Tuesday, June 24, 2008
Alternative Investments and Bogus Benchmarks
This week, I will dig deeper into the issue of alternative investments, focusing once again on the benchmarks that Board of Directors use to compensate their investment managers at public pension funds.
The bear market that gripped public markets following the tech meltdown was a perfect storm for pension funds. Returns on public stock indexes fell and liabilities grew as interest rates fell to historically low levels.
At the time, pension funds were worried they would suffer severe funding shortfalls. To juice up their sagging portfolios, pension fund managers moved their asset allocation away from public stocks and bonds and into alternative investments like real estate, private equity, hedge funds, infrastructure, commodities and timberland. A recent study by Watson Wyatt Research shows that despite their skepticism, pension funds continue to drive the growth in alternative investments. Every sophisticated and not-so-sophisticated pension fund wants to emulate the Harvard and Yale endowment funds with their aggressive exposure to alternative asset classes.
In his seminal book, Pioneering Portfolio Management (2000), Yale University's Chief Investment Officer David Swensen emphasized the advantages of illiquid investments:
"Active managers willing to accept illiquidity achieve a significant edge in seeking high risk adjusted returns. Because market players routinely overpay for liquidity, serious investors benefit by avoiding overpriced securities and locating bargains in less widely followed, less liquid market segments." (p.56)
It's too bad that most pension fund managers and supervisors did not bother reading Swensen's book more carefully. If they did, they would quickly discover that while alternative investments offer tremendous portfolio diversification (at least in theory) and added yield that pensions so desperately seek, they also offer their own set of unique risks that need to be reflected in the benchmarks that pension funds use to assess the performance of these investments.
I will continue to make the case that benchmarks of alternative investments at most of the large Canadian (and global) public pension funds do not accurately reflect the risks of the underlying portfolio. The table above looks at the 2007 returns of Real Estate returns relative to their benchmark returns from the five following pension funds:
1) Caisse de dépôt et placement du Québec (Caisse)
2) Ontario Teachers' Pension Plan (OTPP)
3) Ontario Municipal Employees' Retirement System (OMERS)
4) Canada Pension Plan Investment Board (CPPIB)
5) Public Sector Pension Investment Board (PSPIB)
All the information was obtained from the publicly available annual reports. You can click on the table above to enlarge the image. It is important to remember that the Caisse, OTPP and OMERS have fiscal years that end December 31st while CPPIB's and PSPIB's fiscal years end March 31st.
Nevertheless, the table clearly shows that Real Estate at OTPP, OMERS, CPPIB and PSPIB significantly outperformed the asset class benchmarks at these pension funds. Conversely, Real Estate underperformed its benchmark at the Caisse by 3.5% in 2007. What explains this discrepancy? The simple answer is that the Caisse's Real Estate benchmark does a better job accounting for the underlying risk and beta of its real estate investments. (Those of you who want to dig deeper into institutional real estate as an asset class should consult TIAA-CREF Asset Management's research.)
But the Caisse still needs to bolster some of its benchmarks. In particular, most of the value added in 2007 came from Private Equity, which earned 13.6% in 2007 or 8.5% over its benchmark which returned 5.1% in 2007. (Those of you who want to read more on benchmarks for private markets should consult Wilshire Private Market Group's Benchmarks for Private Investments).
I can't overemphasize the point that benchmarks matter because compensation is based on benchmarks. The next time your pension fund manager boasts of creating "significant value added", check in what asset class this alpha came from and check the benchmark of that asset class. Chances are that the "significant value added" came from private investments into real estate, private equity or infrastructure. In almost every case, if the asset class "significantly outperformed" its benchmark, it is because that benchmark does not account for the risks or beta of the underlying portfolio.
Now, if you want an example of a large pension fund that has done an excellent job thinking about its benchmarks and properly disclosing them in their annual report, look at the annual report of the California State Teachers' Retirement System (CALSTRS) (see footnotes on page 61 for details on each asset class benchmark). In my opinion, CALTRS is way ahead of its peers in terms of proper governance, proper disclosure and using proper benchmarks that accurately reflect the underlying beta and risks of each asset class. It is hardly surprising that CALSTRS consistently ranks among the first percentile of large public pension fund peers.
I can go on and on about flimsy benchmarks in alternative investments, including bogus benchmarks governing hedge funds or absolute return strategies at pension funds, but I will leave that for another time.
The important point is that when it comes to evaluating "alpha", make sure you ask your pension fund managers and the Board of Directors some tough questions regarding the benchmarks they use to measure the performance of every investment activity and make sure those benchmarks accurately reflect the 'beta' and risks of the underlying portfolio.
I end my post by wishing all Quebecers Bonne Fête Nationale and by paying a tribute to George Carlin, one of the greatest anti-establishment comedians of our time. Carlin died yesterday at the age of 71. Here is his classic skit on "The American Dream". The world needs more George Carlins and less establishment monkeys.