Wednesday, June 1, 2011

Reducing the Risk?

Roger L. Martin, dean of the Rotman School of Management and author of Fixing the Game: Bubbles, Crashes and What Capitalism Can Learn from the NFL, writes in the Ottawa Citizen, Reducing the risk (HT: Bill Tufts):

In the wake of the spectacular 2008 financial markets crash, much has been made of the fact that no one has been held to account. Life has returned to near normal, and other than the failures of Lehman Brothers and Bear Stearns, little has changed in reaction to the mortgage meltdown.

The too-big-to-fail banks received hundreds of billions in bailout funds. Compensation for corporate executives is back on the upswing -by 11 per cent in 2010, according to the Wall Street Journal. Citigroup's Vikram Pandit, almost turfed back in the darkest days of the crisis, just received a nearly $17-million bonus package aimed at keeping him in his job through 2015.

But the most concerning number for many pundits is zero. That's how many corporate executives have been charged, indicted or convicted of malfeasance related to the crisis. It seems unimaginable -billions of dollars in wealth wiped away through risky, profit-maximizing deals and not one individual crossed the line into illegality.

This outcome has had many clamouring for greater regulation of the financial markets -more oversight, tighter controls and new regulations on complex derivatives. Unfortunately, those clamouring for greater accountability for private sector firms are fighting the wrong battle. As just one small player in a global economy, there is precious little Canada can do in the way of regulation in the financial markets to prevent another crash.

But, instead of ineffectually regulating at the margins, we can take clear and decisive action on one of the real root causes of the meltdown: the 2&20 formula.

The 2&20 formula is shorthand for the way in which hedge funds and other large market makers are compensated. They receive a base fee of two per cent (or three per cent or five per cent) of assets under management, plus 20 per cent (or 30 per cent or sometimes more) of any upside returns -called "carried interest." This fee structure is almost identical to the stock-option compensation models that came into vogue in Silicon Valley in the late 1990s. Those kinds of stock options fell into disrepute when it became clear that allupside options give executives precisely the wrong kind of incentives.

Give a CEO a good base salary and significant stock options, and you've given her a mandate to swing for the fences, taking on huge risk in hopes of accruing huge rewards. If the risks don't pan out, the CEO can fall back on that base salary, even as the company takes substantial losses. If the risks do pan out, however, the CEO gets massively rich.

The same structure applies to a hedge fund with a 2&20 formula. The fund gets two per cent of assets under management no matter what. So downside losses aren't terribly worrisome when balanced against the potential reward of a huge home run on the upside. Hedge funds are therefore incented to take massive, risky gambles in the market. And the nature and size of those risks have the effect of actually increasing the volatility of our capital markets.

Of course, hedge funds aren't going anywhere, and the Canadian government would have a limited capacity to regulate a massive global industry regardless. So, what can we do to better regulate and de-risk our financial markets?

Simple: We can better regulate some of the hedge funds' biggest customers -public sector pension funds and endowments. Canada's public sector pension funds are incredibly sophisticated and many, notably the CPP Investment Board, are exceptionally well run. But far too many have fallen under the thrall of "alternative investments" -which run directly counter to the best interests of their pensioners. The funds, whether university endowments or public sector union pension plans, should have incentive to generate long-term, steady growth in order to meet their future commitments. Yet those same funds have been chasing the high-risk, massively volatile, all-or-nothing returns promised by hedge funds.

This misalignment came into stark relief in 2008. In the lead-up to the crisis, pension funds began chasing higher and higher returns, wary of being found in an underfunded position relative to future commitments. Soon, they were caught up by promises of supernatural returns and public sector funds found themselves holding toxic and worthless alternative vehicles from funds of funds and the like. As the market declined, the pension funds lost billions. My own university's endowment fund lost more than a quarter of its value in fiscal 2009, as it unwound its alternative investment strategy.

Clearly the public sector funds were chasing returns, and they used hedge funds and risky investments to do so. They need clearer direction about the appropriate risk profile for the investment of public pension funds. They need clearer regulations to prevent them from heeding the siren call of hedge fund investing. In short, they need to be banned from investing with any firm that uses a 2&20-type formula.

Public pension funds should be permitted to invest only in funds that charge either an asset fee or a carried interest, but not both. The funds in which they invest must have some downside risk along with the investor.

Only under this structure would the needs of pensioners be better aligned with the incentives of their money managers.

Mr. Martin makes an excellent point on hedge funds becoming large asset gatherers, collecting 2% management fee and ignoring the 20% performance fee. When hedge funds have more sales staff than investment professionals, run away, they're not aligning their interests with their investors who are looking for high risk-adjusted returns (that means you protect the downside).

But Mr. Martin is completely wrong blaming hedge funds and public pension funds who invest in hedge funds and alternatives as the root cause of the financial crisis. You can blame greedy bankers, but not the hedge funds or private equity managers. By throwing the baby out with the bathwater, he demonstrates his ignorance on hedge funds.

While 2&20 can be a problem when assets explode, the truth is it aligns interests with investors because the best managers focus on delivering high risk-adjusted returns. Unlike mutual fund managers and bank prop traders, hedge fund managers have ther own personal wealth in the fund - - skin in the game which is why they focus on minimizing downside risk.

Admittedly, the bulk of hedge funds are just selling beta as alpha, but there are plenty of managers that are generating real alpha. Should we do away with management fees? Maybe after a hedge fund passes a critical asset threshold. The other option is to use managed accounts and negotiate lower fees. This is where more and more of the large pension funds are heading because it allows them to have full control of their hedge fund investments, allowing them to control liquidity and operational risk.

I disagree with Mr. Martin. Public pension funds should be investing and even seeding hedge funds, but they should be going about it in an intelligent way, using managed accounts. Only then will they be truly aligning their interests with their stakeholders. Finally, as far as Mr. Martin's university endowment fund and other endowment funds, I know for a fact they took stupid risks that had nothing to do with the alternative investments they invested in (like asset-backed commercial paper).

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