Thursday, December 8, 2016

US State Pensions Need a Miracle?

Frank McGuire of Newsmax Finance reports, Former Fed Adviser: 'Some Miracle' Needed to Defuse $1.3 Trillion Pensions Time Bomb:
America will need “some miracle” to survive the looming economic disaster of $1.3 trillion worth of underfunded government pensions, a former Federal Reserve adviser has warned.

“The average state pension in the last fiscal year returned something south of 1%. You cannot fill that gap with a bulldozer, impossible,” Danielle DiMartino Booth told Real Vision TV.

The median state pension had 74.5 percent of assets needed to meet promised benefits, down from 75.6 percent the prior year. The decline followed two years of gains. The shortfall for states overall was $1.1 trillion in 2015 and has continued to grow.

“Anyone who knows their compounding tables knows you don't make that up. You don't get that back unless you get some miracle,” Business Insider quoted the president of Money Strong as saying.

“The baby boomers are no longer an actuarial theory,” she said. “They're a reality. The checks are being written.”

Pressure on governments to increase pension contributions has mounted because of investment losses during the recession that ended in 2009, benefit increases, rising retirements and flat or declining public payrolls that have cut the number of workers paying in. U.S. state and local government pensions logged median increases of 3.4 percent for the 12 months ended June 30, 2015, according to data from Wilshire Associates.

State and local pensions count on annual gains of 7 percent to 8 percent to pay retirement benefits for teachers, police officers and other civil employees. The funds are being forced to re-evaluate projected investment gains that determine how much money taxpayers need to put into them, given the recent run of lackluster returns.

And while many aging Americans have accepted the “new reality” that they would be retiring at 70 instead of 65, any additional extension won’t be welcome. “They're turning 71. And the physiological decision to stay in the workforce won't work for much longer. And that means that these pensions are going to come under tremendous amounts of pressure,” she said.

“And the idea that we can escape what's to come, given demographically what we're staring at is naive at best. And it's reckless at worst,” DiMartino Booth said. “And when you throw private equity and all of the dry powder that they have -- that they're sitting on -- still waiting to deploy on pensions’ behalf, at really egregious valuations, yeah, it's hard to sleep at night,” she said.

DiMartino Booth cited Dallas as an example of the pensions crisis, where returns for the $2.27 billion Police and Fire Pension System have suffered due to risky investments in real estate.

“We're seeing this surge of people trying to retire early and take the money. Because they see it's not going to be there. And if that dynamic and that belief spreads-- forget all the other problems,” DiMartino Booth said. “The pension fund -- underfunding is Ground Zero.”

DiMartino Booth warned of public violence if her pensions predictions come to fruition. Large pension shortfalls may lead to cuts in services as governments face pressure to pump more cash into the retirement systems.

“This is where the smile comes off my face. We are an angry country. We're an angry world. The wealth effect is dead. The inequality divide is unlike anything we've seen since the years that preceded the Great Depression,” she said.

To be sure, New Jersey became the state with the worst-funded public pension system in the U.S. in 2015, followed closely by Kentucky and Illinois, Bloomberg recently reported.

The Garden State had $135.7 billion less than it needs to cover all the benefits that have been promised, a $22.6 billion increase over the prior year, according to data compiled by Bloomberg. Illinois’s unfunded pension liabilities rose to $119.1 billion from $111.5 billion.

The two were among states whose retirement systems slipped further behind as rock-bottom bond yields and lackluster stock-market gains caused investment returns to fall short of targets.
Danielle DiMartino Booth, president of Money Strong, is one smart lady. I've heard her speak a few times on CNBC and she understands Fed policy and the economy.

In this interview, she highlights a lot of the issues I've been warning of for years, namely, state pensions are delusional, reality will hit them all hard which effectively means higher contributions, lower benefits, higher property taxes and a slower economy as baby boomers retire with little to no savings.

I've also been warning my readers that the global pension crisis isn't getting better, it's deflationary and it will exacerbate rising inequality which is itself very deflationary.

I discussed all this in my recent comment on CalPERS getting real on future returns:
So, CalPERS is getting real on future returns? It's about time. I've long argued that US public pensions are delusional when it comes to their investment return assumptions and that if they used the discount rates most Canadian public pensions use, they'd be insolvent.

And J.J. Jelincic is right, taking too little risk in public equities is walking away from upside but he's not being completely honest because when a mature pension plan with negative cash flows the size of CalPERS is underfunded, taking more risk in public equities can also spell doom because it introduces a lot more volatility in the asset mix (ie. downside risk).

When it comes to pensions, it's not just about taking more risk, it's about taking smarter risks, it's about delivering high risk-adjusted returns over the long run to minimize the volatility in contribution risk.

Sure, CalPERS can allocate 60% of its portfolio to MSCI global stocks and hope for the best but can it then live through the volatility or worse still, a prolonged recession and bear market?

This too has huge implications because pension plans are path dependent which means the starting point matters and if the plan is underfunded or severely underfunded, taking more risk can put it in a deeper hole, one that it might never get out of.

...

The main reason why US public pensions don't like lowering their return assumptions is because it effectively means public sector workers and state and local governments will need to contribute more to shore up these pensions. And this isn't always feasible, which means property taxes might need to rise too to shore up these public pensions.

This is why I keep stating the pension crisis is deflationary. The shift from defined-benefit to defined-contribution plans shifts the retirement risk entirely on to employees which will eventually succumb to pension poverty once they outlive their meager savings (forcing higher social welfare costs for governments) and public sector pension deficits will only be met by lowering return assumptions, hiking the contributions, cutting benefits or raising property taxes, all of which take money out of the system and impact aggregate demand in a negative way.

This is why it's a huge deal if CalPERS goes ahead and lowers its investment return assumptions. The ripple effects will be felt throughout the economy especially if other US public pensions follow suit.
The point is CalPERS is a mature plan with negative cash flows and it's underfunded so it needs to get real on its return assumptions as do plenty of other US state pensions that are in the same or much worse situation (most are far worse).

Now, to be fair, the situation isn't dire as the article above states the median state pension has had 74.5 percent of assets needed to meet promised benefits, down from 75.6 percent the prior year. Typically any figure close to 80% is considered fine to pension actuaries who smooth things out over a long period.

But as DiMartino Booth correctly points out, the structural headwinds pensions face, driven primarily by demographics but other factors too, are unlike anything in the past and looking ahead, the environment is very grim for US state pensions.

Maybe the Trump reflation rally will continue for the next four years and interest rates will normalize at 5-6% -- the best scenario for pensions. But if I were advising US state pensions, I'd say this is a pipe dream scenario and they are all better off getting real on future returns, just like CalPERS is currently doing.

Defusing America's pensions time bomb will require some serious structural reforms to the governance of these plans and adopting a shared-risk model so that the risk of these plans doesn't just fall on sponsors and taxpayers. Beneficiaries need to accept that when times are tough, their benefits will necessarily be lower until these plans get back to fully funded status.

Below, Danielle DiMartino Booth discusses Fed policy, Italy and the state pension time bomb on Real Vision Television. Listen carefully to all her comments, she knows what she's talking about. You need to subscribe to Real Vision TV to see the entire interview.

Wednesday, December 7, 2016

Does Size Matter For PE Fund Performance?

Dylan Cox of Pitchbook reports, Size doesn't matter in PE fund performance over the long term:
Despite the dueling claims that smaller PE fund managers lack sophistication or sufficient scale, or that larger fund managers lack the nimbleness, operational focus and expertise necessary to improve portfolio companies, returns across different fund sizes are relatively uniform in the long term. 10-year horizon IRRs for PE funds of any size bucket are all between 10% and 11%.

When comparing returns on a horizon basis, it’s important to remember that the data is indicative of market conditions over time, and not the returns of any one vintage. For example, a lower IRR across the industry between the five- and 10-year horizon is not indicative of a loss of alpha-generating capacity after the five-year mark, but rather a reflection of the stretched hold periods and asset write-offs that plagued many PE portfolios during the recession. Similarly, the three-year horizon IRR is the highest we observe, due to the fact that these investments were made before the recent run-up in valuations and have been subsequently marked as such—even though many of these returns have yet to be fully realized through an exit.

Interestingly, funds with less than $250 million in AUM have underperformed the rest of the asset class on a one- and three-year horizon. This is at least partially due to the aforementioned run-up in valuations which stemmed from cash-heavy corporate balance sheets that went looking for inorganic growth through strategic acquisitions—a strategy that often doesn’t reach the lower middle market (LMM) of PE. Only in the last few months have valuations started to rise in the LMM and below, as PE firms of all stripes increasingly look for value plays through add-ons and smaller portfolio companies.

Note: This column was previously published in The Lead Left.

For more data and analysis into PE fund performance, download our new Benchmarking Report.
Let me first thank Ken Akoundi of Investor DNA for bringing this up to my attention. You can subscribe to Ken's distribution list where he sends a daily email with links to various articles covering industry news here.

As far as this study, I would be careful interpreting aggregate data on PE funds and note that previous studies have shown that there is performance persistence in the private equity industry.

Yesterday I covered why big hedge funds are getting bigger or risk going home. You should read that comment because a lot of what I wrote there is driving the same bifurcation between small and large PE funds in the industry.

Importantly, big institutions looking for scale are not going to waste their time performing due diligence on several small PE funds which may or may not perform better than their larger rivals. They will go to the large brand name private equity funds that everybody knows well because they will be able to invest and co-invest (where they pay no fees) large sums with them.

And just like big hedge funds are dropping their fees, big PE funds are dropping their fees but locking in their investors for a longer period, effectively emulating Warren Buffet's approach. I discussed why they are doing this last year in this comment.

These are treacherous times for private equity and big institutional investors are taking note, demanding a lot more from their PE partners and making sure private equity's diminishing returns and misalignment of interests don't impact their long-term performance.

Still, large PE funds are generating huge returns, embracing the quick flip and reorienting their internal strategies to adapt to a tough environment.

In Canada, there is a big push by pensions to go direct in private equity, foregoing funds altogether. Dasha Afanasieva of Reuters reports, Canada’s OMERS private equity arm makes first European sale:
Ontario’s municipal workers pension fund has sold a majority stake in marine-services company V.Group to buyout firm Advent International in the first sale by the Canadian fund’s private equity arm in Europe.

Pension funds and other institutional investors are a growing force in direct private investment as they seek to bypass investing in traditional buyout funds and boost returns against a backdrop of low global interest rates.

As part of the shift to more direct investment, the Ontario Municipal Employees Retirement System (OMERS) set up a private equity team (OPE) and now has about $10-billion invested.

It started a London operation in 2009 and two years later it bought V.Group, which manages more than 1,000 vessels and employs more than 3,000 people, from Exponent Private Equity for an enterprise value of $520-million (U.S.).

Mark Redman, global head of private equity at OMERS Private Markets, said the V.Group sale was its fourth successful exit worldwide this year and vindicated the fund’s strategy. He said no more private equity sales were in the works for now.

“I am delighted that we have demonstrated ultimate proof of concept with this exit and am confident the global team shall continue to generate the long-term, stable returns necessary to meet the OMERS pension promise,” he said.

OMERS, which has about $80-billion (Canadian) of assets under management, still allocates some $2-billion Canadian dollars through private equity funds, but OPE expects this to decline further as it focuses more on direct investments.

OPE declined to disclose how much Advent paid for 51 per cent of V.Group. OPE will remain a minority investor.

OPE targets investments in companies with enterprise values of $200-million to $1.5-billion with a geographical focus is on Canada, the United States and Europe, with a particular emphasis on Britain.

As pension funds increasingly focus on direct private investments, traditional private equity houses are in turn setting up funds which hold onto companies for longer and target potentially lower returns.

Bankers say this broad trend in the private equity industry has led to higher valuations as the fundraising pool has grown bigger than ever.

Advent has a $13-billion (U.S.) fund for equity investments outside Latin America of between $100-million and $1-billion.

The sale announced on Monday followed bolt on acquisitions of Bibby Ship Management and Selandia Ship Management Group by V.Group.

Goldman Sachs acted as financial advisers to the shipping services company; Weil acted as legal counsel and EY as financial diligence advisers.
Now, a couple of comments. While I welcome OPE's success in going direct, OMERS still needs to invest in private equity funds. And some of Canada's largest pensions, like CPPIB, will never go direct in private equity because they don't feel like they can compete with top funds in this space.

[Note: It might help if OPE reports the IRR of their direct operations, net of all expenses relative to the IRR of their fund investments, net of all fees so their stakeholders can understand the pros and cons of going direct in private equity. Here you need to look at a long period.]

There is a lot of misinformation when it comes to Canadian pensions 'going direct' in private equity. Yes, they have a much longer investment horizon than traditional funds which is a competitive advantage, but PE funds are adapting and going longer too and in the end, it will be very hard, if not impossible, for any Canadian pension to compete with top PE funds.

I am not saying there aren't qualified people doing wonderful work investing directly in PE at Canada's large pensions, but the fact is it will be hard for them to match the performance of top PE funds, even after fees and expenses are taken into account.

Who knows, maybe OPE will prove me wrong, but this is a tough environment for private equity and I'm not sure going direct in this asset class is a wise long-term strategy (unlike infrastructure, where most of Canada's large pensions are investing directly).

Hope you enjoyed this comment, please remember to subscribe or donate to this blog via PayPal on the top right-hand side to support my effort in bringing you the every latest insights on pensions and investments [good time to remind all of you this blog takes a lot of work and it requires your ongoing support.]

Below, CNBC's David Faber speaks with Scott Sperling, Thomas H. Lee Partners co-president, at the No Labels conference about how President-elect Donald Trump's policies could affect private equity and jobs.

And back in October, Hamilton Lane Vice-Chairman, Erik Hirsch, talked about the state of the private markets, saying that this market benefits from a “lack of emotion” that public markets are affected by daily. Read my recent comment on institutions piling into illiquid alternatives.


Tuesday, December 6, 2016

Hedge Funds Get Big or Go Home?

Lisa Abramowicz of Bloomberg reports, Hedge Funds Get Big or Go Home:
Hedge funds have had a rough year.

They have delivered unimpressive returns. They're battling one another for a stagnant pool of investor money. They're steadily lowering fees. The pressure is bifurcating the $3 trillion industry, helping to make big hedge-fund firms even bigger while sending many smaller ones into extinction (click on image).


Firms with more than $10 billion of assets under management can more easily afford to reduce fees and customize strategies. And that’s exactly what they’re doing, according to a recently released Ernst & Young global hedge-fund report.

Bigger firms have lowered fees more than smaller ones, which makes them more appealing to clients such as pension funds and insurers. Consider Brevan Howard, for example, which earlier this year cut some management fees to zero for certain clients. The once-average 2 percent management fee has fallen to 1.35 percent this year, Ernst & Young data show.

There have already been a slew of studies, some conflicting, about whether big or small hedge funds tend to outperform. The matter hasn't been settled.

But it certainly seems as if a higher concentration of money in a smaller group of firms will raise the financial importance of the largest ones. And this could be problematic if the risk isn't properly monitored. This is especially true among hedge funds, which tend to use leverage and derivatives.

While regulators have pushed more derivatives through clearinghouses to reduce the potential systemic risk from firm failures, the financial system is hardly immune to hiccups. For example, a Dec. 1 study from the U.S. Treasury's Office of Financial Research found that large firms that are significant net sellers of credit-default swaps could pose a significant threat to the financial system.

Meanwhile, this shift toward larger hedge-fund firms will only accelerate as fees continue to decline. Survival becomes a scale game. If a hedge-fund firm has enough assets, it can cut costs by outsourcing human resources, legal and back-office services and pay more to attract talented programmers and traders. It'll also have an easier time negotiating with its prime brokers. (click on image)


If not, the firm will likely go out of business in short order. Many have already done so this year, with the fastest pace of hedge-fund liquidations relative to new formations since 2009, according to HFR data (click on image).


Investors want to pay less for bigger returns. The result will likely be a smaller clutch of dominant, behemoth asset managers and a revolving door of smaller upstarts. While this may help cut costs, it also puts the onus on regulators and institutional investors to closely oversee any concentrated risks that may develop.
This is another excellent article by Bloomberg's Lisa Abramowicz. No doubt, big hedge funds are getting bigger and I'm going to explain to you why this trend will continue and what are the implications for markets and the global financial system.

First, there is a lot of money out there from large global pension funds and sovereign wealth funds all looking for the same thing: non-correlated, scalable, high risk-adjusted returns (ie "alpha") in public and increasingly in illiquid private markets.

Why illiquid private markets? There are a lot of reasons but I think the biggest reason is big institutional investors are fed up with the volatility in public markets and looking for consistent long-term yield they can find in real estate and increasingly in infrastructure investments. These asset classes not only provide solid, consistent yield over the long run (in between stocks and bonds), they also offer scale, meaning pensions and other big investors can put a lot of money to work quite easily, and they fit better with the long-term liabilities of pensions (long dated liabilities that go out 75+ years).

Now, hedge funds aren't illiquid alternatives, they are liquid alternatives. Sure, they aren't as liquid as investing directly in futures, stocks and bonds but they are far more liquid than private equity, real estate or infrastructure investments where capital is tied up for years, sometimes decades. And when a crisis hits, liquidity risk matters a lot, especially for mature, chronically underfunded pensions with negative cash flows.

But even with hedge funds that are suppose to offer uncorrelated alpha (most offer leveraged beta or sub-beta returns), scale is a huge factor for big investors which is why the big hedge funds are getting bigger.

Of course, one can also argue big hedge funds have unlimited resources to hire the best and brightest programmers, to outsource HR, legal and back-office services and negotiate lower fees with existing clients. Big hedge funds are also able to hire a big compliance department which is very expensive but needed as well as a big investor relations team to help market their fund and gather more assets.

Smaller hedge funds are in survival mode, especially in the beginning when they are building their track record. They need to charge 2 & 20 or some sort of fixed fee because they have higher fixed costs as a proportion of assets under management than their larger rivals.

But I don't think that is the biggest impediment for pensions to invest in smaller hedge funds. The big issue is scale. It's much easier writing a big cheque to Bridgewater, Brevan Howard, Appaloosa, Citadel, Renaissance Technologies and a bunch of other large funds than taking career risk to invest in a bunch of smaller hedge funds that may or may not outperform their largest rivals in a brutal environment.

This trend toward bigger hedge funds, however, presents opportunities to other smaller investors (like big family offices or small to mid-sized corporate and public plans) to focus their attention on smaller hedge funds that are not on the radar of the big pensions and sovereign wealth funds.

It also presents opportunities to revive funds of hedge funds which were almost extinct following the 2008 crisis. Good funds of funds are are better at tracking and finding small hedge fund gems and they have no issue signing good, mutually beneficial terms with smaller hedge funds who need to be properly incubated during their first three years after they launch.

The trend toward bigger hedge funds also places a need for policymakers to think of how they can use public money to incubate smaller funds or how the financial industry can create platforms to support smaller funds.

For example, in Quebec we have the Emerging Managers’ Board (EMB), a non-profit organization whose mission is to promote and contribute to the growth of Canadian emerging managers. There is even a Quebec Emerging Managers Program for hedge funds that can be found here.

Why is it important to support an emerging manager ecosystem? Because giving more money to big hedge funds supports jobs at their shops but it isn't enough to promote the financial industry and it also exacerbates rising inequality as the big fund managers get a lot richer, managing the bulk of the industry's assets (this concentration of wealth is unprecedented and while it's in their best interests, it isn't necessarily in the best interests of society and the economy or always in the best interests of their clients).

Smaller hedge fund managers are hungrier and typically have better alignment of interests with their clients than large asset gatherers looking to collect a management fee on billions (focusing less and less on performance and more and more on asset gathering).

However, this doesn't always translate into better performance because like I stated above, the big funds have all the money in the world to hire the best and brightest and negotiate better terms with their prime brokers, many of which do not even deal with smaller hedge funds (forcing these funds to deal with third tier brokers which adds operational risk to their performance).

Lastly, another negative of this trend into bigger hedge funds is that it dilutes returns, promotes crowding of trades (like Valeant but plenty of other positions across stocks, bonds and derivatives), and increases systemic financial risks as big hedge funds lever up their book to squeeze yield out of big trades (read "When Genius Failed").

Come to think of it, maybe this trend toward bigger hedge funds presents golden opportunities for smaller, nimbler, hungrier and smarter hedge fund managers that can capitalize on the collective stupidity of the larger funds. Maybe, just maybe, that remains to be seen.

Below, an older Opalesque interview with Bryan Johnson who explains why 89% of all hedge funds never get over $100m. Johnson believes that the primary reason why most managers do not get over the hundred million hurdle is not because of poor performance but because of poor marketing.

I couldn't agree more and wish I embedded this clip in an earlier comment on whether emerging managers can emerge as he highlights very important points far too emerging managers ignore.

Monday, December 5, 2016

CalPERS Gets Real on Future Returns?

Randy Diamond of Pensions & Investments reports, CalPERS balancing risks in review of lower return target:
The stakes are high as the CalPERS board debates whether to significantly decrease the nation's largest public pension fund's assumed rate of return, a move that could hamstring the budgets of contributing municipalities as well as prompt other public funds across the country to follow suit.

But if the retirement system doesn't act, pushing to achieve an unrealistically high return could threaten the viability of the $299.5 billion fund itself, its top investment officer and consultants say.

“Being aggressive, having a reasonable amount of volatility and (being) wrong could lead to an unrecoverable loss,” Andrew Junkin, president of Wilshire Consulting, the system's general investment consultant, told the board at a November meeting. CalPERS' current portfolio is pegged to a 7.5% return and a 13% volatility rate.

The chief investment officer of the California Public Employees' Retirement System and its investment consultants now say that assumed annualized rate of return is unlikely to be achieved over the next decade, given updated capital market assumptions that show a slow-growing economy and continued low interest rates.

Still, cities, towns and school districts that are part of the Sacramento-based system say they can't afford increased contributions they would be forced to pay to provide pension benefits if the return rate is lowered.

A decision could come in February.

Unlike other public plans that have leaned toward modest rate of return reductions, a key CalPERS committee is expected to be presented with a plan in December that's considerably more aggressive.

That was set in motion Nov. 15 at a committee meeting when Mr. Junkin and CalPERS CIO Theodore Eliopoulos said 6% is a more realistic return over the next decade.

At that meeting, it also was disclosed that CalPERS investment staff was reducing the fund's allocation to equities in an effort to reduce risk.

Only a year earlier, CalPERS investment staff and consultants had agreed that CalPERS was on the right track with its 7.5% figure. So confident were they that they urged the board to approve a risk mitigation plan that did lower the rate of return, but over a 20-year period, and only when returns were in excess of the 7.5% assumption.

Two years of subpar results — a 0.6% return for the fiscal year ended June 30 and a 2.4% return in fiscal 2015 — reduced views of what CalPERS can earn over the next decade. Mr. Junkin said at the November meeting that Wilshire was predicting an annual return of 6.21% for the next decade, down from its estimates of 7.1% a year earlier.

Indeed, Mr. Junkin and Mr. Eliopoulos said the system's very survival could be at stake if board members don't lower the rate of return. “Being conservative leads to higher contributions, but you still have a sustainable benefit to CalPERS members,” Mr. Junkin said.

The opinions were seconded by the system's other major consultant, Pension Consulting Alliance, which also lowered its return forecast.

Shifting the burden

But a CalPERS return reduction would just move the burden to other government units. Groups representing municipal governments in California warn that some cities could be forced to make layoffs and major cuts in city services as well as face the risk of bankruptcy if they have to absorb the decline through higher contributions to CalPERS.

“This is big for us,” Dane Hutchings, a lobbyist with the League of California Cities, said in an interview. “We've got cities out there with half their general fund obligated to pension liabilities. How do you run a city with half a budget?”

CalPERS documents show that some governmental units could see their contributions more than double if the rate of return was lowered to 6%. Mr. Hutchings said bankruptcies might occur if cities had a major hike without it being phased in over a period of years. CalPERS' annual report in September on funding levels and risks also warned of potential bankruptcies by governmental units if the rate of return was decreased.

If the CalPERS board approves a rate of return decrease in February, school districts and the state would see rate increases for their employees in July 2017. Cities and other governmental units would see rate increases beginning in July 2018.

Any significant return reduction by CalPERS, which covers more than 1.5 million workers and retirees in 2,000 governmental units, would cause ripples both in and outside the state. That's because making such a major rate cut in the assumed rate of return is rare.

Mr. Eliopoulos and the consultants are scheduled to make a specific recommendation on the return rate at a Dec. 20 meeting. But they were clear earlier this month that they feel the system won't be able to earn much more than an annualized 6% over the next decade.

Gradual reductions

Thomas Aaron, a Chicago-based vice president and senior analyst at Moody's Investors Services, said in an interview that many public plans have lowered their return assumption because of lower capital market assumptions and efforts to reduce risk. But Mr. Aaron said the reductions have happened “very gradually, it tends to be in increments of 25 or 50 basis points.”

Statistics from the National Association of State Retirement Administrators show that 43 of 137 public plans have lowered their return assumption since June 30, 2014. But NASRA statistics show only nine plans out of 127 are below 7% and none has gone below 6.5%.

“CalPERS is the largest pension system in the country; definitely if CalPERS were to make a significant reduction, other plans would take notice,” said Mr. Aaron.

Mr. Aaron said it would be hard to predict whether other public plans would follow. While there has been a general trend toward reduced return assumptions given capital market forecasts, some plans are sticking to higher assumptions because they believe in more optimistic longer-term investment return forecasts.

Compounding the problem is that CalPERS is 68% funded and cash-flow negative, meaning each year CalPERS is paying out more in benefits than it receives in contributions, Mr. Junkin said. CalPERS statistics show that the retirement system received $14 billion in contributions in the fiscal year ended June 30 but paid out $19 billion in benefits. To fill that $5 billion gap, the system was forced to sell investments.

CalPERS has an unfunded liability of $111 billion and critics have said unrealistic investment assumptions and inadequate contributions from employers and employees have led to the large gap.

Previously, CalPERS officials had said that any return assumption change would not occur until an asset allocation review was complete in February 2018. But Mr. Eliopoulos on Nov. 15 urged the board to act sooner, saying the U.S. could be in a recession by that date.

Richard Costigan, chairman of CalPERS finance and administration committee, said in an interview that he expects a recommendation and vote by the full board meeting in February, adding there is no requirement to wait until 2018 to consider the matter.

Some board members at the Nov. 15 meeting said CalPERS was moving too fast to implement a new assumption. “I'm a little confused at the panic and expediency that you guys are selling us right now,” said board member Theresa Taylor. “I think that we need to step back and breathe.”

But other board members suggested CalPERS needs to take immediate action even if it is uncomfortable.

Already adjusting

In a sense the system already has. Even without a formal return reduction, members of the investment staff have embarked on their own plan to reduce overall portfolio risk by reducing equity exposure, a policy supported by the board.

Mr. Eliopoulos said Nov. 15 that a pitfall of CalPERS' current rate of return is the need to invest heavily in equities, taking more risk than might be prudent. He also said the system was reviewing its equity allocation.

The system's latest investment report, issued Aug. 31, shows equity investments made up 51.1% or $155.4 billion of the system's assets, down from 52.7% or $160 billion as of July 30 and down from 54.1% in July 2015.

CalPERS took $3.8 billion of the $4.6 billion in equity reduction and increased its cash position and other assets in its liquidity asset class. Liquidity assets grew to $9.6 billion as of Aug. 31 from $5.8 billion at the end of July.

But an even bigger cut in the equity portfolio occurred after the September investment committee meeting, when board members meeting in closed session reduced the allocation even more, sources said. It is unclear how big that cut was, but allocation guidelines allow equity to be cut to 44% of the total portfolio.

Board member J.J. Jelincic at the Nov. 15 meeting disclosed the new asset allocation was made at the September meeting closed session. But Mr. Jelincic said based on revisions the board approved in the system's asset allocation, he felt the most CalPERS could earn was 6.25% a year because it was not taking enough risk.

Mr. Jelincic did not disclose the new asset allocation but said in an interview: “We are taking too little risk and walking away from the upside by not investing more in equities.”
So, CalPERS is getting real on future returns? It's about time. I've long argued that US public pensions are delusional when it comes to their investment return assumptions and that if they used the discount rates most Canadian public pensions use, they'd be insolvent.

And J.J. Jelincic is right, taking too little risk in public equities is walking away from upside but he's not being completely honest because when a mature pension plan with negative cash flows the size of CalPERS is underfunded, taking more risk in public equities can also spell doom because it introduces a lot more volatility in the asset mix (ie. downside risk).

When it comes to pensions, it's not just about taking more risk, it's about taking smarter risks, it's about delivering high risk-adjusted returns over the long run to minimize the volatility in contribution risk.

Sure, CalPERS can allocate 60% of its portfolio to MSCI global stocks and hope for the best but can it then live through the volatility or worse still, a prolonged recession and bear market?

This too has huge implications because pension plans are path dependent which means the starting point matters and if the plan is underfunded or severely underfunded, taking more risk can put it in a deeper hole, one that it might never get out of.

Yeah but Trump won the election, he's going to spend on infrastructure, build a wall on the Mexican border and have Mexico pay for it, renegotiate NAFTA and all other trade agreements, cut corporate taxes, and "make America great again". Bond yields and stocks have surged, lowering pension deficits, it's all good news, so why lower return assumptions now?

Because my dear readers, Trump won't trump the bond market, there are huge risks in the global economy, especially emerging markets, and that's one reason why the US dollar keeps surging higher, which introduces other risks to US multinationals and corporate earnings.

I've been warning my readers to take Denmark's dire pension warning seriously and that the global pension crisis is far from over. It's actually gaining steam because the risks of deflation are not fading over the long run, they are still lurking in the background.

What else? Investment returns alone will not be enough to cover future liabilities. The best plans in the world, like Ontario Teachers and HOOPP, understood this years ago which is why they introduced a shared-risk model to partially or fully adjust inflation protection whenever their plans experience a deficit and will only restore it once fully funded status is achieved again.

In Canada, the governance is right, which means you don't have anywhere near the government interference in public pensions as you do south of the border. Canadian pensions have been moving away from public markets increasingly investing directly in private markets like infrastructure, real estate and private equity. In order to do this, they got the governance right and compensate their pension fund managers properly.

Now, as the article above states, if CalPERS decides to lower its return assumptions, it's a huge deal and it will have ripple effects in the US pension industry and California's state and local governments.

The main reason why US public pensions don't like lowering their return assumptions is because it effectively means public sector workers and state and local governments will need to contribute more to shore up these pensions. And this isn't always feasible, which means property taxes might need to rise too to shore up these public pensions.

This is why I keep stating the pension crisis is deflationary. The shift from defined-benefit to defined-contribution plans shifts the retirement risk entirely on to employees which will eventually succumb to pension poverty once they outlive their meager savings (forcing higher social welfare costs for governments) and public sector pension deficits will only be met by lowering return assumptions, hiking the contributions, cutting benefits or raising property taxes, all of which take money out of the system and impact aggregate demand in a negative way.

This is why it's a huge deal if CalPERS goes ahead and lowers its investment return assumptions. The ripple effects will be felt throughout the economy especially if other US public pensions follow suit.

Unfortunately, CalPERS doesn't have much of choice because if it doesn't lower its return target and its pension deficit grows, it will be forced to take more drastic actions down the road. And it's not about being conservative, it's about being realistic and getting real on future returns, especially now that California's pensions are underfunded to the tune of one trillion dollars or $93K per household.

Below, CalPERS' Finance & Administration Committee (Part 2) which took place on November 15, 2016. Watch the entire meeting and listen to Ted Eliopoulos's comments very carefully as he makes a persuasive case as to why CalPERS needs to lower its return target. 

You can watch all CalPERS' board meetings here and if you have any questions or comments, feel free to email me at LKolivakis@gmail.com. Just know this, if CalPERS lowers its return target, it's a huge deal and will have ripple effects throughout the US pension industry and economy.

Friday, December 2, 2016

Institutions Piling Into Illiquid Alternatives?

BusinessWire reports, World’s Largest Institutional Investors Expecting More Asset Allocation Changes over Next Two Years Than in the Past:
Institutional investors worldwide are expecting to make more asset allocation changes in the next one to two years than in 2012 and 2014, according to the new Fidelity Global Institutional Investor Survey. Now in its 14th year, the Fidelity Global Institutional Investor Survey is the world’s largest study of its kind examining the top-of-mind themes of institutional investors. Survey respondents included 933 institutions in 25 countries with $21 trillion in investable assets.

The anticipated shifts are most remarkable with alternative investments, domestic fixed income, and cash. Globally, 72 percent of institutional investors say they will increase their allocation of illiquid alternatives in 2017 and 2018, with significant numbers as well for domestic fixed income (64 percent), cash (55 percent), and liquid alternatives (42 percent).

However, institutional investors in some regions are bucking the trend seen in other parts of the world. Many institutional investors in the U.S. are, on a relative basis, adopting a wait-and-see approach. For example, compared to 2012, the percentage of U.S. institutional investors expecting to move away from domestic equity has fallen significantly from 51 to 28 percent, while the number of respondents who expect to increase their allocation to the same asset class has only risen from 8 to 11 percent.

“With 2017 just around the corner, the asset allocation outlook for global institutional investors appears to be driven largely by the local economic realities and political uncertainties in which they’re operating,” said Scott E. Couto, president, Fidelity Institutional Asset Management. “The U.S. is likely to see its first rate hike in 12 months, which helps to explain why many in the country are hitting the pause button when it comes to changing their asset allocation.

“Institutions are increasingly managing their portfolios in a more dynamic manner, which means they are making more investment decisions today than they have in the past. In addition, the expectations of lower return and higher market volatility are driving more institutions into less commonly used assets, such as illiquid investments,” continued Couto. “For these reasons, organizations may find value in reexamining their investment decision-making process as there may be opportunities to bring more structure and accommodate the increased number of decisions, freeing up time for other areas of portfolio management and governance.”

Primary concerns for institutional investors

Overall, the top concerns for institutional investors are a low-return environment (28 percent) and market volatility (27 percent), with the survey showing that institutions are expressing more worry about capital markets than in previous years. In 2010, 25 percent of survey respondents cited a low-return environment as a concern and 22 percent cited market volatility.
“As the geopolitical and market environments evolve, institutional investors are increasingly expressing concern about how market returns and volatility will impact their portfolios,” said Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation. “Expectations that strengthening economies would build enough momentum to support higher interest rates and diminished volatility have not borne out, particularly in emerging Asia and Europe.”

Investment concerns also vary according to the institution type. Globally, sovereign wealth funds (46 percent), public sector pensions (31 percent), insurance companies (25 percent), and endowments and foundations (22 percent) are most worried about market volatility. However, a low-return environment is the top concern for private sector pensions (38 percent). (click on image)

Continued confidence among institutional investors

Despite their concerns, nearly all institutional investors surveyed (96 percent) believe that they can still generate alpha over their benchmarks to meet their growth objectives. The majority (56 percent) of survey respondents say growth, including capital and funded status growth, remain their primary investment objective, similar to 52 percent in 2014.

On average, institutional investors are targeting to achieve approximately a 6 percent required return. On top of that, they are confident of generating 2 percent alpha every year, with roughly half of their excess return over the next three years coming from shorter-term decisions such as individual manager outperformance and tactical asset allocation.

“Despite uncertainty in a number of markets around the world, institutional investors remain confident in their ability to generate investment returns, with a majority believing they enjoy a competitive advantage because of confidence in their staff or access to better managers,” added Young. “More importantly, these institutional investors understand that taking on more risk, including moving away from public markets, is just one of many ways that can help them achieve their return objectives. In taking this approach, we expect many institutions will benefit in evaluating not only what investments are made, but also how the investment decisions are implemented.”

Improving the Investment Decision-Making Process

There are a number of similarities in institutional investors’ decision-making process:
  • Nearly half (46 percent) of institutional investors in Europe and Asia have changed their investment approach in the last three years, although that number is smaller in the Americas (11 percent). Across the global institutional investors surveyed, the most common change was to add more inputs – both quantitative and qualitative – to the decision-making process.
  • A large number of institutional investors have to grapple with behavioral biases when helping their institutions make investment decisions. Around the world, institutional investors report that they consider a number of qualitative factors when they make investment recommendations. At least 85 percent of survey respondents say board member emotions (90 percent), board dynamics (94 percent), and press coverage (86 percent) have at least some impact on asset allocation decisions, with around one-third reporting that these factors have a significant impact.
“Institutional investors often assess quantitative factors such as performance when making investment recommendations, while also managing external dynamics such as the board, peers and industry news as their institutions move toward their decisions. Whether it’s qualitative or quantitative factors, institutional investors today face an information overload,” said Couto. “To keep up with the overwhelming amount of data, institutional investors should consider revisiting and evolving their investment process.

“A more disciplined investment process may help them achieve more efficient, effective and repeatable portfolio outcomes, particularly in a low-return environment characterized by more expected asset allocation changes and a greater global interest in alternative asset classes,” added Couto.

The complete report with a wealth of charts is available on request. For additional materials on the survey, go to institutional.fidelity.com/globalsurvey.

About the Survey

Fidelity Institutional Asset ManagementSM conducted the Fidelity Global Institutional Investor Survey of institutional investors in the summer of 2016, including 933 investors in 25 countries (174 U.S. corporate pension plans, 77 U.S. government pension plans, 51 non-profits and other U.S. institutions, 101 Canadian, 20 other North American, 350 European, 150 Asian, and 10 African institutions including pensions, insurance companies and financial institutions). Assets under management represented by respondents totaled more than USD $21 trillion. The surveys were executed in association with Strategic Insight, Inc. in North America and the Financial Times in all other regions. CEOs, COOs, CFOs, and CIOs responded to an online questionnaire or telephone inquiry.

About Fidelity Institutional Asset Management℠

Fidelity Institutional Asset Management℠ (FIAM) is one of the largest organizations serving the U.S. institutional marketplace. It works with financial advisors and advisory firms, offering them resources to help investors plan and achieve their goals; it also works with institutions and consultants to meet their varying and custom investment needs. Fidelity Institutional Asset Management℠ provides actionable strategies, enabling its clients to stand out in the marketplace, and is a gateway to Fidelity’s original insight and diverse investment capabilities across equity, fixed income, high‐income and global asset allocation. Fidelity Institutional Asset Management is a division of Fidelity Investments.

About Fidelity Investments

Fidelity’s mission is to inspire better futures and deliver better outcomes for the customers and businesses we serve. With assets under administration of $5.5 trillion, including managed assets of $2.1 trillion as of October 31, 2016, we focus on meeting the unique needs of a diverse set of customers: helping more than 25 million people invest their own life savings, nearly 20,000 businesses manage employee benefit programs, as well as providing nearly 10,000 advisory firms with investment and technology solutions to invest their own clients’ money. Privately held for 70 years, Fidelity employs 45,000 associates who are focused on the long-term success of our customers. For more information about Fidelity Investments, visit https://www.fidelity.com/about.
Sam Forgione of Reuters also reports, Institutions aim to boost bets on hedge funds, private equity:
The majority of institutional investors worldwide are seeking to increase their investments in riskier alternatives that are not publicly traded such as hedge funds, real estate and private equity over the next one to two years to combat potential low returns and choppiness in public markets, a Fidelity survey showed on Thursday.

The Fidelity Global Institutional Investor Survey showed that 72 percent of institutional investors worldwide, from public pension funds to insurance companies and endowments, said they would increase their exposure to these so-called illiquid alternatives in 2017 and 2018.

The survey, which included 933 institutions in 25 countries overseeing a total of $21 trillion in assets, found that the institutions were most concerned with a low-return investing environment over the next one to two years, with 28 percent of respondents citing it as such. Market volatility was the second-biggest worry, with 27 percent of respondents citing it as their top concern.

Private sector pensions were most concerned about a low-return environment, with 38 percent of them identifying it as their top worry, while sovereign wealth funds were most nervous about volatility, with 46 percent identifying it as their top concern.

"With the concern about the low-return environment as well as market volatility, as a result we’re seeing more of an interest in alternatives, where there’s a perception of higher return opportunities," said Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation.

Investors seek alternatives, which may invest in assets such as timber or real estate or use tactics such as betting against securities, for "uncorrelated" returns that do not move in tandem with traditional stock and bond markets.

Young noted, however, that illiquid alternatives can also be volatile without it being obvious, since they lack daily pricing and as a result may give the perception of being less volatile.

"We would hope and would expect that institutional investors would appreciate the volatility that still exists within the underlying investments," he said in reference to illiquid alternatives.

The survey, which was conducted over the summer, found that despite their concerns, 96 percent of the institutions believed they could achieve an 8 percent investment return on average in coming years.

U.S. public pension plans, on average, had about 12.1 percent of their assets in real estate, private equity and hedge funds combined as of Sept. 30, according to Wilshire Trust Universe Comparison Service data.
And Jonathan Ratner of the National Post reports, Low returns, high volatility top institutional investors’ list of concerns:
Low returns and market volatility topped the list of concerns in Fidelity Investments’ annual survey of more than 900 institutional investors with US$21 trillion of investable assets.

Thirty per cent of respondents cited the low-return environment as their primary worry, followed by volatility at 27 per cent.

“Expectations that strengthening economies would build enough momentum to support higher interest rates and diminished volatility have not borne out, particularly in emerging Asia and Europe,” said Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation.

The Fidelity Global Institutional Survey, which is now in its 14th year and includes investors in 25 countries, also showed that institutions are growing more concerned about capital markets.

Despite these issues, 96 per cent of institutional investors surveyed believe they can beat their benchmarks.

The group is targeting an average return of approximately six per cent per year, in addition to two per cent alpha, and short-term decisions are being credited for those excess returns.

Institutional investors remain confident in their return prospects due to their access to superior money managers. They also have demonstrated a willingness to move away from public markets.

On a global basis, 72 per cent of institutional investors said they plan to increase their exposure to illiquid alternatives in 2017 and 2018.

Domestic fixed income (64 per cent), cash (55 per cent) and liquid alternatives (42 per cent) were the other areas where increased allocation is expected to occur.

However, institutional investors in the U.S. are bucking this trend, and seem to have adopted a “wait-and-see” approach.

The percentage of this group expecting to move away from domestic equity has fallen from 51 per cent in 2012, to 28 per cent this year. Meanwhile, the number of respondents who plan to increase their allocation to U.S. equities has risen to just 11 per cent from eight per cent in 2012.

“With 2017 just around the corner, the asset allocation outlook for global institutional investors appears to be driven largely by the local economic realities and political uncertainties in which they’re operating,” said Scott Couto, president of Fidelity Institutional Asset Management.

He noted that with the Federal Reserve expected to produce its first rate hike in 12 months, it’s understandable why many U.S. investors are hitting the pause button when it comes to asset allocation changes.
On Thursday, I had a chance to speak to Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation. I want to first thank him for taking the time to go over this survey with me and thank Nicole Goodnow for contacting me to arrange this discussion.

I can't say I am shocked by the results of the survey. Since Fidelity did the last one two years ago, global interest rates plummeted to record lows, public markets have been a lot more volatile and return expectations have diminished considerably.

One thing that did surprise me from this survey is that the majority of institutions (96%) are confident they can beat their benchmark, "targeting an average return of approximately six per cent per year, in addition to two per cent alpha, and short-term decisions are being credited for those excess returns."

I personally think this is wishful thinking on their part, especially if they start piling into illiquid alternatives at the worst possible time (see my write-up on Bob Princes' visit to Montreal).

In our discussion, however, Derek Young told me institutions are confident that through strategic and tactical asset allocation decisions they can beat their benchmark and achieve that 8% bogey over the long run.

He mentioned that tactical asset allocation will require good governance and good manager selection. We both agreed that the performance dispersion between top and bottom quartile hedge funds is huge and that manager selection risk is high for liquid and illiquid alternatives.

Funding illiquid alternatives is increasingly coming from equity portfolios, except in the US where they have been piling into alternatives for such a long time that they probably want to pause and reflect on the success of these programs, especially considering the fees they are paying to external managers.

The move into bonds was interesting. Derek told me as rates go up, liabilities fall and if rates are going up because the economy is improving, this is also supportive of higher equity prices. He added that many institutions are waiting for the "right funding status" so they can derisk their plans and start immunizing their portfolios.

In my comment on trumping the bond market, I suggested taking advantage of the recent backup in yields to load up on US long bonds (TLT). I still maintain this recommendation and think anyone shorting bonds at these levels is out of their mind (click on chart):


Sure, rates can go higher and bond prices lower but these big selloffs in US long bonds are a huge buying opportunity and any institution waiting for the yield on the 10-year Treasury note to hit 3%+ to begin derisking and immunizing their portfolio might end up regretting it later on.

Our discussion on the specific concerns of various institutions was equally interesting. Derek told me many sovereign wealth funds need liquidity to fund projects. They are the "funding source for their economies" which is why volatile returns are their chief concern. (Oftentimes, they will go to Fidelity to redeem some money and tell them "we will come back to you later").

So unlike pensions, SWFs don't have a liability concern but they are concerned about volatile markets and being forced to sell assets at the wrong time (this surprised me).

Insurance companies are more concerned about hedging volatility risk to cover their annuity contracts. In 2008, when volatility surged, they found it extremely expensive to hedge these risks. Fidelity manages a volatility portfolio for their insurance clients to manage this risk on a cost effective basis.

I told Derek that they should do the same thing for pension plans, managing contribution volatility risk for plan sponsors. He told me Fidelity is already doing this for smaller plans (outsourced CIO) and for larger plans they are helping them with tactical asset allocation decisions, manager selection and other strategies to achieve their targets.

On the international differences, he told me UK investors are looking to allocate more to illiquid alternatives, something which I touched upon in my last comment on the UK's pension crisis.

As far as Canadian pensions, he told me "they are very sophisticated" which is why I told him many of them are going direct when it comes to alternative investments and more liquid absolute return strategies.

In terms of illiquid alternatives, we both agreed illiquidity doesn't mean there are less risks. That is a total fallacy. I told him there are four key reasons why Canada's large pensions are increasing their allocations to private market investments:
  1. They have a very long investment horizon and can afford to take on illiquidity risk.
  2. They believe there are inefficiencies in private markets and that is where the bulk of alpha lies.
  3. They can scale into big real estate and infrastructure investments a lot easier than scaling into many hedge funds or even private equity funds.
  4. Stale pricing (assets are valued with a lag) means that private markets do not move in unison with public markets, so it helps boost their compensation which is based on four-year rolling returns (privates dampen volatility of overall returns during bear markets).
Sure, private markets are good for beneficiaries of the plan, especially if done properly, but they are also good for the executive compensation of senior Canadian pension fund managers. They aren't making the compensation of elite hedge fund portfolio managers but they're not too far off.

On that note, I thank Fidelity's Derek Young and Nicole Goodnow and remind all of you to please subscribe and donate to this blog on the top right-hand side under my picture and show your appreciation of the work that goes into these blog comments.

I typically reserve Fridays for my market comments but there were so many things going on this week (OPEC, jobs report, etc.) that I need to go over my charts and research over the weekend.

One thing I can tell you is that US long bonds remain a big buy for me and I was watching the trading action on energy, metal and mining stocks all week and think a lot of irrational exuberance is going on there. There are great opportunities in this market on the long and short side, but will need to gather my thoughts and discuss this next week.

Below, Ian Lyngen, BMO Capital Markets head of US rates, discusses the outlook for the US bond market with Bloomberg's Vonnie Quinn and David Gura on "Bloomberg Markets."