Saturday, July 31, 2010

AIMCo Sees Returns Rebound in 2009-2010

Last Saturday, Lisa Schmidt of the Calgary Herald reported that AIMCo sees returns rebound:

The province's investment manager has won back significant ground over the past year, its chief executive said Thursday, following tough losses in 2008.

Alberta Investment Management Corp., known as AIMCo, said overall returns are running in the range of about 17 per cent, said Leo de Bever, who will mark two years at the helm next week.

"If you look at the return on the Heritage Fund, that's sort of indicative of what we did on the endowments and for the pension plans," he said. The rainy day fund gained $2 billion to $14.4 billion for the 2009-10 year, compared with a $2.6-billion loss a year earlier.

But the recent market volatility has already pared back some of those overall investment gains, de Bever also cautioned.

"So far, we're still above water, but it's mostly been because of our effort in active management. The markets themselves haven't given us very much," he said.

The crown corporation, which oversees about $69 billion in provincial savings, employee pensions and endowment funds, lost 10.1 per cent on its investments in fiscal 2009. Despite the expected gains in 2010, the overall fund did not increase in value due to government withdrawals, de Bever noted.

Official figures won't be released until this fall, when AIMCo files its annual report. The agency was set up by the provincial government in January 2008.

But the much improved performance is sure to spark a gusher in staff bonuses, an issue that needs to be monitored, said Alberta Liberal finance critic Hugh MacDonald.

"They are going to be rewarded," he said, noting the agency paid out significant bonuses for the previous year when the fund lost money.

"We have to keep AIMCo accountable, because they have well in excess of $60 billion of Albertans' dollars under their control.

"We're going to have to wait and see," he said.

"With the instability that has occurred in the financial markets, it will be five years or more before we see . . . just how effective this new approach is with AIMCo."

For his part, de Bever acknowledged the payouts will be higher, but said the sums are warranted if the organization hopes to retain and attract talented staff.

He also noted that external management costs have been slashed by about 30 per cent to $120 million over the past year.

"I feel that the trade-off for Albertans was pretty good," he said.

"I paid $120 million to managers that lost me $500 (million). I paid a much, much smaller amount to people internally that did make me money."

Meanwhile, the Edmontonbased agency has hired 90 new staff over the past 18 months. and de Bever plans to hire another 30 by next year for a total of about 250.

"We've spent a lot of money in the last two years beefing up the operations side of things," he said.

"It's just now that we're starting to hire for the investment side."

But that aggressive recruitment drive has not hampered deal-making over the past few months.

AIMCo is currently working on several international deals, de Bever said, though he declined to give details, given that talks were currently underway.

He said the investment focus for private equity remains on key areas such as energy, materials and food amid a slow economic recovery.

"There's still an awful lot of companies that got in over their heads in 2008," he said. "They are now looking for a partner."

As reported in the article, official figures won't be released until this fall, when AIMCo files its annual report. You can, however, read AIMCo's 2008-2009 Annual Report and find some very interesting information [Note: Pay attention to the benchmarks used to evaluate alternative asset classes].

Despite the rebound in returns, Mr. de Bever continues to deal with PR issues. But as Gary Lamphier of the Edmonton Journal reports, PR perils part of life for CEO at AIMCo:

It's been two years since Leo de Bever assumed the top job at Alberta Investment Management Corp. (AIMCo), and he has plenty of reasons to smile.

AIMCo's returns have snapped back nicely since the bear market ended and economic recovery took hold. Although formal results for fiscal 2009-10 won't be out until fall, the $69-billion Crown corporation will show much improved numbers.

After posting a loss of 10.1 per cent last year, AIMCo -- which manages Alberta's public pension and endowment funds -- will report gains of about 17 per cent on its balanced funds for the year ended March 31.

Since the firm also manages the province's Sustainability Fund, which invests mainly in ultrasafe low-return bonds, AIMCo's overall returns will be slightly lower than that.

Meanwhile, de Bever has engineered a sweeping overhaul of operations, including a move into spiffy new headquarters on Jasper Avenue earlier this year.

By replacing costly external managers with in-house talent and spending millions on new computer systems, AIMCo has shaken off its bureaucratic roots and now operates like any other sophisticated, professional fund manager.

AIMCo's execs are judged -- and rewarded -- on performance, bringing a dose of Bay Street's edgy business culture to a city that's still getting used to the idea of being home to one of Canada's top institutional money managers.

AIMCo's growing clout hasn't gone unnoticed. The Edmonton-based firm has a growing profile in the national media and de Bever pops up regularly on business news shows. With investments all over the world, from Asia to Europe, AIMCo's reach is increasingly global.

Despite that, de Bever says he's sometimes frustrated by the parochial politics of Alberta, where AIMCo is still regarded by many as an appendage of the Tory government.

"The biggest surprise is, I thought everyone knew what the government intended to do here (by spinning off AIMCo as an independent entity) and that there was a fairly strong understanding of that, but that turns out not to be the case," de Bever says.

"It's taken longer than I'd hoped to gain the trust of the people I manage money for. They see me -- or did see me -- as an agent of government, rather than someone who is trying to help solve their long-term funding problems."

In reality, de Bever insists the Stelmach government has taken a hands-off approach to AIMCo from Day 1, and has never tried to meddle in its portfolio decisions.

"The one thing that hasn't happened is that the government has had absolutely no influence on anything we've done over the last two years, directly or indirectly," he says. "But I must tell you that whenever I do something in Alberta, I have to do that second check, and ask myself: 'Gee, how could this be perceived?' "

De Bever got a taste of Alberta's political realities last year, when AIMCo invested $330 million in Calgary-based Precision Drilling Trust. Critics slammed the deal as a thinly veiled attempt to bail out a debt-saddled player with a big footprint in the oilpatch.

De Bever staunchly defended the deal as a solid investment for AIMCo, and Precision's performance since has confirmed that. Still, he was bruised by the experience and says he no longer makes investments in Alberta without first considering the optics.

"It's tempering my willingness, and in some cases my board's willingness, to sign up for certain things that could have PR implications," he says.

"Whenever I do something I have to look at how much management time it's going to take to defend that decision in public. And in a fairly significant way, it's causing me to say, 'All right, if I can do some things in Alberta or outside of Alberta, it may be easier to do it outside.' "

In particular, de Bever says PR worries are affecting how AIMCo positions itself in the province's sprawling energy sector. Although AIMCo sees plenty of opportunity for upside, it's also wary of appearing to be a tool of government.

"I've had several opportunities where, from an economic standpoint, I should have made that investment. But from an overall 'how will this be perceived' point of view, it didn't happen," he admits.

"Now is that good or bad? It probably means investors from out of province, in some cases, probably can do it easier than we can."

De Bever doesn't offer any specifics, but it seems likely that some of those investments involved key energy infrastructure such as oil-sands upgraders.

As for the market outlook as a whole, de Bever remains cautious. He sees "choppy" stock markets ahead as investors try to sort out whether the recent strength in corporate earnings is sustainable.

His biggest worry is that governments will curtail fiscal stimulus and begin to focus -- prematurely, in his view -- on reining in their budget deficits.

"I'm a fiscal conservative in the long run, but I think you have to be really careful that you don't repeat the mistakes of the 1930s," he says.

"It may be necessary to prime the pump a while longer. I know all the arguments against that, but the alternative is so much worse. We could be in for protracted slow growth or even negative growth with deflation. The way out of that is to keep the stimulus going."

I agree with Mr. de Bever. I am a fiscal conservative but fear that if governments pull the stimulus too quickly, then we risk heading into a third depression.

Another interesting article that caught my attention was from Tara Perkins of the Globe & Mail, Infrastructure king in no rush to invest again:

Leo de Bever is one of the godfathers of infrastructure financing, but these days you couldn’t get him to touch the stuff.

“The time to be in infrastructure is not now,” he says point blank. “It’s too expensive, everyone’s in it. Whenever everyone’s in it, you want to back off.”

Infrastructure investments are a hot commodity thanks to the predictable long-term cash flows that they generate. Pension plans, insurers and banks are expanding their burgeoning infrastructure teams and chasing deals such as the Canada Pension Plan Investment Board’s $3.2-billion preliminary offer for Sydney-based toll road operator Intoll Group, whose largest asset is its stake in Highway 407 north of Toronto.

Mr. de Bever, the chief executive of Alberta Investment Management Corp. (AIMCo), knows the space as well as anybody. During the ten years he spent as a senior vice-president of the Ontario Teachers’ Pension Plan, he developed a reputation as the king of alternative asset classes. He came to run what he affectionately referred to as his $13-billion orphanage: a pile of assets that Teachers’ scooped up – including infrastructure and timberland – that other investors balked at because they didn’t fit neatly into any traditional asset classes. Manulife Life Financial Corp. lured him away from Teachers’, but after two years with the insurer he moved to Australia to become chief investment officer of Victorian Funds Management Corp., one of the country’s top public sector pension funds.

These days price isn’t his only concern. “The problem with infrastructure is, particularly in tight fiscal periods, you run into regulatory risk and you have to be absolutely sure – just like we saw with the 407 – that the government sticks to the original deal and doesn’t try to change it after the fact,” he said during a recent interview in Calgary.

Mr. de Bever’s caution speaks to the dilemmas confronting policy makers and investors around the globe, as cash-strapped governments look for ways to get their fiscal houses in order. Governments are seeking to do deals with the private sector as a means of raising funds, but have trouble justifying the moves unless the terms are extremely favourable to them.

When the financial crisis was still in full force, California Governor Arnold Schwarzenegger invited a number of American pension plans and a few Canadian pension plans to a meeting to discuss financing for the state’s numerous infrastructure requirements.

“We sat together with his advisers for a day or two, and went through that, and at the end of it the advisers were basically saying, ‘You guys have a lot of money, you could put it to good use, you don’t have to charge us as much as somebody else,’” said Mr. de Bever. “And I said, ‘Wait a minute, that last part I don’t get. We have to make money on these investments.’”

“I did a fair bit of the early infrastructure stuff among Canadian pension funds,” he said. “And in the beginning you could get an honest 14 per cent return on equity because the market was very inefficient.” To do the same thing these days, with a number of players competing for deals, would take a whole pile of leverage, he suggested.

The reason he got a very good real return bond deal on the 407 project when he was at Teachers’ is that initially, no bank wanted to finance the 407 because they were not convinced that Ontarians would pay tolls, he said. “I was the first one to finance the debt behind that equity, and we got a five and a quarter real return bond, which now seems obscene.”

That’s not to say that he’s written infrastructure off entirely.

“In most places, water and sewage are going to take an enormous amount of capital because everything is starting to leak,” he said. “Given that the fiscal positions of a lot of these governments is pretty weak, private capital has to come in at some point, and that’s when I think infrastructure will become attractive again.”

That could be as soon as two or three years from now. In the meantime, he’s sitting tight.

Mr. de Bever is one of the smartest pension fund managers I've ever met. He knows what value means and is patient enough to "sit tight" waiting for the right opportunities to come along. Two years ago, I wrote that AIMCo was lucky to get him as their CEO. I stand by that comment.

Friday, July 30, 2010

Are Treasuries the Last Diversifier Left?

Luca Di Leo and Darrell Hughes of the WSJ report, U.S. Growth Slowed in 2nd Quarter:
The U.S. economy slowed in the second quarter as the government said the recession was deeper than earlier believed, adding to concerns over the recovery's strength.

The Commerce Department Friday said U.S. gross domestic product, or the value of all goods and services produced, rose at an annualized seasonally adjusted rate of 2.4% in April to June. In its first estimate of the economy's benchmark indicator, the government report showed growth was lifted by business investments and exports. Consumer spending, a key growth engine for the U.S. economy, made a smaller contribution to growth.

Economists polled by Dow Jones Newswires were expecting GDP to rise by 2.5% in the second quarter. Stock futures weakened after release of the data; Standard & Poor's 500 futures were recently down about 11 points to 1086; Dow Jones Industrial Average futures were off 82 points to 10327.

In the first quarter, the economy grew by 3.7%, revised up from an originally reported 2.7% increase. But growth estimates all the way back to the start of 2007 were revised lower.

The report showed a bright spot continuing in the economy: the growth of business spending on equipment and software. This spending continued to surge, increasing by 21.9% in the second quarter, compared with a 20.4% rise in the first three months. The figures highlight the contrast in the economy between high company profits and a persistently feeble jobs market keeping consumers at bay.

Business spending actually climbed at the fastest rate since 1997, but the big story was the downward revision in the level of real GDP in Q1 2010, a point that Yanick Desnoyers, Assistant Chief Economist at the National Bank, addressed in his comment on the report:

The U.S. economy increased 2.4% in the second quarter, slightly below market expectations. Q2 delivered slower GDP growth compared to Q1 but with a marked acceleration in real domestic demand from 1.3% to 4.1%. We prefer to see a weaker GDP growth due to a rise in imports with strong domestic demand than a weaker GDP growth due to a weaker domestic demand.

That said, what was more striking in today’s report was the BEA’s annual revisions to the National Income and Product Accounts. The level of real GDP in the first quarter of 2010 was revised down by $100 billion. From a component perspective, consumption registered the largest revisions in dollar terms with a decrease of $134 billion. Accordingly, U.S. consumption is not in an expansion mode as originally reported but rather still in the recovery stance.

There are mainly two consequences with the BEA’s revisions. First, it means that the savings rate probably was higher than first thought and job creation is more than ever needed to sustain consumption growth (conversely it means that the U.S. consumer is deleveraging more quickly than expected). Secondly, the U.S. output gap is deeper in excess supply territory than before the BEA’s revision.

Bottom line: The Fed is on the sidelines for a longer period of time.

The output gap is deeper than we previously thought, but there is another reason why the Fed will remain on the sidelines for longer than we think: it wants to see asset reflation translate into mild inflation and avoid a protracted deflationary scenario at all cost.

Importantly, Fed policy remains geared entirely towards banks, allowing them to continue borrowing on the cheap to invest in risk assets all around the world as they shore up their balance sheets. This is why I remain bullish on stocks.

But what about bonds? I recently wrote a comment asking whether or not we're on the cusp of a global bond hiccup. My point was that global growth will put upward pressure on bond yields, and I thought the US economy was in better shape than what most analysts thought.

Obviously today's downward revisions in US GDP will continue anchoring down long-term inflation expectations. Some strategists think that Treasuries are still a buy:

Treasury yields fell Friday, with the 2-year note hitting a record low 0.55%, after the government said U.S. GDP grew a weaker-than-expected 2.4% in the second quarter.

Get used to both more weak economic data and lower Treasury yields says, Yves Lamoureux, investment advisor at Macquarie Private Wealth.

"If you're looking at leading [economic] indicators, they are pointing down," he says. "There's no doubt the next quarter and the one following are going to be disappointing." (On Friday, the ECRI said its weekly leading index rose to 121.1 for the week ended July 23 from 120.6 the prior week; but the index's growth rate fell for an eighth-straight week.)

With the economy slowing, the "secular bull market" in Treasuries should continue, Lamoureux says, predicting 30-year bond yields will fall as low as the average of comparable debt in Japan and Germany, which is currently 2.575%.

Furthermore, he argues the high rates of the 1970s and 1980s were the "black swan" resulting from the Fed's mismanagement of the money supply. Excluding that period, Treasury yields have mainly been in the 2-4% range since the 1900s; Lamoureux calls that the "natural equilibrium" for yields, while expressing faith the Fed has learned its lesson of the 1970s.

"I believe the Fed won't make the same kind of mistake again," he says. "From a long-term perspective, inflation is coming down. You will not get a big inflation shock."

Lamoureux's reasons for why Treasuries are still a good buy (and not in a bubble) also include:

Financial deflation: While the price of many goods and services continue to rise, Lamoureux estimates there has been a 2-4% annual contraction in the money supply since 2008. In other words, deleveraging is overcoming the expansion of the Fed's balance sheet.

Diversification: Treasuries are "the only asset class that compensates you" if stocks go down, he says, calling U.S. debt the "last diversifier left."

You can watch the interview with Mr. Lamoureux below. His views on financial deflation are echoed in Hoisington Investment Management's Q2 economic letter.

Also, his point on diversification is important because in a low interest rate environment, asset classes tend to be a lot more correlated than investors think. With so much pension money flowing into hedge funds, real estate, private equity, commodities, and infrastructure, this should worry us.

If a protracted period of deflation does materialize, it will ravage private markets. The Fed will do whatever it takes to avoid such an outcome.

Bottom line: We might be in for a long period where both bonds and stocks trade in a range. Better pick your spots carefully.

Thursday, July 29, 2010

Circling Back to the Caisse's 2009 Annual Report

A senior officer at the Caisse inadvertently brought something to my attention yesterday. When the Caisse released its 2009 results back in February, the annual report wasn't made available then, and I didn't provide a full discussion on it.

The Caisse did publish its 2009 Annual Report in mid-April, stating that accountability has greatly improved:
The Caisse de dépôt et placement du Québec released its annual report for fiscal year-end 2009 this morning, after it was tabled in the National Assembly by the Finance Minister.

In addition to the detailed analysis of the financial results published on February 25, the 2009 annual report contains a new section that, among other things, includes all the accountability reports requested by the Quebec government following the May 2009 Parliamentary Commission. Here are the highlights from these reports.

Report on the Caisse’s Contribution to Québec Economic Development

• The Caisse uses three levers to support its action in Québec: investment, partnerships and knowledge sharing.

The Caisse’s total assets in the private sector in Québec were $18.7 billion at the end of 2009, up $1.4 billion from 2008.

• In 2009, the Caisse launched various initiatives to support Québec businesses, totalling $1.6 billion.

The Caisse Roadmap

• Two-pronged plan to generate the returns expected by our depositors.

• The first part established in collaboration with our clients–is based on five priorities that will build solid foundations for the Caisse.

• The second part first based on our medium-term strategic thinking about the use of our existing comparative advantages and the need to develop new capabilities to meet our clients’ expectations.

Report on Risk Management

• Accelerated implementation of plan to strengthen risk management.

• Integration of risk-return concept in day-to-day operations.

Strengthening of risk management methodologies, tools and team.

Reduction in active risk of 13 specialized portfolios.

• Reduction in financing liquidity risk.

Report on Compensation Policy

• Implementation of a more demanding and rigorous compensation program based on long-term portfolio performance (4 years).

• Introduction of a qualitative risk management factor in the performance evaluation of portfolio managers.

Report on Strengthened Governance

• Review of Board composition and committee chairmanships.

• Integration of new directors.

• Review of director roles and responsibilities and mandates of the Board and its committees.

• Establishment of an effective relationship between the Board and management.

Significant decrease in incentive compensation for senior management

In keeping with its obligations under the Act Respecting the Caisse, the annual report also addresses the annual salary of the president and CEO and the five most highly compensated executives.

During the presentation of its financial results earlier this year, the Caisse indicated that the total amount of incentive pay would be cut by about 50% compared to 2007. The final reduction of the total amount was 52%. No incentive compensation was paid to Caisse employees in 2008.

For the senior management positions presented in this year’s annual report, incentive compensation was $1.1M, compared to $4.6M for 2007.

These incentive amounts were determined by a rigorous process of analysis and benchmarking, based on two principles:

• Paying for performance

- Incentive compensation reflects the major progress made in refocusing and simplifying the Caisse in 2009.
- The Caisse posted a net investment results of $12 billion for the year and outperformed its benchmark in the second half of the year.
- Ten of the 17 portfolios performed very well and surpassed their benchmarks for the entire year (click on image above).

• Competitiveness

- Compensation is commensurate with the Caisse’s results. Since 2009’s performance was below the median, incentive compensation was also below the median, between the 30th and 40th percentiles.

It was on this basis that the Human Resources Committee and the Caisse’s Board of directors approved the incentive compensation amounts.

The summary compensation table below (click on image to enlarge) is available on page 119 of the Caisse's 2009 Annual Report.

Moreover, the Caisse disclosed a summary of senior officers' pensions (p. 120) and a summary of their severance pay (p. 121). Interestingly, the Caisse's President & CEO, Michael Sabia, got a total compensation of $436,154 in 2009, a negligible sum for pensions, and gets zero in severance if he's asked to step down. As explained on p. 118, Mr. Sabia voluntarily waived the right to incentive programs and perks:
The compensation and other employment conditions of the President and Chief Executive Officer are based on parameters set by the Government in consultation with the Board. The annual base salary of Mr. Michael Sabia was set at $500,000. The other conditions of employment to which Mr. Sabia has a right are aligned with the Caisse’s policies and comply with its Regulation respecting internal management. He received $40,000 in annual fringe benefits and participated in the Caisse Employee Group Insurance Plan. Upon his appointment, Mr. Sabia waived participation in the 2009 and 2010 incentive compensation programs. For the duration of his mandate, he waived participation in any pension plan. He also waived severance pay, whatever the cause.

However, given mandatory participation in the Basic Pension Plan for Management (under CARRA rules), Mr. Sabia must participate despite his waiver. The mandatory plan represents an annual cost of $12,900 to the Caisse.
As you can see, there are no golden parachutes or perks for the Caisse's CEO. And the focus on transparency, risk management and accountability is the primary reason why after the disaster of 2008, the Caisse is on the right path.

So why am I circling back to the Caisse's 2009 Annual Report? Because I forgot to cover it when it came out in mid April since it was after they announced their results in February. But the real reason it's worth covering is because this is one of the best annual reports the Caisse ever produced, on par with bcIMC's 2009-2010 Annual report, which I just recently covered and praised for its transparency, simplicity and rigor.

Everything is there. Returns of specialized portfolios, the benchmarks covering each specialized portfolio (including benchmarks for private markets, hedge funds and commodities), an in-depth analysis of performance by asset class, a detailed discussion on risk management, and of course, a detailed discussion on compensation. About the only thing missing is a list of their main investment partners by asset class.

One of the things I really liked was Table 7 on page 24, shown below. It's basically the changes in benchmark indexes over the last five years (click on image to enlarge):

Benchmark indexes are key in understanding the Policy Portfolio risk ("beta" risk) and they also provide important information as to whether pension officers are being appropriately evaluated for the risks they're taking. The Caisse's benchmark indexes for each specialized portfolio do reflect the "beta" risk of each investment activity.

Let me conclude by going over something Mr. Sabia wrote in his message on page 11:
...we will need to deepen our understanding of a variety of asset classes and how a changing environment will shape them. So we will have to develop the skills and the agility that we will need to take full advantage of the opportunities we see. Among many other things, that means continuing to invest in the development of our people and in establishing partnerships with like-minded investors who share our long-term horizons.

We will do all of this in a well ordered way, always in line with our principles of simplicity, rigour, performance and focus on the client. We will do it step by step, always first developing the necessary skills and capabilities before we invest. It’s the only way to build— brick by brick—a solid organization that will meet the needs and the expectations of our depositors.
Investing in employees is crucial but it's not enough. You have to challenge each investment unit to stop working in silos, and start sharing information and thinking about the bigger picture and how their investment activities are correlated to other investment activities. You need to stimulate discussion not just at the level of senior management, but at the level of junior and intermediate analysts as well as operational and support staff.

Let them learn about hedge funds, private equity, commodities, infrastructure, real estate debt, etc. -- either through regular workshops or by attending quarterly investment discussions led by senior managers of each specialized portfolio. In short, employees need to feel engaged, and they need to see the bigger picture. That's what I find sorely missing in a lot of these big shops -- everybody gets lost in the weeds and they forget what the common purpose is all about.

[Note: I love teaching and presenting big picture ideas to employees. I also enjoy moderating debates among investment gurus, which is another way of stimulating discussion among senior officers and employees.]

Finally, please take the time to carefully go over the Caisse's 2009 Annual Report. It really is the best report they produced in a long time and among the best annual reports I've read this year.

I am working on a detailed comparison of Canadian public pension funds, but for many reasons this is a complex undertaking. Differences in fiscal years, maturities, funded status, risk profiles, liquidity profiles and investment policies make it very difficult to make direct comparisons. If I ever complete it, you will understand why comparing pension funds isn't as simple as it sounds.


Jonathan Jacob of Forethought Risk sent me these comments:
I sympathize as I have tried it myself. The worst offender is the benchmark relative comparisons as benchmarks are anything but uniform and mandates may be different. I think benchmarks and appraisal MTM are the most offensive aspects of public pensions these days – nice to see the Caisse marking down RE and PE (benchmark relative) – still wary as to benchmark values…
He is absolutely right on appraisals at public pension funds, but as I mentioned before, the Caisse has some of the toughest private market benchmarks in the country.

Wednesday, July 28, 2010

False Recovery in Commercial Real Estate?

Daniel Thomas of the FT reports, CBRE upbeat on global recovery:

CB Richard Ellis, the world’s largest real estate consultancy, has reported the strongest growth in revenue and earnings since 2007 as it has benefited from the global recovery in commercial property activity.

CBRE, whose main business is advising on the acquisition and leasing of commercial property around the world, has been one of the main beneficiaries of improving market conditions. Commercial property markets slumped for almost two years after peaking in 2007, but have stabilised in most countries over the past year.

Brett White, chief executive of CBRE, told the Financial Times that the rebound in global commercial real estate was progressing apace. “We are a good proxy for the global property market. Virtually all global economies are in early stages of recovery and others such as China are in full-blown expansion phase, and [so] the majority of property markets are either flat or slightly improved.”

Mr White said that occupiers were more optimistic on the mid- to long-term horizon, with a more normal market for lease terms, which tended to be a forward indicator for job growth. He pointed out that rents were rising in 48 of the 55 markets tracked by CBRE in Europe, while yields – which measure rental income as a percentage of property value – on property transactions had begun to narrow again.

The US saw a strong increase in transactions over the past year, while Europe also produced robust growth in the period, fuelled by recovering property sales markets in the larger economies such as the UK, Germany and France. Asia-Pacific sustained strong growth that had begun late last year.

This recovery boosted CBRE’s second-quarter results. Property sales rose globally by 61 per cent year-on-year, led by a 93 per cent improvement in sales in Europe and 67 growth in Asia Pacific.

One side effect of the recovery in the market has been that the number of distressed owners of property being forced to sell has been lower than expected, although CBRE said that it was still marketing more than $7.5bn of distressed assets in the US, and had sold more than $1.3bn of such assets since the beginning of the year.

Mr White predicted that there would be no new wave of distressed property sales as banks were working with borrowers rather than foreclosing on property backed by bad debts.

CBRE isn't the only one calling for a revival in commercial real estate (CRE). Darren Currin of The Jounal Record recently reported that Prudential and Moody’s offer positive news for national market:

The good news continues to pour in for the national commercial real estate market. Either improvement is occurring in the market or some industry experts have hired some great public relations experts as a majority of the news stories released over the past week related to the industry have been extremely positive.

The latest news comes from Prudential Real Estate Investors, which said earlier this week that the national commercial real estate market will recover much more quickly than it did in the downturn of the 1990’s. The reason for this being that a lack of financing will limit new supply and investors flush with cash will be competing for properties. Marc Halle, a manager of the Prudential Global Real Estate Fund, noted that Prudential is “relatively optimistic” about the office, retail, apartment and hotel sectors as large institutional owners in these sectors are seeing multiple bids for their assets.

Halle said the following:

“Last time it took five years for real estate values to go down to where they bottomed. … We’ve done that now in about two years. So we are going to see a faster recovery, a faster write-up in the market.”

Halle also explained that the way credit markets are limiting financing to developers will prove beneficial to the national market’s recovery. He said this trend may keep new supply from hitting the market for up to five years. Rents are also bottoming, which should prove beneficial to commercial owners’ cash flows, according to Halle.

In other good news, Moody’s/REAL Commercial Property Price Indices reported that U.S. commercial real estate prices increased 3.6 percent in May. This marked the second-straight monthly increase as average prices in April also rose 1.7 percent.

Nick Levidy, managing director of Moody’s, said the following in a press release about their findings:

“We expect commercial real estate prices to remain choppy in the coming months. The positive news of increasing prices over the past two months is tempered by low transaction volumes, forecasts for slowing macroeconomic growth and the rising risk of a double dip recession.”

While this is encouraging, the reality is that commercial real estate activity remains weak. David M. Levitt of Bloomberg BusinessWeek reports, U.S. Commercial Property Sales Trail Six-Year Average:

U.S. commercial real estate sales in the first half totaled about a quarter of the average of the previous six years as owners kept properties off the market, impeding investors with record funds for purchases.

Buyers and sellers completed $34.2 billion of deals through June, or 26 percent of the average first-half dollar volume since 2004, according to preliminary figures from Real Capital Analytics. The total was about 12 percent of the 2007 peak, when $277.7 billion of properties changed hands in the same period, data from the New York-based real estate research firm show.

Sales climbed 58 percent from last year’s first half, when purchases dried up after the U.S. credit crisis and recession sent values tumbling. A dearth of available properties has sparked demand for the few deals being offered, according to Alan Kava, co-head of Goldman Sachs Group Inc.’s Real Estate Principal Investment Area in New York.

“People are frustrated that not a lot has been trading,” Kava said. “When something does come to market, that lack of supply is causing almost a feeding frenzy. People have real estate funds that are not on an infinite time line -- they need to put capital to work.”

Private equity real estate funds have a record $104 billion of equity available for U.S. deals, London-based research firm Preqin Ltd. reported last month. Blackstone Real Estate Advisors has the most to invest, with Goldman Sachs second, Preqin said.

Goldman Sachs, Blackstone

More than half of the $8.4 billion available for Goldman Sachs’s property funds is reserved for overseas investments, Kava said. Blackstone has about $12 billion for real estate purchases, said Peter Rose, a spokesman for the New York-based private-equity firm.

Much of the money raised by private equity firms was in anticipation of a rush of foreclosure sales that failed to materialize, said Sam Chandan, Real Capital’s chief economist.

In top cities such as New York and Washington, owners who owe more than their properties are worth are instead finding new sources of equity and lenders are willing to restructure their loans, he said. In less attractive markets, banks have been extending loans, waiting for higher prices so they don’t record losses, according to Chandan.

“Many people were looking to acquire distressed assets, but those opportunities have been few and far between,” he said in a phone interview from New York. “That’s been leading to bidding more aggressively for some of these core assets.”

No ‘Armageddon Scenario’

Record-low interest rates make it easier for owners to hold a distressed property, said Tom August, president and chief executive officer of Equity Office Properties, a unit of Blackstone Group LP. Equity Office owns more than 60 million square feet (5.6 million meters) of so-called Class A office properties in cities including Boston, New York and Los Angeles.

“The Armageddon scenario that several people predicted two or three years ago just hasn’t occurred,” August said in a phone interview from Chicago. “Part of it is the lenders realize the current borrowers are in a better position to work out problems than they the lenders are.”

Landlords will eventually need more money to maintain or lease their properties, likely triggering more sales, he said.

There is little incentive for owners who bought as the market climbed to sell now. Values in April were down 41 percent from their October 2007 peak, according to the Moody’s/REAL Commercial Property Price Index.

Four Markets

Demand for properties is strongest in New York, Boston, Washington and San Francisco, “where domestic and foreign investors alike have sought to acquire high-quality assets,” said Chandan.

Those four markets accounted for 20 percent of first-half sales, compared with about 15 percent last year, according to Real Capital. For office buildings, the largest category, the cities made up almost 35 percent of the volume, up from almost 32 percent in 2009.

Manhattan totaled $2.92 billion of completed sales in the first half, up 70 percent from a year earlier. About $1.42 billion were office deals, up 62 percent.

SL Green Deals

SL Green Realty Corp., New York’s largest office landlord, was both a buyer and seller. The company agreed in May to sell a 45 percent stake in Manhattan’s McGraw-Hill Building at 1221 Avenue of the Americas to Canada Pension Plan Investment Board for $576 million, a deal that values the building at about $500 a square foot, according to Real Capital.

It also purchased 600 Lexington Ave. for $636 a square foot, and agreed to buy 125 Park Ave., a tower across 42nd Street from Grand Central Terminal. That deal was valued at about $507 a square foot, based on data in a company statement.

Those prices reflect a rebound off market lows reached last year, when similar midtown Manhattan properties sold for about $350 a square foot, said Chandan. In 2006 and 2007, readily available loans that were packaged and sold as commercial mortgage-backed securities helped drive prices for top Midtown skyscrapers beyond $1,000 a square foot.

“We basically went around the world talking to capital sources, in Asia, Europe, Middle East, Canada, and domestically, and hearing the same thing,” said Andrew Mathias, SL Green’s president and chief investment officer. “People’s confidence in Manhattan was not at all shaken, because of the extraordinary supply/demand metric that exists here, where you have very, very limited new supply, and the interest rate environment.”

Monsanto Purchase

The company paid $523 million for its two acquisitions, combining both closed and contracted deals. Its sales of partial property interest totaled $663 million.

The biggest completed deal of the year so far was Monsanto Co.’s purchase of Chesterfield Village Research Center, a research and development complex in Chesterfield, Missouri, from Pfizer Inc., according to Real Capital. Monsanto paid $435 million, said Kelli Powers, a spokeswoman for the St. Louis- based company.

Distressed building sales probably will remain scarce, Chandan said. There are $184.6 billion of troubled properties facing foreclosure or bankruptcy, out of a total $239 billion since the credit crisis started in 2008, according to a June 1 Real Capital report.

“There’s tons of liquidity out there,” said Barden Gale, chief executive officer of JER Partners, a McLean, Virginia- based company with about $500 million available for investment. “The trouble is it’s having a problem finding a place to reside.”

There is tons of liquidity out there - and that's the problem. Prabha Natarajan of the Dow Jones Newswire reported earlier this month, commercial real estate bargain hunting is making bargains scarce:

At a bankruptcy auction in Washington late last month, the winning bidder paid almost 90 cents on the dollar for the mortgage on the Shops at Georgetown Park even though the developers are suing each other over who actually owns the property, the current operator has defaulted on its mortgage and the original lender is bankrupt.

Such high prices and long lines for such a distressed property are not unusual these days despite rising delinquencies and surging vacancies in commercial real estate. Sometimes it seems that so many investors are cruising for so few bargains in this troubled sector that they are making true bargains hard to find.

Many investors had raised billions of dollars to create opportunity funds to buy such troubled assets. They had envisioned a scenario similar to the early 1990s when through the Resolution Trust Corp., banks and savings and loans sold distressed properties at 5 cents on the dollar, and buyers booked stupendous gains within three years. They have been disappointed, with many closing down such funds.

"This market is different," said Jack Taylor, a managing director and head of Prudential Real Estate Investors' global high-yield debt group, adding some hyperbole about buyers' enthusiasm: "There is no such thing as distressed asset."

There is, however, some hope of a flood of troubled assets coming to market, and these are expected to trade at more reasonable prices.

Taylor and other market participants say overlevered properties and distressed sellers are likely to emerge in the next few months and peak next year as banks and lenders start looking to clean up their books.

The paucity of troubled assets for sale is mainly due to the practice of lenders not forcing owners into foreclosure, preferring instead to "pretend and extend" - an industry term to describe lenders' preference to extend maturing loans by a year or two in the hope that both the economy and the property's finances will improve during that time.

This, in turn, has helped maintain status quo in commercial real estate despite a 10% delinquency rate. Typically, delinquency rate averages below 1% in this sector.

"The pig in the python has now grown to elephant size, and only small bits of it has been digested," Taylor said, describing the volume of dodgy assets banks have been forced to swallow.

The bits that have been digested are mostly loans backed by high-end or trophy properties in large metro areas.

"Demand has exceeded supply, and as a result, the pricing is just not appropriate for the risks still there," said Maury Tognarelli, president and chief executive of Heitman LLC, a real estate investment management company with $22.9 billion in assets globally.

Not only that, it also creates an illusion of normalcy.

"This makes some investors think a rapid, broad-based recovery is underway; but these transactions don't paint a good picture of what's happening for a substantial segment of the industry, where properties remain under-capitalized," said John Murray, a senior vice president and a portfolio manager at PIMCO, while talking about the company's extensive study on commercial real estate released in June.

Market participants say that delinquent properties that are slowly creeping into defaults and foreclosures are likely to hit the market later this year.

"We are at the start of the period when banks start looking at their balance sheets, and try to repair them, while the economy stabilizes," said Taylor of Prudential.

This period of resolution is likely to extend until 2013, and during that time "commercial real estate will see a slow recovery, where the returning capital is met by deleveraging at banks and CMBS levels," Murray of PIMCO said.

Others are raising similar concerns. Jeff Harding of the Daily Capitalist recently asked, Is The Real Estate Market Turning Around?, and concluded:

Reports from people I know who are active in CRE in the L.A. area also lead me to believe that lenders are starting to do deals on REO properties. While two years ago no deals were being made, today there is more opportunity and activity. Further there appears to be less “extend and pretend” as banks are less willing to accommodate defaulting borrowers; lending standards have tightened rather than loosened. They have about $500 billion in CRE loans maturing in the next couple years.

In my view, it is CRE that is critical to a recovery. We will need to see more positive signs, such as an increase in business loans, more CRE foreclosures, and a reduction in bank excess reserves, before we can say there is some kind of trend, but it could be that the CRE logjam is starting to break up. I do not expect any recovery of the CRE market any time soon because of the volume of debt maturing, but I am beginning to think that more defaults will be pushed into special servicing resulting in foreclosures. The result will be further downward pressure on CRE prices (they have already declined 24% since the peak in Fall 2007).

And it is interesting to note that Deutsche Bank just recently announced that it's dismantling a group that advises companies on commercial real estate transactions. Hardly the sign of confidence in the CRE market.

Finally, I had the pleasure of meeting up with a former colleague of mine who is a real estate expert. He is bearish on residential and commercial real estate, and told me "it's too risky taking equity stakes in CRE". He advises pension fund managers to play "junior debt on high quality assets".

We also talked about active management in real estate, which he believes can add tremendous value to a pension fund "if they have the right expertise". "Why have a real estate group if all they do is farm out money to funds? Unlike private equity, real estate deals are very similar, so you don't need outside experts to deliver alpha -- you just need a smart team that knows how to structure deals". He did however mention that "there are excellent real estate funds" but there are a lot of "mediocre ones" as well.

We ended off by talking about the revival of structured finance, which he thinks is "essential" for the market as it would fill the gap in the market in term of financing CRE as banks become more reluctant at lending in order to preserve their capital. He told me that pensions can play a key role here and that funds like CPPIB and the Caisse de dépôt et placement du Québec should be originating commercial real estate backed debt, selling it off to insurance companies who by regulation have to invest in AAA debt.

The problem is that following the crisis, "'structured finance" is a dirty expression and depositors' appetite for anything sounding remotely risky or "structured" is just not there. It's too bad because the truth is the real estate professionals at the Caisse have been at it for decades and are years ahead of others when it comes to structuring complex real estate deals. They should be taking advantage of this internal expertise, capitalizing on opportunities in commercial real estate debt markets.

***UPDATE: Interview with Citigroup's head of real estate***

Below, Thomas Flexner, Citigroup global head of real estate, discusses the state of CRE:

Tuesday, July 27, 2010

bcIMC Up 16.3% in 2009-2010

Living in Montreal, I tend to focus way too much on Quebec and Ontario based funds. I was skimming through BC Investment Management Corporation's (bcIMC) website today and saw they posted their 2009-2010 Annual Report.

bcIMC doesn't get a lot of press coverage but they're one of the largest public pension funds in Canada and have performed well over the long-run sticking to sound principles. I briefly covered their 2008-2009 results last year in my post on cleaning up pension funds, and mentioned the following:
How did it perform in 2008-2009? From the annual report, we see that they lost 14.6% in 2008-2009 relative to their benchmark of -11.1%. In other words, they underperformed their benchmark by 3.5%, which is considerable, but their overall results are among the best of the large funds. Interestingly, bcIMC which is known to be "less sophisticated' than its counterparts in Canada, managed to lose a lot less than most of them and its senior managers didn't get paid anywhere near as well as most of their counterparts out east (not that they got paid badly either after losing billions).
Just like PSPIB and CPPIB, which I recently compared in terms of their FY 2010 results, bcIMC's fiscal year ends on March 31st.

So how did bcIMC perform in 2009-2010? Doug pearce, bcIMC's President & CEO went over the results in his message in the 2009-2010 Annual Report (p. 14):
The last decade has been very challenging from an investment perspective. For the 10 years ending March 31, 2010, bcIMC’s combined pension return was 4.6 per cent on an annualized basis. Despite this challenging market environment, I am pleased that bcIMC’s activities contributed $979 million in additional value over our clients’ combined benchmark of 4.3 per cent, net of all investment management fees.

In looking specifically at the investment returns for 2009-2010, clients benefitted in the shorter term from a stronger than expected recovery in capital markets. The one-year annual return net of fees, for our combined pensions was 16.3 per cent. While clients had solid results, bcIMC unfortunately did not meet our clients’ combined benchmark of 17.3 per cent. Although many of our public equities, fixed income and mortgage funds outperformed their benchmarks, our real estate portfolio detracted from the returns. Declines in real estate valuations typically lag publicly traded investments and the 2009-2010 economic downturn drove property valuations lower, even though income levels (rents) were fairly stable and vacancy rates remained low. I am not concerned; real estate is a long-term asset and we have a sound portfolio of quality properties that over a 15-year period, has exceeded its benchmark by 4.1 percentage points. We anticipate that it will take another year for the value of the portfolio to recover.

This past year saw a number of highlights beyond the investment returns. We introduced the Active Global Equity Fund and the Global Government Bond Fund, and expanded our currency hedging program to include the euro. These product offerings will provide clients with greater exposure to global markets while providing opportunities to manage currency fluctuations.

We maintained our ongoing commitment to responsible investing by participating in industry-related initiatives such as the Mercer’s Climate Change and Asset Allocation study and the Prince of Wales’ P8 Group Climate Solutions Investments Made to Date project. We also endorsed the Institutional Limited Partners Association’s (ILPA) Private Equity Principles that addresses governance practices and transparency within the private equity sector. Instituting our new Mortgage Risk Rating system was another noteworthy initiative; properties with energy conservation initiatives will be identified and rewarded with a more favourable credit risk rating.
As shown in the table below, Private Placements and Real Estate underperformed their benchmarks (click on image to enlarge):

Again, as I mentioned last year, their benchmark for Private Placements is a tough one to beat, much tougher than most other comparable funds. And I am not sure a spread over a Canadian small cap index is appropriate given that the portfolio is invested in large buyouts around the world.

And even though the 2009-2010 results didn't beat the combined benchmark of 17.3%, they were better than CPPIB's return of 14.9% for FY 2010, but worse than PSPIB's return of 21.5% for FY2010. The latter fund outperformed in fiscal year 2010 because of Private Equity and Infrastructure, but its FY 2009 results were much worse than CPPIB and bcIMC's results.

[Note: CPPIB's Policy Benchmark was 20.8% in FY 2010, PSPIB's was 19.8%, both of which were higher than bcIMC's 17.3% for its Policy Portfolio. Relative weightings in equities explain this difference.]

And as far as compensation, bcIMC's senior officers aren't compensated anywhere near the levels of their counterparts in Eastern Canada (click on image to enlarge):

I find it laughable that the media in Vancouver harps on the compensation of Doug Pearce, without comparing his total comp, or that of other senior officers, to their counterparts in Eastern Canada. And again, keep in mind this is one of the largest and best run public pension funds in Canada. Look at the total comp of their senior officers - nothing to scoff at, but nowhere near what they'd be making in Toronto (and Victoria, just south of Vancouver, is one of the most expensive cities in Canada in terms of housing).

Finally, if you take the time to carefully read bcIMC's 2009-2010 Annual Report, you'll see they are completely transparent, presenting all their benchmarks and objectives clearly, and the report is a pure pleasure to read. A layperson can read it and make sense of it. For me, bcIMC sets the bar in terms of reporting. And here's the kicker: they even ask their members and the general public to fill out a survey and provide feedback on their annual report. Kudos to them, they keep it simple as they deliver the long-term results their members are looking for.

Monday, July 26, 2010

On the Cusp of a Global Bond Hiccup?

The Netherlands CPB Bureau of Economic Policy Analysis just released its world-trade monitor for the month of May:
World trade volume

Based on preliminary data, world trade volume increased by 1.8% in May from the previous month, following anupwardly revised decrease of 1.1% in April. Import volumes went up in the advanced economies as well as emerging Asia and emerging Europe, whereas Latin America and Africa / Middle East posted sizable declines. Import growth was extraordinarily high in Japan. Export volume increased in all major regions with the exception of emerging Europe. In May, world trade was 3% below the peak level reached in April 2008 and 23% above the trough reached in May 2009.
Monthly trade figures are volatile and focus on ‘momentum’ is therefore preferable. Momentum remains strongly positive. In the three months up to May, world trade was up by 5.0% from the preceding three months. Momentum was again highest in Latin America, while it declined somewhat in emerging Asia. Momentum of Euro Area exports went up for a third month in a row.

World industrial production

On the basis of preliminary data, world industrial production grew by an impressive 1.0% in May 2010, following a downwardly revised 0.7% increase in April. Production grew rapidly in all regions, with the exceptions of Japan and Latin America, where production was (nearly) flat. Growth was highest in the Euro Area and emerging Europe. In April, industrial production was finally back at the previous peak level reached in March 2008, which is 14% up from the March 2009 trough.
Yanick Desnoyers, Assistant Chief Economist at the National Bank of Canada commented on the trade report:
Global trade flows continue to surge. According to the Dutch Bureau for Economic Policy Analysis, the volume of world trade grew 1.8% in May, the eighth increase in nine months. World trade volume is now only 3% below its peak level reached early in 2008. As Today’s Hot Charts shows (see above), trade flows are currently expanding at a 23% annual clip on a year over year basis. On the flip side, this surge in trade flows pushed global industrial production virtually back to its pre-recession level. Despite the fact that IP is still down 9.8% in advanced countries, production is already up a whopping 11.1% in emerging markets since the pre-recession peak. After today’s data on trade flows, we can now say that industrial production, on a global basis, has left the stage of recovery and can now be qualified as being in an expansion mode.
Surging global trade and the recovery in world industrial production are key harbingers for gauging the health of the global economy. And as far as industrial production in advanced countries, there are signs that this too is gaining momentum.

Last Thursday, Mark Perry of Carpe Diem blog wrote an excellent comment, Rail Traffic Continues To Post Gains Vs. Last Year:

The Association of American Railroads released its weekly update today on rail traffic through last week, reporting that rail activity continues to show improvements compared to the same weeks last year. Highlights include:

1. U.S. railroads originated 282,199 carloads for the week ending July 17, 2010, up 5.5% compared with the same week in 2009, but down 13.8% from pre-recession levels in 2008.

2. Intermodal traffic totaled 227,661 trailers and containers, up 20.1% from the same week a year ago and down only 2.5% compared with 2008. Compared with the same week in 2009, container volume increased 22.1% and trailer volume rose 10%. Compared with the same week in 2008, container volume increased 5.6% and trailer volume dropped 32.5%.

3. For the first 28 weeks of 2010, U.S. railroads reported cumulative volume of 7,874,125 carloads, up 7.3% from 2009, but down 13.2% from 2008, and 5,855,507 trailers or containers, up 13.1% from 2009, but down 6.4% from 2008.

4. Combined North American rail volume for the first 28 weeks of 2010 on 13 reporting U.S., Canadian and Mexican railroads totaled 10,278,759 carloads, up 10.3% from last year, and 7,319,184 trailers and containers, up 13.8% from last year.

MP: Overall, this was a fairly positive report, despite the AAR's headline "Weekly Rail Traffic Continues to Reflect Sluggish Economy." Compared to the same week last year, both carload and intermodal volumes were up, by 5.5% and 20.1% respectively. The graph above displays 4-week moving average growth rates for both series (to smooth out the weekly fluctuations), and shows ongoing weekly improvements in rail traffic compared to last year, especially for intermodal shipping. Intermodal traffic volume has registered year-to-year gains for 30 straight weeks, starting late last December; and the last 20 weeks have all been double-digit gains.
The evidence clearly indicates that fundamentals are much stronger than what is reflected in mainstream media. Global trade, global industrial production and US rail traffic are all reflecting an expanding global economy.

Finally, I had a nice lunch with Francois Soto of EMphase Finance today. Francois passed his CFA level II and was ecstatic, so I wanted to treat him to lunch to celebrate. He is only 27 years old, extremely bright and has tremendous potential. I enjoyed our discussion, felt his passion for finance and markets as we discussed several proprietary indicators he developed.

In fact, he just updated his "Rough Times" indicator shown below:

And he explains:
Basically the index needs to reach a level of 5 to trigger a US Recession. So far, the model reached 3 and two sub-indicators more are required. One of these is ISM Manufacturing below 50 while the other is proprietary. I am not saying a recession is impossible. It is quite possible but so far it would only point for a very short-lived recession. That's all we can infer for now.
Given the evidence presented above, I don't see rough times ahead. In fact, the stimulus might be working a lot better than we think, and if this is the case, global growth will surely surprise to the upside in the second half of the year. With global economic activity picking up steam, and global equity markets humming along, the only question I have is how long before we see a significant backup in global bond yields? More importantly, are pensions and other institutional investors prepared for a big bond hiccup? We'll find out soon enough.

Sunday, July 25, 2010

A Bearish Predisposition?

From systemic risk of capitalism, we move on to more current events. I had lunch today with Greg Gregoriou, a professor of Finance at SUNY (Plattsburgh) Greg has published many books and articles, and his most recent article with Razvan Pascalau on the optimal number managers in funds of hedge funds has garnered much attention.

Interestingly, while some major funds of hedge funds lost out in the crisis, assets from global pensions remain stable. Moreover, hedge funds are much more focused on meeting institutional demands:

Pension funds globally typically allocated less than 5 per cent of their portfolio to hedge funds or funds of hedge funds (while targeting an allocation of 6-10 per cent), and while this share has increased over the last few years, many expect it to double or triple in the years ahead.

In the US, private sector pension funds look to allocate on average up to 10 per cent of assets to hedge funds, a little ahead of America’s public sector pensions, which target about 8 per cent. In the UK, some of the biggest schemes allocate up to 15 per cent of their portfolio to hedge funds. In continental Europe, the take-up of hedge funds by pensions has been more mixed, but pension funds in some markets, such as the Netherlands, have embraced hedge funds and other alternative investment strategies.

The global economic crisis provided only a temporary interruption in the growth of institutional investments. Investors pulled about $300bn (£197bn, €232bn) out of hedge funds between October 2008 and June 2009, but inflows returned to healthy levels in the second half of 2009. Recent surveys by Credit Suisse and Deutsche Bank suggest the industry may attract $200bn-$300bn of new capital this year. It appears a large part of redemptions that followed the 2008 crunch were from wealthy individuals rather than institutions, and that institutions continued contributing new capital throughout most of 2009.

As part of their own growth and maturation, and in response to greater institutional investor demand, hedge fund managers and firms of all sizes have become more institutionalised in terms of their internal systems, structures and general operational infrastructure. This can be seen in the use of risk management practices and systems, compliance procedures, performance and risk reporting, governance structures and overall operational sophistication.

Institutional investors demand the highest quality operational and risk management systems from the funds they invest in, and to attract and in response to investor feedback, hedge fund managers have developed sophisticated asset management and trading infrastructures.

These demands have required significant investments by managers in systems, technology and people. However, the benefits to investors and managers outweigh costs. The emphasis by investors and policymakers on transparency and systemic risk analysis will serve to reinforce and continue this infrastructure build.

The institutionalisation of the hedge fund industry has been a developing theme for the past 10 plus years and is likely to continue. It will also assist them to meet new regulatory demands.
FINalternatives reports that three of New York City’s five public pension funds are mulling their first allocations to hedge funds. So why the fixation on hedge funds? Part of it is gaining access to top investment managers who deliver alpha no matter what market cycle we are in, part of it has to do with the focus on risk management and managing liquidity risk, and part of it is the whole fixation with alternatives (hedge funds, private equity, real estate, commodities and infrastructure).

Here in Canada, sophisticated public pension funds are scaling back, being a lot more selective with the hedge funds they partner up with, preferring to manage assets internally.

But whether or not you farm out assets to hedge funds or manage assets internally, you still need to understand the cycle we're in. Greg told me he sees a repeat of the 1966-82 period where the Dow basically traded sideways. He told me some of his colleagues at SUNY are working a little longer before retiring, but they plan on "pulling their money out of the market once the Dow goes over 13,000 again".

In his article, A Bearish Predisposition, MarketWatch's Mark Hulbert notes that advisers are not betting on a rally:

The stock market had its best day in over two weeks on Thursday, with the Dow gaining more than 200 points.

And yet, the short-term stock market timers I monitor didn't budge: They finished the day just as bearish as they were before the session began.

But, when I recently went back and reviewed what the advisers were saying then, one of their arguments stood out as providing a good illustration of how excessive pessimism got the better of some of those advisers.

The particular argument involved drawing a parallel between the rally that began at the Mar. 2009 stock market low with the rally that began in late 1929, following that year's stock market crash, and which lasted until the following April. A number of the advisers I monitor drew charts superimposing the post-Mar. 2009 performance of the Dow Jones Industrial Average with the index's rally 80 years previously -- and, upon noticing a superficial resemblance, predicted that the market would continue to follow the same script this time around.

That was a very scary prospect, of course, since the Dow dropped some 85% from its Apr. 1930 high to its Jul. 1932 low.

Have those advisers' worries come to pass? Not so far, at least. Almost immediately after they began drawing the ominous parallels, it became clear that the stock market was following an entirely different path. In fact, the market today is about twice as high as it would have been had it followed the script that so worried advisers last fall.

These advisers' response? They just quietly stopped mentioning the alleged parallels, focusing instead on some new found reason for concern.

In any case, it should have been clear to everyone that drawing parallels in this way is shoddy analysis. With over 100 years of daily data available for the Dow, as well as countless more years of stock market performance in other countries, one can fairly easily find any of a number of past instances that appear to bear an "uncanny" resemblance to the market's recent performance. And, yet, hardly ever is it the case that the market behaved in exactly the same way following each of those prior instances.

Of course, the advisers rarely acknowledge that history doesn't speak with one voice on a particular issue. Instead, they too often choose to highlight just one of the historical parallels.

Their behavior reminds of a famous remark attributed to Adlai Stevenson, the Democratic Party's candidate for President in the 1952 and 1956 elections: He was fond of mocking opponents by saying "Here's the conclusion on which I will base my facts."

And it's bullish from a contrarian perspective when the conclusion on which advisers are basing their facts is that the market is going to decline.

But the bears keep on growling, reminding us that systemic, structural problems aren't going away anytime soon. Bob Chapman of the International Forecaster notes this in his latest comment, Talk of a Recovery Hides Collapse:
Talk today centers around a stillborn recovery that never quite held on long enough to materialize. Five quarters of 3% to 3-1/2% growth traded for $2.5 trillion. Money and credit was thrown at the system again, and again it didn’t work. Keynesianism at its finest.

The housing purchase subsidies are gone, and real estate sales and prices are again falling. Even with interest rates near 4-1/2% for a 30-year fixed rate mortgage there are few takers in the hottest sales period of the year. There are four million houses in inventory for sale or 1-1/2 years supply. That figure could be 5 to 6 million by yearend, as builders’ build 545,000 more unneeded homes. More than 25% of mortgages are in negative equity. Excess mortgage debt is $4 trillion and headed much higher. Government is so desperate that they have begun to take punitive action against those whose homes are under water, but they can still make the payments, but are bailing out. What a disincentive for anyone to buy a house. Will debtors prison be far behind?

There certainly have been strategic defaults, but not as many as government would have you believe. Twenty-five percent of all borrowers are stuck with negative equity, which we expect will worsen. That could mean a wealth loss of some $4 trillion. Obviously, homeowners are hoping for higher prices. If that does not happen you can expect more walk-away foreclosures. There are already four million homes for sale and many more could be on the way. Plus, more than 500,000 more new homes are being added to saleable inventory annually. Next year will be another bad year for builders. Some will fail and others will merge. Government is having ongoing meetings with three major builders in an effort to nationalize the industry, as they will do with banking. Government is doing the worst thing possible. It reminds us of Sovietization. The only thing government has going for it is that underwater homeowners usually do not default until they are down 62% from equity, but that could change. Interest rates at 4-5/8% for a 30-year fixed rate mortgage should keep them in their homes for now, but if interest rates rise that plus could become a negative. That leads us to believe that interest rates will stay that way for a long time. As a result the Fed must keep interest rates at zero for a long time to have millions of mortgages kept from falling into foreclosure.

At $15.3 trillion the world’s holdings of US dollar denominated assets in ten years rose from 60% of GDP to 108%. This in part has been caused by a never-ending current account deficit. This factor alone makes one wonder how the US dollar can be a strong international reserve currency.

In just six years from 2001 to 2006, mortgage debt grew to $14.5 trillion - a credit expansion unheard of in history. In the past almost two years government borrowings have grown 49% just slightly more than the 45% in 1934-35. The Keynesian game is the same, it is just the time frame is different.

Over a 20-year time frame total US credit rose from $13 to $52 trillion, or to 370% of GDP. A good part of these credit excesses have been exported to the rest of the world and they are increasing exponentially; almost 160% just in the last six years, or to $8.5 trillion.

The deliberate move to expose Greece’s problems, which those in government and finance had been aware of for years, backfired and exposed all the problems in Europe in the process. The impact of Greece, and the elucidation of the depth of problems in Portugal, Ireland, Italy and Spain curtailed the so-called global recovery and exposed extraordinary weakness in the euro zone throughout the EU and Eastern Europe. That in turn will ultimately cause problems for the US dollar and the pound. There is now no question that the dollar rally is over and the question is when will the dollar retest the 74 area on the USDX? The leverage in banking is still 40 times deposits and we see no way to easily reduce that. We believe dollar reflation will have to be the answer for the Fed.

The financial terrorists that inhibit our banking system and Wall Street still remain confident that inflation caused by quantitative easing won’t show up for years, if ever. What else can the Fed and ECB do except use stimulus? The sovereign debt contagion in 20 major countries and as many creditor countries, is not going to go away anytime soon. These are systemic, structural problems. We certainly do not see the likelihood of the dollar proving any safe harbor. Those who have flocked to the perceived safety of the dollar are going to be very unhappy with the results.

Many countries are enmeshed in major debt and in the case of the US the debt is colossal. It is hard for markets to appreciate this in Europe, the UK and US. The problems of the credit crisis are not over and there won’t be a recovery, unless the Fed injects $5 trillion into the economy. That will keep the economy going sideways for two years as inflation rises. Small and medium sized business cannot get loans, so they cannot expand and hire. About 23% of large corporations may expand and hire. Offshore US corporations have far too much excess capacity already. As you all know there are many speed bumps on the road ahead. You had better be prepared for them.

Switching gears again, we find very little coverage of the problems in Eastern Europe. Hungary is a good example. Financial exposure is Austria $37 billion, Germany $32 billion, Italy $25 billion, Belgium $17.2 billion and France $11 billion. This kind of exposure to the banking systems of these countries could be very painful. It will be interesting to see if national governments, or the ECB step in as they did in Greece, and manage the problems. The world should be paying attention because there are 20 major countries in the same dilemma.

The sovereign debt crisis is just getting underway as observed with foresight. There has been no containment and 56% of Hungarian real estate loans are in Swiss francs. The problem, which we have been citing for some time, could cause a domino effect across Europe and we wonder if the solvent nations and the ECB can handle the debt rescue. Our answer is no. The next shoe to drop could be in this region and surprise almost everyone.

Mr. Chapman isn't the only one waiting for "another shoe to drop". Some market watchers point to the recent weakness in the Economic Cycle Research Institute’s Weekly Leading Index (a.k.a. ECRI WLI, see chart above) as evidence that growth rate and stocks will continue to plunge.

But others correctly point out that the ECRI WLI is pointing to a slowdown, not recession:
The Economic Cycle Research Institute's Weekly Leading Index has been on a downward trend since late April and has now hit a 49-week low, but does that mean a recession is close? According to Globe and Mail, some bears think so:

[The WLI’s] annualized growth rate of negative 9.8 per cent is perilously close to a 10 per cent decline, which the pessimists note has always been accompanied by a recession.

The Wall Street Journal last week quoted a British economist as saying the WLI is “very sensitive to financial indicators … leaving it vulnerable to feedback loops from the markets.”

Managing director of ECRI Lakshman Achuthan, however, is hesitant to follow the WLI blindly; he believes that predictions must be based on more complicated indicators:

He notes, it’s not a simple positive-to-negative swing that forecasts a recession, making the BMO analysis oversimplified, he says. ECRI is looking for “pronounced, pervasive and persistent” changes in the WLI.

And while David Rosenberg thinks a double-dip is imminent, Don Hays, founder of Hays Advisory Group, says a double dip is off the table and that the market will rally into the November elections.

My own feeling is that the liquidity tsunami has not crested and will push risk assets higher. Now that European bank stress tests are over, expect them to join the party on Wall Street. I also expect banks will start slowly lending again as employment growth finally shows some sustained improvements.

Finally, keep an eye on some shipping companies that will be reporting this week (for example, Dryships: DRYS). Any rally in shares of companies that are heavily leveraged to the global economic recovery signals that risk appetite is back. In fact, last week's one day bounce of Goldman Sachs and Amazon shares on the day they reported disappointing earnings may be an ominous sign of things to come. All those hedge funds desperately trying to find the next big bubble -- and they aren't alone. Stay tuned, we might not need QE 2.0 after all.