Tuesday, June 28, 2011

Pensions Move to Direct Hedge Fund Investments?

Before getting into my latest topic, I want to thank those of you who took the time to write me after reading my last comment on the ugly truth. Rest assured this blog is not my open diary but sometimes I like delving deep into personal matters because I believe certain frustrations, anxieties and worries are common and if by expressing my thoughts, I can help someone else, so much the better. I have nothing to ashamed of and if some people choose to use my openness against me, then shame on them. The real ugly truth is that far too many people in finance and business are money whores and would screw over anyone for money. That's all I'll say about the ugly truth.

Now, onto the latest topic, direct investments into hedge funds. Christine Williamson of Pensions & Investments reports, Move to direct hedge fund investments boosting business for consultants:

The pace of searches and hires is up sharply this year for specialist and general consultants advising institutional investors on direct hedge fund investments.

That increase is the result of the trend toward direct investment in single and multistrategy hedge funds and away from hedge funds of funds, especially by large public pension funds, industry insiders say.

Among the pension funds that hired their first consultants for specialist hedge fund and alternative investment assignments so far this year:

• The $23 billion Employees Retirement System of Texas, Austin, hired Albourne Partners Ltd. in May.

• The $49.5 billion Massachusetts Pension Reserves Investment Management Board, Boston, hired Cliffwater LLC in April.

• Trustees of the $76 billion Ohio Public Employees Retirement System, Columbus, hired Hewitt EnnisKnupp in April for alternative investments, including hedge funds, but also signed a contract with Cliffwater to provide non-discretionary operational due diligence for a new $1.2 billion direct investment program.

• Three of the five pension funds in the New York City Retirement Systems — the $24.3 billion police fund, the $7.9 billion fire fund and the $41.2 billion employees' retirement system — hired Aksia LLC in January.


“In the last 18 months, a lot of the groundwork has been laid through intensive education for public and corporate pension plan trustees, and now, clients are beginning to implement their direct investment programs in hedge funds,” said Mary Bates, a senior hedge fund consultant in Hewitt EnnisKnupp's Chicago office.

Market observers said the pace of direct investment will accelerate further as more experienced hedge fund investors pump more money into hedge funds. For example, staff of the $109.1 billion Texas Teacher Retirement System of Texas, Austin, recently received legislative approval to double the hedge fund limit to 10% of plan assets. Texas Teachers' hedge fund assets totaled $4.06 billion as of March 31.

The $51.2 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, also increased its hedge fund target to 12% of plan assets from 10% in March; hedge fund assets totaled $4.92 billion as of March 31.

For advice on direct investments, Texas Teachers' investment staffers rely on specialist hedge fund consultant Albourne Partners; Pennsylvania Schools officials use Aksia.

A chosen few

A handful of sophisticated specialist consultants and a few general consultants are winning most of the new assignments as well as retaining existing clients or, increasingly, snatching clients away from each other, according to a review of reported searches and hires in Pensions & Investments' archives.

The top specialist alternative investment consultants include:

• Albourne Partners, which advised 202 clients on $230 billion in hedge fund investments as of May 31.

• Aksia, which advised 42 clients with $42 billion as of April 30 in hedge fund investments.

Cliffwater, which provided customized consulting services to 27 clients with $19 billion invested in hedge funds as of May 31.

The Beryl Consulting Group LLC also offers clients both basic research and highly customized portfolio services.

General investment consulting firms with a reputation for robust hedge fund expertise include Cambridge Associates LLC, NEPC LLC, Hewitt EnnisKnupp, Rocaton Investment Advisors LLC and Fund Evaluation Group LLC.

Specialist hedge fund consultants are at “the leading edge of the phenomenon of many pension plans, especially public plans, moving to direct hedge fund investment,” said David Harmston, partner and global head of Albourne Partners' client group. Mr. Harmston is based in the London-based firm's Norwalk, Conn., office.

Each of the specialist consultants offers different services and specializations in combination, ranging from manager research and due diligence reports to highly customized portfolio construction, including manager selection as well as negotiation on fees and terms.

For larger funds, like Texas Teachers, Albourne Partners' in-depth, extensive research on hedge fund managers has served the fund well since 2005.

During a June 16 board meeting discussion about renewing the Albourne contract, Jerry Albright, deputy chief investment officer, told trustees: “I can't imagine running this portfolio without them. It would be devastating to lose Albourne.”

The Pennsylvania Schools fund is one relying on a more collaborative relationship with specialist consultants for hedge funds, private equity and real estate.

“We view our consultants as an extension of our investment staff,” said Alan Van Noord, chief investment officer. “It's like a basketball team: Our staffers are the starters, and the consultant is the sixth man, getting a lot of playing time.”

With an additional 2.3% or about $1.2 billion to put to work in new direct hedge fund investments under the fund's new asset allocation, Mr. Van Noord said Aksia and investment staff will gradually add new managers. The fund also is considering adding emerging hedge fund managers.

Many large plans are moving fast into direct investments. According to FinAlternatives, Ohio Pension Eyes Hedge Funds For $1.2B Buy:

The Ohio Public Employees Retirement is poised to make its first foray into single-manager hedge funds a big one. The $76 billion pension plans to invest about $1.2 billion in single and multi-strategy funds in the third quarter, Pensions & Investments reports.

The move follows OPERS’ investment of $700 million in funds of hedge funds last year. The pension boosted its allocation to hedge funds to 3% last year, as well.

OPERS will not issue requests for proposals; instead, the pension has asked interested managers to contact the system directly. Those interested managers should have at least $1 billion in assets under management.

Hedge fund consultant Cliffwater will assist the pension in due diligence and will recommend managers to OPERS. The first round of funds is expected to be completed during the third quarter of the year.

I already shared my thoughts on public pensions betting the farm on hedge funds. Is it better to use "specialist consultants" over funds of funds? That really depends on the size and experience that pension funds have with hedge funds. I know of very large hedge fund programs where they use specialist consultants, fund of funds, and specialized capital introduction people (if you are a US fund, contact me and I will be glad to share some names with you of independent, qualified hedge fund consultants with years of experience.)

I'm also toying with the idea of "specialized consulting" on hedge funds and thinking of teaming up with friends who are experts in operational due diligence, performance, risk management, and ripping apart hedge fund strategies to see who is truly delivering alpha and who is selling beta as alpha. My biggest fear with this rush into hedge funds is that far too many institutional investors will get bad advice, are not mindful of conflicts of interest and will find refuge by investing in "brand names" even if this isn't in their best interest. For example, I believe if done properly, public pensions can benefit enormously by seeding hedge funds.

After my last post on betting the farm on hedge funds, I received this comment from a senior pension fund manager from a large US plan:

Hi, Leo - thanks for posting the article. I wish you'd provided more commentary, because there's a lot to be said about pension plans investing more in hedge funds. (Then again, I know you've commented extensively on the topic elsewhere.) A key question: what is a 2-5% allocation to HFs really going to do for a plan's overall risk/return profile? (We're at 2.5% and are always having this discussion. As well we should. But I'm not sure others are.)

He's absolutely right. Don't just follow the pension herd into hedge funds. You can use specialist consultants as an extension of your investment staff but at the end of the day, they want you to invest in hedge funds because that's their bread and butter. Very few will stop and have a critical discussion with you as to how hedge funds fit into the overall portfolio and whether or not you should be investing in hedge funds to begin with.

This is where I will make my shameless plug. I have close friends in Montreal with extensive experience covering all aspects of hedge funds. Moreover, despite what people think, I'm not horny for hedge funds and will give it to you straight on how you should invest in them properly covering all risks, including operational and liquidity risks, not just investment risks. Feel free to contact me at LKolivakis@gmail.com and let me at least share some thoughts on how to conduct a proper due diligence on hedge funds and fund of funds, explaining what you should steer clear of even if "specialist consultants" are telling you otherwise. Again, if done properly, hedge funds can add value to your overall pension portfolio, but if done poorly, they will come back to haunt you.

Thursday, June 23, 2011

Betting The Farm On Hedge Funds?

Following my last comment on Japan's pensions betting on hedge funds, Jonathan Jacob of Forethought Risk sent me an Institutional Investor article by Imogen Rose Smith, Public Pension Plans Bet Their Future On Hedge Funds:

It didn’t sound like much, even at the time. In April 2002 the California Public Employees’ Retirement System invested a total of $50 million with five hedge fund firms. For the then-$235.7 billion CalPERS, the largest state pension plan in the U.S., writing $50 million in checks was hardly a noticeable occurrence. But as the first step in an initial $1 billion allocation, the investment was a monumental moment for the hedge fund industry. It marked one of the first significant commitments by a public pension fund to a program of investing with hedge fund managers, a group that the pension community and its advisers had previously shunned as too risky and secretive. And in ways that are only now starting to become completely clear, it would dramatically change how public pensions invest.

CalPERS had good reasons for wanting to get into hedge funds. By 2002 the U.S. stock market, which had overheated during the late 1990s as the mania for technology and telecommunications stocks generated trillions of dollars in paper wealth for individuals and institutions, was plunging in a bear market rout. Like most U.S. public pensions, CalPERS had heavily invested in such securities as part of an outsize allocation to large-cap equities that had made the plan rich during the boom years but hurt on the way down. The fund lost $12.3 billion in the fiscal year ended June 30, 2001, and $9.7 billion the next year. CalPERS had gone from having 110 percent of the assets it needed to meet its future pension liabilities in fiscal 2000 to being underfunded, with a 95.2 percent — and falling — funding ratio.

One person who saw the writing on the whiteboard was Mark Anson. A lawyer with a Ph.D. in finance, Anson had been recruited to CalPERS from OppenheimerFunds in New York in 1999 to head up its alternative investments. By the time he became CIO in December 2001, he was seriously worried.

“I could see the dot-com bubble popping and the impact it would have,” Anson tells Institutional Investor. “I was concerned that our asset growth would not be faster than what I could see on the liabilities side.”

Anson believed that hedge fund investing would help protect CalPERS during times of market stress. For Anson, hedge funds are their own asset class and a valuable tool for diversifying a portfolio beyond traditional bonds and equities. In The Handbook of Alternative Assets, which Anson wrote while at CalPERS and published in 2002, he devoted more than 150 pages to hedge funds, including sections on how to set up an investment program and handle risk management. Unfortunately, by the time CalPERS began seriously investing in hedge funds, it was too late to prevent the carnage from the 2000–’02 bear market, but Anson remained convinced that the asset class would help the retirement plan in the future.

He was not alone. In New Jersey newly elected governor Jim McGreevey in 2002 appointed hedge fund manager Orin Kramer to the board of the New Jersey State Investment Council, which oversaw management of the Garden State’s then-$62 billion retirement system. Like CalPERS, the New Jersey fund had been badly scarred by the bear market; it was also laboring under a debt burden in the form of $2.75 billion in pension obligation bonds. Kramer started pushing for the system to invest in alternatives, stressing the diversification and risk management benefits. But the politically charged environment made change difficult.

In Pennsylvania, Peter Gilbert was having more luck. As CIO of the Pennsylvania State Employees’ Retirement System, Gilbert had gotten permission from his board in 1998 to start investing in hedge funds. After a failed attempt at “going direct” by investing in four long-short equity managers, he says, the then-$23 billion in assets PennSERS in 2002 hired Blackstone Alternative Asset Management (BAAM), the hedge fund arm of New York–based private equity firm Blackstone Group. Gilbert was one of the early public fund adopters of “portable alpha,” the strategy of taking the alpha, or above-market returns, of an active manager — often a hedge fund — and transporting it to the more traditional parts of the portfolio (large-cap U.S. equities, in the case of the Pennsylvania retirement system).

Between 2002 and 2006 other large state pension funds began investing in hedge funds, with varying levels of sophistication. They included New York, Missouri, Massachusetts, Texas, Utah and finally New Jersey. By May 2006, Marina del Rey, California–based investment consulting firm Cliffwater, itself a product of the growing interest by institutional investors, found that 21 U.S. state retirement systems were using hedge funds, with a total investment commitment of $28 billion. But there were also funds that held back, like the Public Employee Retirement System of Idaho and the Washington State Investment Board. Some were legally prohibited from making investments; others were not convinced hedge funds were right for public plans. Hedge fund investing remained controversial.

The hedge fund experiment was put to the test in 2008, when, under the pressure of too much bad debt, the U.S. housing and mortgage markets collapsed. That was soon followed by the near-failure of the banking system, the credit markets and the entire global financial system. State pension plans lost, on average, 25 percent in 2008, according to Santa Monica, California–based Wilshire Associates’ Trust Universe Comparison Service. That was better than the broad U.S. stock market — the Standard & Poor’s 500 index plummeted 38.5 percent in 2008, its third-worst year ever — but it lagged the performance of the typical hedge fund, which was down 19 percent, according to Chicago-based Hedge Fund Research.

Hedge fund managers often like to tell investors they’ll be able to deliver positive absolute returns regardless of what happens to the market, but in 2008 most managers didn’t live up to those expectations. Hedge funds did, however, cushion their investors against the near-record drop in the stock market and proved their value as portfolio diversifiers. Now, a decade after the first generation of public pension plans started to invest in hedge funds, more and more are looking to do so. In fact, today some of the biggest holdouts from the past decade are beginning to embrace hedge funds, including the $153 billion California State Teachers’ Retirement System, the $152.5 billion Florida State Board of Administration and the $74.5 billion State of Wisconsin Investment Board.

If things looked bad for defined benefit pension plans in 2002, they look a whole lot worse today. The 126 public pension systems tracked by Wilshire Associates had, on average, a funding ratio for the 2009 fiscal year of 65 percent — meaning they had only 65 percent of the assets needed to pay for the current and future retirement benefits of the firefighters, police officers, schoolteachers and other public workers covered by their plans. The situation has been exacerbated in states like Connecticut and Illinois, which in the intervening decade decided to increase benefits without increasing their contributions to pay for them.

“The pension benefit promises that have been made to unions by politicians have been in many respects unrealizable,” says Alan Dorsey, head of investment strategy and risk at New York–based asset management firm Neuberger Berman.

To make up for the shortfall, public pension plans have few places to turn. In the current economic environment, it is political suicide to even broach the topic of raising taxes. And despite calls from some high-ranking officials, like New Jersey Governor Chris Christie, to reduce health care and retirement benefits for public workers, getting state legislators to approve such cuts won’t be easy. For beleaguered public pension officers, the best and perhaps only solution is to try to figure out a way to generate better investment returns.

“Hedge funds start looking attractive because of their superior liquidity relative to private equity and real estate, and superior risk-adjusted returns relative to the overall market,” says Daniel Celeghin, a partner with investment management consulting firm Casey, Quirk & Associates, who wrote a seminal paper on the future of hedge fund investing in the aftermath of the 2008 crisis.

That is, of course, assuming that hedge funds continue to put up superior risk-adjusted returns. Capturing alpha — skill-based, non-market-driven investment returns — is, at the end of the day, the whole point of putting money in hedge funds. Although hedge funds as a group didn’t produce the same amount of alpha in the past few years as they did early last decade, it appears that they added some.

The ability to generate alpha enables hedge funds to justify their high fees. Managers typically charge “2 and 20”: a management fee of 2 percent of assets and a performance fee of 20 percent of profits. It’s been harder for funds of hedge funds to make the case for their management and performance fees — typically 1 and 10 — which investors must pay on top of the fees of the underlying managers. As a result, many fee-conscious pension plans that initially invested through funds of funds are now electing to go direct. That approach, however, can make hedge fund investing much more challenging, especially for pension plans with small investment staffs.

Hedge funds are not like traditional money managers, says former PennSERS investment chief Gilbert, now CIO of Lehigh University, responsible for managing the Pennsylvania school’s $1 billion endowment. Hedge fund managers require more due diligence and constant monitoring because in their search for alpha they operate with few if any constraints. “You really have to know what to expect from each particular hedge fund manager and how you are going to use them,” Gilbert says. Most investment consultants, the group that public plans typically rely on to help with manager selection — which can step in to take over the role of a fund of funds at a lower cost — are still grappling with advising on hedge funds.

Public pension plans, for their part, with their billions of dollars and stringent investment requirements, are changing the parameters of the hedge fund experiment. In a January 2011 report, consulting firm Cliffwater found that 52 of the 96 state pension plans it surveyed had a total of $63 billion invested in hedge funds as of the end of fiscal 2010, more than double the amount from four years earlier. “Public pension funds are the investment group that is going to shape the hedge fund industry,” says Scott Carter, head of global prime finance sales and capital introduction in the U.S. for Deutsche Bank, as well as co-head of hedge fund consulting.

Christopher Kojima, global head of the alternative investments and manager selection group at Goldman Sachs Asset Management in New York, would agree with Carter’s assessment. “The debate we are seeing at public plans today is much less about whether hedge funds are a sensible contributor to their objectives,” Kojima says. “The question we encounter much more is how to invest with hedge funds.” Pension funds are looking at how to identify and monitor top managers, think about risk management and connect hedge funds to their broader portfolios. “Are hedge funds even a separate asset class?” Kojima asks. More and more, the answer is no.

Public pension plans were not the first institutional investors to experiment with hedge funds. During the late 1980s and early ’90s, a group of influential endowment and foundation investors steeped in Modern Portfolio Theory started exploring the notion that these managers, freed from the constraints of more-traditional funds, could enhance their returns. The hedge-fund-investing hothouses of those early years were located on the campuses of a handful of universities, including Duke, Harvard, North Carolina, Notre Dame, Virginia and Yale.

As head of the Yale University Investments Office in New Haven, Connecticut, David Swensen pioneered an approach to endowment investing that put a heavy emphasis on alternatives, including hedge funds. Swensen’s acolytes at Yale would go on to run a network of school endowments, taking his ideas with them. Duke, North Carolina and Virginia were close to Julian Robertson Jr., founder of New York–based Tiger Management Corp. and one of the top hedge fund managers of that era. They embraced the Tiger investment ethos — fundamentally focused long-short strategies, sometimes with a tilt toward macro — as a source of returns.

For those early adopters, hedge funds proved their worth. In 1993 the HFRI fund-weighted composite index was up 30.88 percent, more than three times the total return of the S&P 500 composite index, which was up 10.1 percent. As the bull market started to roar, hedge fund results, on a relative basis, didn’t look so impressive. In 1997 the HFRI index rose 16.79 percent, roughly half the total return of the S&P 500, which was up 33.34 percent.

The first public plan to start looking seriously at hedge funds was the Virginia Retirement System. In the early 1990s the fund had made a controversial investment in a railroad company, leading to a legislative review, published in December 1993, that found the system had too many active managers and was paying too much in fees while not seeing much in the way of results. The review recommended that state law be amended to allow the retirement system broad discretion in the types of investments it could make. The change was enacted the following year, opening the door to hedge fund investing. By 1998, Virginia had invested $1.8 billion of its then-$23 billion in assets in market-neutral, long-short managers while at the same time indexing a significant portion of its equity portfolio.

In 2001, Virginia started talking to D.E. Shaw & Co. about having the New York–based hedge fund firm run a benchmarked long-only strategy for the retirement system. D.E. Shaw, a quant shop founded in 1988 by computer scientist David Shaw, was the classic hedge fund firm: supersecretive, using leverage, charging high fees and focused on finding returns. The firm didn’t have any close relationships with public pension plans before Virginia, but it quickly realized their potential value. “For years and years we had an absolute-return focus,” says Trey Beck, head of product development and investor relations at D.E. Shaw in New York. “This gave us an opportunity to go into the benchmarked business.”

The decision to build an institutional business meant that D.E. Shaw would need to produce funds that could perform on a relative basis. It would also need to become more transparent, which the firm had already started to do (in 1999 it had registered with the Securities and Exchange Commission as an investment adviser). D.E. Shaw began to expand its investor relations and reporting. “We had to get up the curve very quickly,” Beck says. “Because ten years ago the demands placed on managers by hedge fund investors were very different from the demands placed on investors in more-traditional products.”

The CalPERS hedge fund story begins with Bob Boldt, who was brought in from money manager Scudder, Stevens & Clark as senior investment officer for public markets in December 1996. Boldt was a big advocate for hedge funds, and by September 1999 it looked like he had gotten his way. CalPERS hired its first hedge fund manager, investing $300 million with San Francisco–based, technology-focused Pivotal Asset Management, and Boldt’s plan for CalPERS to invest $11.25 billion in hedge funds surfaced in the press. Then, Boldt left in April 2000. Seven months later he landed at Pivotal.

Paying talent has always been an issue for public pension plans. But the added challenge of running the more-sophisticated portfolios that typically accompany hedge fund investments makes it an even bigger issue, especially given the wide gulf in compensation scales between the hedge fund industry and the public pension world. Boldt was not alone in making the switch, though his stint at Pivotal would be short. (The firm folded after the dot-com bubble burst.)

In the absence of Boldt, CalPERS continued to take steps toward building a hedge fund program. In November 2000 the board approved a plan to invest $1 billion in hedge funds. (By that time, Anson had been promoted to senior investment officer for public markets.)

The following May, CalPERS hired fund-of-funds firm BAAM as a strategic adviser to its hedge fund portfolio, to help identify and interview potential managers, perform due diligence and provide risk management and reporting. This was a major change in the way an institution worked with a fund-of-funds firm. CalPERS paid less in fees than it would have if BAAM had been managing the money, and it had more control over the portfolio and transparency into the underlying managers. It also got to educate itself about hedge fund investing and grow its in-house expertise.

“We had not yet built up the staff within CalPERS, and we did not have feet on the ground,” says Anson, who became CIO in December 2001. “There were only so many due diligence trips I could take myself as CIO. We needed to really outsource some human capital.”

For all its pioneering work, CalPERS was actually slow to invest its first $1 billion in hedge funds. By December 2002, PennSERS had overtaken it as the largest public pension investor in hedge funds, with $2.5 billion allocated to four absolute-return fund-of-funds managers: BAAM, Mesirow Advanced Strategies, Morgan Stanley Alternative Investment Partners and Pacific Alternative Asset Management Co. (Public pension funds like PennSERS preferred the moniker “absolute-return funds” over “hedge funds” because it was more politically palatable when discussing their investments.)

But rather than carve out a separate allocation, PennSERS housed its hedge fund investments in its equity portfolio as part of its portable-alpha strategy. That made it much easier for then-CIO Gilbert to build a hedge fund portfolio that rivaled many endowments’ in size and scope. By June 2006, PennSERS had invested $9 billion of its $30 billion in assets in hedge funds.

New Jersey’s Kramer is also a big believer in the benefits of investing in hedge funds. But when he became chairman of the board of the New Jersey State Investment Council in September 2002, he couldn’t act on that belief because the state’s antiquated pension system was prohibited from using any outside managers — alternative or traditional. By November 2004, Kramer had gotten the Investment Council to agree to allocate 13 percent of its assets to alternatives (private equity, real estate and hedge funds), overcoming the objections of state unions, which accused Kramer and his fellow board members of wanting to give fees to their Wall Street fat-cat friends. New Jersey made its first hedge fund investments in the summer of 2006.

“There is no avoiding politics at public plans, in the same way that you would have it at a school district or at an investment board,” says Neuberger Berman’s Dorsey. “What winds up happening is that you end up handcuffing the investment performance.”

With their high fees, wealthy founders and reputation for risk-­taking, hedge funds became an attractive political target. Hedge fund managers, for their part, were not used to dealing with the scrutiny that invariably comes with running public money. Some decided it wasn’t worth the hassle. For those managers that did take public money and suffered major losses, the headlines were especially unforgiving. Just ask Nicholas Maounis, the founder of Amaranth Advisors, a Greenwich, Connecticut–based multistrategy manager that at one time was among the 30 largest hedge fund firms in the world. In the summer of 2006, the press skewered Amaranth after the firm’s supposedly diversified flagship fund lost more than $6 billion betting on natural-gas futures and had little choice but to shut down.

Amaranth’s investors included some of the U.S.’s biggest public funds, including the New Jersey system, PennSERS and Massachusetts’ Pension Reserves Investment Management Board, though most of their exposure was through funds of hedge funds. New Jersey’s CIO at the time, William Clark, pointed out in a January 2007 memo to the Investment Council on Amaranth and the lessons learned that the fund had taken greater hits from individual stock positions that same month. (New Jersey’s total exposure to Amaranth was $21.8 million, or 3 basis points of its total investment portfolio.)

Before Amaranth, the largest hedge fund disaster had been another Greenwich-based firm, Long-Term Capital Management, which famously lost 44 percent of its capital in August 1998, after Russia defaulted on its debt, and had to be bailed out by a consortium of 14 banks assembled by the Federal Reserve Bank of New York. The group put up $3.6 billion for 90 percent of the fund. But LTCM had little or no institutional money.

Public pension plans did not get off so easy during the recent financial crisis, which began with problems in the subprime mortgage market in 2007 and spiraled out of control in September 2008 when Lehman Brothers Holdings filed for bankruptcy. That month the HFRI index dropped 6.13 percent. In October 2008 the index lost a further 6.84 percent, and hedge funds started putting up gates to prevent investor redemptions. Firms liquidated struggling funds or moved troubled illiquid assets into so-called side pockets, trapping the invested capital until the walled-off assets were unwound. A record 1,470 hedge funds liquidated in 2008, according to HFR. It was an exceedingly tough time to be a hedge fund investor.

Between 2002 and the start of 2008, the hedge fund industry tripled in size, skyrocketing from $625.5 billion in assets to nearly $1.9 trillion, according to HFR. The bulk of the new money — approximately $610 billion — came from institutions, including public funds. These large investors wrote bigger checks than most managers were used to receiving; direct commitments of $50 million to $150 million were not unusual. In much the same way that scientists can change the results of an experiment simply by observing it, the influx of institutional investors, though they were more than mere observers, was bound to impact the return profiles of hedge funds.

As the last decade progressed, some experts began to suspect that much of hedge funds’ returns was not in fact alpha but market-driven returns, or beta, that had been leveraged using borrowed money to produce seemingly superior results. The events of 2008, when the markets collapsed and suddenly it became very expensive to borrow, bore this out. Neuberger Berman’s Dorsey and former CalPERS CIO Anson are among the money managers looking into beta creep, the notion that over time hedge fund performance has become increasingly market-driven. “Or, as I like to call it, ‘creepy beta,’ ” quips Anson, who is now a managing partner with Oak Hill Investment Management in Menlo Park, California. It’s not that beta itself is bad, just that investors do not want to pay hedge funds 2-and-20 for market returns.

After Anson left CalPERS in 2005, the hedge fund program picked up speed under the guidance of senior portfolio manager for global equities Kurt Silberstein. Two years earlier, CalPERS had replaced BAAM with Paamco and UBS and embarked on a program of direct hedge fund investments as well as fund-of-funds commitments. Silberstein is proud of what the U.S.’s biggest public pension plan has achieved. “We run a very conservative portfolio, and for each unit of risk we take, we have been rewarded with a unit of return,” he says.

Going into 2008, however, CalPERS had too much beta in its hedge fund portfolio, which fell 19 percent that year. Silberstein freely admits that 2008 was “a really black eye” and that the pension system would probably not still be investing in hedge funds “if 2008 had happened two years into us building out the program.” Since the crisis, Silberstein has almost completely redone the direct hedge fund portfolio, terminating relationships with many of the long-short equity and multistrategy managers that underperformed in 2008. Today he prefers to invest with smaller managers he believes are more likely to add alpha.

CalPERS has also taken much closer control of its hedge fund investments. It now demands what it perceives as a better alignment of fees from its hedge funds, enabling the California plan to reclaim some of the 20 percent performance fee it pays during a good year if a manager loses money the next. Cal­PERS invests whenever possible using separate or managed accounts instead of commingled funds; this means it, not the manager, holds the underlying securities.

“You can mitigate business risk by having control of your assets,” says Silberstein. “Once you have control you don’t have to be so adamant on the terms of the contract, because if I don’t like what a manager is doing, I can just take my money and walk.”

CalPERS is not alone in making such demands. Its crosstown Sacramento counterpart, CalSTRS, is making its first move into hedge funds with a global macro program that will be handled exclusively using managed accounts. At the $19.8 billion Utah Retirement Systems, deputy chief investment officer Lawrence Powell also has been playing hardball with hedge fund managers over fees.

Fees continue to be a big issue for funds of hedge funds, as more and more public funds opt to use less expensive investment consultants to help them construct and monitor hedge fund portfolios. Still, Neuberger Berman’s Dorsey, who worked at Darien, Connecticut–based consulting firm RogersCasey from 2002 through 2006, thinks funds of funds can play an important informational role for public plans. “Most funds of hedge funds have a large staff, and these people are engaging in continuous contact, monthly conversations and conference calls with hedge fund managers,” he says.

Although some public pension officials were disappointed with the 2008 performance of hedge funds, they are increasingly starting to look at hedge funds not as a distinct asset class but as a way of managing money. The Virginia Retirement System, for example, doesn’t separate hedge fund managers into their own group but categorizes them according to the types of securities in which they invest. Scott Pittman, CIO of the New York–based Mount Sinai Medical Center Foundation, which has more than 70 percent of its $1 billion endowment invested in hedge funds across different asset classes, thinks this approach makes a lot more sense.

“When you take hedge funds that have lots of different securities and strategies and group them together and call it an asset class, you are ignoring the consequences of those exposures on the overall portfolio, both unintended and intended,” Pittman says. “Hedge funds are just a vehicle by which we invest.”

One of the effects of 2008 was to increase discussions about risk management. Institutional investors realized they had not been doing a good enough job of paying attention to risk. The result is that some institutional investors — including Alaska Permanent Fund Corp., CalSTRS and the Wisconsin Investment Board — have been working with hedge funds or money managers that offer hedge-fund-like strategies to put together portfolios that, through tactical asset allocation and hedging, can offer overall risk protection.

“We are trying to develop a system that does not seek to time the market but does try to identify those extreme left-tail events,” CalSTRS CIO Christopher Ailman recently told Institutional Investor, referring to statistically rare events, like those experienced in 2008, that can have a seismic impact on markets and returns. Funds designed to hedge against tail risk often rely on derivatives-trading strategies and as a result have their own built-in leverage. Such funds can act as a drag on a portfolio when markets are rising, but they are expected to provide a valuable hedge in times of significant market stress and volatility.

The real key to pension fund investing has always been asset allocation — long the purview of investment consultants. As hedge funds, which roam all over the capital structure looking for returns, become a more integrated part of what pension plans do, investment officers and their boards are leaning on their managers to answer more of their general asset allocation and investment concerns.

Hedge funds have had to learn to become more receptive to such inquiries from their largest clients. “The industry mind-set has changed,” says D.E. Shaw’s Beck. Hedge fund managers realize that public funds want to be able to call up investment professionals at their firms for insights into what is happening in the markets and for their views on macroeconomic events.

The Washington State Investment Board is looking forward to just such a relationship with D.E. Shaw. In April the board voted to approve the firm for a global non-U.S. active equity mandate. “Part of the reason we chose the manager was not just for the product but because of the depth of resources and talent at the investment manager that we will have access to,” says CIO Gary Bruebaker. “I call it noninvestment alpha.”

Bruebaker was a member of the President’s Working Group on Financial Markets’ investors’ committee when it released its report on hedge fund investing in April 2008. Although he appreciates the merits of D.E. Shaw, he has no plans to invest in the firm’s hedge fund strategies or, indeed, with any hedge funds at all.

“I take my responsibilities very personally; I manage the financial future of over 400,000 public employees, many of whom work a lot harder than I do,” says Bruebaker, whose mother was a public employee. “If there was a way I could make more money on a risk-adjusted basis, I would find a way to do it.” But he just does not believe the $82.2 billion Investment Board has any competitive edge when it comes to investing in hedge funds.

Public funds, he says, should be cautious investing in hedge funds: “Many of them don’t have the flexible budgets or the dollar amounts to hire the kind of skill sets they need to help them do the due diligence that would be necessary to do it correctly.”

New Jersey lost a highly skilled investor when Kramer resigned from the Investment Council in February. In his last year on the board, he successfully pushed to raise the limits on how much New Jersey could invest in alternatives. But even Kramer was finally exhausted by the years of battling to move the $74.7 billion retirement system into the modern investment era. Though public scrutiny serves an important role as a guard against corruption, the political nature of the public pension system can alienate the very best investment talent. And yet it is the resource-constrained, funding-challenged public funds that need the most help, especially as their investment portfolios become more and more complex.

Bruebaker is right that public pensions should be cautious about hedge funds. But I am very surprised that he invested with D.E. Shaw to leverage off their knowledge investment managers because D.E. Shaw is the quintessential epitome of a ultra-secretive "black-box" hedge fund which is why after 2008, some of the public pension fund managers I know, pulled their money out of D.E. Shaw and other black-box shops.

When it comes to hedge funds, public funds have to understand a few critical things. First, the data is full of biases so take the aggregate returns of hedge fund databases with a shaker, not a grain of salt. Second, hedge funds are not an asset class, they're a way to manage risk efficiently. At least that's what they're suppose to do, protect against downside risk as they deliver true alpha. But the truth is hedge funds are selling beta as alpha. It's ludicrous to pay 2 & 20 in fees for beta, and yet that's exactly what's going on right now.

The final thought I want to leave you with is that hedge funds are not a panacea or cure-all for public pension funds. There is a symbiotic relationship between public funds and hedge funds. This relationship is being transformed ever so slowly, but the truth is hedge funds need public funds and public funds need hedge funds, but this model is not going to "cure" chronically underfunded pension plans. Only tough concessions from all stakeholders will put public pensions back on the right track. In other words, tough political discussions have to be made. In the meantime, public pensions will continue allocating billions to hedge funds, at least until the next crisis hits. Then we'll see if these bets pay off.

Wednesday, June 22, 2011

Japan Pensions Bet on Hedge Funds

Chikafumi Hodo and Nishant Kumar of Reuters report, Japan pensions bet on hedge funds to boost returns:

Japan's corporate pension funds, hobbled by a sluggish domestic stock market, are raising their allocations to hedge funds as they scramble to boost returns for the country's ageing population.

The move is part of a broader trend in Asia where institutions are looking to raise exposure to hedge funds in search for absolute positive returns and as confidence in the asset class improves, lifting prospects for the $2 trillion (1.2 trillion pound) global hedge fund industry.

Nearly all of Japan's corporate pension funds, which collectively manage more than $900 billion, have lowered their guaranteed yield in the last decade from about 5.5 percent to below 3.5 percent on average, industry observers said.

"Considering that they have had a very hard time raising decent returns by directly investing in equities over the past years, pension funds are now very seriously considering taking more exposure in alternatives," Tamotsu Adachi, the co-head of private equity firm Carlyle's Japan unit, told the Reuters Rebuilding Japan Summit in Tokyo this week.

A survey of 31 Japanese corporate pension funds by U.S. fund manager Russell Investments showed pensions slashing investment in domestic equities to 14.6 percent of their assets on average as of end-March from 18.7 percent a year earlier.

By contrast, the 31 pension funds, which manage 7.54 trillion yen, said they had increased allocations to hedge funds and other alternative assets to 13.1 percent of their assets from 11.6 percent a year ago.

"In these conditions where Japanese pension funds are having trouble finding a return driver, they have to rely more on alternative assets, mainly hedge funds," said Mitsuhiro Arakawa, executive consultant at Russell Investments.

"They don't want to be in stocks after seeing them slump over the last 10 to 20 years. In fact, they may want to cut them at a quicker pace after the disaster in Japan," Arakawa said.

The blow of the March 11 earthquake and tsunami and ensuing nuclear crisis knocked the Japanese economy into recession and battered stocks. Japan's benchmark Nikkei average is still down about 7 percent since the earthquake.

Some corporate pensions are aiming to park as much as 40 percent of their assets in hedge funds, said Futoshi Ago, director at the prime brokerage arm of Bank of America Merrill Lynch in Tokyo.

Takahiro Mitani, president of the Government Pension Investment Fund, told the summit that while he had no plans to start investing in hedge funds immediately, the fund was evaluating the option. The GPIF, which holds about $1.4 trillion in assets, is known as a conservative fund that parks about two-thirds of its assets in Japanese government bonds.


The Nikkei stock average has lost about a third of its value in the last 10 years. By comparison, the Eurekahedge Hedge Fund Index has surged 160 percent, forcing institutions to rejig their asset allocations.

While Japanese corporate pension funds have kept their allocations to foreign stocks at around 20 percent of their assets in the past decade, they have cut their exposure to domestic shares by half. Investments in alternatives have risen to 13 percent from less than 3 percent.

Across Asia, institutions are preparing to invest more or are looking to start investing in hedge funds, after shying away from the asset class, as an uncertain economic outlook forces them to look at instruments that could benefit from falling markets.

South Korea's National Pension Service, the world's No. 4 pension fund with about $300 billion of assets, said earlier this month that it plans to raise its investment in alternatives to above 10 percent by 2016 from 5.8 percent in 2010 as a part of its move to diversify.

The industry has also received allocations from Chinese, Taiwanese and Malaysian institutions among others in Asia with more likely to join the fray.

"The market is far more ready now to make allocations to hedge funds. Clearly I think that the large institutions are setting the path for others to follow," said Max Gottschalk, co-founder of Gottex Fund Management, one of the world's biggest fund of hedge funds.

Only about 18 percent of global hedge fund assets are sourced from Asia, according to a Credit Suisse survey of 600 institutional investors representing $1.2 trillion of allocations to single-manager hedge funds.

"I think we are still in the early phase of adoption to alternatives in Asia and I think over the next 5-10 years Asia will become a far more prominent investor in this asset class," said Gottschalk who moved to Hong Kong earlier this year.

Several thoughts came to me as I read this article. First, global assets into hedge funds are growing ever larger, meaning their influence in financial markets will become even more important. This is another source of liquidity and leverage, and keep in mind most hedge fund assets are in directional strategies: Long/Short Equity, global macro and commodity trading advisors (CTAs). This means you will see ever larger swings in risk assets on the way up and on the way down.

Second, with an aging population, Japan's corporate plans need to manage liquidity risk very carefully. This too means they will be biased towards directional absolute return strategies where liquidity and scalability are not as much of an issue as market neutral strategies. The problem is that there a lot of beta in these directional strategies and these corporate plans don't want to end up paying 2 & 20 in fees for beta.

Third, Asian institutions have an advantage of knowing who the good managers are in their own backyard but I would recommend they diversify into North American and European funds. They can go the fund of funds route, but they will end up paying an extra layer of fees, which might work fine until the next global crisis hits. These corporate plans need a strategy, and I would recommend managed account platforms (not just brand names) and direct investment into hedge funds. This is where funds like Ontario Teachers' are moving and for good reason, they and others got hammered with illiquid hedge funds putting up gates (and side pocket letters) during the 2008 crisis and are now managing liquidity risk much tighter.

Fourth, I worry that all these assets flowing into global hedge funds will dilute returns going forward and sow the seeds of the next crisis. It's not guaranteed but you have to pay attention to global trends in hedge funds because they're increasingly becoming the alternative investments of choice for global pension funds looking to juice their returns while they manage liquidity risk very closely.

Finally, there is an intelligent way and a dumb way to invest in hedge funds. I'd be glad to discuss some more ideas with these Japanese corporate pension plans and introduce them to some of Quebec's absolute return managers. In particular, one experienced manager who is setting up his relative value commodities trading fund with his partners, is a perfect fit for these plans. If you're interested in knowing more, please contact me at LKolivakis@gmail.com.

Monday, June 20, 2011

What if 8% is Really 0%?

Mebane Faber of Cambria Investment Management sent me an excellent paper he authored, What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed:
It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return.

By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate.

In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison - the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.
So how does a pension manager get 8% in the current environment? Mr. Faber writes:
With government bonds yielding about 4% plan sponsors must invest in other outperforming assets to bring the cumulative return to 8%. The problem with allocating assets away from the risk-free rate is that they are, by definition, risky and uncertain. If a pension manager is employing the benchmark 60% stock/40% bond allocation, the 60% in equity or diversifying assets must return approximately 11% to achieve 8% total returns.

The second major problem outlined in this paper is that pension managers, in an attempt to deal with the realities of underfunding, may be tempted to chase higher performing and riskier asset classes, and may end up compounding the underfunding problem even more through exposure to these risky asset mixes.

Interestingly, according to Biggs, the targeted equity allocation does not correlate with projected return. Even worse, as shown in Exhibit 1 (above), funds using the highest return assumptions have the most underfunded pensions, a scenario that could be called, “fingers crossed and eyes closed”
Mr. Faber goes on to write:
The focus on illiquid assets (private equity, venture capital and timberland investments, for example) made the Endowment Model particularly attractive to funds that in theory have long time horizons, such as endowments and pensions.

Yet, as real money investors sought diversification through the same methodology, their portfolios were, in fact, becoming more correlated to each other while portfolio risks were becoming more concentrated and increasingly dependent upon illiquid equity-like investments.

Most real money funds were not prepared for the following stress scenario to their portfolio:
  • US and Foreign Stocks declining over 50%
  • Commodities declining 67%
  • Real Estate (REITs) declining 68%
The figures above are the peak drawdowns from the bear markets of 2008-2009, and, importantly, they all occurred simultaneously. It is critical that pension funds – especially funds pursuing high equity allocations – consider all possible stresses to portfolio viability.
Mr. Faber then asks a simple question:
Are funds prepared for a lengthy bear market in equities like when stocks declined nearly 90% in the 1930’s? Are funds prepared for both raging inflation of the 1970’s and 1980’s and sustained deflation like Japan from 1990 to the present? It is our opinion that most funds do not consider these outcomes as they are seen as extraordinary and beyond the scope of either feasible response or possibility.
He's absolutely right, the majority of pension funds are hoping -- nay, praying -- that we won't ever see another 2008 for another 100 years. The Fed is doing everything it can to reflate risks assets and introduce inflation into the global economic system. Pension funds are also pumping billions into risks assets, but as Leo de Bever said, this is sowing the seeds of the next financial crisis, and when the music stops, watch out below. Pensions will get decimated. That's why the Fed will keep pumping billions into the financial system. Let's pray it works or else the road to serfdom lies straight ahead. In fact, I think we're already there.

Below, Mebane Faber talks about the benefits of the ETF he manages, Cambria Global Tactical ETF (NYSE:GTAA). I thank him for sharing this paper with me.

Sunday, June 19, 2011

Honoring My Humble Father

Let me begin by wishing all the dads out there a very Happy Father's Day. It's another beautiful day in Montreal and I want to head out there and enjoy it, but first let me introduce you to the most important man in my life, my father, Dr. Thomas Kolivakis. That's him with his two grandchildren, Thomas and George. Another Thomas, their cousin, is in Crete with my sister and brother-in-law.

My father was born on December 22, 1931. As a child he lived through the second World War, an experience that had a profound effect on him. First, like many of his generation, he is deeply religious and has repeatedly told me that his most important relationship is the one with God. It has helped him persevere and deal with his personal challenges and it has given his life extraordinary meaning.

My father doesn't believe in what Marx described as using religion as the "opium for the masses." Instead, he prays, reflects and strives to be a better person by understanding the deeper meaning of the gospel. I often catch him reading the bible, and even though I'm not religious, I'll ask him what he's reading because I'm curious. He will explain it to me and relay it back to every day life.

The second thing that I noticed about my dad being brought up during the war is that he values education and hard work and doesn't believe in materialism and waste. If he sees me throwing away a piece of bread, he'll chastise me and tell me to freeze it instead. Drives me bananas sometimes but he's right, people are starving out there and we tend to take a lot of things for granted.

When it comes to his work, my father is incredibly devoted. He's almost 80 and has worked for over 40 years as a psychiatrist and still follows hundreds of patients very closely. My brother followed in his footsteps and I know part of me wanted to, but I got sidetracked and developed an addiction to macroeconomics and financial markets which I still have. Ironically, with his limited knowledge of financial markets, my father is much wiser than I am, stating flatly that the "stock market is all gambling," all part of what he calls "aero-capitalism" where individuals make a lot of money "selling nothing but hot air."

One of the things my dad keeps repeating to me is John Updike's famous quote: "sex is like money, only too much is enough." He's seen a lot in his career and knows that money doesn't buy you happiness. He knows all about what Pete Peterson, another product of Greek immigrants, calls the meaning of enough. Having been diagnosed with MS at the age of 26, and recently turned 40, I know money isn't going to bring me happiness, but it can buy you leisure and peace of mind (it can also make you miserable).

Both my parents taught their three kids proper values in life. They believe in education, hard work, and treating people with compassion and respect. My father sent us to French private schools and always told us that as long as we lived in Quebec, we should value the French language and culture.

But going to French private school also exposed me to money and other value systems. I remember back in high school, my well-to-do friends' parents were buying them cars, so I sat down with my father and asked him to buy me a car too. He listened to me patiently as I ranted on about how it's important to fit in, and asked my brother to join the conversation. I'll never forget what he told us: "I will never buy you a car. As long as you're doing well in school and complete a Master's at a minimum, I will pay for your food, clothes, vacations, give you some allowance, love you and support you. That's it. I learned how to drive at 29 at Soldier Field in Chicago when I was a resident and bought my own car. You will buy your own car when you can afford it."

I also remember when I first got to CEGEP (two year college mandatory in Quebec before university), I was enjoying my new found freedom. I had a hard time going from a strict French private school to college, so I abused my freedom and partied a lot. My grades suffered and my parents were not pleased. They decided not to send me to Greece that summer and I was fuming. I told them I would find work and leave on my own. My father told me to "do it."

So I did it, found any job I could. I worked in a smoked meat factory in the east end. Never ate smoked meat ever again. I worked at a Jewish cemetery digging graves with a shovel and wheelbarrow. That was the hardest job I ever did. Didn't last long there too. Finally, I found a job cleaning tennis courts near my house which paid me well. It was fun, got to tan, and made enough money to head off to Greece and party with my buddies on the islands. Best years of our lives! But the lesson my parents taught me was that I was fortunate enough to go to school and should take it a lot more seriously. I never took the value of an education for granted ever again.

Last summer, my sister told me that when she had her boy, she realized just how much we owe everything to our parents. We do owe everything to our parents and I don't tell them often enough how much I love and cherish them.

The Quebec Association of Psychiatrists recently awarded a lifetime achievement award to my father for clinical work. He's an extremely humble man and wasn't comfortable making a speech. I was in Toronto that day helping a Montreal commodities manager seed his fund, but my brother, sister-in-law, and two of his three grandchildren were in attendance.

Words cannot express how proud I am of my father and how much I love him. He has put up with my insufferable character which has gotten worse ever since and I was diagnosed with MS, especially in recent years. I have been through a lot, and he has stuck by my side every step of the way. He's still there for me, patiently listening to all my problems, consoling me when things aren't going my way with uncanny compassion, and praising me when he's proud of me. I'm learning to listen more to him, going to the gym, and will take the necessary steps to be a better person, a lot more like him.

That's why today I want to honor the most important man in my life, my father. Thank you for being the greatest father and grandfather in the world. If at the age of 80, I can look back at my life and be half the man you are, I will be proud of myself. I leave my readers with the one video I absolutely love watching on this special day. Enjoy.

Friday, June 17, 2011

Notes From Montreal Pension Conference

Spent the last couple of days at a pension conference here in Montreal, Sommet Avantages & Retraite. There were numerous excellent presentations covering all sorts of pension issues. Here are some brief bullet notes:
  • Bernard Morency, Executive Vice-President, Depositors and Strategic Initiatives at the Caisse de dépôt et placement du Québec, kick-started the conference with an excellent presentation on the future of pension plans. Mr. Morency made a forceful argument that if defined-benefit plans are going to survive, then all stakeholders will need to make concessions. During the question period, I asked him if he sees a role for the private sector and he said "yes because if we leave pensions all up to the government, chances are they will understate the true cost."
  • I assisted most of the investment workshops. Ron Chesire of Triasima spoke on integrating lessons on behavioral finance in risk management.
  • Bernard Augustin of Addenda Capital focused on liability-driven investments (LDI) arguing that the low interest rate environment requires a better understanding of how to separate out the alphas and betas in a portfolio.
  • There was an excellent presentation by Emmanuel Matte of Standard Life on how to properly assess a fund's risk across all investment portfolios. Importantly, instead of dollar allocations, risk budgeting should be implemented based on economic scenarios. Mr. matte demonstrated that this approach adds significantly to returns while minimizing downside risk.
  • Rene Martel of PIMCO gave a good technical overview of LDI, explaining bond leverage using repos and total return swaps into various equity indexes.
  • My former boss at PSP, Pierre Malo, now at Perseus Capital, explained how to manage the hidden bomb of currency risk. I have already referred to this topic on my blog. And I thank Pierre for inviting me to this conference as his guest.
  • Finally, the most fascinating and inspiring presentation came from Martin Lafontaine of GSK who worked at Project Hope in Munsieville, South Africa. Martin discussed the five factors of success and how they united rival factions in Munsieville to hold World Cup mock games for the children of Munsieville. You can follow Martin's blog but please donate generously to Project Hope.
That's all from me. Not much in a blogging mood lately as the weather is spectacular and I plan on enjoying my weekend. Wish you all a great weekend and wish all dads a Happy Father's Day. Below, a video from Project Hope on Munsieville International Children's Cup.

Thursday, June 16, 2011

Beware Contagion From Greeks Baring Rifts?

Richard Barley of the WSJ reports, Beware Contagion From Greeks Baring Rifts:

Euro-zone politicians may be fiddling while Athens burns. Tuesday's meeting of finance ministers brought no progress on how to address Greece's funding problems and avoid setting off a financial crisis. But conditions in European markets are deteriorating. The main risk from Greece has always been contagion, and that process is already under way.

Most directly, prices of Portuguese and Irish bonds have fallen sharply, with 10-year yields rising above 11% and the cost of insuring their debt at record levels. The gap between Spanish and German 10-year bond yields is at its widest since January. The market is effectively giving no credit for any reforms or budget policies set out in the past six months.

The next link in the chain, the banking system, has been affected. In Spain, progress by banks on regaining market access has gone into reverse: Average borrowing from the European Central Bank jumped to €53 billion ($76.32 billion) in May from €42 billion in April.

Meanwhile, the contagion into core banks may be being underestimated by investors. Moody's on Tuesday said it could downgrade France's BNP Paribas, Société Générale and Crédit Agricole due to their holdings of Greek debt, and the ratings firm is looking at whether other banks could face similar risks.

Disturbingly, the worries have now reached non-financial companies, which have been virtually bulletproof this year. Investment-grade bond issuance has come to a near-standstill. The yield premium on Portugal Telecom's February 2016 euro bond over German Bunds has widened a stunning 2.3 percentage points in the last two weeks, data from Société Générale show. Italian and Spanish credits are under pressure too. The credit market now starts by pricing government risk and then works back to price debt from financials and companies, one investor says: Greece is a destabilizing influence at the center of the market's deliberations.

When German Finance Minister Wolfgang Schäuble last week proposed a seven-year maturity extension for Greek bondholders, setting up the current standoff with the ECB, he suggested there was a chance to minimize the negative impact on financial markets. That was always an optimistic hope. The reality is that markets are starting to wake up to the risks of a Greek debt restructuring. Europe's politicians need to act fast to stem the tide.

Markets have started to wake up to the risks of Greek debt restructuring? No kidding? The problem is that Eurozone politicians still have their heads up their asses (I'm sorry, calling it like I see it, and there is no way I'm going to sugarcoat this crisis). With each passing day, there is a huge risk of another international banking crisis -- and this one will make 2008 look like a walk in the park! (Had lunch with two of Montreal's most promising hedge fund managers yesterday and they're both bearish on this market).

Meanwhile, over in Greece, Reuters report that Greeks of all ages want politicians to pay:

Greek workers of all ages and professions, pensioners, students, the old and young marched on parliament in Athens Wednesday to vent their anger at the country's politicians and their austerity plans.

Tens of thousands took part in the protest rally, which follows three weeks of peaceful evening gatherings in the central Syntagma Square of people from all walks of life, tired of tightening their belts a year after Greece received an EU/IMF bailout.

"I feel rage and disgust," 45-year-old civil servant Maria Georgila, a mother of two, said in front of parliament.

"These measures are very tough and they won't get us out of the crisis. I can't believe they have no alternative."

Like others yelling "Thieves!" and raising open hands toward parliament in a traditionally offensive gesture, 38-year-old Maria Koutroumba said she felt betrayed.

"They are traitors, they've plagued the country," the unemployed woman said of the politicians as she helped form a human chain around the parliament building.

"These measures are hurting us, the ordinary people," said Koutroumba, who used to get by on short-term contracts in the private sector but is now out of work, like over 800,000 Greeks.

The jobless rate hit a record 16.2 percent in March as cutbacks to rein in Greece's huge debt burden of 340 billion euros stifled the economy further. The EU and the IMF expect the Greek economy to contract 3.8 percent this year.

Greece's international lenders have also insisted that the country sell 50 billion euros of state assets to reduce its debt mountain.

"More people must take to the streets and say that Greece is not for sale," said Koutroumba, who spent the night on the square and said she would stay as long as needed.

Greek lawmakers were due to discuss a new austerity package of 6.5 billion euros in tax rises and spending cuts this year, including higher tax on cars and restaurants and slashing the public sector workforce.

"We wouldn't be here if they (the politicians) had made sacrifices as well," said 60-year-old pensioner Panayotis Dounis, who said he had joined the non-political rally in front of parliament nearly every night for about half an hour.


Dounis said he wanted no violence at the anti-austerity rallies. Most protesters marched peacefully Wednesday, though the rally was marred by clashes between stone-throwing youths and police.

"I am willing to make sacrifices, to live only on bread and olives, but what are they (politicians) doing for us?" asked the former builder, who retired last year.

"I want them to work for four years without getting paid, for Greece, for their country," said Dounis, whose three children are jobless and who believes MPs can afford to work for free for a while.

Singer Vassilis Theodorakopoulos, 32, who performs in various places to make ends meet, has been camping in central Syntagma Square for the past 20 days.

"All of these governments must vanish," he said. "We want to reorganize Greece away from any memorandum, the EU and the IMF."

If I were an ordinary Greek citizen, I would be enraged as well. While Greece's elite are parking their money offshore in Cyprus, Switzerland, UK and Germany, most Greeks are struggling to get by on crumbs, bearing the brunt of the strict austerity measures being imposed on them. There is no long-term game plan on creating jobs, much like in the US where the jobs crisis is getting worse. I think politicians from around the world should carefully listen to professor Robert Shiller below on how to revive America's 'animal spirits'.

Tuesday, June 14, 2011

TimberWest Sold to PSPIB and bcIMC

Gordon Hamilton of the Vancouver Sun reports, TimberWest unitholders approve $1 billion sale to pension funds:

Unitholders of TimberWest Forest, the largest landowner in B.C., approved the sale of the company Tuesday to two public pension funds, a move that president Paul McElligott said should result in better decision-making on the company’s Vancouver Island lands.

“We look forward to a new future as a private company,” McElligott said after unitholders voted 98 per cent in favour of the $1 billion deal.

In an interview, he said TimberWest’s structure as a publicly-traded company worked well until the U.S. housing downturn led to a collapse in lumber demand. TimberWest had thrived on selling logs into modern sawmilling sector that has developed in the U.S. Pacific Northwest.

“The U.S. economic downturn had a very punishing effect on this sector, and I think private ownership is more patient capital; it’s a longer-term view. You are not under the same kind of pressures to shore up short-term income and profits because there’s a quarterly analyst’s report being produced in a few weeks,” he said.

“I expect it will result in better decision-making,” he said of the new ownership structure.

TimberWest owns 327,000 hectares of land, mostly along the eastern spine of southern Vancouver Island.

The forest company’s new owners, the British Columbia Investment Management Corporation (bcIMC) and the federal Public Sector Pension Investment Board (PSPIB), plan no management changes, Gordon Fyfe, president of the Public Sector Investment Board said in an interview. The two pension plans are buying the company for $1.03 billion in cash, including assumed debt, which will return $6.16 a stapled unit to unitholders.

Fyfe said he can speak only for his own pension board, but described TimberWest as an ideal match for the board’s liabilities — making pension payments for the federal employees whose money they are investing.

Timberlands have 50 to 55-year harvest cycles, are not very liquid and are subject to market fluctuations, attributes that make them more attractive as a long-term investment, he said.

“If markets aren’t great, you don’t have to cut trees,” he said.

The transaction still requires approval under the Competition Act and by the B.C. Supreme Court. The sale is expected to be finalized before the end of June.

While Timberland is not correlated with stocks, institutional investors need to understand that there are risks in timberland investments:
Despite their appeal, timberland investments can present considerable risks to institutional investors. The primary risks of timberland investing are market uncertainty (fluctuation of timber and timberland prices associated with macroeconomic conditions such as the health of the housing market), relative illiquidity compared to stocks and bonds (the absence of an organised timber exchange can make it difficult to find a buyer), and environmental risks, which are the focus of this report.
Add to this forest fires, insects, regulations and tariffs. Moreover, with so much money flowing into this asset class, future returns will not be as strong as past ones. But Timberland does have unique characteristics that can help hedge a pension portfolio during downturns.

Monday, June 13, 2011

Air Canada's Great Pension Divide?

CBC reports on Air Canada's great pension divide:

One of the key issues that had Air Canada management and union negotiators talking right up to the Monday midnight strike deadline was pensions. The Canadian Auto Workers union — which represents the airline's 3,800 sales and service agents — says the pension changes proposed by Air Canada would make new hires "second-class workers."

What is Air Canada proposing?

The airline wants the CAW to agree to a number of changes to the pension program that its customer service employees pay into. The union says Air Canada's demands for pension concessions are not negotiable.

There appear to be two major stumbling blocks:

  • The airline's demand for pension cuts that could see new retirees having their pensions being chopped by an average of 40 per cent, according to the CAW. (The airline says the cuts aren't that big.)
  • The airline's demand that all new hires into the bargaining unit be routed into a new, defined contribution pension plan, rather than joining the current employees' defined benefit plan.

What's the difference between these two types of pension plans?

The latest figures show that only about six million Canadians — roughly 40 per cent of employees — were members of a registered pension plan at the start of 2010. About half were in the public sector and half in the private sector.

For those with pensions, the two main kinds are defined benefit plans (75 per cent of those with a pension plan) and defined contribution plans (16 per cent of all pension plan membership). The rest are in some kind of hybrid plan.

For employees, a defined benefit plan is the gold standard in the pension world. Air Canada's current pension plan for its customer service reps is this kind of plan.

Here are the key points of defined benefit plans:

  • DB plans guarantee a pre-set lifetime pension after a certain number of years of service. The better plans include partial or full indexing for inflation.
  • Both the employee and the employer contribute to this type of plan.
  • It's the employer's responsibility to make sure the plan is properly funded to pay the promised benefits.
  • It is the employer that must make up any plan shortfall.

Defined contribution plans, on the other hand, sport some key differences:

  • The level of payout is not guaranteed. These plans are often not indexed for inflation.
  • You and/or your employer contribute a set amount of money each year.
  • Your retirement income is based on how the pension plan's investments perform.
  • Since there is no specific pension payout guarantee, the employer is not on the hook for future pension plan shortfalls.
  • Pension risk with this type of plan is transferred from the employer to the employee.

Aren't defined contribution plans becoming more common?

Yes, especially in the private sector. Statistics Canada says the number of private-sector employees covered by defined-contribution schemes rose by almost 400,000 people between 1991 and 2006. At the same time, the number of private sector workers covered by defined-benefit plans fell by 270,000.

Defined benefit plans are still the most common plans, with 75 per cent of those with a registered pension plan having a DB plan. But 10 years ago, that figure was 85 per cent.

Private companies are increasingly switching over their pension plans to the less-costly defined contribution arrangements in order to reduce the potential cost of their pensions, Statistics Canada said.

"Although [defined contribution] plans have some undeniable advantages for employees, their increased prevalence suggests a transfer of risk from employers to workers since 1991," the agency said.

Why is the airline asking for pension concessions?

Since Air Canada is responsible for making up shortfalls in its pension plan, it says it has no choice but to insist on concessions. The airline says it had a pension deficit of $2.1 billion at the start of 2011.

"This deficit is not sustainable and has not been sustainable for most of the decade, as it puts at risk both the viability of the company and the pensions of all employees," says Air Canada spokesman Peter Fitzpatrick.

Federal pension legislation requires Air Canada to make hefty payments in coming years to address that deficiency. By the airline's estimate, it will have to make $550 million in past and current pension contributions in 2014 alone.

Air Canada spokeswoman Isabelle Arthur says the airline has 26,000 active employees in its pension plan, which has to provide pensions for 29,000 retired workers, "so we have to find a solution that ensures that Air Canada remains a viable company."

Why is the union fighting so hard on this issue?

The CAW says making new hires join a new, defined contribution pension plan weakens the existing defined benefit plan because all new contributions would be diverted into the new plan.

Defined contribution plans, which offer no guarantees of final pension payouts, also create (in the CAW's words) a two-tier system "which would make second-class workers of future generations."

The CAW, along with two other unions representing Air Canada workers, jointly pledged last month to fight any further attempts by the airline to reduce or eliminate their defined benefit plans.

The union also notes that the airline's top managers continue to make millions of dollars annually and enjoy generous guaranteed pensions.

To be fair, I don't know the details of the dispute, but Air Canada is doing what most private companies with defined-benefit (DB) plans are doing, cutting benefits and shifting new entrants into defined-contribution (DC) plans. Basically, new employees get screwed and older ones get squeezed.

What I do know about Air Canada's pension plan is that it was poorly managed for years. The new team running Air Canada's pension is much better, much more sophisticated and they strive to match assets and liabilities using both public and private investments. But the pension deficit they inherited is enormous, leaving them an impossible task of closing an ever widening gap. That's why the company is fighting the unions hard on pensions. But as the deadline approaches for a strike at Air Canada, union leaders are paying close attention to a fight over pension, and by the looks of things, this fight is just getting started.


Bernard Dussault, the former Chief Actuary of Canada, was kind enough to share his thoughts on Air Canada's pension dispute:

It is not the first time that I hear the representative of a defined benefit plan sponsor saying, like Air Canada spokeswoman Isabelle Arthur (“the airline has 26,000 active employees in its pension plan, which has to provide pensions for 29,000 retired workers, so we have to find a solution that ensures that Air Canada remains a viable company"), that the high ratio of pensioners to active members of the pension plan causes financial hardship to the sponsoring company. This is a myth. When a private plan is fully funded, this ratio has no impact whatsoever on the financial status of the sponsor because all money required to pay all future benefits to existing pensioners is already “in the bank” (i.e. the pension fund). Air Canada’s pensions-related financial hardship is mainly (if not exclusively) caused by all contribution holidays taken so far by the sponsor.

For a different perspective, read Jonathan Forethought Risk blog comment on Air Canada. Jonathan states that he believes that the divide was caused by a mismatch of risk, not contribution holidays. In fact, he demonstrates that Air Canada has been making regular contributions to its fund. I think mismanagement by the previous pension fund officers and contribution holidays are to blame.