Monday, December 22, 2008

Yale's Yardstick Leaves Pensions in Peril

Let me begin where I left off yesterday - the great alternatives pension debacle. Earlier this month, I wrote about how Harvard's horror will decimate pension funds.

Last week, Yale disclosed that its endowment had fallen at least 13.4 percent in the four months since June:

Richard C. Levin, Yale’s president, said in a letter to the university’s faculty and staff that the endowment totaled about $17 billion, and he warned that Yale could be facing a $100 million shortfall in the 2009 school year.

He said the value of Yale’s marketable securities had declined 13.4 percent for the first four months of the university’s fiscal year, which started July 1, and that it had since fallen even more.

Taking into account such illiquid assets as real estate and private equity, he said, the endowment, which is led by David Swensen, was down 25 percent, and Yale is now anticipating it will be down that much for its full fiscal year.

That figure is significantly better than Harvard’s endowment, which recently said that the value of its $36.9 billion endowment had fallen 22 percent during the same period and that the total decline for the full fiscal year is expected to be as much as 30 percent.

But the figures given by each university are essentially projections and could vary sharply from now to the end of the year, financial experts warned. “We have no idea to say where they are going to come out,” said David Salem, the president of the Investment Fund for Foundations, which manages money for endowed charities. “In this environment, the relative success or failure of any of these endowments will depend on how they mark to market all their nonmarketable assets at the end of the fiscal year.”

Endowment experts follow Harvard and Yale in particular because Yale has had the best performance with its endowment investments over the last decade, with Harvard a close second.

Yale, whose portfolio was expanded beyond stocks and bonds into alternative investments by Mr. Swensen in a widely imitated strategy, has posted a 16.3 percent average annualized return, while the comparable number for Harvard was 13.8 percent.
There is no doubt in my mind that David Swensen is one of the sharpest minds in the investment community. Mr Swensen was a student of James Tobin, one of the great Keynesian economists.

In his seminal book, Pioneering Portfolio Management, Mr. Swensen acknowledges Tobin's strong influence on his life:
James Tobin bears more responsibility than anyone else for the happy professional position in which I find myself. As my teacher, dissertation adviser, and friend at Yale, Jim provided the intellectual framework for my approach to understanding economics and finance.
I wonder what Jim Tobin would be advising his student and friend nowadays if he were alive to witness the follies in financial markets and pension funds that followed Harvard and Yale into alternative investments.

He would probably remind Mr. Swensen of the Keynesian beauty contest:

The Keynesian beauty contest is the view that much of investment is driven by expectations about what other investors think, rather than expectations about the fundamental profitability of a particular investment.

John Maynard Keynes, the most influential economist of the 20th century, believed that investment is volatile because investment is determined by the herd-like “animal spirits” of investors.

Keynes observed that investment strategies resembled a contest in a London newspaper of his day that featured pictures of a hundred or so young women. The winner of the contest was the newspaper reader who submitted a list of the top five women that most clearly matched the consensus of all other contest entries.

A naïve strategy for an entrant would be to rely on his or her own concepts of beauty to establish rankings. Consequently, each contest entrant would try to second guess the other entrants’ reactions, and then sophisticated entrants would attempt to second guess the other entrants’ second guessing. And so on.

Instead of judging the beauty of people, substitute alternative investments. Each potential entrant (investor) now ignores fundamental value (i.e., expected profitability based on expected revenues and costs), instead trying to predict “what the market will do.”

The results are (a) that investment is extremely volatile because fundamental value becomes irrelevant, and (b) that the most successful investors are either lucky or masters at understanding mob psychology – strategic game playing.

“Animal spirits” are now known as “irrational exuberance,” and this beauty contest model is an explanation for such phenomena as stock market bubbles. Contrast this model with efficient markets and present value.
Professor Tobin would also remind Mr. Swensen of Paul Samuelson's famous quote: “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

Pension funds got bored "watching paint dry or watching the grass grow," so they all decided to follow Mr. Swensen and Jack Meyer (former head of Harvard's endowment fund) by diversifying away from government bonds into illiquid alternative investments.

The problem is that pension funds are not endowment funds and no matter how hard they tried, they never managed to produce the same stellar returns that these endowment funds were able to produce.

Sure, they allocated to private equity, hedge funds and real estate, but they never managed to produce the same returns because they were late in the game, they were not as aggressive in their allocations and even if they were, they couldn't get in with the top funds that both Harvard and Yale were investing with.

Instead, pension funds screwed it all up by blindly throwing billions of dollars into these asset classes, thinking that the party in alternative investments would last 100 years. In their insatiable thirst for alpha, they all contributed in destroying alpha by fueling a reckless bubble that will take years to clean up.

Consider the bubble in commercial real estate. Today I read that the commercial real state industry is seeking a bailout from the US government:

Some of the country's biggest commercial real estate players are asking the government for help, as their $6 trillion industry of hotels, office buildings and shopping malls faces a record amount of debt coming due in the next few years.

Trade association executives said that in the last few weeks they have met with members of President-elect Barack Obama's transition team, Congressional leaders and officials at the Treasury Department and Federal Reserve to make their case for assistance.

In the next three years, they pointed out, an estimated $530 billion of commercial mortgages will come due for refinancing -- with about $160 billion due next year, according to Foresight Analytics, based in Oakland, Calif. But with the credit markets virtually collapsed, thousands of those properties could go into foreclosure or bankruptcy if owners are unable to get new loans.

"If you can't get a loan and you owe the bank the money, you have to find the cash to pay the loan back or you default on the property," said Steven A. Wechsler, who has been lobbying as president and chief executive of the National Association of Real Estate Investment Trusts, a D.C. association with 3,000 members.

"Banks' jobs are to make loans, not own real estate. That's something we'd like to avoid. It could be a downward spiral that's driven by a compromised system of credit delivery. Some constructive step by federal policymakers would be wise and appropriate to be able to free up the market."

The real estate industry is going to the government for help because "they can," said Jim Sullivan, a managing director at Green Street, a real estate research firm in Newport Beach, Calif.

"They see what everybody else has gotten," he said. "Real estate is a capital-intensive business and there is no capital. They'll take cheap money from whoever is giving it out and now there's only one source -- the government."

The trade associations are asking that their members be included in a $200 billion lending facility that was created by the government to support the market for consumer debt such as car loans, student loans and credit cards.

In a recent letter to Treasury Secretary Henry M. Paulson Jr., industry leaders from a dozen groups described the troubled situation. "The paralysis of credit, which began in the short-term market, has coursed through the system and it now severely affects longer-term credit, especially secured and unsecured commercial real estate loans," they wrote.

When Paulson announced the $200 billion initiative, he noted that it could possibly be expanded to aid the commercial real estate market.

The real estate groups say they aren't asking for direct bailouts for their members, but rather for credit market support. "This is the same thing they're doing for car loans and student loans. We're asking them to help restart the credit markets for commercial real estate mortgages," said Jeffrey D. DeBoer, president and chief executive of the Real Estate Roundtable, a major industry trade group.

"Banks can't possibly absorb, manage and turn around properties at this scale if they come back to the lenders," he said.

The commercial real estate market boomed in the last few years, fed by easy credit. But starting in mid-2007, the credit crisis essentially froze the securities market.

The amount of new commercial mortgage-backed securities -- loans that are sliced, packaged and sold as bonds -- fell from $200 billion in 2007 to only $12 billion in the first six months of the year, Wechsler said. "We've gone from 55 miles per hour to zero," he said.

When money was flowing, investors drove up the prices of real estate, banking that rents and occupancy rates would keep going up. But cash from properties is falling as more space becomes available and rents drop, making it harder for owners to repay their debts.

While delinquency rates are low, they increased by one-third in November to .96 percent and could rise to more than 3 percent by the end of next year, according to figures from Deutsche Bank. Atlanta, Detroit, New York and Tampa are among the markets showing signs of rising defaults. In the Washington region, defaults are below the national average.

"It won't help the economy if commercial real estate continues to fall like residential," said Lisa Pendergast, managing director of commercial real estate finance at RBS Greenwich Capital Markets. "Then ultimately it will cause the recession to lengthen and deepen."

Too late, we are already heading for a long and deep recession. Let me ask you a question, who do you think was buying all the commercial mortgaged-backed securities and investing billions into private real estate funds? Who else? Pension funds searching for "alpha".

Bloomberg reported today that John Carrafiell, who helped oversee Wall Street’s largest real estate investment division as Morgan Stanley’s global co-head of property investing, will step down and become a senior adviser to the firm in January:

Carrafiell’s resignation follows the departures earlier this year of several Morgan Stanley real estate executives in Asia and job cuts in the division he helps oversee, which numbered more than 700 people as of Sept. 30. Kalsi declined to comment and Carrafiell didn’t respond immediately to requests for comment placed after regular business hours.

Real estate funds are reeling from the scarcity of debt financing and the outlook for falling rents and occupancy as the economy slows. Morgan Stanley posted a $2.2 billion loss for the fourth quarter ended Nov. 30, reflecting $1.8 billion of investment losses from real estate funds and other principal investing. At Goldman Sachs Group Inc., Stuart Rothenberg will leave as head of real estate investments at the end of the month after 21 years at the firm.

Morgan Stanley, whose property investments include London’s Canary Wharf, lost other real estate executives in Asia this year, including Zain Fancy, Roy Kwok, Bharat Khanna and Anand Madduri. The four in November joined Och-Ziff Capital Management Group LLC to build its business in Singapore, China, India and Hong Kong. Fancy had run Asian real estate investing excluding Japan and Kwok and Khanna had worked for the firm in China and India, respectively. Madduri was portfolio manager for the real estate unit’s Special Situations Asia fund.

Morgan Stanley likely will finish raising its new global real estate investment fund in the first quarter of 2009 instead of the end of this year, according to investors. The firm’s prior $8 billion fund, Morgan Stanley Real Estate Fund VI International, had a loss of 20 percent for the 12 months ended June 30, the investors said. Much of that fund has been invested in Japan.

Morgan Stanley also is phasing out the management of separate real-estate accounts to concentrate on managing high-yield funds. As part of that move, the firm is closing offices in Boston and Chicago and has reduced staffing in Atlanta.

“We are transitioning over time our separate accounts business to focus on our commingled funds business,” Ali said in a telephone interview earlier this month. She declined to comment on fund-raising or possible writedowns.

Once the second-largest U.S. securities firm, Morgan Stanley converted to a bank holding company in September and accepted $10 billion in government bailout funds to survive the credit crisis.

Banks and brokerages worldwide have disclosed $800 billion of writedowns and credit losses since the collapse of the subprime mortgage market last year, which led to a slump in markets ranging from commercial real estate to private equity, according to data compiled by Bloomberg.

How bad will things get in private equity? While some still contend that 2009 could herald strong returns for private equity, a new report predicts that between 20% to 40% of private-equity firms are expected to fail due to the current financial turmoil:

Heinrich Liechtenstein, a professor at Spain's IESE Business School, and Heino Meerkatt, a Munich-based senior partner and private-equity expert at Boston Consulting Group, predict in their report that about a third...(subscription required)

Finally, to round out alternatives, the Financial Times reports that hedge funds face failure and shake out:

Listed funds of hedge funds have been failing to produce any kind of positive return in the past couple of months, with share prices plummeting and some funds, such as F&C Event Driven, now planning to wind up.

In part, this failure has been due to the fall in share prices across all asset classes. But the funds have also been affected by the poor performance of underlying hedge funds, which have struggled to raise money and meet requests for redemptions. As a result, the hedge fund universe is expected to contract dramatically over the next year.

On average, listed funds of hedge funds have now lost 15.9 per cent in the year to date. For investors who thought they were buying into absolute returns and an asset uncorrelated to the wider equity market, this has come as a huge disappointment.

But analysts say there is still a significant difference in the performance of the funds. "It's almost as though investors haven't really differentiated between the different managers and the different styles," argues James Brown, analyst at Wins Investment Trusts.

As a consequence, analysts are continuing to recommend funds that they believe to be good buying opportunities.

Tom Skinner, investment companies analyst at Cazenove, is recommending AceniA and Absolute Return Trust. He also says investors can take advantage of wide discounts to the funds' net asset values, and buy in the expectation that they will be wound up. If this happens, investors will be paid the full net asset value per share, and so could potentially make a profit.

Skinner suggests Dexion Equity Alternative, currently on a 28 per cent discount, is one to watch. "I think it's quite likely that investors will be given the opportunity for a cash exit," he says.

Meanwhile, managers of funds of hedge funds are still aiming to find value within the hedge fund sector.

Ken Kinsey-Quick at Thames River Capital admits that funds of hedge funds showing double digit losses this year will "struggle to survive". But he believes funds sitting on cash are in a strong position to negotiate with hedge fund managers to buy in at a discount.

In fact, he says double- digit returns in the future should be possible, even "pretty easy". The reason he gives is the high return currently seen on credit, with investment-grade corporate bonds currently yielding more than 10 per cent. He also sees opportunities in refinancing the financials, healthcare and energy.

Peter Pejacsevich, managing director at CrossBorder Capital, an investment advisory firm, says managers should be looking for hedge funds that do not have strict redemption terms. "In times like this, it's important to know you can get your money quickly if you want to," he says.

Some investors are also realising that hedge funds may have previously outperformed simply because they were able to borrow money. In a rising stock market, this meant that their returns were amplified without any extra skill on the part of the fund manager.

"Now people will ask which hedge fund managers add alpha through stockpicking, rather than through leverage," says Pejacsevich.

He suggests this will mean a focus on hedge funds that are not too large, and hold a smaller number of stocks. "If you're a good stockpicker, you can't run huge portfolios, and you can't put huge amounts in as you'll shift the price," he explains.

"There's going to be a premium put on stockpicking which will mean hedge fund sizes diminish."

Andrew Ross, chief executive at Cazenove Capital Management, says the lack of positive returns in funds of hedge funds should not deter investors. Absolute Return Trust, for example, is down 7 per cent in the year to date, but he points out that was achieved against a background of the FTSE All Share index falling 22 per cent.

"Hedge fund longer-term returns are actually very like equities - returning 8 to 10 per cent, but with half the volatility," he argues. "And if you're only in cash and equities you have to wonder when to call the market."

Almost all the experts agree that the hedge fund industry won’t be quite the same again. The New York Times published an article from Richard Beales citing the six changes that hedge fund managers (who survive) need to prepare for:

Liquidity is the new watchword. Like investment banks, hedge funds didn’t think much about the structure of their financing during the boom times. But a flood of redemption requests in late 2008, just as they were struggling with illiquid markets and scarce credit, caught them out. Many hedge funds annoyed their investors by blocking withdrawals. In the future, funds that invest in illiquid assets will need to lock in their investors for longer. And those wishing to give investors regular access to their money will have to focus on liquid markets.

Fees will face greater scrutiny. The archetypal hedge fund charges 2 percent of assets and skims off 20 percent of investment gains, the longstanding “2-and-20” structure. But some funds have had to offer breaks on fees lately to persuade investors not to take their money out. Investors will be more selective and are likely to put downward pressure on fees. All the same, it is probably too soon to sound a Last Post bugle call for 2 and 20.

High water marks will blur. If hedge managers lose money, they normally have to get the fund back up to its previous high for each investor, the so-called high water mark, before the investor has to pay any more performance fees. Broadly speaking, a fund that is down 20 percent from its peak and has a standard high water mark mechanism would need to deliver returns of 25 percent before getting back to its high water mark and earning performance fees again on further gains.

That prospect is daunting. It can leave hedge funds short of cash and their employees wondering where their bonuses will come from. Some managers will throw in the towel. This is why some already use a modified mechanism allowing them to earn reduced performance fees on gains even before they have recouped earlier losses in full. Expect more funds to adopt similar policies.

Regulation will intensify. Many hedge funds, including big names like the Citadel Investment Group, have had a dismal 2008. But unlike the banking sector, they haven’t needed bailouts. That doesn’t, however, mean hedge funds will escape tighter regulation. Big losses, excess leverage, unexpected curbs on investor withdrawals, and the impact of short-selling on fragile markets make hedge funds easy targets for a crackdown.

Regulators also missed warning signs surrounding Bernard Madoff, who is accused of running a Ponzi scheme that cost investors as much as $50 billion. His investment operation appeared like a hedge fund in that it was private and he purportedly traded options as well as stocks. Watchdogs and investors will, therefore, share a desire for greater disclosure, so long as it is meaningful. The challenge will be in writing sensible regulations that can be applied across a diverse industry.

Concentration will accelerate. Consolidation among hedge funds was under way before the pain of 2008. Hedge funds are set to start the new year managing little more than half the nearly $2 trillion of investor money they held earlier in 2008. Only a handful of top performers — like Paulson & Company, which oversees $36 billion — are bigger than a year ago. Smaller firms, many of which have lost money and become smaller still, will be vulnerable to closure and consolidation. Funds under management will become increasingly concentrated among larger hedge funds, which are favored by institutional investors and in some cases have achieved better investment performance than their rivals.

Unleveraged returns should improve. The credit boom allowed funds to prosper even if their investment strategy was simply to use borrowed money to amplify tiny returns. But a smaller hedge-fund industry operating in a deleveraged financial world should be able to find more opportunities to make decent returns without exploiting leverage.

That’s another way of saying that after a rotten year, stable and committed hedge funds should be able to do well again. That’s cold comfort for those who have lost big. But it suggests that some in the industry will live to fight another day.
Hedge funds also got some relief from the government knowing they can now borrow from the Fed:
The government is committed to keeping the wheels of consumer credit greased. To
that end, it has launched a $200 billion effort to support the market for consumer receivables.

The Fed announced it will "offer low-cost three-year funding to any U.S. company investing in securitized consumer loans under the Term Asset-backed Securities Loan Facility (TALF)," reports the Financial Times.

"This includes hedge funds, which have never been able to borrow from the U.S. central bank before." The TALF will likely be expanded to cover mortgage-backed securities next year. We'll have to see if this really adds liquidity to the secondary markets.
So where does all this leave pension funds? It leaves pensions in peril. And here is the kicker: the U.S. Pension Benefit Guaranty Corp. (PBGC) - the government agency that insures pension retirement savings for roughly 44 million workers - tapped three investment firms to help manage $2.5 billion in real-estate and private-equity assets, segments the pension insurer's board approved earlier this year for expansion into:

BlackRock Inc. (BLK), Goldman Sachs Group Inc. (GS) and JPMorgan Chase & Co. (JPM) were selected to manage the investments, provide support to PBGC's in-house investment staff and help build the corporation's institutional capacity.

"These relationships will benefit the PBGC, not only with private equity and real estate investments, but in risk analytics and mitigation, consolidated reporting and staff augmentation," said Director Charles E.F. Millard.

Last month, PBGC said it reduced its deficit by roughly $3 billion to $11.15 billion in its latest fiscal year but warned the ongoing financial crisis could cause fiscal instability in this new year. The agency had $4.34 billion in stock market losses for the fiscal year.

Wait till the PBGC gets clobbered in their real estate and private equity portfolios. These are the perils of following the herd who tried to follow Harvard and Yale.

And if you thought Harvard and Yale's returns were awful, wait until the large public pension funds report their results. Let's just say 2009 can't come soon enough for most pension funds.

The problem is that next year will likely be another tough year for pension funds who heavily invested in illiquid alternative investments like real estate and private equity.

The most important lesson in this alternatives pension debacle is that when you blindly follow the leaders, you risk being left out in the cold.

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