Tuesday, February 10, 2009

It's All About the Benchmarks, Stupid!


The Board of Directors of the Caisse de dépôt et placement du Québec held a meeting today during which it unanimously adopted a resolution reiterating its confidence in the senior management team. The resolution reads as follows:

“That the Board of Directors unanimously and unequivocally reaffirms its confidence in the President and Chief Executive Officer, Fernand Perreault, and the senior management team of the Caisse;

“That the Board of Directors reiterates its support for the work plan prepared and implemented by the President and Chief Executive officer and the senior management team in response to the global financial crisis;

“That the Board of Directors declares it is satisfied with the progress made to date with the application of senior management’s work plan; and

“That the Board of Directors deplores the current situation as conveyed by the media and its impacts on the Caisse’s employees.”

At the same time, the Board denied the media’s allegations that a plan to replace most of the Caisse’s senior officers was being prepared.

So, after a barrage of negative media, the Board of Directors felt compelled to reaffirm their commitment to senior management and "deplore the current situation as conveyed by the media and its impact on Caisse's employees."

While they have a point on the media attacks, which I will discuss below, there is no mention of their responsibility in the ABCP fiasco and their lack of proper oversight which allowed senior management to buy a disproportionate amount of non-bank asset-backed commercial paper on leverage.

Also, what exactly is senior management's work plan to deal with the financial crisis? After losing $38 billion (and possibly more depending on how they write down their ABCP holdings), don't all stakeholders deserve to know how senior management is dealing with the financial crisis?

If I were sitting on that board, I would demand that they publish a work plan and make it publicly available so people can understand how they are dealing with the crisis. In fact, every major public pension plan should publish their own work plan, explaining in detail where they lost money and how they are addressing the global financial crisis.

Meanwhile, the political debate is heating up. The Montreal Gazette reports that the PQ wants an urgent review of the Caisse:

The Charest government should order a parliamentary commission to probe the management style and decision-making that led the Caisse de Dépôt et Placement du Québec to losses equivalent to about $10,000 per working Quebecer in 2008, Parti Québécois finance critic François Legault said Tuesday.

Legault said Quebecers are entitled to a full explanation of why the province’s main pension fund lost 26 per cent when the average Canadian pension fund lost about 18 per cent, an underperformance that translates into about $12 billion of the reported (but as yet unconfirmed) $38 billion in losses at the Caisse last year.

“That’s enormous,” he said. “How will we ever get that back?”

Investments in asset-backed commercial paper, overseas airports and foreign currencies raise serious questions about the Caisse’s risk-taking, Legault told reporters.

He wants the Caisse’s former president, Henri-Paul Rousseau, to appear before the commission to explain the investment choices that led to last year’s results. Rousseau’s successor, Richard Guay, took sick last fall just a couple of months into the job and stepped down in January.

“It’s urgent,” Legault said, to initiate a public debate on its mission and mandate. “The credibility of the Caisse is in jeopardy.”

The Caisse’s board of directors, for its part, “unanimously” and “unequivocally” endorsed acting president Fernand Perreault and the rest of the management team after a meeting yesterday.

It denied a massive management shakeup was in the works, and described as deplorable the media’s portrayal of the Caisse and its impact on employees.

The pension fund manager will officially present its 2008 results later this month.

The Globe and Mail published an article stating that the Quebec government is mulling over the idea to have representation on the Board:

Quebec Finance Minister Monique Jérôme-Forget yesterday fiercely denied the news report. She speculated that a letter allegedly leaked to the Radio-Canada reporter by someone at the Caisse is a fake.

She also told Radio-Canada yesterday that she will recommend a return to a previous policy calling for a representative of the Quebec government to sit on the Caisse's board.

That policy was overturned several years ago as part of an overhaul of the Caisse intended to make it more independent from the provincial government.

Now, let me give you my take on this mess. First, the media loves to beat up on the Caisse. It's amazing reading the negative slant from reporters without placing things in proper context.

Importantly, the global financial crisis hit all pension funds that were highly exposed to equities and alternative investments that were leveraged up to their eyeballs.

CalPERS lost $24 billion in Q3 alone and all of the large U.S. and Canadian (and most global) public pension plans got clobbered last year. This pension crisis has hit every major pension plan, and if you think the Caisse's results are horrible, wait until you see Ontario Teachers' and OMERS' results which are due to be released shortly. It's going to be a bloodbath there too.

I am curious to see if the media will cover their results as intensely as they covered those of the Caisse. But they are Ontario pension funds and it is much funner slamming Quebec Inc. and kick it while it's down!

This brings me to my second point: not all beta is created equal at pension funds. I know for a fact that the policy portfolio at the Caisse is made up of much tougher benchmarks than those at any other public pension fund in Canada.

Why is this significant? Because if you are going to compare pension funds, you need to drill down and understand the underlying investments of the portfolios to gauge whether the benchmarks adequately capture the beta and risks of those investments.

This is a crucial point and no reporter has bothered to stop and think about it. If one pension fund uses much tougher benchmarks to capture all the risks of their public and private markets, including leverage, liquidity and the beta of the asset class, then by extension their results will be worse than those of pension funds that use bogus benchmarks to make bogus bonuses.

Let me repeat it again. One of the reasons the Caisse will report worse results is because of their disproportionate exposure to ABCP. Fine, we all got that. But another reason the Caisse will report worse results is because they have much tougher benchmarks governing all their investment portfolios.

And who was behind these tough benchmarks? Richard Guay was the guy who fought hard to make sure that the investment managers in all asset classes got no free lunch. Admittedly, he shares responsibility for the ABCP investments but he definitely got the benchmarks right in most of the other investments.

If you click on the table above from the 2007 annual results, you'll see that the benchmark for real estate returned 15.5% or 3.5% higher than the real estate investment portfolio. This was the highest benchmark return in real estate of all the major public pension funds and it accurately reflected the leverage and beta of the underlying portfolio.

Conversely, the 12.4% value added in private equity seems high to me, suggesting that this benchmark index does not capture the risks (including leverage) and beta of that asset class. And T-bills did not reflect the risk of asset-backed commercial paper in the cash portfolio (liquidity risk and leverage)!

Importantly, if you get the benchmarks right, then you will deliver higher risk-adjusted returns on a consistent basis and that is what ultimately counts.

Let's not forget that beta (or passive) risk swamps alpha (or active) risk in a pension fund. This brings me to my final point. The clients of the Caisse have to share their responsibility for the staggering losses. After all, it's the depositors at the Caisse who are responsible for asset allocation decisions.

If they were looking to make some crazy actuarial figure that required extra risk, then they should be comfortable with the accompanying volatility this entails. If this wasn't properly explained to them by their consultants, then they should fire these consultants and find new ones.

Let me end by what I wrote yesterday on risk management. It is up to the stakeholders to clearly define their risk parameters and they should work with external consultants to make sure they set the parameters in a formal asset allocation that will ensure they minimize the likelihood of catastrophic losses in any given year.

Pension funds are not mutual funds and the compensation structure should not reward excessive risk taking. Pension fund managers should try to consistently meet their actuarial returns to cover future pension liabilities without taking undue risks.

As for the Quebec government looking to sit on the Board of the Caisse as was done in the past, I think it's a terrible idea that will backfire on them. Instead, they should adopt a model that respects the arms-length relationship but implements rigorous independent investment and operational audits at least once or twice a year above and beyond the financial audits and Quebec Governor General audits.

Finally, let me state that I am all for parliamentary hearings but not for political jockying. I think it is high time we transform the governance framework that governs public pension funds, making sure we introduce more transparency and accountability in our pension system.

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