Thursday, May 27, 2010

Easy Money, Hard Truths?

I want to share with you comments on my last entry on a pension chief's exit. A senior pension fund manager emailed me with some important observations which I will share with you (some comments are edited out):

Here are some things you may want to consider in shaping your argument:

I believe that economies of scale are important in asset management so having public sector related funds operate at arm's length on competitive terms is a good thing.

Moving from a fund to a supplier is a bit much, but what drove the guy out is problematic as well.

The public seems more worked up about paying internal managers for performance than paying external managers double or triple regardless of performance

This year, my internal team added 600 million over public market benchmarks and may get 10 million (in addition to about 10 in wages and benefits); external managers lost 500 million relative to market and their fees are related to assets and amount to 120 million. Want to guess what the headlines will be?

On benchmarks my landing spot is that the simplest way to implement a policy is with index funds. Return will be index - implementation costs.

If you run an active program, incremental return on incremental risk has to be attractive.

Most of the time incremental risk is actually insignificant or negative. A good active manager tries to improve on market return/risk and cap weighted markets are not quite risk efficient. Consequently, active risk tends to be negatively correlated with the market.

Benchmarks for unlisted assets are tough. Has nothing to do with fraud in most cases.

In any case the principle has to be that it will do better that the listed assets it displaces. Private equity should improve on listed equity adjusted for leverage.

For infrastructure and timber we know that the unlevered return is typically between stocks and bonds once the market becomes reasonably efficient. I think it should do better than some combination of stocks and RRBs.

Hedge funds are a hodge podge. Few can deliver uncorrelated return on risk. The HFRX usually tracks global equities except for 2000-2003

Annual value added does not tell you much. Good active programs can easily be negative 1 year out of 4. My experience is that longer periods are better.

The 4 year rule was chosen by most funds because that is all CRA allowed. I proposed a perpetual inventory method over ten years ago. It now appears that this may fly as long as the balance is at risk.

I feel that something like 5 cents per dollar of net value added over net index return is fair to clients and managers if incremental risk is insignificant.

Typically, if you can do something for x internally, you pay 3x or 5x externally.

If the public really prefers to pay more for what it cannot see, vs less for what it can see, more power too them.

My goal is to squeeze margin out of total asset management and increase net return to my clients.

No one care who gets paid what as a percent of a reasonable price of toothpaste. All we consider is whether the toothpaste does the job. Why should we care in pension management.


If I can deliver an extra 1 or 2 % over market with an all in total pension asset management cost of 30 bps my clients should be well served, and that is the only criterion that should matter.

But it seems that doing so will get you vilified by all sides: you make more than the Prime Minister (so the public thinks you are overpaid), and you cut into the external manager industry income.


And he added :

We have been arguing over comp since Plato.

As I recall he thought philosopher kings were the most deserving. I am not sure what the right answer is.


However, there is a market for talent out there, and it works reasonably well. I have to compete with what external managers pay as well as what the public plans pay.

Like it or not, comp systems have to hold on to people in bad times and good. There will always be some optionality involved.

The comparisons at any point in time are not always very easy.

Benchmarks are one issue.

Maturity of portfolios (J-curve effects) can be important.

Legacy portfolios when you have a new manager coming in.

All these things average out over longer periods.

The smell test is net investment cost in bps. For a 60-100 billion fund that should be in the 30-40 bps range. Bonuses usually are a very small part of that.

I have financed all the corporate remedial investment in operations and investment out of a 40 million cut in fees so far.

Yet the argument has not been over fees or net costs but over whether I should be paid more or less than a mediocre hockey player. If I sound cynical it is because I have become so.

We need more focus on the forest, less on individual trees.

The comments above come from one of the wisest people in the pension industry. He is absolutely right to say that too much focus goes on internal compensation and not on external fees.

At the end of the day, what counts is returns net of all fees. If you can bring assets internally, deliver alpha and cut a huge chunk of external manager fees, then all power to you. Moreover, if you're adding value over a long period using appropriate benchmarks in all asset classes, then you deserve to be paid for this added value.

What gets under my skin is when I see pension fund managers getting paid big bonuses for what is essentially leveraged beta. The leverage can come internally through alpha strategies using derivatives or externally through hedge fund or private equity funds taking huge leveraged bets on markets. It doesn't matter where it comes from - at the end of the day leveraged beta is beta, not alpha, and we shouldn't pay big bonuses for it. Quite simply, benchmarks must reflect the risks taken in each investment activity.

As far as costs are concerned, the senior pension fund manager is right, the smell test is investment cost in basis points. All public funds should report these costs clearly in their annual reports.

Finally, take the time to read David Einhorn's op-ed article in the NYT, Easy Money, Hard Truths. Some have criticized Mr. Einhorn for "blatant gold book talking", but he makes several important observations and asks a very simple question:
At what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that risk?
As Congress weighs a pension bailout, I fear that they're past the point of thinking about that risk. In my mind, it's crystal clear. Financial oligarchs and their political puppets are doing everything in their power to reflate risk assets hoping that it will translate into moderate (or severe) inflation for the economic system. Their biggest fear is debt deflation, and if their gambles don't work, they're going to get get it sooner than they think.

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