Friday, April 29, 2011

A Fairy Tale Ending?

Over two billion people around the world watched the royal wedding on Friday. My hunch is that the overwhelming majority were women (guys aren't that into fairy tales). I have to admit I caught a glimpse of the royal wedding as it ended this morning and thought they were a beautiful couple. Kate looked so poised while William looked a bit nervous but happy.

The royal couple looks very much in love, which along with health is the most important thing in life. Without love and health, all the money in the world is meaningless. Whenever I look at William and Harry, I'm reminded of their mother and the summer of 1997. She died a couple months after I was diagnosed of multiple sclerosis (MS) and while her death was tragic, it helped distract me from my diagnosis and gain some perspective on life.

Opinions are divided on the royal wedding. Cynics will claim that it's a major distraction, opium for the masses to divert attention from the harsh reality of austerity in England. Royal watchers will claim that it's all about tradition and being proud of the royal family. I'm somewhere in between and look at it for what it is, a boon for tourism.

But what's really amazing is how fast London has bounced back after the 2008 financial crisis, leading Brett Arends of MarketWatch to ask if it's the world’s hottest real-estate market?:
I hesitate to use the overplayed word “bubble.” But in the case of London property, it’s hard to avoid.

What’s happening here is absolutely ridiculous.

Markets are being impacted by housing-sales data along with fears over northern European economies and a stronger Japanese yen.

Look in the window of any real-estate agent here and you think people have gone crazy — and then you realize that the prices are in British pounds, and that to convert to dollars you have to add another 60%.

Half a million pounds ($800,000) for a one-bedroom condo with a small garden on the southern, unfashionable side of the river Thames? Really? And $2 million for a modest two-bedroom condo in Chelsea?

As John McEnroe used to say at Wimbledon, you cannot be serious.

While the rest of Britain grapples with austerity, falling real wages and budget cuts, London real estate — super-prime London real estate, the best of the best — is back in the grip of another mania.

According to an index maintained by high-end real-estate firm Knight Frank, prime central London prices are nearing and may even be surpassing the giddy levels seen at the peak a few years ago. The brokers’ windows tell the same story.

It’s like that whole Lehman thing never even happened.

What’s going on?

“London property is the ‘Swiss bank account’ of the 21st century,” Robin Hardy, an analyst at London investment firm Peel Hunt, explained to me. Rich people in places like Egypt, Syria and southern Europe are rushing to get their money away from the turmoil, and for want of a better alternative, they are plunking it down in the “millionaire’s playground” of central London.

“It’s seen as a relatively safe place to put your money if your objective is capital preservation,” he said. They think money is “safer invested in an apartment in Sloane Street than in a bank account in Damascus.”

Foxtons, a high-end real-estate agency, told me that 80% of its sales this year at its Sloane Square branch have come from overseas buyers.

This is just the latest twist to a story that’s been running for some time. Gulf sheikhs. Russian oligarchs. Newly rich Indian and Chinese tycoons. London has become a magnate for the international super-rich: a millionaire’s playground. Russian money has been flooding in for at least a decade. One hedge-fund manager here told me London property was a “laundromat for Russian money.”

You can see it in the fanciest shopping districts, from Jermyn Street and Old Bond Street.

The booms in oil and emerging markets have been very good for prices here for at least a decade. Great Britain, through generous tax treatment of foreign nationals, has cleverly encouraged the trend.

A friend of mine a few years ago described how a Gulf sheikh was steadily buying up more and more of her condo development just north of Hyde Park. The sheikh liked to come to London for two months every summer to escape the Gulf heat, and he liked to bring his extended family and entourage. He didn’t care much about price, and he wanted as many condos as he could get.

There are other factors at work. London has become the financial capital of Europe. The giant money machine has spread far beyond the old financial district of the City of London. High-powered hedge funds and secretive commodity firms crowd the alleys and lanes of Mayfair and the towers of redeveloped Docklands. The windfalls have long been seen as a major driver of property prices.

Housing supply is limited, especially in the best areas. London has tough zoning laws, so there is very little new development.

And you can also throw into the mix low interest rates. A friend explained how his grossly overpriced home cost him very little every year, because he is paying just 1% interest on a flexible mortgage.

To hear people tell it here, this miracle will go on indefinitely. Prices will keep rising skyward. You no longer encounter many bears of London property. Most have given up.

But there are a couple of wrinkles that should give people pause.

First, you see more and more dark windows. On Sunday I went to a pub with one of my oldest friends. He described how more and more properties in central London were simply unused most of the year. You’d look up at the windows as you walked down the street, and very few were lit up.

A recent study by Knight Frank found that one of the top reasons the international elite gave for selling a London home was simply that it was surplus to their needs.

The second concern is that more and more actual British are being crowded out of the city. Over dinners in the past 10 days, both a London member of Parliament and a top executive at a fund firm here have bemoaned the fact that young people can no longer afford to move into the usual London neighborhoods when they start their careers here. They’ve been priced out. Many of the middle-class are suffering the same fate. Ultimately, this simply becomes unsustainable. It will strangle the city’s vitality.

The third problem is that 1% interest rates will not last forever. Sooner or later they will have to rise, and when they do, a lot of home loans will become unmanageable as well as unrepayable. Happy times.

The fourth issue is one that often gets forgotten. In the age of the Internet and modern technology, the comparative advantages of big, expensive cities like London are actually in decline. Twenty years ago, if you wanted to run a hedge fund in the British Isles, you probably had to do it in London. That is no longer the case. It is a lot cheaper — and the quality of life much better — if you move out of town.

The fifth problem, though, is probably most ominous: the plunge in rental yields.

According to Knight Frank, while prime London sales prices have doubled in the past 10 years, prime London rents have risen by less than 10%. The net result is that landowners are getting a gross yield of maybe 3.6% on average, compared to more than 6% a decade ago. Conversations I’ve had — with renters and owners — suggest some are getting even less.

Once you subtract all the costs of buying and selling a home, maintenance, taxes and condo fees, some landlords are making very little — if anything.

As usual, the defenders of current prices are quick with a rebuttal: “But people aren’t investing for the yield,” they say. “They are investing for the capital gains!”

Alas for this argument, in a rational market, yields are the drivers of capital gains. The price of an asset goes up because the current owners are earning so much money that outsiders want in. The idea that people will keeping bidding up prices of an asset that makes no money is quixotic at best.

Will it turn? If so, when? It’s anyone’s guess. But for those living and working in Britain, the conclusions are pretty obvious. If I moved back to this country, I would avoid living and working in London if at all possible. And if I had to be in London, I’d rent.

If I had to live there, I'd rent too but I wouldn't live in London if you paid me all the hedge fund bonuses in the world! Loved visiting the city but it's way too overcrowded and outrageously overpriced. Blame the "Russian oligarchs" or the "Gulf sheiks", but at the end of the day there is a lot of hedge fund money in London that is bidding up prime real estate prices (that's how hedge fund managers compare penis sizes).

It's ridiculous and the same nonsense is happening in Canada. I see condos in Old Montreal selling at ludicrous prices. My buddy out in Vancouver just bought a $2 million home in the outskirts (modest house; no comparison to his $1 million dollar house in Mont-Royal here in Montreal) and could have easily made 10% if he flipped it after a month. He tells me rich Chinese are snapping up properties like crazy so they have have one foot outside China. Little do they know they're contributing to the Canada bubble fed by Canada's mortgage monster which will eventually explode.

Whatever the case, I've heard these stories of "real estate prices can only go up" forever in Greece. Guess what? When people need to sell, they sell, and that's what is happening right now in Greece, Spain, Portugal and even in the coast of France (many British sold their summer houses there for financial reasons). If you're looking for deals, forget London, you're better off looking at these countries first. When it comes to London's property market, I fear there will be no fairy tale ending.

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Thursday, April 28, 2011

Are States' Pensions the Next Crisis?

Virginia's News & Advance reports, Are States' Pensions the Next Crisis?:

Just as America is finally showing signs of digging out of the financial meltdown and the Great Recession of 2008, there are already warning bells being sounded for the next possible scare: government pension programs.

Earlier this week, the Pew Center on the States issued the results of its “fiscal stress test” of the 50 state pension programs, and the results are troubling to say the least.

All told, the Pew center estimates that government pension funds and health care programs are underfunded by more than $1.2 trillion today, a clear sign that something must be done now to avoid a great deal of misery down the road.

Though the Pew study looked at pension funds during 2008 and 2009, the depth of the Great Recession, the results should serve as a wake-up call to political leaders across the nation, including here in the Commonwealth of Virginia.

The Pew center reports that 31 states are funding their government pension funds at levels below the point most experts consider safe, 80 percent of the plan’s expected needs.

Several states — California, Illinois and Ohio are among the worst — have shortfalls dangerously below safe levels. Illinois, the worst state, has only 51 percent of its plan’s projected needs currently funded.

Here in Virginia, while we’re not as bad off as some, there’s not much to be proud of.

The Virginia Retirement System, with about $56 billion is assets, currently has a projected shortfall of $17.6 billion. While that doesn’t mean that VRS, the source of retirement income for thousands of state and local government workers, is in any danger of becoming insolvent, it’s not a sign of long-term health.

Leaders of the General Assembly and the governor recognize the long-term problem of underfunding the VRS, but that hasn’t stopped them from dipping into the plan’s reserves in the past to cover holes in the commonwealth’s budget.

Such was the case during the 2010 session of the Assembly, when more than $620 million was shifted from the VRS coffers to the General Fund in order to balance the budget.

The Assembly promised to repay the VRS, with interest, but, to date, their promise remains just that: words.

Virginia’s not alone in “borrowing” from its pension funds, according to the Pew study. Many states decided to skip their payments to their employees’ pension plans in order to shore up their current cash reserves.

But what they don’t want to admit is that, sooner or later, the bill will come due. And the longer they wait, the higher the bill will be.

There is still time for state leaders, here in Virginia and across the country, to own up to the magnitude of the problem and take the actions needed, whether that’s cutting benefits or raising taxes and cutting spending in other areas to cover their obligations.

And they need to do it sooner rather than later.

You can read details on the Pew study by clicking here. Below are the highlights on The Trillion Dollar Gap Growing Wider:

The gap between the promises states have made for public employees’ retirement benefits and the money set aside to pay for them grew to at least $1.26 trillion in fiscal year 2009—a 26 percent increase in one year—according to a Pew report.

The Widening Gap: The Great Recession’s Impact on State Pension and Retiree Health Care Costs analyzes 2009 and 2010 data on states' funding of pensions and retiree health care. The report shows how states’ retirement systems—many of them already on shaky ground—were affected by the Great Recession:

  • Pension funding shortfalls accounted for $660 billion of the $1.26 trillion gap, and unfunded retiree health care costs accounted for the remaining $635 billion.
  • States had only about $31 billion, or 5 percent, saved toward their obligations for retiree health care benefits.
  • State pension plans were 78 percent funded, declining from 84 percent in 2008.
The decline in states' funded status isn't shocking. Assets got hit during the financial crisis and liabilities exploded up as interest rates hit historic lows. It's important to remember that funded status will vary considerably year-to-year but swings a lot less over a four-year period. It took pensions many years to recover after the tech meltdown back in 2000, and this time it will take longer.

The problem now is that state pension funds still hold onto rosy investment assumptions, still use a high discount rate and states are still not topping up pension plans, increasing the retirement age and contribution rate or cutting benefits. Sooner or later, the chicken will come home to roost. Nonetheless, I don't buy all the fear mongering going on right now, all in an effort to weaken traditional defined-benefit plans. US state pensions need to be reformed, and new governance standards need to implemented at many state plans, but let's not blow things way out of proportion. This isn't the next crisis and anyone who thinks so is completely out to lunch.

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The L Word?

On Wednesday I had a nice chat with Jonathan Jacob of Forethought Risk, an independent risk advisory firm that educates and advises public and private pension funds, asset managers, an insurance companies to create a greater understanding an appreciation for the nature of risk and how to use it to the firm's advantage. They also advise treasury management functions on risk, risk valuation, how to hedge risk and provide transaction oversight to ensure pricing fairness.

Jonathan traded interest rate swaps for many years at Bank of Montreal and
even worked a year with the Fixed Income division at Ontario Teachers' Pension Plan during the financial crisis. After speaking with him, I simply don't understand how Teachers' let a guy like this slip through the cracks (absolutely terrible decision and just goes to show you that really smart and honest people get the short end of the stick during tumultuous times).

If you want someone to help you hedge risk, this is the person you want to talk to. Stop paying consultants who provide you with cookie cutter "one size fits all" solutions and get a hold of Jonathan who will provide you with tailor made strategies that fits the maturity of your plan and the duration of your liabilities. We both agree that the state of pension consulting is simply atrocious, with too many consultants cutting corners, offering the same advice to all pension funds without taking into consideration their unique characteristics.

Jonathan and I talked a lot about leverage, specifically how pension funds are using or misusing leverage. In June 2010, he wrote a comment for Benefits Canada, The L Word:
The global financial crisis has acted as a catalyst for many things—perhaps most importantly for pension funds, a renewed focus on risk. No longer does a lack of obvious correlation between assets presume protection, and the startlingly simple mantra “don’t buy what you don’t understand” has taken renewed prescience.

However, the decision to increase efforts at risk management does not make the process any easier. There are many mathematical measures of risk, including:

  • volatility: the magnitude of potential returns of a particular asset;
  • leverage: the borrowing of funds to increase exposure to a particular asset; and
  • correlation: how assets perform relative to one another.

Watch your liabilities

A pension fund may choose to measure the risk of its assets on a stand-alone basis or it may choose to measure it against the risk embedded in its liabilities. This second method of measuring risk often leads to liability-driven investing (LDI), which attempts to manage the risk of the assets in tandem with the risk of the liabilities. The implementation of LDI is subject to vast interpretation and may include the use of various tools, such as derivatives and hedge funds, not previously accessed by many pension funds.

One interpretation of liability-driven investing involves the hedging of all interest rate risk while maintaining current allocation to equities. Hedging is the attempt to minimize exposure to a particular risk (in this case interest rate risk), and it can be done through the use of a derivative called an interest rate swap, which does not require the use of cash, thus enabling the fund to maintain its cash in equities. It would seem that the use of swaps in this fashion reduces the financial risk of the pension fund as interest rate risk has now been hedged, while it retains upside exposure to equities. However, the fund has exchanged one form of risk for another.

The fund has undertaken a degree of leverage in that the notional value of the assets exceeds that of the liabilities. While this may be within acceptable risk parameters, it depends significantly on the expected correlation (how two securities move in relation to each other) of two asset classes. For example, the fund that layers interest rate hedging through derivatives on top of a cash equity mandate must consider the expected correlation of bonds and equities. Experience over the past 25 years shows that in times of stress Treasury prices are highly negatively correlated with (or opposite to) equity prices. Our pension fund manager can thus feel comfortable with the decision to layer on leverage since the interest rate hedge will outperform in an equity meltdown, while a rally in equities will likely improve funding ratios regardless of the underperformance of the interest rate hedge.

In the current environment, however, such analysis is fraught with potential pitfalls. The world economy is facing a tug-of-war between inflationary and deflationary forces. In the late 70s and early 80s when the world last faced significant inflation, equities and bonds were positively correlated as both sold off. A fund with leverage can lose much more than its allocated risk budget in such a scenario.

Another matter to consider is the “basis” risk between the interest rate hedge and the liabilities. There are many health ratios for pension plans, including the funding ratio and the solvency ratio. Depending on the ratio in question, the yields discounting the liabilities may be determined from the use of only Government of Canada bonds or it may also include corporate bonds. Interest rate swaps are highly correlated to both Government of Canada bonds and corporate bonds as the core interest rates are the same in each subclass of fixed income. However, both corporate bonds and swaps trade as a spread to Government of Canada bonds and these spreads can fluctuate significantly and in opposite directions. For example, at the outset of the credit crisis, corporate spreads widened significantly while swap spreads simultaneously tightened.

A final consideration for any pension plan considering leverage is the funding rate for the financed asset. The minimal benchmark for any asset should be the funding rate; otherwise, the leverage employed is a financial drag on performance. The asset being measured against this minimal benchmark depends on the outlook of the plan sponsor. If, in our example above, the benchmark asset allocation is a typical 60/40 equity to fixed income ratio then the additional 60% of assets used to hedge interest rate risk would be measured against this minimal return hurdle. On the other hand, if the pension fund’s benchmark asset allocation is a full interest rate hedge, then the equity allocation should be measured against this hurdle even though the interest rate swap is the financed asset.

Historically, strategic leverage of assets was not employed by pension funds because many did not use derivatives nor were they able to issue bonds. As funds have become more sophisticated, however, new avenues have opened up including the ability to use leverage. If employed with the proper understanding and risk limits, leverage can assist pension funds in reaching their funding goals.

Benefits Canada also had a recent summit notes on one plan's use of leverage:

Calvin Jordan, CEO of the Nova Scotia Association of Health Organizations Pension Plan (NSAHO) in Bedford, N.S., discussed how this DB plan uses leverage to improve its asset liability matching at the Pension & Benefits Conference today in Toronto.

The $3.6-billion plan’s asset mix is 25% fixed income (65%, but 40% is leveraged), 40% equities and 35% alternatives. “That [alternatives] may be on the high side,” said Jordan, “but it’s not including hedge funds.”

Using leverage in its asset strategy causes an increase in risk to the assets but a decrease in risk to the balance sheet, he explained.

Strategy has nothing to do with past results, said Jordan, it’s whether your strategy glues everything together.

Watch for more to come on this topic.

Jonathan and I also discussed the increasing allocation to private markets in many of the large Canadian pension funds. He rightly notes that a lot of this is done for mark-to-market reasons because pension fund managers have more flexibility marking these assets up and down whereas they can't do this in public markets.

I told him that when I started my blog, I started writing on the ABCPs of pension governance and blasted pension funds that were using bogus benchmarks in alternative investments. I strongly feel that it's critical that we demystify pension fund benchmarks once and for all, and stop claiming that added value at pension fund A is the same as added value in pension fund B. Importantly, if they use different benchmarks for their individual investment portfolios and if one uses a lot more leverage than the other, then added value is not the same!

Go back to read my recent comments on apples and oranges, OTPP's Neil Petroff on active management, and a look at the Caisse's 2010 Annual Report. It's worth noting that while Teachers' is leveraging up, the Caisse is reducing leverage across the board. Does this mean Teachers' is better at managing risk? Maybe or it just means they'll get whacked harder during the next crisis as they did in 2008 when they crashed and burned.

I have discussed how public pension funds are increasingly leveraging up to make the returns they're looking for. I have also discussed how public pension funds are increasingly allocating to private markets and hedge funds, another source of additional leverage (juice). The truth is private markets have been good to pension funds and senior pension fund managers. Guys like Claude Lamoureux, the former president and CEO of Ontario Teachers' made millions by allocating to private markets. In fact, almost all of the added value among all the large Canadian pension plans in the last 10 years or more came from private equity and real estate (and more recently infrastructure). No wonder senior pension fund managers can't get enough of private markets -- they've become stinking rich allocating to these investments.

To be fair, if you look at how corrupt and manipulated public markets have become -- with high frequency trading and naked short-selling -- you have to ask yourself why would pension funds not move all their assets into private markets. I used to think funds like OMERS were nuts to set long-term strategic asset allocation of private markets at 60%. I still feel this is going to be difficult but I understand why pension funds want to have more control over their investments and not rely as much on volatile public markets.

Getting back to the use of leverage at public pension funds, Jonathan shared some additional comments with me:

Just to let you know, I believe that many pension funds employ some use of leverage either knowingly or unknowingly. Some of the large consulting firms are recommending use of interest rate derivatives to hedge interest rate risk even while maintaining exposure to equities.

As I mentioned in the Benefits Canada article I sent you, there is extreme danger in times like these where the potential for serious inflation is non-negligible, to take care as fixed income is not necessarily negatively correlated with equities. My research has shown that this negative correlation (equities & FI) was a Greenspan invention which he used to fix the market after the ’87 crash by lowering administered rates. If you go back to the ‘70s, equities and fixed income both sold off due to inflation. Therefore, I recommend funds using these strategies to employ stops on some form of the leverage – either the equity or fixed income portion.

You should also be aware that I am not fundamentally against leverage as I think good uncorrelated alpha product on top of interest rate derivatives used to hedge the interest rate risk in a pension fund is a relatively solid approach. The trick is to find those types of assets.

Funds that employ leverage but may not be aware of such will find it buried in some private market investments such as private equity or real estate, which may use borrowed money to lever funds.

Funds that use leverage knowingly include OTPP, which issued bonds to back its real estate portfolio (this is a continuation of the way Cadillac Fairview managed its real estate portfolio).

I want to emphasize again that not all leverage is bad, but it should be used with the proper level of risk management and portfolio expertise.

On the question of inflation, I told Jonathan I don't see it without wage inflation. He agreed with me and sent me a recent comment of his on the wall of worry:

The stock market continues to climb a wall of worry, buoyed by "free money" - zero interest rates. But zero rates are really here to create inflation - real inflation, not the kind that increases prices of food, metals and energy. Real inflation is wage inflation and with high unemployment in the US, it is hard to see a way into real inflation. Meanwhile, the inflation generated by zero rates (higher prices of food, energy and metals) are simply taxes on the normal citizen. With greater funds set aside to drive, eat and build (shelter), there is less room for discretionary spending.While the demographics are not similar, we could be seeing a new iteration of Japan.

I thank Jonathan for providing me with his comments on the use of leverage in pension funds. We both agree that if used properly, leverage can add value to overall results. But we also fear that fiduciaries don't understand all the risks of using leverage in both public and private markets and all too often rely on spurious "one size fits all" advice that pension consultants routinely peddle. Unfortunately, much more needs to be done to address this lack of knowledge among fiduciaries.

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Tuesday, April 26, 2011

Currency Risk: Are You Feeling Lucky?

Pierre Malo, my former supervisor at PSP Investments and now president of Pierre Malo Consulting, sent me an article he published in the Canadian Investment Review, Currency Risk: Are You Feeling Lucky?:
Since the elimination of the Foreign Property Rule in 2005, most Canadian pension plans have become more exposed to foreign investments and therefore to currency risk. While a lot of attention has been paid to strategic asset allocation (and rightly so), fiduciaries often don’t know their exact FX exposure. Furthermore, they rely on luck when it comes to currency risk. This article will consider the reasons why a clear FX hedging policy is so important and what plan sponsors should consider when implementing one.

How exposed are Canadian pensions?

According to data from PIAC, the typical Canadian Asset Mix as of December 2009 included 21% “alternative” asset classes (Real Estate, Venture Capital/Private Equity, Infrastructure and others), and 37.5% foreign equities and bonds. Determining how much foreign exposure pension funds have from the PIAC data is not a straightforward process. One needs to make some assumptions. For the purpose of this analysis, we assumed that “alternative” asset classes (real estate, venture capital/ private equity, infrastructure, other assets and hedge funds) involve 50% foreign content.

Given this assumption, the foreign content of the representative Canadian pension plan would be hovering around 50%. This means that currency movements have the potential to seriously impact the risk/return profile, at least in the short term. The surprising point is that most fiduciaries do not realize the importance of their exposure to currencies, and therefore do not think enough about how to manage it.

Currency volatility

Since foreign returns need to be reported in Canadian dollars, pension plans face a “translation” risk at the end of each fiscal year. As we all know, currencies can fluctuate wildly from year to year. For illustrative purposes, let us look at the 1999-2010 period, using the IMF database.

The average yearly change for the period is “only” -2.5%. However, the standard deviation stands at 11.8%. Moreover, the range of the annual changes is -23.9% and +18.2%, and the USD is down a whopping 29.3% for the period.

Few fiduciaries would be willing to accept such large swings on 50% of their assets without having seriously thought about it.

Possible impact

What are the potential consequences of not addressing the FX questions?

To say the least, the impact of currency volatility on 50% of the portfolio can potentially have disastrous effects. To illustrate this point, let us look at the returns of Canadian diversified portfolios since 2002. According to the Morneau Sobeco data, the average difference between the 1st and the 3rd quartile for a diversified fund is 3.9%, while the average difference between the 5th centile and the 95th centile is 10.3%.

Now, let us bring our currency volatility measure back into play. If 50% of your assets were exposed to a standard deviation of 11.8%, you would have about one chance out of three (one standard-deviation) that your overall returns would be impacted by more than 5.9%. If returns are normally distributed, this means that you would have a 15% chance to drop from 1st to last quartile (or vice versa if you were lucky). You also would have a 2.5% chance of dropping from 5th centile to 95th.

Yes, Foreign Exchange exposure should be managed.

Managing your FX risk.

At a minimum, fiduciaries need to know their exposure to foreign exchange in order to avoid surprises. Centralizing the information within a single department would help accomplish this. The collected information will serve as the basis for the development of a hedging policy. Fiduciaries also need to decide how this exposure is managed (passively or actively), and by whom.

Deciding on a hedging policy is not a simple task. Many conflicting theories have persisted over the years:

  1. The long term expected return of currencies is zero, therefore, the hedging ratio should be zero.
  2. Canadian pension plans have Canadians liabilities, therefore the hedging ratio should be 100%.
  3. Canadian inflation includes a portion of international inflation, therefore the hedge ratio should reflect this basket
  4. There is a high positive correlation between equities and the Canadian dollar. Therefore, Canadian pension plans should not hedge their foreign equity exposure, but they should hedge their fixed income exposure as it is negatively correlated to the Canadian dollar.

Discussing the issues related to the hedging policy is not the point of this analysis. The point is that fiduciaries need to align their hedging policy with their investment beliefs.

Once the hedging policy has been decided, fiduciaries need to address the question of active versus passive FX managing. This decision is by no means easy.

For many people, including Mr. Greenspan, it is impossible to forecast FX rates. He once compared this exercise to tossing a coin. Others see an opportunity in the long-term trends of many major currencies. Here again, the decision should be aligned with the investment beliefs of the fiduciaries.

The third decision relates to the implementation of the FX policy: who has the knowledge, and therefore is best suited to oversee the global exposure?

In many pension plans, mandates are given to external managers. These mandates often incorporate some sort of FX exposure, as would be the case for an EAFE-based or an emerging market debt mandate. This situation can cause two major problems. First, the fragmentation of mandates often makes it very difficult to know the overall FX exposure of the fund, unless there is a centralized FX function. Second, different managers probably have different (and maybe incoherent) hedging policies, resulting in suboptimal overall hedging.

A related question pertains to the external managers’ skill at managing currencies. The foreign exchange market reacts to different stimuli and has its own intricacies. One should question the implicit belief that an equity manager has the proper skills to trade foreign exchange. Fiduciaries would not likely give a real estate mandate to a commodities manager, so why is would they assume that an equity manager has foreign exchange skills? The manager should be required to prove their skill in this area.

Finally, the operational mechanic of hedging can result in important differences in returns. A professional FX manager will know the best orders to leave at a specific time, and will know the various hedging vehicles available, including currency options and non-deliverable forwards.

FX risk is one of the biggest investment risks investors face today. Yet, in many cases, fiduciaries do not give this topic as much attention as they do to other aspects of investment. They should carefully consider their decisions going forward.

History has shown that the short-term volatility of currencies can have a huge impact on the returns of pension plans. To avoid unwelcome surprises, fiduciaries need to implement four measures:

  1. Develop a clear foreign exchange hedging policy,
  2. Decide between passive or active FX management,
  3. Centralize foreign exchange operations,
  4. Ensure that FX professionals handle FX operations.

I thank Pierre for sending me this article. When it comes to currencies, he's an expert. And he's right, too many pension funds ignore currency risk, leaving it up to luck, which ends up costing them on their overall return. If you have any questions on your hedging policy, I recommend you contact him at Pierre Malo Consulting. Currency risk shouldn't be ignored and fiduciaries need to address it properly by implementing a well thought out, comprehensive hedging policy.

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Sunday, April 24, 2011

The Big Secret?

Morgan Korn at Yahoo's Breakout reports, Superstar Managers Don’t Mean Superstar Returns: Renowned Investor:

Renowned investor Joel Greenblatt can't keep a secret.

The founder of Gotham Capital, the hedge fund he started in 1985 that produced 40 percent annualized returns under his 20-year tutelage, wants you to be rich. Very rich. And it doesn't mean pouring your hard-earned money into five-star rated funds or hiring talking head money managers (they are plenty of them on cable business channels). In Mr. Greenblatt's latest book, The Big Secret for the Small Investor, he decodes the secrets of Wall Street for the average investor and debunks the most common myths of investing.

What's the biggest secret revealed? "Investing comes down to valuing something and paying a big discount to that value," Greenblatt recently told Breakout. In his book, Greenblatt gives plenty of examples of how to determine a company's valuation with simplified numbers and mathematical equations. He strips away the grandeur and lays bare the basics of investing. Greenblatt says investors should look for a basket of companies that appear undervalued, because winning big in the stock market means "figuring out what something is worth and paying a lot less." Of course, determining a company's value and future earnings can be very difficult, even for the most sophisticated and experienced money managers, Greenblatt admits.

Another secret Greenblatt divulges is that market-cap weighed indexes beat most active managers —- and all successful managers go through periods of underperformance. Therefore, investors should avoid chasing managers based on prior performance stats -- as we know, past performance does not guarantee future success. Historically speaking, Greenblatt said 70 percent of active managers have underperformed the market over the past 10 years and "odds are investors are not going to find that superstar manager." Believe it or not, retail investors and money managers really do compete on an equal playing field, he adds. The market is "very emotional," and to separate the emotion from the reward, Greenblatt recommends buying ETFs —- specifically Value Index ETFs.

Follow Greenblatt's advice and your portfolio could soon be well ahead of the markets and outperforming even the most eminent managers. Warren Buffett and Ben Graham made fortunes looking for value, and so can you.

You can watch the interview below. Let me comment on Mr. Greenblatt's advice. Fist, I agree with him but with a qualifier (see below). The overwhelming majority of active managers underperform the market, especially after fees, so small investors are better off buying Value Index ETFs. In fact, some argue that large investors, like pension funds, are better off investing in a Fundamental Index instead of the traditional cap weighted index.

Go back to read my conversations with AIMCo's Leo de Bever on when the music stops and with OTPP's Neil Petroff on active management. Mr. de Bever discusses how he cut external manager fees considerably and moved assets internally to control costs and Mr. Petroff discusses the advantage that pension funds have over mutual funds which typically churn their entire portfolio every 12 to 18 months. Importantly, pension funds' longer time horizon allows them to be patient enough to ride out any short-term volatility and realize huge gains if they invest at the right time.

Now, let me share with you another secret, one that Mr. Greenblatt doesn't discuss. There are elite asset managers who have stellar long-term track records. I'm not just talking about some elite hedge funds, like Citadel, but other top long-only managers like Dodge & Cox Funds. I track the quarterly filings of roughly 50 top funds very closely, paying close attention to which positions they're increasing considerably, which positions they're cutting, and what are their new holdings. For me, this is all information that I use when analyzing markets.

I'm very careful not to read too much into quarterly filings because some hedge funds churn their entire portfolio every quarter, but that's why I also look at more long-term funds that look at holding positions for a longer period. I like seeing a bunch of elite funds buying the same stock at the same time, and then I put it on my watch list, paying close attention to technical and fundamental trends.

In my personal portfolio, I prefer taking concentrated bets on a few stocks than investing in any ETF, but if I were to give advice to the majority of small investors, I'd say stick with what Mr. Greenblatt is recommending and invest in Value Index ETFs. Most Long/Short hedge funds are long small cap value stocks and short large cap stocks. Most of these hedge funds underperform the small cap value index over a long period. So why pay 2 & 20 for mediocre results?

If you want to know where the elite hedge funds and asset managers are investing in, I am willing to share this information, but it's not going to be free. And just knowing where they're investing isn't enough. You have to also know whether they're manipulating certain stocks/sectors and how to beat the high-frequency trading platforms which are wreaking havoc in these markets. Knowing when to buy is crucial, especially for long-term investors.

Finally, I wish you all a Happy Easter.

Thursday, April 21, 2011

Caisse's 2010 Annual Report

Bernard Morency, Executive Vice-President, Depositors and Strategic Initiatives at the Caisse de dépôt et placement du Québec let me know that the Caisse just published their 2010 Annual Report, Building the Future on Solid Foundations (click here to download English PDF).

I've already covered the Caisse's 2010 results back in February but the annual report was not available at the time. The French version was available last week and on Thursday, the Caisse posted the English version.

Let me begin by going over some priorities mentioned by Robert Tessier, Chairman of the Board (pages 8-9):
During the past year, the quality of the relationship between the Caisse and its depositors remained one of the Board’s top priorities. From this perspective, it should be noted that we implemented a new collaborative model to ensure this relationship takes place in a climate of transparency and trust. In the process, the Board approved the fundamental reorganization of the Caisse’s portfolios to better suit the performance objectives, risk tolerance and asset allocation of the depositors.

The Board strongly supported the continued improvement of the Caisse’s risk management and is also very satisfied with the progress in this area. With the support of the Board’s Risk Management Committee and the close collaboration of the senior management team, the Caisse strengthened its risk management tools and processes with the adoption of best practices.

In addition, the Board is pleased that rating agencies Standard & Poor’s, Moody’s and DBRS confirmed the Caisse’s credit ratings, citing among others its enhanced risk management and financial strength.
Mr. Tessier adds:
The Caisse’s achievements in 2010 were also due to employees who brilliantly met their goals in an atmosphere of renewed confidence. We would like to thank them for their loyalty and commitment.

Overall, the Board believes that the Caisse made progress on all fronts. The financial results testify to this fact. The Board encourages the entire team to pursue the work under way with energy and to build a strong organization striving to improve its management in order to deliver, over time, the results expected by its depositors.
Next, we move on to the President and CEO, Michael Sabia, who wrote the following in his message (pages 10-12):
2010 was a year marked by economic and financial uncertainty. At the Caisse, we stuck to our basic principle of “common sense” that we have followed for the last couple of years: performance, client focus, rigour and simplicity.

This disciplined approach, I believe, enabled us to make a great deal of progress on our five strategic priorities aimed at strengthening the Caisse’s foundations for the long term. Our efforts were aimed at a number of key issues:
  • Collaborating with our clients
  • Restructuring our portfolios
  • Enhancing risk management
  • Strengthening our presence in Québec
  • Redesigning our internal operations
  • Improving our balance sheet
With rigour and discipline, our teams have refocused the Caisse on its core areas of expertise and, by emphasizing the importance of high-quality assets, they managed to navigate a difficult-to-predict landscape.

Thanks to their efforts, the Caisse is healthy again.

What strikes me most about our performance in 2010 is that the Caisse team clearly demonstrated its ability to execute an ambitious strategic plan while generating solid returns. In the coming years, facing an uncertain, volatile environment much like today’s, this execution capability will be fundamental to our success.

Many significant economic changes are under way worldwide – changes that offer as many opportunities to earn returns as to make costly mistakes. This will be an environment that demands vigilance and a capacity to understand underlying trends both in the near term and over the long run. The Caisse, like all investors, will have to remain very attentive to these shifts over the next 12 to 18 months – and especially over the longer term – to grasp their scope and better understand their significance.

In the Short-Term Two Opposing Forces

2010 was the second year of recovery after the 2008 crisis. Up until now, renewed growth required support from public authorities, at least in developed countries. Such support has exceeded US$2 trillion and largely contributed to the stock market rebound in the latter part of the year.

In 2011, however, we expect a deceleration in growth due to the removal of economic stimulus, debt reduction by consumers and governments in developed countries, tighter monetary policies in developing countries as a response to higher commodity prices, and austerity measures in overly indebted eurozone countries.

Two major trends will then struggle for dominance.

On the one hand, the marked improvement in several key economic indicators suggests that the renewed growth will continue for some time. In Québec, the infrastructure program launched before the economic crisis has supported growth, which helped eliminate the gap between unemployment rates in Québec and the rest of Canada for the first time in recent history. In North America, a significant improvement in corporate profits largely explains the increase in business confidence. In this environment, non-residential private investment is increasing rapidly and the employment situation continues to improve. All in all, this trend suggests that the recovery – albeit uneven – will persist despite volatility and lingering uncertainty.

On the other hand, this benign scenario is challenged by the persistence of worrisome downside risks. For example, will geopolitical changes in North Africa and the Middle East significantly disrupt oil production? Is political cohesion in Europe robust enough to ensure that austerity efforts are equitably shared? Will measures by the People’s Bank of China to ease inflationary pressures be successful? Will U.S. residential real estate finally show signs of stabilization?

The struggle between these two opposing forces will continue over the next 12 to 18 months. In our view today, it is very difficult to predict which of these tendencies will prevail. For that reason, remaining vigilant and agile will continue to be our top short-term priority.

If the moderate growth trend weathers the storm over the next 18 months, markets will nervertheless be buffeted by the consequences of the predictable exit strategies of public authorities, including both tightening monetary supply and government budget cuts. Of course, these impacts and their timing are likely to vary by region. Europe is already moving in that direction. In the United States, a fiscal adjustment will likely be initiated only after the next election. The Bank of Canada may resume its tightening cycle, while avoiding major policy differences with the U.S. Federal Reserve.

Market developments over the next 18 months will occur against a backdrop of profound structural changes in the global economic and financial environment. Every investor and every major economic bloc will be confronted with this reality.
Indeed, following 2008, it was easy to ride the beta wave higher, in the next few years, it will be challenging to deliver value added and risk management will be critical for large asset managers like the Caisse who invest in public and private markets all around the world.

Mr. Sabia goes on to write:
How can the Caisse successfully fulfill its mission in a changing and complex world both in the short term and in the years to come? At a minimum, I think we will need three things.

A Better Understanding of Fundamentals

It will be essential to stay disciplined and continue to invest where we have comparative advantages, for instance, in Québec. We must also develop a deeper understanding of the broader world that can be factored into day-to-day portfolio investment decisions. In that sense, greatly advancing our fundamental research capabilities has become an essential priority. Mathematical techniques alone are not sufficient to evaluate issues that are often qualitative in nature and demand judgment. An enhanced research capacity will be a vital tool for identifying sectors and markets with high growth potential, implementing appropriate strategies and making the right choices to generate long-term returns.

At the same time, an enhanced research capability will enable us to strengthen our risk management. Not only will we continue to closely monitor “conventional” risks, but we will also conduct more in-depth assessments of risks related to the economic, financial and political environment. To that end, in addition to the rigour and accuracy of our existing calculation methods and analytic tools, we will need to rely on informed, good judgment, based on a broader, more global view.

A Partnership Strategy

As well, we will consolidate and further develop our alliances with partners worldwide in order to make profitable investments for our depositors. Our strategy will place an emphasis on partnering with local stakeholders in promising markets where we plan to invest, so that the Caisse can benefit from their finer understanding of the market in question. We believe that the development of our global networks and multiple partnerships will also enable us to better support the international expansion plans of promising Québec companies.

The Expertise of Our Team, The Cornerstone of Our Future

The Caisse’s success ultimately depends on the expertise, talent and commitment of our people. Those qualities are very much evident at the Caisse, as reflected by our solid 2010 results. Our people will continue to make the difference in the future. Given the intense competition for professional expertise in today’s global financial markets, talent retention and recruitment will remain one of our top priorities.

With their rigorous and disciplined approach, our people possess the capabilities required to identify and seize real investment opportunities – not investment fads – that will create value for the next 10 or 15 years and provide the source of depositor returns.

In this way, we will realize the Caisse’s full potential to continue meeting the long-term needs of depositors and supporting the growth of Québec companies.

Ultimately, what matters to us is the long run. Because we are in a marathon, not a sprint. The Caisse is here for the long haul.
It truly is a marathon for pension funds. Go back to read my post discussing views from OTPP's CIO, Neil Petroff. Mr. Petroff said that pension fund's have a much longer time horizon than mutual funds, allowing them to capitalize on opportunities that take longer to reach their fully realized potential. When you're thinking over 10 years, not just next year, then you don't manage assets the same way and you're not afraid to take a concentrate position which may take longer to materialize.

Next, I bring to your attention Table 7 on page 28 which shows the evolution of the benchmark indexes over the last five years (wish every single major pension fund in Canada produced such a table!).

On page 30, there is a detailed analysis of the overall results. Some key points below:
  • For 2010, foreign currency depreciated against the Canadian dollar: 5.2% for the U.S. dollar and 2.6% for the EAFE basket of currencies. Hedging most of the currency exposure risk reduced the negative impact of the stronger Canadian dollar by approximately two thirds.
  • The Short Term Investments portfolio produced a return of 0.7%, 12 b.p. (0.12%) above its benchmark index. This performance is due to an environment of very low short-term rates.
  • The Bonds portfolio returned 8.4%, 160 b.p. (1.60%) above its benchmark index.Lower medium- and long-term rates during the year positively contributed to portfolio returns. About three quarters of the added value is due to insightful corporate bond selection. The other quarter comes primarily from provincial and sovereign bond selection.
  • The Real Return Bonds portfolio posted a return of 11.1%, practically identical to its benchmark index. This performance is essentially due to the decline in real long-term interest rates.
  • In the first half of 2010, infrastructure investments were grouped in the Investments and Infrastructures portfolio. In the second half, these investments were integrated into the new Infrastructure portfolio. For the year, the combined return of these portfolios stood at 25.4%, 1,413 b.p. (14.13%) above the benchmark index. This return is due to the good operational performance of the assets in the portfolio, particularly the airport service investments, including BAA, and energy assets, such as Enbridge Energy Partners, Interconnector UK and Noverco (Gaz Métro). The performance also stems from a general reduction in discount rates.
  • In 2010, the Real Estate portfolio’s return was 13.4%, 184 b.p. (1.84%) above its benchmark index. The portfolio benefited from a gradual improvement of the global climate for quality assets. Price increases in the retail and office building sectors in Canada and the United States, combined with a stabilization of fundamentals in the office building benchmark markets in the United States (New York, Washington and Boston), explain most of the portfolio’s performance.
  • The Canadian Equity portfolio generated a return of 15.7%,190 b.p. (1.90%) below its benchmark index. The portfolio’s absolute return is mainly due to high exposure to the energy and materials sectors. Relative to its benchmark index, the Canadian Equity portfolio maintains a greater exposure to large-capitalization companies with compelling fundamentals. In an environment where small companies outperformed their large counterparts, this stock selection primarily explains the underperformance of this portfolio relative to its benchmark index. However, the absolute return strategies contributed positively to portfolio performance.
  • The Private Equity portfolio posted a 26.7% return, outperforming its benchmark index by 2,474 b.p. (24.74%). The portfolio showed resilience to the financial crisis and its aftershocks in 2008 and 2009, due to the quality of its assets. In 2010, the portfolio’s high return was due to the combined effect of the good operational performance of the companies in the portfolio, increase in their EBITDA (earnings before interest, taxes, depreciation and amortization) and the notable reduction of their leverage, given this performance. The portfolio also benefited from the positive effect of rising stock markets on corporate valuations.
  • Leveraged buyout financing activities contributed nearly 50% to the portfolio’s performance. At the same time, development capital activities account for nearly 25% of the return, largely due to the stake in Quebecor Media, given its portfolio weight and excellent performance.
  • The Hedge Funds portfolio produced a 6.3% return, 11 b.p. (0.11%) above its benchmark index (see table 24). Directional strategies (i.e. Managed Futures) and strategies for distressed loans and emerging markets were the largest contributors to portfolio performance. In 2010, the Caisse tightened its hedge fund selection criteria in favour of transparency.
  • In a year that saw a sharp rise in public debt, corporations overall pursued their deleveraging efforts, contributing to narrower spreads. This improvement was particularly noteworthy in the United States. In this environment, management of the new ABTN portfolio, created on January 1, 2010, translated into a $509 million contribution to net investment results (see Table 24). This outcome is largely due to a $781 million increase in the value of the portfolio’s assets, buoyed by improving credit markets, reduced by the $284 million cost of hedge transactions.
  • As at December 31, 2010, the Asset Allocation portfolio posted a negative return of $77 million, particularly reflecting the cost of defensive measures taken to protect the Caisse’s portfolio (see table 24). Overweighting and underweighting of specialized portfolios had a $171 million negative impact on overall performance.
As I stated previously, strong outperformance in private equity, infrastructure, real estate, and bonds helped the Caisse beat its policy (benchmark) portfolio. The underperformance in public equities isn't drastic but I would be curious to know if they're using their full risk budget. (Go back to my comment on OTPP's Neil Petroff and read the concentrated bet they took on Transocean. There were many other large cap stocks that significantly outperformed their indexes in all global regions).

The table below shows an analysis of depositors' net assets for the period 2006-2010 (page 46; click on image to enlarge):

I bring this table up because it clearly shows how the Caisse recovered from the disaster of 2008. It also shows that operating expenses have been steadily declining. From the 2010 Annual Report:
In 2010, depositors’ net assets increased by $20.1 billion, with $17.7 billion in net investment results and $2.4 billion in depositors’ net deposits.

Over the last five years, depositors’ net assets climbed by $29.5 billion, increasing from $122.2 billion as at December 31, 2005 to $151.7 billion as at December 31, 2010. This increase stems from, on the one hand, $15.3 billion in net investment results and, on the other hand, $14.2 billion in depositors’ net contributions (see Table 25 above).

As at December 31, 2010, depositors’ total assets were $183.2 billion, compared to $170.7 billion as at December 31, 2009, an increase of $12.5 billion (see Table 26). This rise stems mainly from the $10.8 billion increase in investments. The Caisse also continued to strengthen its financial position, with a reduction of $7.6 billion in liabilities, which fell from $39.1 billion in 2009 to $31.5 billion in 2010. Liabilities, primarily used to finance investment purchases, largely consist of short sales, securities sold under repurchase agreements, derivatives and financing programs issued by the Caisse’s subsidiary, CDP Financial. The 2010 decrease in liabilities is largely due to the reduced use of securities sold under repurchase agreements.
This brings me to the use of leverage. You'll notice the Caisse is reducing its use of leverage whereas Ontario Teachers' is increasing it. This point was brought up in my comment on OTPP's Neil Petroff and in a recent article in La Presse by André Dubuc, Une avenue plus risquée pour Teachers' (only available in French). Mr. Dubuc cited yours truly and Michel Nadeau, the former second in command at the Caisse who said the "proportion of debt at Teachers' has increased constantly in the last four years and is approaching the dangerous peak reached by the Caisse five years ago". Mr. Nadeau added: "Just how far will Teachers' go on borrowing to keep increasing their returns?". The article also cites a finance professor who says that this type of leverage requires strong risk management, which Teachers' has implemented, focusing on liquidity risk.

The use of leverage is a contentious issue among pension funds in Canada. Some have that option, others don't. That's another reason to be careful when looking at headline performance figures. Teachers' 14.3% return in 2010 is higher than the Caisse's 13.6% but on an unlevered or equally levered basis, Teachers' underperformed the Caisse in 2010. Moreover, the Caisse's benchmarks for their specialized portfolios are tougher to beat.

And that brings me to my final comment on compensation. The Caisse's annual report had a detailed discussion on compensation. Not just boring details, but how individual performance is assessed. Table 68 below shows details on executive compensation. Once again, Michael Sabia has the distinction of being the lowest paid President and CEO of every major pension fund in Canada and the leaders of his executive committee are well paid, but still compensated less than their counterparts at Teachers' and CPPIB (to be fair, Mr. Petroff has been at OTPP longer than Mr. Lescure has been at the Caisse and he oversees both public and private markets, something which I think Mr. Lescure should be doing as well in his CIO functions).


I highly recommend everyone reads the Caisse's 2010 Annual Report. It's excellent and offers many insights for all institutional investors.

Finally, in the spirit of transparency, I will disclose that I recently finished a contract at the Caisse and had the privilege of working with a group of exceptional professionals, some which I knew and others that I just met. I saw firsthand the changes at the Caisse and have no doubt whatsoever that they're on the right track (if I didn't believe it, I wouldn't write it). There is still more work that needs to get done, but they have the right people to implement changes and confront the challenges that lie ahead.

Wednesday, April 20, 2011

Inflation Fears Dampen Pension Plan Gains?

Barbara Shecter of the Financial Post reports, Inflation fears dampen pension plan gains:

Inflation jitters and a stronger loonie dampened pension plan gains in the first quarter on the back of healthy stock market returns, according to a survey released Wednesday by RBC Dexia Investor Services.

Within the $340-billion RBC Dexia universe, pension assets earned 2.3% in the quarter that ended March 31, bringing 12-month results to 10.8%.

“Equities continued to do well despite the geopolitical tensions in the Middle East and the tragic events in Japan, but have been exceedingly volatile,” said Don McDougall, director of advisory services for RBC Dexia.

Canadian stocks were the top performing asset class for a third successive quarter as the S&P TSX Composite index gained 5.6%.

The two largest sectors, financials, which were up 9.1%, and energy, which gained 8.7%, accounted for the bulk of the increase. However, pensions were “generally under-exposed to both and subsequently lagged the index by 0.3%,” said Mr. McDougall.

“Over the year, pensions are up a solid 19.0% but trail the S&P TSX benchmark by 1.4%,” he said.

Canadian pension plans saw their bond holdings lose 0.2% for the first three months of 2011, as price declines outpaced coupon payments for a second successive quarter.

Digital Journal added some more details on the RBC Dexia survey:

Healthy stock market returns helped pension plans maintain momentum in the March quarter but inflation jitters and a stronger loonie dampened their gains, according to a survey just released by RBC Dexia Investor Services, which maintains the industry's most comprehensive universe of Canadian pension plans and money managers.

Within the $340 billion RBC Dexia universe, pension assets earned 2.3 per cent in the quarter ending March, bringing 12-month results to 10.8 per cent. "Equities continued to do well despite the geopolitical tensions in the Middle East and the tragic events in Japan, but have been exceedingly volatile," said Don McDougall, Director of Advisory Services for RBC Dexia.

Canadian stocks were the top performing asset class for a third successive quarter as the S&P TSX Composite index gained 5.6 per cent. "The two largest sectors, financials (up 9.1 per cent) and energy (up 8.7 per cent) accounted for the bulk of the increase, but pensions were generally under-exposed to both and subsequently lagged the index by 0.3 per cent," noted McDougall. "Over the year, pensions are up a solid 19.0 per cent but trail the S&P TSX benchmark by 1.4 per cent."

Foreign equities also contributed but currency losses on US and Japanese assets muted their gains. In the quarter, the MSCI World index appreciated 3.6 per cent in local currency terms but pensions only rose 2.6 per cent once converted to Canadian dollars. Year-over-year, currencies had less impact on performance as the loonie's strength in relation to the US dollar was more than offset by it's weakness against the other major currencies.

Canadian pension plans saw their bond holdings lose 0.2 per cent for the first three months of 2011, as price declines outpaced coupon payments for a second successive quarter. McDougall added, "With mounting speculation over higher inflation, weakness came from the longer end of the curve as long-term bonds declined by 1.4 per cent versus 0.3 per cent for the DEX Universe."

You can read the full RBC Dexia release by clicking here. Late this evening I spoke to a senior fund manager from an insurance company and he told me 2010 was one of their best years whereas Q1 2011 isn't as strong because their bond portfolio isn't doing as well.

The big question is inflation already a problem in Canada, forcing the Bank of Canada to resume increasing interest rates? According to Stéfane Marion and Yanick Desnoyers of the National Bank of Canada, the brisk rebound in March CPI will put pressure on the Bank of Canada to raise rates in July:
After the February low core inflation rate, a brisk rebound occurred in March with almost all of the components showing strong acceleration. As a result, the twelve- month core CPI experienced a substantial change from February to March (0.8 percentage points). In our opinion, the underlying trend of inflation in Canada is closer to 1.5% rather than the February number of approximately 1%. Core goods CPI registered its biggest March increase in more than 20 years. Despite the high flying Canadian dollar, core goods CPI is now back in positive territory on a y/y basis. Thus, the cyclical low for core CPI is now behind us. In its last monetary report, the BoC described Canada as an economy with "material excess supply". In light of this morning’s inflation data this wording appears to be too strong. The process of normalizing interest rates must resume in Canada. We think that a July rate hike is the most likely scenario.
Will the Bank of Canada resume increasing rates? Given the rise in core inflation, it's highly likely but remember, the Bank of Canada can't veer too far off from the Fed, so any rise in rates will be modest and gradual. Also, the Bank of Canada is concerned with the rise in personal debt. And then there is the bigger problem of the Canada bubble fueled by Canada's mortgage monster.

In other words, while inflation pressures are building, I wouldn't be reducing my exposure or actively shorting Canadian bonds, because when the Canada bubble bursts -- and mark my words, it will eventually burst -- those Canadian bonds will outperform all other asset classes.

Tuesday, April 19, 2011

How Low Can the VIX Go?

What's going on with market volatility? You'd think with Standard and Poor's putting the US government on notice that it risks losing its AAA credit rating and Greece teetering on the abyss, markets would be going haywire waiting for the next shoe to drop.

David Berman of the Globe and Mail asks, Why did stock market panic?:

Here’s yet another theory why U.S. government bonds are failing to react much to the Standard & Poor’s cut to the U.S. credit rating outlook: The bond market had already priced it in.

From Jan Hatzius at Goldman Sachs: “Clearly, the U.S. fiscal situation is unsustainable unless a large, multi-year fiscal tightening is implemented. However, there is no information in today’s report about the fiscal situation that was not already known. Academic research has generally found that rating agency actions lag market pricing, rather than lead it.” [Double SIGH!!]

This sounds reasonable, though it raises the question why the stock market was so quick to panic. The Dow Jones industrial average was down nearly 250 points at its low point during the day. Even though the Dow recovered about 100 points in afternoon trading, the stock market nonetheless stood out for its hysterical reaction to the S&P report.

The CBOE volatility index, or VIX – which is considered a fear gauge of the market – had jumped in early trading. But the gains were still slight: The index hit an intraday high of 19 before settling back to 17 in the afternoon, which is exceptionally low.

Last spring, during the stock market correction that followed the European debt crisis, the VIX had shot above 40. And during the initial reports of the Japanese earthquake and tsunami in mid-March, it rose close to 30. By comparison, Monday’s blip looks like nothing.

True, after surging as much as 23% Monday, the VIX dropped 7% closing at 15.83 on Tuesday, just above the 15.32 close of last Friday, its lowest finish since July 2007. So what's going on? Why are markets so complacent? Isn't the world coming to an end?

Perhaps the VIX isn't the right gauge of fear. At Zero Hedge, Tyler Durden posted a comment late Monday afternoon that the SKEW does not paint a remotely as rosy picture as does the VIX. Moreover, Tyler noted that the Credit Suisse Fear Barometer, another measure the "pros" look at is exploding up, suggesting that smart money is very scared right now.

I read the comment and then asked one of the best TAA pension fund managers I know to share his thoughts:
With vol at 15..it is reasonable for skew to be so steep. This market is a very low vol market, point in fact is 100 day realized vol on spx is below 12. However, it is prudent risk management to buy short term vol or gamma at these low levels because you benefit if a you have a big move in the markets. But the biggest anomaly is still long term volatility, which is sitting at 30. The past 5 years realized vol on spx is at 28. Unless you think we will have another banking crisis it will be very difficult for vol to realize this level. Interest rate curves are steep and the Fed hasn’t yet increased short term interest rate.
He added:
"...that is why I am moderately bullish..hedge funds are quick to short and real money is hedged.... We are climbing a wall of worry!"
We talked about the S&P debt warning on US debt and both quickly dismissed it as "bullshit". I want you all to repeat this sentence a trillion times: The US will never default on its debt -- EVER! Get that silly thought out of your head. It's beyond stupid and I'm sick and tired of the media fueling this nonsense.

Some lady on CNN tonight was painting a "nightmare scenario" where the Chinese "woke up one morning and stopped funding US debt". I was rolling my eyes as I listened to this nonsense. The Chinese need the US consumer and they're still an export-led economy. China's middle class is growing by leaps and bounds but they're nowhere near the point where they can wake up tomorrow and tell the US to screw off.

I'm also sick and tired of hearing about how Bill Gross is selling US bonds (yeah right!) and how the US is the next Greece. Total rubbish! When a possible Greek restructuring hit the newswires, investors fled to the safety of US Treasuries.

On the subject of Greece, that TAA manager sold his 2-year Greek government bonds last week and made a nice profit. On Monday, the yield on those 2-year Greek bonds rose to 20%. On Tuesday, risk appetite was buoyed after Greek debt sale:
Athens sold €1.625bn of 13-week notes and although the yield demanded by investors was 4.1 per cent – up from the 3.85 per cent paid at its last sale of these notes in February – there was healthy demand with orders for 3.5 times the bonds on offer.
I asked another sharp pension fund manager his thoughts on 2-year Greek bonds and here is what he had to share:

I’d want to buy ones with lower prices (discount to face); the assumption being that restructuring could take the form of a haircut off of face value. However, you don’t want to get too long a maturity, so you end up looking at 5- to 10-years. With short maturities, you’re playing the game of guessing how long they can delay any restructuring event, which we have no expertise in.

It looks reasonable from a risk-return standpoint even under the assumption that they will restructure; and if for some insane reason they don’t restructure, you make out like a bandit.

Even though Greece is forced to pay sky-high rates to borrow, and restructuring looks more likely than ever, I have a feeling some large hedge funds and asset managers are going to "make out like bandits" snapping up Greek debt at these levels.

As far as how low the VIX can go, it's anyone's guess, but it can go much lower and stay low for a very long time as the market continues to climb the wall of worry, which I predicted back in January in my Outlook 2011. There is a tremendous amount of liquidity which will propel all risk assets higher. Don't say you weren't warned.

Monday, April 18, 2011

OTPP's Neil Petroff on Active Management

On Monday, after S&P issued an unprecedented warning to the United States government, I was lucky enough to find Neil Petroff, Executive Vice-President, Investments and CIO at Ontario Teachers' Pension Plan (OTPP). Mr. Petroff only had a few minutes but was kind enough to discuss some issues which I will get to below.

First, Paula Vasan of aiCIO reports, Ontario Teachers' Petroff: 'Active Management Outperforms':

The Ontario Teachers' Pension Plan (Teachers') chief investment officer Neil Petroff, riding a 14% annual return in 2010, claims the fund's active strategy has added more than C$23 billion to the bottom line since its inception in 1990.

In a wide-ranging interview with Petroff, the CIO of Canada’s third-biggest retirement-fund manager claims: "If we were a passive fund, we'd be C$23.2 billion lower in value, with liabilities at the same level. That really speaks to the value of active management - you add value when you pay for active management."

This seeming evidence of the effectiveness of active management also supports the fund's mix of external vs. internal structures that come at a time of stellar growth for the fund. Regarding the value of internal vs. external management, Petroff replies that all departments of the fund outperformed last year due to their embrace of both processes of active management. "As long as the internal team earns appropriate risk-adjusted returns given the cost, I'm indifferent to which approach is utilized," Petroff tells aiCIO.

Furthermore, Teachers' benefitted from a range of transactions and investments in 2010, such as the fund's purchase of UK's national lottery operator, Camelot, a UK high-speed rail, and interest in a Brazilian investment bank. "All those investment from 2010 have great potential to help pay our pensions going forward."

"This was the best year in the past 20 years in terms of dollar-value added," Petroff states, noting that large increases in real estate and private capital fueled the superior returns. According to a statement released by the fund today, Teachers' achieved its double-digit return in 2010 thanks to rising stock prices and gains in real estate. Net investment income totaled C$13.3 billion ($13.8 billion) last year, up from C$10.9 billion in 2009. The fund managed C$107.5 billion in assets as of December 31, compared with C$96.4 billion a year earlier.

Teachers' revealed that real assets such as infrastructure and timberland returned 13.9% for the year, followed by stock and private-equity investments (10.4%), fixed-income (9.9%), and commodities (3.2%). At the end of 2010, Ontario Teachers’ equity portfolio holdings were C$47.5 billion, up from C$41.2 billion a year earlier. Fixed-income assets were C$45.9 billion, up from C$35.3 billion. Meanwhile, the fund’s allocation to commodities rose to 5% last year from 2% in 2009, and was valued at C$5.2 billion at year end, up from C$1.9 billion.

Still, Petroff knows such high returns can't last forever. "This kind of return is something that's tough to repeat," he says. Despite the optimistic returns, the plan said it continues to face funding challenges due to factors such as member longevity, retirement periods that exceed working years, and low real interest rates, with an estimated funding shortfall that increased to C$17.2 billion from C$17.1 billion a year earlier.

Nevertheless, Petroff will try to repeat 2010's strong results. In terms of asset allocation, Petroff asserts that emerging markets will continue to be an area of intense interest for the fund. "I'd say that from a global perspective, emerging markets will do better than North American markets, and North America will do better than Europe," he claims, emphasizing his confidence in the long-term value of the sector. "We took most of our exposure in 2005 and 2006. Emerging markets are overheating now from an inflation perspective, but long-term, with their young populations and growing middle classes, the asset class is growing rapidly."

When questioned about the embrace of alternatives, which have enjoyed heightened popularity among institutional investors, Petroff voices his belief that the sector serves not as an asset class but more as an investment strategy. "We started our research in alternatives in 1995, and entered our first hedge fund in 1996. It's been an area that adds diversification to the total fund and it will always have a place in our portfolio."

It's interesting that Mr. Petroff mentioned the focus on emerging markets because I was reading an excellent white paper by AIMCo's Brian Gibson, a former colleague of Mr. Petroff, on how investing in emerging markets "is not what it used to be". Mr. Gibson concludes that "emerging markets are certainly not what they used to be, but they still represent a fertile area for generating attractive amounts of value added."

As far as hedge funds, it's no secret that Teachers' is one of the best institutional investors in the world (along with others like ABP). Claude Lamoureux and Neil Petroff hired Ron Mock in 2001 and he has done an outstanding job allocating billions to external hedge funds. Ron is now Senior Vice-President, Fixed Income and Alternative Investments, and one of the best pension fund managers I ever had the pleasure of meeting.

Back to Neil Petroff. We didn't have much time to chat but I did listen carefully to his comments. First, we talked about liabilities. He told me that every pension fund is different and has different liabilities. The duration of a plan's liabilities should determine the asset allocation and the benchmarks they use for their investment portfolios.

Teachers' has one client and manages both assets and liabilities. The profile of their liabilities has changed since now the ratio of working-to-retired members is 1.5 to 1 (was 4 to 1 when he first started working there). And those retired teachers are living much longer, placing additional pressure on the plan. Great news for teachers but you still have to pay out pensions longer. But the biggest problem with liabilities has been the decline in real rates (read my comment on Teachers' 2010 results for details).

He explained to me how benchmarks are set in accordance with liabilities and are routinely reviewed by senior staff and the board. I mentioned the case about T-bills in money markets and how prior to 2008, some Canadian pension fund managers were investing in illiquid non-bank asset backed commercial paper (ABCP) to easily beat their benchmark. He told me that Teachers' uses a spread over the OIS rate instead and manages liquidity risk extremely well, especially after 2008.

I let him know that I've been tough on Teachers' in regards to private market benchmarks. We talked a lot about benchmarks. He explained that Teachers' Private Capital does use a spread over public markets. As for real estate, infrastructure and timberland, they're long-term cash flow providers and the benchmark (CPI+575 bps) "isn't easy to beat over the long-term". True but I've seen some funny things in real estate where pension fund managers took big risks to easily beat their CPI+ benchmark. Mr. Petroff explained that Cadillac Fairview still has an operating benchmark of IPD and their operations focus on stable cash flows, just like infrastructure and timberland.

On this last point on benchmarks, one senior pension fund manager shared these thoughts with me:

Leo, I now you are very involved in comparing benchmarks. The more important difference is leverage implied by gross versus net assets.

OTPP made a lot of money on being able to run a leveraged balance sheet (150 B gross versus 100 net assets). They effectively borrowed 50 billion at an average cost of around 2% and made a decent 10% on that capital in 2010 and 2009, not so well in 2008.

If one is restricted from non-real estate borrowing, as some provincial rules require, that road for return/risk is closed. OTPP unlevered returns work out to about 10%, which is what I got to, with a lot of historical j-curve baggage.

One can argue whether it should be or how big it should be but those are the facts. Not sure where CDP (Caisse) fits on that scale, but my guess is that between recovering 2008 write-offs and leverage, you have a big part of the differential.

Finally, and most importantly, I liked what Neil Petroff told me about being "non-conventional and opportunistic". I mentioned that I wrote about the time Teachers' took a big position in Transocean Ltd. and publicly commended them for having the guts to take that position. "We did our homework and found that Transocean had virtually no liabilities". That position alone earned Teachers' nearly 80%.

Here is where the discussion got interesting. I told Mr. Petroff that I like asset managers who take concentrated positions. Teachers' did their homework, saw an opportunity and bought Transocean shares as they tanked. Did they also consult their external hedge fund partners? Maybe, but the point is they took a big position in a company that most institutional investors were steering clear from at that time. "We won't always be right but if we're right 60% of the time, making more on average than we lose, then we come out ahead."

Mr. Petroff added that unlike mutual funds "who churn their portfolio every 18 months" pension fund managers have a long horizon - ten years - and should be compensated that way. "The reason we can take concentrated positions is that we're not looking at quarterly returns like most mutual funds that are closet indexers." He also noted that a four or six years horizon is too short to evaluate a pension fund's performance.

I then proceeded to discuss how I see ideological warfare going on against traditional defined-benefit plans. He mentioned that the Economist did a special report on pensions falling short, and agreed with me that defined-contribution plans aren't the solution to the retirement crisis. "The value added we generated over the years would not have been available to teachers doing their own investing."

As we ended our discussion, I thanked him and asked him why Teachers' isn't a lot more transparent on their operations. "We can't share all our secrets because the minute we do, everyone is trying to mimic us." I agree, they can't share all their secrets, but pension funds can learn a lot from Teachers' and for me the most important lesson is to invest opportunistically with a long-term view and not be afraid of taking concentrated positions after doing your homework. If you're right most of the time, you come out ahead. That explains a big part of Teachers' success and why more and more plans are trying to emulate their active management style.