he hasn't convinced his colleagues on the Fed to reverse course. I believe the reason is that the doves, led by Yellen, call the shots and they feel the environment is not right to hike rates.