Thursday, July 24, 2014

Will Higher or Lower Rates Hurt Pensions?

Randall W. Forsyth of Barron's reports, Pension Funds Should Take Care What They Wish for:
U.S. corporate pension funds are in the best shape they've been in since before the 2008 financial crisis as their shortfalls were cut nearly in half in 2013. Credit surely goes to the rising stock market, but last year's improvement in the funds' positions also owed much to the rise in bond yields.

Indeed, fully closing the gap between pension funds' assets and their future liabilities may depend more on higher interest rates than continued gains in the stock market.

Corporate pension plans among the Standard & Poor's 500 companies were last fully funded in 2007, before the financial near-meltdown of the following year. From 2009 to 2012, the plans' underfunding ranged between 16% and 23% -- with the worst shortfall in 2012, when S&P 500 index already had made a huge recovery from its recession lows.

These data cover the traditional, defined-benefit plans that were the norm for Corporate America a generation ago. As S&P Credit Week observes, U.S. companies have dealt with the burden of pension costs by shifting it to employees with defined-contribution plans such as 401(k) plans. The result: 46% of workers had saved $10,000 or less for retirement while an additional 20% had socked away between $10,000 and $49,900, according to a 2013 study by the Employee Benefit Research Institute. Only half of all workers receive any retirement benefits from their employers.

For those lucky enough to look forward to a monthly check in retirement, their employers have to set aside and invest funds to meet those obligations. Among the S&P 500 companies, 51 were fully funded at the end of 2013, up from just 18 in 2012.

The list of the most under-funded defined-benefit plans were dominated by old-line manufacturing companies, notes Tobias Levkovich, Citi Research's chief investment strategist. Leading that less-august list were General Motors (ticker: GM ), ExxonMobil ( XOM ), Boeing ( BA ), Ford Motor (F), DuPont ( DD ), Pfizer ( PFE ) and Caterpillar ( CAT. ) And that was after the 30% surge in the S&P 500 last year.

There was another, less obvious boost to corporate pension plans in 2013: higher bond yields. Given that the jump in yields, which took the benchmark 10-year Treasury to 3% from a low of about 1.65%, resulted in bond price declines and negative returns from investment-grade debt last year, that might seem counterintuitive.

But the higher yields lowered the present value of future pension fund liabilities. (A higher discount rate for a stream of future payments lowers that stream's discounted present value. At a higher interest rate, it's possible to set aside a smaller sum to meet a future savings goal, and vice versa.) The discount rate on pension funds' liabilities, which is based on the yield from investment-grade corporate bonds, rose in 2013 to 4.69% from 3.93% in 2012.

The impact on interest rates is apparent from the experience of the two preceding years. According to S&P, despite 2012's 13.4% equity return, pension underfunding among the S&P 500 companies actually increased over 27%, to an aggregate $451.7 billion from $354.7 billion, owing to the decline in interest rate and the resulting increase in the present value of future liabilities. And while the 29.6% gain in the S&P 500 index in 2013 helped reduce underfunding by over 50%, to $224.5 billion, the increase in the discount rate on future liabilities "assisted considerably," S&P observed.

While 2014 is only a bit more than half over, the trends are less positive than last year's. The S&P 500 is up 7.5%, setting another record Wednesday. But contrary to expectations of virtually every forecaster, bond yields have fallen markedly this year, to 2.47% on the Treasury 10-year note as of Wednesday, a hair above the 2014 low of 2.44%.

The gain in the S&P 500 and the fall in bond yields suggest a rerun of 2012's experience, when pension fund underfunding increased despite positive equity and debt market returns.

To be sure, writes Citi's Levkovich, "the stock market is crucial to the asset side of pension story." But given the likelihood of "modest single-digit gains through mid-2015, it will not close the gap entirely."

"The most significant impact on pensions will come when interest rates move higher, thus reducing the present value of future pension obligations, which will accelerate the time line of fully funded status," he concludes.

S&P agrees, but it also avers while higher interest rates would drastically improve the funding of corporate pensions, they would also be potentially damaging to parts of the economy.

Indeed, it is difficult to reconcile pension plans' hope for higher stocks and higher bond yields. Low interest rates without a doubt have increased price-earnings multiples as low yields have lured investors into equities. Low interest rates also have provided an important lift to corporate profits as well by sharply reducing interest costs, while stock buybacks have boosted earnings per share for public corporations. The bottom lines of financial companies such as banks also have benefitted from the reduction in loan-loss reserves, which have flowed directly to the bottom line of the S&P 500.

Thus, Corporate America -- or at least the portion that still offer pension plans -- would like higher interest rates to reduce their future liabilities to retirees. But the impact on the economy and the stock market likely would be negative.

Another reason to heed the admonition to be careful what you wish for.
Take the time to read my recent comment on when interest rates rise where I wrote:
A rise in interest rates will benefit pension plans (discount rate rises, lowering the net present value of liabilities) and savers but it will crush many debt-laden consumers and businesses struggling to stay afloat and will lead to a full-blown emerging markets crisis, which is very deflationary.
So should pensions be careful for what they wish for? It all depends on how dramatic the rise in interest rates will be. If interest rates spike up, it will hurt pensions on the asset front real hard but it will significantly lower the liabilities those pensions pay out.

Here we have to introduce the concept of duration. It's important to understand the duration of liabilities are a lot longer than the duration of assets. This means that when interests rates are low, a fall in rates will disproportionately impact liabilities a lot more than it impacts assets. In other words, in a low rate environment, when rates fall, liabilities go up more dramatically than the rise in the value of assets.

This is why many corporations are scrapping defined-benefit plans and replacing them with 401 (k) (RRSP) type plans which effectively places the onus entirely on individuals to make wise investment decisions to retire in dignity. If a bear market strikes them, too bad, they're left fending for themselves.

The problem nowadays is rates keep falling. My former colleague, Brian Romanchuk notes the bond bear market of 2014 has been delayed:
Strategists went into 2014 with a consensus bearish view on bonds (as was also the case in 2010-2013...). The market action so far has not been kind to that view, with yields plunging in the developed markets. It may be that I have fallen into a too mellow summertime mood, but my guess is that this is largely a squeeze of the bond bears during quiet markets (although there are obvious geopolitical concerns).

The JGB market has not been cooperating with those who have been calling for collapse and hyperinflation; rather yields have marched from stupidly expensive to insanely expensive levels. At a 0.54% yield, the 10-year JGB is at a very interesting position. As I have pointed out before (when yield levels were slightly higher...), the payoff on an outright short position which can be held for a considerable period looks attractively asymmetric (click on image above).

It's A Forward Story

What is interesting about the rally in the U.S. Treasury market is that it a story about the forwards. My crude proxy of the 5-year rate, 5-years forward has been marching steadily lower since peaking around New Year's. Meanwhile, the spot 5-year rate has been tracking sideways (click on image above). Therefore, the rally has not been about revising the timing of rate hikes, rather it is a downward revision of "steady state" interest rates. This could be explained by a number of factors:
  • Quantitative Easing (why now?);
  • belief in Fed jawboning future rates;
  • forward rate expectations slowly adapting to lower realised rates;
  • demand for duration by liability-matching investors.
Although I believe that long-term rate expectations needed to be revised lower from the 5% average that held before 2012 as a result of the demand for duration, 3¼% may be too far. In any event, there is unlikely to be clarity until market liquidity comes back in September.
What else explains this move in the yield curve? In a recent comment, I discuss how Japan's private pensions are eying more risk, snapping up corporate bonds, REITs, leveraged loans and U.S. bonds. And they're not the only ones. Other countries facing low yields are also looking at U.S. bonds because of the spread (see Hoisington's second quarter economic letter).

By far, the largest purchaser of U.S. Treasuries after the Fed is China (click on image below):
Investors wrestling with the mysterious U.S. bond rally of 2014 got a clue about where to look: China.
The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago, data released Wednesday show. The purchases help explain Treasurys' unexpectedly strong rally this year. The yield on the 10-year U.S. Treasury note has fallen to 2.54%, from 3% at the end of 2013. Yields fall as prices rise.

The world's most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014, according to the U.S. government data. The buying has been fueled by China's efforts to lift its export-driven economy by weakening its currency, the yuan, against the dollar, market analysts said, a strategy that encompasses hefty purchases of U.S. assets.

China officially holds roughly $1.27 trillion of U.S. debt, about 10.6% of the $12 trillion U.S. Treasury market.

The country's purchases have salutary effects on both sides of the Pacific. In addition to the weaker yuan in China, they hold down U.S. interest rates, making houses more affordable and generally easing financial conditions in the U.S. economy.

On the other hand, lower yields mean lower income for bond investors. They have spurred investors to chase assets globally for returns, fueling asset-price increases and investor fears that some market valuations are stretched.

Also, investors fear any reduction in Chinese purchases, along with other macroeconomic events, could destabilize the U.S. bond market and send rates higher, slowing the housing industry, widely viewed as a key driver of economic growth. Some analysts contend that low rates also can allow capital to be misallocated, fueling the risk of future economic disruption.

In a bid to boost returns, China has sought to diversify its foreign-exchange holdings away from U.S. government bonds in recent years. But it finds itself having to keep purchasing the U.S. debt due to a lack of investment choices elsewhere. "There is no other market that is as liquid and deep as the U.S. Treasury market," an official at China's central bank said in a recent interview.

China's aggressive purchases of dollar assets also present the authorities with problems at home. That is because the purchases cause the money supply to expand and can fuel inflation within China unless the central bank soaks up the excess liquidity injected into the system.

The bond rally has left many traders on Wall Street scratching their heads. Most investors had forecast that interest rates would rise this year as the U.S. economy picked up steam and the Federal Reserve slowly pared its stimulus measures, in a shift that was widely expected to push rates higher.

But yields remain far below 2013 highs even as U.S. job creation has gained pace in recent months. The disclosure of China's holdings underscores the frayed nerves in the bond market as the Fed prepares to raise interest rates as early as next year, for the first time since the financial crisis. Many investors fear that reduced Fed support and unpredictable buying by foreign governments could spell bond-market tumult.

"The big picture is that China buying may be helping to keep bond yields lower than they should be ahead of the Fed moving closer to raising rates," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ. "The market could wake up and get quite a shock…if China changes course." The risk for the U.S. economy, said Mr. Rupkey, is that any slowdown in Chinese purchases could push U.S. bond and mortgage rates higher, which would put "the fragile housing recovery in jeopardy."

At the same time, many investors over the past decade have warned of the risks of reduced purchases from China precipitating a U.S. interest-rate spike—predictions that haven't been borne out.

The rise in China's Treasury holdings disclosed Wednesday marks the biggest first-five-month increase since record keeping began in 1977 and surpasses the $81 billion of Treasury debt bought by China for all of 2013, according to Ian Lyngen, senior government-bond strategist at CRT Capital Group LLC.

China has increased its U.S. Treasury holdings every year since the 2008 financial crisis except for 2011. China continued to log a trade surplus with the U.S., thanks to its aggressive efforts to boost exports over the past decade. That has led to a huge accumulation of foreign-exchange reserves, and the Treasury market is the most liquid bond market for China to invest reserves, analysts said.

China held $1.2633 trillion in notes and bonds at the end of May, compared with $1.156 trillion at the end of 2013, according to Jeffrey Young, U.S. rates strategist at Nomura Securities International in New York.

The gain reflects in part China's decision to shift its U.S. investments to longer-term securities from short-term debt known as bills. Including bills, which mature in a year or less, China held $1.2709 trillion of Treasury debt at the end of May, compared with $1.2700 trillion at the end of December 2013, according to the latest data from the Treasury Department.

Analysts have long cautioned that the Treasury report isn't a complete picture because it doesn't account for China's holdings at third-party custody institutions in other nations, such as the U.K. and Belgium.

China's foreign-exchange regulator, the State Administration of Foreign Exchange, didn't immediately respond to a faxed request for comment.

China's purchases come as U.S. issuance slows, amid higher tax receipts from an improving economy. Mr. Young at Nomura Securities International estimated that net supply of Treasury notes and bonds this year would be $650 billion to $690 billion, down from $836 billion last year and $1.565 trillion in 2010.

The Fed has been dialing back its monthly purchases as well. Mr. Young said the central bank's buying this year would account for about 38.5% of net Treasury issuance, down from 65% last year.

China hasn't been the only big buyer this year. Japan, the second-largest foreign owner of Treasury bonds, increased its note and bondholdings by $9.56 billion during the first five months of the year. Including bills, Japan's holdings of Treasury debt was $1.2201 trillion.

China's foreign-exchange reserves currently approach $4 trillion, the world's biggest in size. China doesn't disclose the composition of the reserves, but analysts say most are denominated in U.S. dollars. This year, China has taken actions to weaken its local currency to make its exports cheaper. When China sold the yuan, it bought the U.S. dollar, and analysts said China likely often used the proceeds to purchase more Treasury debt.

"China will continue to buy Treasury bonds as long as they want to keep the yuan's value lower to support exports," said Peter Morici, professor at the Robert H. Smith School of Business at the University of Maryland. "I don't think China will pull away from the Treasury bond market even if the Fed raises interest rates."

Christopher Sullivan, who oversees $2.35 billion as chief investment officer at the United Nations Federal Credit Union in New York, added that "China's investment in Treasury bonds is mostly trade driven and not opportunistic," like hedge funds or other bond traders.

U.S. bonds yield more than Germany's, which are at 1.2%, and Japan's, at 0.54%. Strategists at Goldman Sachs Group Inc., J.P. Morgan Chase& Co. and Morgan Stanley expect the 10-year Treasury yield to rise to 3% by the end of 2014. Goldman recently cut its year-end forecast from 3.25%.

Some investors caution that higher-yield forecasts may not pan out. China's buying will be "a restraint on yields,'' said Mr. Sullivan. "I think 3% is highly suspect for 2014."
No doubt about it, when it comes to interest rates and currencies, the China factor is huge. One currency trader put it this way to me: "Even if Bridgewater, Brevan Howard, Moore Capital and other big global macro shops are short the euro, the Chinese will squash them like bugs. They have huge F/X reserves and they're not marked to market."

At the end of the day, China will do what's in China's best interest. If they want to the USD and euro to hover around a certain level, they can easily manipulate currency markets to boost their exports. How long will this go on? Until they create sufficient internal demand so they don't need to rely on the export driven growth model.

And there is something else keeping rates lower, the ominous threat of global deflation, which now threatens Europe. But not everyone buys the deflation story. Ted Carmichael recently revisited his inflation or deflation scenarios and concludes:
If one believes that US growth will accelerate, that current high level of geopolitical risk will diminish, and that the Rising Inflation scenario will prevail, my preference at mid-year would still be the conservative 45% Equity, 25% Bond, 30% Cash portfolio. The evolving, highly uncertain environment still argues for a cautious and flexible approach.
True but I agree with CNBC's Ron Insana who wrote an interesting comment on why inflation is about to fall -- and fall hard. Watch the clip below and read my comment on when interest rates rise. If I'm right and deflation is the ultimate end game, pensions will get clobbered on both assets and liabilities.

Wednesday, July 23, 2014

Co-investments Entering Hedge Fund Arena?

Christine Williamson of Pensions & Investments reports, Co-investing entering new arena: Hedge funds:
Institutional investors increasingly are translating co-investment experience in private equity, real estate, infrastructure and energy funds to their hedge fund portfolios.

Co-investment with hedge fund managers is growing, if a bit slowly, especially with credit and activist equity managers as institutions become more comfortable with an even more direct type of hedge fund investing.

Appetite is growing: 52% overall of investors surveyed by J.P. Morgan Capital Introduction Group for its 2014 Institutional Investors Survey said they were willing to participate in hedge fund co-investments.

A breakdown of respondents showed 74% of endowments and foundations would co-invest with hedge funds, followed by 68% of consultants; pension funds, 60%; family offices, 59%; and insurance companies and hedge funds of funds, both 46%.

Despite this professed interest, the overall pace of pension funds, endowments, foundations and sovereign wealth funds in hedge fund co-investments has been a tad slow, sources said.

“This is a good investment space, but there are a significant percentage of institutional investors that are too boxy to be comfortable with co-investing,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

“You have to be flexible to take advantage of co-investing because it does fall into the cracks between asset classes,” Mr. Nesbitt added.

“The interest level in co-investments is about the same as a year ago, but the difference is that institutional investors had a desire to see co-investment ideas but not to invest,” said Richard d'Albert, principal, co-chief investment officer and portfolio manager at credit specialist hedge fund manager Seer Capital Management LP, New York.

“The credibility factor has risen and now the conversations are turning more often to investment,” Mr. d'Albert said.

Seer Capital has set up co-investment vehicles with a handful of larger clients, Mr. d'Albert said, noting the firm's hedge funds “get first dibs on any of our investment ideas, but sometimes we do run across an outsized opportunity that has great potential, but is too big to accommodate in our funds.”

Seer Capital managed $2.2 billion in structured credit hedge fund approaches as of June 30.

Hedge fund managers offering occasional one-off co-investment opportunities or permanent, dedicated co-investment funds are grouped within event-driven equity and fixed-income approaches, as well as specialists who invest in structured products, lending, mortgage- and asset-backed securities and more esoteric credit investments, such as Iceland bank debt.

In addition to Seer Capital, among those managers attracting institutional investor interest in their co-investment funds are JANA Partners LP, Pine River Capital Management LP, Solus Alternative Asset Management LP, Starboard Value LP and Taconic Capital Advisors LP.

New niche

One reason for the slow buildup in hedge fund co-investment is the relative newness of the niche. Institutions have been co-investing with private equity and real estate managers for more than two decades. But hedge fund managers, for the most part, only shifted to co-investment since the 2008 financial crisis.

Before the crisis, hedge fund managers routinely segregated less liquid assets in separate “side-pocket” funds they ran alongside their flagship commingled funds. The crisis made it extremely difficult to divest those illiquid investments and, rather than sell assets at fire sale prices, hedge fund managers shut redemption gates, locking up investor assets for years.

Mr. Nesbitt said hedge fund managers have begun to recapture the institutional market by repackaging their best, most concentrated investment ideas into vehicles with “much better terms,” including lower fees, lower carry, fees charged only on invested capital and “very attractive performance.”

“Performance comparison of the hedge fund co-investment niche is impossible,” said Jon Hansen, managing director-hedge funds for C/A Capital Management, Boston, the investment outsourcing money management subsidiary of consultant Cambridge Associates LLC.

“There's no way to give a range of returns for hedge fund co-investments because performance is so dependent on unique, individual underlying deals,” Mr. Hansen said.

But the returns of individual co-investments, rarely revealed publicly by hedge fund managers or their large investors, will propel more institutions to seek a place in the investment queue, sources predicted.

“Hedge fund co-investment will evolve from the minority sport that it is today into a defining feature of risk capital markets in the future,” wrote Simon Ruddick, CEO and managing director of alternative investment consultant Albourne Partners Ltd., London, in an e-mail.

"Nimbleness and flexibility'

“Hedge fund co-investments embody the nimbleness and flexibility required to give hedge fund managers, and their investors, an essential edge in the ever more competitive quest for alpha. We see hedge fund co-investment as a core component of a larger phenomenon: customized investments,” Mr. Ruddick wrote.

One early example of the type of customization institutional investors are doing with their hedge fund managers is the New Jersey Division of Investment's $300 million investment in February with credit hedge fund manager Solus Alternative Asset Management.

The investment division, based in Trenton, manages investments for the $78.6 billion New Jersey Pension Fund.

Solus' credit mandate specifies flexibility, allowing the firm to invest up to two-thirds of the allocation in its flagship opportunistic event-driven and special situations credit strategy and up to two-thirds in “recovery-like opportunities, including ... high-conviction co-investment opportunities,” according to a report from Christopher McDonough, director of investments, at the Feb. 3 State Investment Council meeting. The council advises the investment division on pension fund management.

Mr. McDonough was unavailable to comment about the division's rationale behind the Solus investment, said Christopher J. Santarelli, a spokesman for the New Jersey Treasury Department, which oversees the Division of Investment.

The Solus investment was not New Jersey's first to a hedge fund co-investment. In May 2013, JANA Partners was awarded $100 million for investment in its flagship Strategic Investments Fund, which invests about 30% of its assets in shareholder activist opportunities. New Jersey also committed $200 million to co-investing with JANA in activist shareholder deals.
It was only a matter of time before co-investments made it into the hedge fund arena. But I share some concerns. First, hedge funds have first dibs on their top ideas and then feed them to pensions co-investing alongside them. And what happens when they exit these positions? Do the pension funds co-investing get an advance warning? How will that impact investors in the co-mingled fund?

Pension funds love complicating things. This push to co-invest with hedge funds is all because they don't have the requisite staff to manage absolute return strategies internally and they want to lower fees hedge funds are charging them.

But if you ask me, U.S. pensions need to improve their governance, improve compensation, hire experts to manage portfolios internally and make better use of publicly available information on what major hedge funds are doing. They can track moves on,, or through my quarterly updates on top funds' activity.

For example, when you see Seth Klarman's Baupost Group owning a 35% stake in Idenix Pharmaceuticals (IDIX), chances are something is up (click on image).

And what happened was Merck bought them out for their Hepatitis C drug, sending shares soaring from $7 to close to $25 (click on image):

This morning, I was checking out shares of Puma Biotechnology (PBYI) soaring 270% in pre-market trading because the company said a clinical trial of its experimental drug blocked the return of breast cancer in women with a type of early-stage disease.

Shares of Puma Biotech took a big hit in Q1with the big unwind and have been falling ever since. But that didn't stop one hedge fund I track closely, Adage Capital Partners, from amassing a 19% stake in the company (click on image):

As you can see, Citadel Advisors, another well known hedge fund I track, also bought positions in Puma Biotechnology. But Adage was the one that made big bucks today, a cool $950 million.

Now, admittedly, these are not the type of co-investments pension funds are looking for (biotech shares are too small and risky for them), but I can show you other examples of well known large cap names too. I just showed you biotech because it's a space I track closely and believe in.

If you have any comments on pensions co-investing with hedge funds, let me know or post them below. Don't get too excited about this "new form" of investing with hedge funds. At the end of the day, overpaid hedge fund managers are looking to gather more assets to manage so they can charge institutions with outrageous fees. That's pretty much it.

Below, Bill Ackman tried to convince investors in a presentation Tuesday that the seller of weight-loss shakes is guilty of fraud. I embedded Bloomberg highlights of his remarks.

Unfortunately for Ackman, he got clobbered yesterday as Herbalife (HLF) shares soared 25% following his "bombshell revelations." He might turn out to be right but some pretty big hedge funds are betting against him, including Soros, Icahn and Perry Capital.

Below, Robert Chapman, Chapman Capital, says he is adding aggressively to Herbalife despite Bill Ackman's criticism of the company. Chapman also  explains why he thinks the stock could hit $150 per share within a year (I would steer clear of Herbalife and let the big boys battle it out).

Tuesday, July 22, 2014

Banks Aid Hedge Funds Avoid Taxes?

John D. McKinnon of the Wall Street Journal reports, Senate Report: Tax Move Helped Hedge Funds Save Billions:
Hedge funds used a tax avoidance technique offered by Wall Street banks for years to skirt federal leverage trading limits, with one well-known trading firm potentially saving $6.8 billion in U.S. taxes, Senate investigators claim in a report released Monday.

Companies involved in the practice have pushed back against the Internal Revenue Service, which warned in a 2010 memo against claiming a tax break based on the use of financial products known as basket options. The companies said use of the products to claim lower long-term capital gains tax treatment for trading activity is legal and doesn't violate tax rules or leverage limits under current law.

The report by the Senate Permanent Subcommittee on Investigations suggests the practice was widespread in the financial industry over the last 15 years or so, with one hedge fund, Renaissance Technology Corp. LLC, potentially saving $6.8 billion in federal taxes.

Investigators said two banks, Deutsche Bank AG and Barclays Bank PLC, sold 199 basket options to more than a dozen hedge funds, which used them to conduct more than $100 billion in trades.

After the IRS released its 2010 memo, banks wound down the sale of basket options as a way for hedge funds to claim long-term capital gains tax treatment. But some still are selling the structures as a way around federal leverage limits, according to the report.

The Senate panel will hold a hearing on the report on Tuesday, featuring witnesses from the hedge fund and the two banks.

"The [basket] options offered by Deutsche Bank which were discussed in the committee's report were at all times fully compliant with applicable laws, regulations and guidance," said Renee Calabro, a Deutsche Bank spokeswoman. "Moreover, they were a niche offering to a small number of clients over a discrete period of time which we completely ceased offering in 2010."

" Barclays has been fully compliant with the law…and looks forward to continuing that cooperation at the hearing," said a spokeswoman, Kerrie Cohen.

Both banks said they cooperated in the Senate investigation.

The report highlights growing worries for the U.S. Treasury over use of numerous tax-avoidance maneuvers by hedge funds and other investment funds, which are typically structured as partnerships. In part because of huge paperwork hassles under current law, the IRS audits large partnerships far less often than major corporations, as the new report notes.

In particular, the report focuses on use of basket options by two hedge funds, Renaissance Technology Corp. and George Weiss Associates. The report concludes that RenTec alone netted about $34 billion in trading profits through the type of basket options that generates tax breaks and could have saved it $6.8 billion in taxes.

"We believe that the tax treatment for the option transactions being reviewed by the PSI is appropriate under current law," said Jonathan Gasthalter, a RenTec spokesman. "These options provide Renaissance with substantial business benefits regardless of their duration."

Investigators believe the basket options maneuver amounts to a "series of fictions," the biggest being that the banks own the account assets, said Sen. Carl Levin (D., Mich.), the subcommittee chairman. In reality, the account is basically a trading account, investigators say.
Gina Chon of the Financial Times also reports, US Senate alleges hedge fund and banks avoided $6bn tax bill:
Hedge fund Renaissance Technologies has been accused of misusing complex financial structures, with the help of Barclays and Deutsche Bank, to avoid paying more than $6bn in US taxes, the Senate Permanent Subcommittee on Investigations said on Monday.

Renaissance is said to have made $34bn in trading profits, while the banks reportedly took more than $1bn in fees, by characterising the gains as long-term capital gains that avoided bigger tax bills, according to the year-long investigation by the subcommittee. Executives of the companies are set to testify before the Senate on Tuesday.

Most of the trades conducted by Renaissance and at least 12 other hedge funds were short-term transactions, with some lasting only seconds, the Senate report said. But the so-called “basket options” of securities were in accounts held for at least a year, allowing the profits to be claimed as long-term capital gains, which are subject to a 20 per cent tax rate.

The securities were also held in options accounts instead of traditional prime broker accounts, which are subject to an ordinary income tax rate of as high as 39 per cent that would apply for daily trading gains.

The report is the Senate’s latest probe of what it sees as efforts by companies, banks and investors to avoid taxes or to help their clients evade such charges. The subcommittee has also held hearings involving Apple, Caterpillar and Credit Suisse.

“These banks and hedge funds used dubious structured financial products in a giant game of ‘let’s pretend’, costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation,” said Carl Levin, head of the subcommittee. He added that the banks and hedge funds created an “alternate universe” based on “fiction”.

Tax experts argue that such structures are not illegal and that it is up to lawmakers to change tax rules if they do not want hedge funds to use basket options. Legislators have considered revamping the tax code, including putting a halt to tax inversion – where US companies use M&A to move their headquarters to more friendly tax regimes, but it has been difficult to come up with a compromise and a broad tax overhaul is unlikely this year.

Both the banks and Renaissance maintain that the tax treatment in question was compliant with applicable laws.

“We believe that the tax treatment for the option transactions being reviewed by the PSI is appropriate under current law,” Renaissance said. “These options provide Renaissance with substantial business benefits regardless of their duration. The IRS already has been reviewing these option transactions for over six years, and Renaissance has co-operated fully with both reviews.”

The subcommittee focused on Renaissance because it said the hedge fund was the biggest buyer of such basket options, but Senate staffers said it was unclear whether the practice was widespread. The funds conducted more than $100bn in trades over 10 years and avoided leverage limits that were aimed at protecting the financial system, the Senate report said.

The IRS issued guidance in 2010 warning investors that profits from these transactions should be counted as short-term gains. The IRS has been negotiating with Renaissance over the past several years over the tax issue.

“The options offered by Deutsche Bank which were discussed in the committee’s report were at all times fully compliant with applicable laws, regulations and guidance,” the bank said in a statement. “Moreover, they were a niche offering to a small number of clients over a discrete period of time which we completely ceased offering in 2010.”

Barclays sold the products only to Renaissance and stopped offering them in 2013. “Barclays has been fully compliant with the law, has co-operated with the committee and looks forward to continuing that co-operation at the hearing,” the bank said in a statement.
You can also read Alexandra Stevenson's article in the New York Times which names other hedge funds like SAC Capital. Here is the press release put out by the Permanent Subcommittee on Investigations:
Two global banks and more than a dozen hedge funds misused a complex financial structure to claim billions of dollars in unjustified tax savings and to avoid leverage limits that protect the financial system from risky debt, a Senate Subcommittee investigation has found.

The improper use of this structured financial product, known as basket options, is the subject of a 93-page report released by the Chairman and Ranking Member of the U.S. Senate Permanent Subcommittee on Investigations, Senator Carl Levin, D-Mich., and Senator John McCain, R-Ariz., and will be the focus of a Tuesday hearing at which bank and hedge fund officials and tax experts will testify.

“Over the years, this Subcommittee has focused significant time and attention on two important issues: tax avoidance by profitable companies and wealthy individuals, and reckless behavior that threatens the stability of the financial system,” said Levin. “This investigation brings those two themes together. These banks and hedge funds used dubious structured financial products in a giant game of ‘let’s pretend,’ costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation.”

“Americans are tired of large financial institutions playing by a different set of rules when it comes to paying taxes,” said McCain. “The banks and hedge funds involved in this case used the basket options structure to change the tax treatment of their short-term stock trades, something the average American investor cannot do. Hedge funds cannot be allowed to have an unfair tax advantage over ordinary citizens.”

The report outlines how Deutsche Bank AG and Barclays Bank PLC, over the course of more than a decade, sold financial products known as basket options to more than a dozen hedge funds. From 1998 to 2013, the banks sold 199 basket options to hedge funds which used them to conduct more than $100 billion in trades. The subcommittee focused on options involving two of the largest basket option users, Renaissance Technology Corp. LLC (“RenTec”) and George Weiss Associates.

The banks and hedge funds used the option structure to open proprietary trading accounts in the names of the banks and create the fiction that the banks owned the account assets, when in fact the hedge funds exercised total control over the assets, executed all the trades, and reaped all the trading profits.

The hedge funds often exercised the options shortly after the one-year mark and claimed the trading profits were eligible for the lower income tax rate that applies to long-term capital gains on assets held for at least a year. RenTec claimed it could treat the trading profits as long term gains, even though it executed an average of 26 to 39 million trades per year and held many positions for mere seconds.

In 2010, the IRS issued an opinion prohibiting the use of basket options to claim long-term capital gains. Based on information examined by the subcommittee, tax avoidance from the use of these basket option structures from 2000 to 2013 likely exceeded $6 billion.
In addition to avoiding taxes, the structure was used by the banks and hedge funds to evade federal leverage limits designed to protect against the risk of trading securities with borrowed money. Leverage limits were enacted into law after the stock market crash of 1929, when stock losses led to the collapse of not only the stock speculators, but also the banks that lent them money and were unable to collect.

Had the hedge funds made their trades in a normal brokerage account, they would have been subject to a 2-to-1 leverage limit – that is, for every $2 in total holdings in the account, $1 could be borrowed from the broker. But because the option accounts were in the name of the bank, the option structure created the fiction that the bank was transferring its own money into its own proprietary trading accounts instead of lending to its hedge-fund clients.

Using this structure, hedge funds piled on exponentially more debt than leverage limits allow, in one case permitting a leverage ratio of 20-to-1. The banks pretended that the money placed into the accounts were not loans to its customers, even though the hedge funds paid financing fees for use of the money. While the two banks have stopped selling basket options as a way for clients to claim long-term capital gains, they continue to use the structures to avoid federal leverage limits.

Data provided by the participants indicates that basket options produced about $34 billion in trading profits for RenTec alone, and more than $1 billion in financing and trading fees for the two banks.

“These basket option deals were enormously profitable for the banks and hedge funds that used them,” Levin said. “But ordinary Americans have shouldered the tax burden these hedge funds shrugged off. Those same ordinary Americans would pay another price if the reckless borrowing outside of federal safeguards were to blow up.”

The Levin-McCain report includes four recommendations to end the option abuse.
  • The IRS should audit the hedge funds that used Deutsche Bank or Barclays basket option products, disallow any characterization of profits from trades lasting less than 12 months as long-term capital gains, and collect from those hedge funds any unpaid taxes.
  • To end bank involvement with abusive tax structures, federal financial regulators, as well as Treasury and the IRS, should intensify their warnings against, scrutiny of, and legal actions to penalize bank participation in tax-motivated transactions.
  • Treasury and the IRS should revamp the Tax Equity and Fiscal Responsibility Act regulations to reduce impediments to audits of large partnerships, and Congress should amend TEFRA to facilitate those audits.
  • The Financial Stability Oversight Council, working with other agencies, should establish new reporting and data collection mechanisms to enable financial regulators to analyze the use of derivative and structured financial products to circumvent federal leverage limits on purchasing securities with borrowed funds, gauge the systemic risks, and develop preventative measures.
Tuesday’s hearing is at 9:30 a.m. in Room 216 of the Hart Senate Office Building. Witnesses will be:

Panel 1: Steven Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center; and James R. White, director of tax issues for the Government Accountability Office.

Panel 2: Martin Malloy, managing director at Barclays; Satish Ramakrishna, managing director at Deutsche Bank Securities; Mark Silber, executive vice president, chief financial officer, chief compliance office and chief legal officer at Renaissance Technologies; and Jonathan Mayers, counsel at Renaissance Technologies.

Panel 3: Gerard LaRocca, chief administrative officer for the Americas at Barclays and CEO of Barclays Capital; M. Barry Bausano, president and managing director of Deutsche Bank Securities; and Peter Brown, co-CEO and co-president of Renaissance Technologies.
Welcome to the wonderful world of tax arbitrage, a source of enormous profits for banks, hedge funds, investment funds and corporations. If there is a way to avoid paying taxes, rest assured banks will find it and aid their clients, including overpaid hedge fund managers, in dodging taxes.

As I read this, a few thoughts came to mind. First, the tax rules need to change to put an end to such blatant abuses. Second, stop treating all hedge funds equally. If Renaissance Technologies wants to trade a million times per day, fine, tax them accordingly. Third, this is more evidence that the financial elite skirt their share of taxes using any means possible, adding to Piketty's thesis on the 1%.

Below, Senator Bernie Sanders addresses The New Populism Conference in Washington, D.C. (May, 2014). Love him or hate him, Bernie cuts through the crap and tells it like it is. America's oligarchs are raking in billions, avoiding their fair share of taxes, and the middle class is being obliterated. And we wonder why the recovery is weak?

Monday, July 21, 2014

On the Brink of Another World War?

Esther Tanquintic-Misa of the International Business Times reports, Will Malaysia Airlines MH17 Tragedy Provoke World War 3?:
Could the disaster that fell upon Malaysia Airlines flight MH17 trigger a major global war after dozens of innocent lives, who definitely had nothing to do with the tensions ongoing between Ukraine and Russia, were lost?

Leaders from Malaysia, Australia, New Zealand, the UN and the U.S. have called for a full-blown investigation in the disastrous accident even as US intelligence authorities said a surface-to-air missile was what downed the Malaysia Airlines flight MH17 commercial passenger jet.

"There is clearly a need for a full and transparent international investigation," UN Secretary-General Ban Ki-moon said.

Suffice to say, the U.S. may consider this unfortunate event as the time it has to step in and take aggressive action to stop the fighting in Ukraine.

U.S. President Obama could be forced to send more advanced arms to Ukraine's security forces, as well as train them. "This will undermine the case of those who have been reluctant," an unidentified U.S. official told Reuters.

What happened on Thursday, the official said, "could go two ways." It could make countries pause and review the seemingly escalating danger of the Ukraine conflict, or force them to join into the fray and "put their heads in the sand."

European flight safety body Eurocontrol on Thursday said it had received an advisory from Ukrainian authorities declaring the country's east portion as a no-fly zone after a Malaysian airliner with 295 onboard crashed in the region.

An intercepted series of phone conversations between Russian separatists said Malaysia Airlines flight MH17 has no business flying over Ukrainian airspace, unless it was carrying spies.

Eurocontrol had explained that while Ukrainian authorities had closed the route from ground to flight level 320, the doomed Malaysia Airlines flight MH17 was flying at Flight Level 330 (approximately 10,000 metres/33,000 feet) when it disappeared from the radar. The level at which the aircraft was flying was therefore open, it added.

It was believed pilots of the doomed Malaysia Airlines flight MH17 opted to fly above Ukraine airspace to save on fuel.

"Flights over troubled regions are very common," Dave Powell, dean of Western Michigan University's College of Aviation and a retired Boeing 777 captain at United Airlines, told International Business Times U.S. "Both governments and airlines take a look at the threats out there, of course. But when you're trying to save money and competing against everyone else, my guess is, everybody is doing that kind of routing."

Eurocontrol said that since the crash, Ukrainian airspace is now closed from the ground to unlimited (altitude) in Eastern Ukraine.

"The routes will remain closed until further notice."
I must admit, the first thing that came to my mind upon hearing of this tragedy was why would any commercial airline fly over that airspace? One of my friends said it best: "What imbecile plotted this flight path?!?"

Well, in an apparent move to save fuel and money, the pilots took that route and everyone on that plane was massacred. Among the dead was Joep Lange, a Dutch physician and professor of medicine at the University of Amsterdam, and one of the world's top AIDS researchers:
Lange, 59, was among what is thought to be dozens of AIDS researchers, consultants and policy experts headed from the Netherlands to Malaysia and onward to an international AIDS conference in Australia when their Boeing 777 plane appeared to have been blown out of the sky Thursday over the battlefields of eastern Ukraine's separatist insurgency.
Now the blame game  has commenced. The U.S. and its allies accused Russian-aided separatists of firing the missile that downed Malaysia Airlines Flight 17, killing 298 people and demanded that Moscow end months of unrest in eastern Ukraine.

U.S. Secretary of State John Kerry appeared on ABC's this Week discussing the crisis in the Middle East and Ukraine, stating: “There are an enormous array of facts that point at Russia’s support for and involvement in this effort.”

As I do every Sunday, I watched ABC's This Week and  Fareed Zakaria GPS. Almost unanimously, everyone blamed Putin and the Kremlin for this tragedy. One guest, however, set the record straight.

Stephen Cohen, professor emeritus of Russian studies and politics at New York University and Princeton University, took on Fareed Zakaria and Chrystia Freedland, who is now an MP for Canada's Liberal Party, saying they and the media fail to understand the context of the crisis in Ukraine.

Cohen wrote an excellent article for The Nation, The Silence of American Hawks About Kiev’s Atrocities, and along with Katrina vandel Hewell, has questioned the media establishment's blind acceptance of the Obama Administration's new Cold War, further isolating Russia.

In his Nation comment, James Carden goes even further asking, Could the Tragedy of Malaysia Airlines Flight MH17 Have Been Avoided?, and states:
The always-predictable mainstream media are now calling for even-more punishing sanctions on Russia. The evening of the incident, The Washington Post scolded the White House for continuing to “avoid measures that could inflict crushing damage on the Russian financial system and force Mr. Putin and the elites around him to choose between aggression in Ukraine and Russia’s economic future.”

Leaving aside the rather elementary fact that sanctions hardly ever change the behavior of the regimes at which they are aimed, consider this counterfactual: What if Mr. Obama had not announced a new round of sanctions against Russia on July 16? It is entirely possible that the murderous recklessness of the pro-Russian forces would have given Mr. Putin sufficient cover from his increasingly vocal right flank—who have been calling for greater Russian involvement, if not an outright invasion—to break with the rebels. What the July 16 sanctions announcement has done is effectively block the off-ramp. Yet the idea that sanctions may be counterproductive never seems to dawn on our establishment elites. Meanwhile the war hawks in Congress are eagerly chomping at the bit to retaliate, with their leader, Senator John McCain, promising there would “be hell to pay” if the Malaysian airliner was shot down by the Russian military or separatists.

One can’t help but wonder: hasn’t there been hell enough?
Finally, Eurasia Group's Ian Bremmer comments, What MH17 means for Russia, Ukraine:
MH17 is an alarming escalation of the Ukraine conflict. In the wake of a surface-to-air missile taking down a Malaysian airliner over Eastern Ukraine, everyone is pointing fingers. Kiev blames the pro-Russian “terrorists,” with Moscow responsible for providing them with intelligence and weapons. The separatists deny involvement and accuse Kiev of planning the attack, citing the Ukrainian military’s accidental shooting of a Siberian Airlines flight in 2001. Moscow blames the Ukrainian government for pushing the rebels into this violent situation — even if Russian President Vladimir Putin stopped short of pinning the airliner attack on Kiev. Despite the confusion, it’s clear what MH17 means: dramatic escalation and an even more combustible conflict.

Some analysts and pundits are viewing the downed flight as an opportunity to force Putin into tempering his support for the separatists. While clearer proof of pro-Russian separatist guilt does, in principle, provide the Russians with a reason to do so, it’s highly unlikely that Russia will seize the chance. The underlying fissures have not gone away — in fact, MH17 makes them even more pronounced.

Putin continues to view his country’s influence over Ukraine and the power to keep it from joining NATO as a national security interest of the highest order — the same way Israel wants to deter Iran from obtaining a nuclear weapon. Recent events haven’t shifted Putin’s interests in the slightest. In fact, the three biggest changes coming out of the MH17 crash point to more escalation. First, Putin’s statements blaming the Ukrainians will be exceedingly difficult to back away from. It’s not yet clear whether Russia will accept that separatists shot down the plane or instead deny, obfuscate and even refute the evidence. But either way, Moscow will maintain its claim that the Ukrainian government is responsible for driving the violence and destabilising the region where the plane crashed. Moscow will leverage its state media to promote this message.

Second, with proof that pro-Russian separatists are to blame, we will see a material ramp-up in sanctions from both Europe and the United States — and on an accelerated schedule. German Chancellor Angela Merkel is out in front of the story, declaring early Friday that “Russia is responsible for what is happening in Ukraine at the moment.” Meanwhile, the United States would forge ahead, broadening financial, energy and possibly other sector sanctions against Russia. These increases will amount to an escalation, rather than a redirection, of the conflict. The sanctions would have a real impact on Russia’s economy and investor sentiment — existing sanctions already do — but it’s highly unlikely that they would shift Putin’s calculus in Ukraine.

Lastly, MH17 gives Ukrainian President Petro Poroshenko more robust international support and more sympathy for his military campaign against the separatists, which has been moderately successful over the past few weeks. Now that he’s claimed that the “terrorists” are behind the attack, he has a responsibility to crack down on them further. He’ll likely make a more concerted push into rebel strongholds Donetsk and Luhansk. But this is going to be a bloody and uphill struggle — MH17 won’t change much on the battlefield, where urban house-to-house fighting will not proceed as cleanly as Poroshenko’s previous operations. We’re most likely heading to a standoff, amidst prolonged violence and shorter tempers on all sides. The downing of MH17 is not as much a sharp turn in the Ukraine conflict as it is an acceleration — shining an international spotlight on this deepening crisis.
Below, U.S. Secretary of State John Kerry appeared on ABC's this Week discussing the crisis in the Middle East and Ukraine. Also, Stephen Cohen, professor emeritus of Russian studies and politics at New York University and Princeton University, appeared on Democracy Now discussing how the downed Malaysian plane raises the risks of war between Russia and the West.

Lastly, Europe is the loser here and China is the big winner, says Ian Bremmer, Eurasia Group president, sharing his thoughts on the ripple effects of the crisis in Ukraine and the shooting down of Flight MH17.

Friday, July 18, 2014

PSP Investments Gains 16.3% in FY 2014

Benefits Canada reports, PSP Investments posts double-digit return:
The Public Sector Pension Investment Board (PSP Investments) recorded an investment return of 16.3% for the fiscal year ended March 31, 2014.

The performance was driven primarily by strong results in public market equities as well as in the private equity, renewable resources, real estate and infrastructure portfolios.

The fiscal year 2014 investment return exceeded the policy portfolio return of 13.9%, representing $1.8 billion of value added over the benchmark return.

“Once again, performance was strong across the board with all investment teams contributing to value added over benchmark returns,” says John Valentini, interim president and CEO, and chief financial officer. “Most notably, from a performance perspective, we have outperformed the long-term rate of return objective used by the chief actuary by 0.9% per year over the past 10 years.”

Consolidated net assets reached a record $93.7 billion, an increase of $17.6 billion, or 23%, over the previous year. PSP Investments generated net investment income of $12.6 billion for fiscal year 2014 and received $5 billion in net contributions.

For fiscal year 2014, returns on public market equities ranged from 6.1% for the emerging market equity portfolio to 38.7% for the small cap equity portfolio. The fixed income portfolio generated a return of 4%, while the return for the world inflation-linked bonds portfolio was 6.9%.

In private markets, all asset classes posted solid investment returns for fiscal year 2014 led by private equity and renewable resources with returns of 24% and 20%, respectively. Real estate recorded a 12.2% investment return, while the infrastructure portfolio earned an investment return of 9.4%. The private asset returns reflect the currency hedging of these assets.

The asset mix as at March 31, 2014, was as follows: public market equities (52.8%), nominal fixed income and world inflation-linked bonds (17.7%), real estate (11.4%), private equity (9%), infrastructure (6.4%), cash and cash equivalents (1.9%) and renewable resources (0.8%).
Janet McFarland of the Globe and Mail also reports, Federal employees’ pension plan earned 16.3% last year:
The pension plan for federal government employees earned a 16.3-per-cent return last year, beating its investment benchmarks and pushing assets under management to almost $94-billion.

The Public Sector Pension Investment Board, which invests pension funds for federal civil servants including the Canadian Forces and the RCMP, said Thursday its assets climbed by $17.6-billion in the year ended March 31 – an increase from $76-billion last year – due to huge stock market returns and strong results in private equity and real estate holdings.

PSP Investments, Canada’s fifth-largest pension fund manager, said it earned $1.8-billion in value above its passive benchmark return of 13.9 per cent last year.

“Once again, performance was strong across the board with all investment teams contributing to value added over benchmark returns,” said interim chief executive John Valentini.

Mr. Valentini was appointed in June following the resignation of former CEO Gordon Fyfe, who left to head B.C.’s pension fund manager, British Columbia Investment Management Corp.

Mr. Valentini said PSP has outperformed the long-term return target it needs to hit to meet its projected pension obligations.

On a 10-year basis, the fund has earned an average annualized return of 7 per cent, which translates into a return of 5.2 per cent after inflation is taking into consideration. The Chief Actuary of Canada said federal pension plans needed to achieve an average return of 4.3 per cent after inflation over the past decade.

Like many pension funds, PSP’s returns in the past year easily topped gains in other recent periods due to steep improvements in stock market returns. The fund’s 16.3-per-cent gain in fiscal 2014 exceeded gains of 10.7 per cent in 2013 and 3 per cent in 2012.

The fund said gains from its public market stock portfolio ranged from 6.1 per cent in emerging markets to 38.7 per cent for its small cap equity portfolio. Private equity investments climbed 24 per cent last year, while renewable resource holdings were up 20 per cent and real estate climbed by 12.2 per cent.

The fund said it holds just over half its assets – 53 per cent in public market equities – while fixed income and bond investments total just 17.7 per cent of its assets. The remainder of its holdings are in real estate, private equity, infrastructure, renewable resources and cash.
You can read the press release PSP put out on their FY 2014 results here. More importantly, take the time to carefully read the FY 2014 Annual Report here. It is extremely well written and provides an in-depth discussion on performance, governance, risk and compensation.

Cheryl Barker, PSP's interim chair of the board (why can't they finally appoint her or someone else as chair?!?), kicks things off on page 6. Ms. Barker discusses the importance of PSP's Policy Portfolio:
The most critical component with respect to the strategic Goal No. 1, Portfolio Management, is the Policy Portfolio, which essentially stipulates how every dollar transferred to PSP Investments is allocated to asset classes. A key Board responsibility, the Policy Portfolio is reviewed annually. The review focuses on the liability structure under the pension plans and examines the appropriateness of the Policy Portfolio to meet these liabilities. This examination includes a major focus on PSP Investments’ long-term capital market assumptions and related methodologies, which are key inputs in the design of the Policy Portfolio. Enhanced scenario testing has been undertaken to validate potential outcomes.

Consideration was given during fiscal year 2014 to adding or expanding asset classes. However, we concluded that the current Policy Portfolio, with its target of 42% Private Markets investments, remains effective and should enable PSP Investments to meet or exceed its long-term rate-of-return objective (4.1% after inflation), with an acceptable level of risk. Supporting this conclusion is the fact that, over 10 years, PSP Investments has outperformed the return objective by 0.9% per year. This excess return per year translates into a cumulative $7.7 billion of investment gains when taking into account the size and timing of cash inflows.
I will come back to PSP's Policy Portfolio later on but let me tell you right away, the next ten years won't look anything like the past ten years and PSP's board will need to take into account many factors, including the mad rush into private markets by global pension and sovereign wealth funds, when reviewing their Policy Portfolio.

One thing Ms. Barker wrote which I personally liked a lot was this passage:
Finally, with regard to strategy, in light of PSP Investments’ increasingly global reach — with more than half our assets now invested in foreign markets — consideration was given to the desirability of opening offices in markets outside Canada. Upon reflection, the Board and senior management concurred that we continue to be well served by our current strategy, which entails working closely with select local partners to identify attractive potential investments abroad,while maintaining the organizational agility to respond quickly to such opportunities.
In my opinion, opening up global offices is a waste of valuable time and resources and PSP's board and senior management are right, if you have solid partners in key areas, you don't need to open up offices and hire employees all around the world (CPPIB, OTPP, the Caisse will disagree but that's my opinion!).

Next, we move onto the president's report on page 10. Gordon Fyfe, who just left PSP to head bcIMC, discusses PSP's FY 2014 results, systems and human resources. Here are some key points which I edited a little:
  • At year’s end more than $70 billion or 75% of consolidated net assets was being managed internally. Some $38 billion of that amount was actively managed by our own teams — representing an increase of 31% from the previous year-end. This contrasts sharply with the situation back in fiscal year 2004, when only $1.7 billion of assets were being actively managed in-house. While actively managing many of our own portfolios involved building the requisite high-calibre teams, it has enabled us to realize significant savings estimated at between $180 million and $265 million in fiscal year 2014 alone. Thanks in large part to the internal active management strategy, PSP Investments’ cost ratio has been trending downwards in recent years and compares favourably with peers in the Canadian pension investment industry. Moreover, results indicate that our internal investment managers have in many instances been significantly outperforming our externally-managed investments.
  • Notwithstanding the increased emphasis on internal management, PSP Investments continues to forge strong relationships with select partners, including other leading pension investment managers...By way of example, it was thanks to our strong relationship with a prominent fund in the Asia-Pacific region that the Private Equity team was able to acquire a significant equity interest in a leading Asian life insurer during the latest fiscal year. With some $21 billion in assets, ING Life Korea is that country’s fifth-largest life insurance company. This investment fits well with PSP Investments’ aim of expanding its holdings in developing economies. In line with our increased focus on direct and co-investments, the Private Equity team also divested approximately $US1.3 billion of private equity funds during the year through a competitive auction process.
  • Other noteworthy transactions during fiscal year 2014 included the Infrastructure team’s purchase of AviAlliance GmbH (formerly Hochtief AirPort GmbH), an airport investment and management company. AviAlliance held interests in the airports of Athens, Budapest, Dusseldorf, Hamburg, Sydney and Tirana which, combined, handle approximately 95 million passengers annually. The complexity of the transaction gave PSP Investments a competitive advantage to acquire an attractive portfolio of airports with long-term growth perspectives.
  • It was another deal-intensive year for our Real Estate team, which completed the sale of its Canadian Westin hotel portfolio — one of PSP Investments’ first major real estate investments. The transaction generated solid annualized returns of close to 15% over eight years. As well, Revera Inc., PSP Investments’ largest Private Markets holding, sold a 75% interest in a sizeable portfolio of Canadian retirement properties, thereby reducing PSP Investments’ exposure while allying Revera with a credible strategic partner. Significant Real Estate acquisitions included a 50% stake in 1250 René-Lévesque, a million-square-foot-plus Class A office tower in downtown Montreal that houses the main business offices of PSP Investments; and the purchase with several partners of a large office property strategically situated on Park Avenue in Manhattan. We also created a $1.5-billion (€1-billion) logistics joint-venture with London-based SEGRO, a leading industrial/warehousing property owner, manager and developer listed on the London Exchange. The joint venture involves 34 estates in Western and Central Europe, totaling more than 17 million square feet.
  • Our Renewable Resources team formed a strategic agricultural joint venture with an established farmland investor and manager in Latin America, which will serve as PSP Investments’ platform for the further acquisition, development and management of farmland in the region. Again, this transaction is consistent with PSP Investments’ strategy to partner with best-in-class investors and operators in key regions.
  • We have made significant investments to build a robust technology and data-management infrastructure to support our rapid growth. We continue to strengthen our capabilities in that respect, focusing on the implementation of scalable systems that can effectively handle public and private market transactions from end to end. As PSP Investments’ portfolios continue to expand, these systems also allow for enhanced monitoring, reporting, analysis and risk management.
  • The solid results we posted for fiscal year 2014 reflect PSP Investments’ exceptional bench strength. The team we have built in Montreal is the equal of any similar-sized pension investment organization anywhere in the world. In that regard, I would suggest our performance speaks for itself. But you need not take my word for it: in the course of my frequent travels to meet with people around the globe with whom we do business, it is gratifying to hear the near universal respect and high regard our partners express for the men and women of PSP Investments with whom they deal. The calibre of our team reflects our uncompromising efforts to identify, attract, retain and develop top-flight talent.
That last part made me chuckle because Gordon sure loves traveling all around the world to meet private equity and real estate partners, racking up those air miles. And while there are many excellent employees at PSP, the organization suffered unacceptably high turnover rates for years and it failed to attract or retain many highly competent professionals in Montreal, including yours truly and plenty more who were either never considered on frivolous grounds, abruptly fired or left in disgust despite PSP's above average compensation (money isn't enough, culture is critical).

Importantly, when it comes to human resources, PSP, the Caisse, CPPIB and others are unfortunately still reverting to mediocrity and they have a lot of work in terms of diversifying their workplace and improving the culture at their organizations (too many huge egos with their heads up their arse!).

Now, let me take you into the nitty-gritty on PSP's fiscal year 2014  performance. First, let's have a look portfolio and benchmark returns on page 21 (click on image):

Here are some of my observations:
  • First, in Public Markets, the performance was pretty much benchmark in bonds and stocks. PSP indexes their Canadian stock portfolio and bonds but I noted strong outperformance in their EAFE Large Cap Equity portfolio in FY 2014 (28.3% vs 27.7%) and over the last four fiscal years (10.7% vs 10.3%). Importantly, this was the only portfolio in Public Markets with significant outperformance over the last fiscal year and last four fiscal years (bravo to Jérôme Bichut and his team!).
  • One thing that struck me in Public Markets was the significant under-performance of U.S. Large Cap Equity in  FY 2014, returning 29.5% vs its benchmark return of 32.4% (an almost 300 basis points miss in U.S. large caps is crazy). Emerging Markets Equity also under-performed its benchmark by 100 basis points (6.1% vs 7.1%).
  • In Private Markets, there was significant outperformance in FY 2014 in Private Equity (24% vs 14.7%), Real Estate (12.2% vs 5.2%), Infrastructure (9.4% vs 4.6%) and Renewable Resources (20% vs 5%). 
  • Over the last four fiscal years, the bulk of the value added that PSP generated over its (benchmark) Policy Portfolio has come from two asset classes: private equity and real estate. The former gained 16.9% vs 13.7% benchmark return while the latter gained 12.6% vs 5.9% benchmark over the last four fiscal years.
That last point is critically important because it explains the excess return over the Policy Portfolio from active management on page 16 during the last ten and four fiscal years (click on image):

But you might ask what are the benchmarks for these Private Market asset classes? The answer is provided on page 18 (click on image):

What troubles me is that it has been over six years since I wrote my comment on alternative investments and bogus benchmarks, exposing their ridiculously low benchmark for real estate (CPI + 500 basis points). André Collin, PSP's former head of real estate, implemented this silly benchmark, took all sorts of risk in opportunistic real estate, made millions in compensation and then joined Lone Star, a private real estate fund that he invested billions with while at the Caisse and PSP and is now the president of that fund.

And yet the Auditor General of Canada turned a blind eye to all this shady activity and worse still, PSP's board of directors has failed to fix the benchmarks in all Private Market asset classes to reflect the real risks of their underlying portfolio.

Importantly, when I see such ridiculously high outperformance in any asset class, especially in private markets where benchmarks are easier to manipulate, my antennas immediately go up.  None of the benchmarks governing PSP's Private Markets reflect the risks of their underlying portfolios.

An easy example of this is from the points above taken from the president's report. Gordon Fyfe wrote that PSP completed the sale of its Canadian Westin hotel portfolio — one of PSP Investments’ first major real estate investments. The transaction generated solid annualized returns of close to 15% over eight years. This is an opportunistic real estate deal that easily trounced its benchmark return of roughly 5% annualized over the last eight years.

And why are benchmarks important? Because they determine compensation. Last year, there was an uproar over the hefty payouts for PSP's senior executives. And this year isn't much different (click on image below from page 65 of the 2014 Annual report):

As you can see, PSP's senior executives all saw a reduction in total compensation (new rules were put in place to curb excessive comp) but they still made off like bandits, collecting millions in total compensation. Once again, Mr. Fyfe made the most, $4.2 million in FY 2014 and a whopping total of close to $13 million over the last three fiscal years.

This type of excessive compensation for public pension fund managers beating their bogus private market benchmarks over a four-year rolling return period really makes my blood boil. Where is the Treasury Board and Auditor General of Canada when it comes to curbing such blatant abuses? (As explained here, the Auditor General of Canada rubber stamps financial audits but has failed to do an in-depth performance audit of PSP).

And don't think that PSP's employees are all getting paid big bucks. The lion's share of the short-term incentive plan (STIP) and long-term incentive plan (LTIP) was paid out to five senior executives but other employees did participate (pages 62-64):
  • The total incentive amount paid under the STIP was $36.5 million in fiscal year 2014 (465 employees), $29.9 million in fiscal year 2013 (404 employees) and $23.1 million in fiscal year 2012 (362 employees).
  • The total incentive amount paid under the LTIP was $17.5 million in fiscal year 2014 (73 employees), $15.2 million in fiscal year 2013 (55 employees) and $6.7 million in fiscal year 2012 (42 employees).
I think it's high time we stop the charade and someone commission an in-depth report on the benchmark portfolios governing all of Canada's large public pension funds. What else? We need to take a much closer look at the compensation of Canada's senior executives at some public pension funds and rein in excessive compensation. When public pension fund managers are making a base salary of a radiologist (one of the highest paid medical specialties in Canada) plus huge long-term and short-term bonuses, something is totally out of whack.

Moreover, as I explained here, these are public pension funds, not private investment funds which have to worry about performance in order to raise assets. They have captive clients giving them billions to manage so I find it hard to swallow all this nonsense that they deserve these hefty payouts because they manage billions and beat some bogus benchmarks based on a four-year rolling return period.

Another thing that disturbs me is the severance packages of PSP's senior executives on page 66 (click on image):

Thank god the board didn't have to fire Gordon Fyfe, it would have cost PSP millions in severance. And what happens when the new CEO comes in and wants to make changes to senior management? It will cost PSP millions (I had to fight to increase my severance from a measly six to eight months after I was wrongfully dismissed from PSP and got harassed afterward through bailiffs and silly legal letters which I chucked in the garbage!).

Ok, granted, these are senior managers, and if they get fired chances are they will never find another job that pays them this well, especially in Montreal, so one can argue that the severance packages are appropriate given their level of responsibility. But it's the responsibility of the board of directors to make sure compensation (and severance) isn't way out of line and reflects the risks these guys take.

I've given you a lot of food for thought in this comment. I don't want to be overly critical. PSP's FY 2014 results are excellent, especially in Private Markets, where they literally trounced their bogus benchmarks, but I wanted to critically examine these results and show you how to properly read the Annual Report.

Finally, I received a few "conspiracy emails" after my last  comment on why Gordon left PSP to head bcIMC. People love conspiracies, even with me (they watch too much television!). I get it all the time: "Why were you fired from PSP? You must have done something really, really bad. Is it true that PSP put a restraining order on you and called the police on you?"

Let me tell you, everything you hear about me from third sources is absolute bullshit. I know exactly what happened between PSP and me and wrote about it. The only bad thing I ever did was piss off some senior managers regarding their bogus benchmarks and sending them emails on the rising risks in the U.S. housing market and how it will impact credit markets (wrote about it here). The other 'bad" thing I did was be open with my employer about my chronic illness (Multiple Sclerosis) thinking they would understand and accommodate my mobility issues (I was wrong, they sacked me, totally violated my rights, harassed me and blacklisted me in the industry).

I also know exactly why Gordon left PSP and gave the board a very short notice before departing for B.C. All you need to know is what I wrote in my comment, for Gordon, just like for most of us, family comes first. That's it, that's all folks, there is no major conspiracy going on as to why Gordon Fyfe left PSP to head bcIMC.

And since I love teasing my good old buddy Gordon, here is what he was saying on that phone call in the annual report (click on image):

And if you think that's funny, check out the clip below taken at the gym when PSP's senior executives found out their FY 2014 hefty payouts passed through Parliament. Brother André (Collin) joined the festivities (he's the slimy guy sporting a mask, cape, wig and green tights; don't know who the beefy chick oiling him up and dancing with him is).

Also, since you all want to know about my last encounter with Gordon, I embedded it below. It really wasn't as bad as it looks, he just told me to "let off some steam." LOL!

Enjoy your weekend and remember that these comments take a lot of time to write, so please show your appreciation and donate and subscribe at the top right-hand side. I'm still waiting for a portion of Gordon Fyfe's fiscal years 2013 and 2014 compensation. Come on Gordon, show me some "love." -:)