Saturday, March 31, 2012

More on Pensions in Budget 2012

A follow-up to my previous Budget 2012 comment focusing on pensions. James Bagnall of the Ottawa Citizen, Pensions still OK for those still on job:

More than 400,000 federal government workers across the country can relax. Their entitlement to rock-solid pensions, fully indexed to inflation, is intact.

Under measures introduced in Thursday's federal budget, employees will have to contribute more to their pensions before they collect them.

Assuming the new requirement passes a number of legal and practical hurdles, government employees eventually will absorb 50 per cent of the costs of providing promised pensions, compared with roughly one-third at the moment. It's not clear how quickly the employees' share will be hiked, though the process will occur over many years.

Current legislation caps the costs borne by employees at 40 per cent and puts annual limits on how much contribution rates may rise. At the moment, employees kick in 6.2 per cent of salary up to $50,100 (Canada/ Quebec Pension Plan current limit), and 8.6 per cent on earnings above that. Current rules allow the government to boost contribution rates of up to 0.4 per cent of salary each year.

Officials from Treasury Board, the government's employer, said legislation would be introduced to change both the cap and contribution rate.

They added that the government also would consult with unions and other interested parties.

Finance Minister Jim Flaherty said he also would increase the normal retirement age to 65 from 60 for anyone joining the public service starting in 2013.

These moves are designed to bring the federal government employee pension plan regime closer to those offered by provinces and parts of the private sector.

However, the reforms, if they indeed are implemented, will do little to narrow the huge gap between the value of pensions enjoyed by federal government workers and their counterparts in most of the private sector.

For one thing, the federal plans - which provide benefits for more than 330,000 retired public servants, military and RCMP workers - are based on a strict formula that guarantees certain levels of pensions: two per cent times years of service (up to 35), times the best five years of salary, all of it indexed. About 80 per cent of federal government workers can count on this kind of largesse, known as a defined-benefit pension.

However, only a small minority of private-sector workers have defined benefit plans, and many of the latter are under threat because the companies that sponsor them are weak financially and can't afford them. Most private-sector workers either have no pension, rely on their own registered retirement savings plan or belong to a defined-contribution plan - that is, they bear the risk of ensuring there's enough money to retire upon.

Just how valuable are the federal plans? Very. Consider the net present value of a $40,000 annual pension - in other words, the lump sum you would need in the private sector to generate this kind of pension. Using a basket of very safe dividends, blue-chip stocks and treasury bills, you would assume a return of roughly four per cent, implying a lump sum of $1 million.

Of course, it's much more complicated than this. For one thing, the federal government pensions are blended with the Canada/Quebec Pension Plan, which doles out small pensions to all Canadians. This would reduce the capital that would need to be set aside for the individual pensioner.

However, the fact of indexing also needs to be taken into account. Clues about the cost of this can be gleaned from government real-return bonds, which currently generate only about two per cent interest. This would imply a $2-million lump sum to create a $40,000 annual pension, absent the blended Canada/Quebec Pension Plan amounts.

Federal officials do not see it this way. A Finance Department expert points out that the Public Service Superannuation Plan assumes its assets will generate an annual return (including inflation) of 6.2 per cent, which implies net present value of $645,000 to create a $40,000 pension. Whether that's an appropriate yardstick is another question. Finance officials also note the government began moving toward a more balanced cost-sharing formula in 2005.

Indeed, the government, for more than a decade, has managed employee pensions through funds, rather than taking money out of consolidated revenue. Officials note the returns generated by these funds are in rough balance with pension obligations. Nevertheless, the net liability for the pension liability of public service, military and RCMP employees as of March 31, 2011, was $141.6 billion. Nearly all of this reflects liabilities incurred before the pension funds were set up in 2000.

With Thursday's budget, Flaherty and his fellow Conservatives are continuing a tradition of gradualism with respect to the public service. They are very aware of the resentment held in many quarters of the rest of the country toward federal pension benefits, but the Conservatives also appear keen to avoid a war over the one benefit that has kept so many employees wedded to the public service.

True, most of the liabilities of federal public sector pension plans were incurred before the Public Sector Pension Plan Investment Board (PSP Investments) was set up in 2000. That fund was set up to manage the liabilities of pension plans of the Public Service, the Canadian Forces, the Royal Canadian Mounted Police and the Reserve Force for post-2000 period.

Prior to 2000, the pension contributions were invested in non-marketable government bonds. Since real rates were deemed too low to fulfill these pension obligations, a pension fund was created to invest contributions in public and private markets to achieve the required actuarial rate of CPI + 4.3%.

On that point, Bernard Dussault, Canada's former Chief Actuary, sent me this comment on the article above:
Your $1,000,000 value of an annual lifetime indexed pension of $40,000 corresponds to an average 25 years life span at age 60 and investment returns at the same rate as inflation, which is quite reasonable for an average non investment expert citizen. The real rate assumed by government is 4.25%, not 6.25%, but its $625K is consistent with a 4.25% real rate of return.
The key point, however, is that public sector workers pay to obtain their defined-benefit pension plans and retire in peace and security. Those in the private sector aren't as lucky because they have to save a lot more and be damn good investors to achieve a retirement comparable to their public sector counterparts. In this wolf market dominated by big banks, elite hedge funds and high-frequency trading platforms, that is a tall, if not, impossible order to achieve.

Large public sector pension funds are able to shield themselves from the vagaries of these highly volatile markets by investing in the best public and private market funds. They're also able to pool assets and internalize many activities, lowering costs and delivering higher risk-adjusted returns than any defined-contribution plan.

This is why I've been calling for major reforms to pensions where all Canadians can have some peace of mind knowing their retirement assets are managed by professional pension fund managers who are able to invest across public, private and absolute return markets. Importantly, expanding coverage and getting the funding right is the only solution to stemming the inexorable tide toward pension poverty.

As far as MPs' pensions, the Canadian press reports, MP pension reform bill to be introduced in fall:

Legislation will be introduced this fall to turn the vague hints of MP pension reform made in this week's budget into concrete plans, government sources say.

Changes will be made to the age of entitlement and benefit levels, though they won't take effect until after the next election in 2015.

In the meantime, MPs will start contributing more to their own pensions next year and by 2016, will pay half.

In advance of Thursday's budget, the Conservatives hinted they would take a hard line on MP pensions, after they raised the eligibility age for Old Age Security benefits to 67 from 65.

But the budget Thursday was thin on details, sparking criticism that politicians weren't ready to take a hit while asking Canadians to take one on the chin.

"The fact that they put their own bank accounts ahead of the country at the same time as they are asking others to sacrifice, it's really disappointing," said Gregory Thomas, the federal director of the Canadian Taxpayers Federation.

MPs can start collecting their pensions at age 55, enjoying benefits worth up to 75 per cent of their salary. Unlike other Canadians, they also have a pension plan immune from any shocks to the stock market and indexed to inflation.

And while private-sector plans see employees and employers equally split the cost of contributions, the government report on the administration of MP pensions says they contribute just $1 into their plan for every $5.80 contributed by taxpayers.

Government House leader Peter Van Loan was coy about the coming changes Friday, saying there had to be consultation before anything could happen.

"I'll let that process unfold," he said.

Opposition MPs were equally uneasy about getting into the details of what changes could or should be made.

"You know, in terms of compensation for MPs, we have always said that … these decisions should be made by an independent body, and we would absolutely go along with whatever their recommendations are," said New Democrat MP Robert Chisholm.

The Liberals said it's not just MPs pensions that need to be addressed.

In 1992, Prime Minister Brian Mulroney implemented a special allowance for prime ministers who had served four years or more to be collected once they turned 65 or when they ceased being an MP.

The annual allowance is equal to two-thirds of the prime minister's salary, so for Prime Minister Stephen Harper's case, that will work out to around $104,000 a year.

"Mr. Harper proposes raising the age of retirement to 67," said Liberal MP Justin Trudeau.

"We propose he does the same thing for his special pension."

Love watching MPs with their snouts in the pension trough squirm trying to explain their generous, guaranteed, gold-plated pensions no matter what market conditions arise while they cut public sector jobs, raise OAS eligibility and do nothing to introduce meaningful pension reforms for all Canadians.

Having said this, I'm not calling for cuts to MP pensions or the Prime Minister's pension. We should raise the age they're eligible to collect these pensions, they should contribute more, but if we're going to attract good, smart people to public office, we should offer them some perks to what is a demanding job where everyone sees you with a cynical eye.

And the Prime Minister of Canada deserves a great pension. Period. If you think Harper's pension is generous, you have not seen the pension benefits accorded to the heads of Crown corporations and large public pension plans in Canada. This is on top of their short and long-term bonuses which run in the millions.

Finally, Jason Fekete of Postmedia News reports, Pension impact won't be small, OAS clawback could hit 6% of seniors:

Millions of Canadians woke up Friday with some disheartening news about their work lives and financial future: they learned that they may now need to work two years longer than initially planned.

The Conservative government's budget announcement on Thursday of a plan to gradually increase the eligibility age for Old Age Security and the Guaranteed Income Supplement to 67 from 65 will have profound impacts on the lives of Canadians across the country.

Finance Minister Jim Flaherty and the Harper government maintain the changes are necessary to ensure the financial sustainability of the OAS program for future generations, while the parliamentary budget officer and some pension experts insist the program is on sound financial footing.

Here's a bit of an explanation on OAS and GIS and what the changes mean to Canadians:

Question: Who is affected? Answer: Beginning April 1, 2023, the age of eligibility for OAS and GIS will gradually change to 67 from 65. Canadians 54 years or older as of March 31, 2012, will not be affected. People born between April 1, 1958, and Jan. 31, 1962, will become eligible to receive OAS benefits between the ages of 65 and 67, depending on their actual birth date. People born on or after Feb. 1, 1962, won't be eligible for OAS until age 67.

Q: What are the OAS and GIS benefits?

A: The average Old Age Security payout is $510.21 a month, with the maximum payment being $540.12 a month for seniors with less than $69,562 in annual net income.

The payment is gradually clawed back for those above that income threshold, until it disappears for those earning more than $112,772. The average GIS monthly payment is $492.26 while the maximum is $732.36. It is paid to seniors who make less than $16,368.

Q: How many seniors are affected by that OAS clawback?

A: The Caledon Institute of Social Policy calculated in a recent research paper that only 6% of seniors are affected by the OAS clawback and just 2.3% receive no Old Age Security. The institute argued that lowering the clawback on OAS would save more cash for the federal government, without affecting the majority of seniors who have low or average incomes.

"One can have a debate about when the clawback should start to happen and how much it ought to be. Those are judgment calls," finance minister Flaherty told reporters Friday following a speech to business leaders.

"We have a sharply progressive income tax system in Canada . . . some Canadians might think it's too sharply progressive or not sharply progressive enough, and similarly with the Old Age Security benefit."

Q: What's the incentive for working longer and deferring OAS payments?

A: People can voluntarily defer receiving their OAS benefits for up to five years, starting July 1, 2013, and will be rewarded with a higher, actuarially adjusted pension. For example, Canadians who defer the OAS pension for one year (to age 66 instead of 65) would receive about $6,948 annually (in 2012 dollars) instead of $6,481. Someone who defers the OAS benefit for the maximum five years would receive $8,814 instead of $6,481.

Q. Will the announced changes affect the Canada Pension Plan?

A. No. The CPP is a separate fund, available to Canadians who were in the workplace. It is actuarially sound and won't be touched.

As I stated before, Canadians have to stop whining on pensions. They have plenty of time to prepare for the increase in OAS eligibility. The Government needs to lower the clawback to ease the strain on low income seniors.

More importantly, the Government needs to introduce meaningful pension reforms to expand coverage for all Canadians, providing them with the same pension privileges of public sector workers and their elected officials. Everything else is like putting a Band-Aid on a pension tumor.

Below, listen once again to Ted Kennedy's famous 1978 speech passionately defending healthcare for every U.S. citizen. How long before courageous Canadian or U.S. politicians stand up to defend defined-benefit pension plans for the millions facing pension poverty? They too have a right to retire in dignity knowing their pensions are defended from the vagaries of this wolf market.

Friday, March 30, 2012

Budget 2012: Where's the Pension Beef?

Mark Kennedy and Jason Fekete of Postmedia News report in the Vancouver Sun, Pension eligibility age rises to 67 starting in 2023; public service will shrink; $5.2 billion spending:
For the first time since taking office in 2006, Prime Minister Stephen Harper's Conservatives have put their imprint on Canada through a budget that includes major changes to pensions, industrial research, immigration, energy and the size of government.

The development came Thursday, as Finance Minister Jim Flaherty introduced a budget touted by the Tories as a forward-looking plan to foster Canada's economic strength in the long term.

The fiscal blueprint, although identifying $5.2 billion in annual cuts to program spending within a few years, falls short of the austerity package that some had feared.

"Our government is looking ahead, not only over the next few years, but also over the next generation," Flaherty told the Commons in his budget speech.

"We are avoiding foreseeable problems while seizing new opportunities in the global economy. The reforms we present today are substantial, responsible, and necessary. They will ensure we are focused on enabling and sustaining Canada's long-term economic growth."

The $276-billion budget comes nearly one year into the government's majority mandate, and the Conservatives say they are using it to make ambitious reforms.

Among the highlights:

- The Old Age Security (OAS), the backbone of the country's public pension system, will be changed, starting in 2023, so that the age of eligibility is gradually increased to 67 from 65. The controversial change will affect Canadians under the age of 54.

- Government funding and incentives on industrial research will be shifted to promote commercial innovation to boost the economy.

- Environmental reviews of major oil, gas and mining projects will be shortened to ensure the ventures get off the ground sooner to promote economic development, and some reviews will be handed to the provinces only.

- The immigration system will be reformed to process applicants faster and emphasize getting skilled immigrants into the country to fill vacant jobs.

- Government program spending will be slashed by $5.2 billion within three years, a 6.9-per-cent reduction of the $75 billion in programs that were reviewed.

- Within the public service, 19,200 jobs will be eliminated over three years (4.8 per cent of the workforce), including 600 senior executives.

- The federal deficit, forecast to be $24.9 billion for the fiscal year ending this month, will be eliminated by 2015-16.

- The country's economy is forecast to grow by 2.1 per cent this year and 2.4 per cent next year.

- The military's budget will be cut by $1.1 billion within three years, while the Foreign Affairs Department will see its funding cut $168 million by 2014-15. Foreign aid will be sliced by $378 million within three years.

- Charities will be required to provide more information about their political activities and their funding from foreign sources.

- There are no major tax reductions and the government says there are no tax increases.

- The employment insurance system will be retooled to cap premium increases and to introduce pilot projects that remove "disincentives" for people on EI to also find work.

- The penny will removed from circulation this autumn, saving the Canadian economy about $11 million a year.

- The Canadian Broadcasting Corporation, the country's national broadcaster, will see its government funding slashed by $115 million — about 10 per cent.

One of the most significant changes is on Old Age Security.

Flaherty said Canadians are living longer and that the government had to act to ensure the sustainability of the retirement system for future Canadians, although the parliamentary budget officer and other pension experts argue the system is sustainable.

"We have to be realistic," Flaherty told reporters. "We want to make sure that the OAS is there for people in the future . . . It has to keep up with the times, quite frankly, with the longevity of people."

This is Flaherty's eighth budget and it comes after months of economic uncertainty worldwide. The debt crisis in Europe has sparked concerns about another global recession, and the economic picture in the United States has been showing signs of improvement after months of uncertainty.

Flaherty reiterated the message that Harper has been declaring — that Canada's economic future is tied to its ability to become a trading nation worldwide and to sell its most prized assets — natural resources — to regions such as Asia.

"Our goal is to strengthen the financial security of Canadian workers and families, to help create good jobs and long-term prosperity in every region of the country," said the finance minister.

"Still, it is not enough simply to maintain Canada's advantage among the major advanced economies. We must also position Canada to compete successfully with the world's large and dynamic emerging economies. In a changing global economy, we must aim higher. We must avoid falling behind. We must realize the enormous potential of our great country."

My first impression on the budget is that it's pretty good. Sure, they cut some programs but it wasn't draconian, most likely because the government is petrified of the looming crisis in Canada's over-leveraged housing market.

One positive, Thursday’s federal budget includes a new requirement for companies to insure any long-term disability plans they offer to employees, ensuring the disability coverage won’t disappear if a company goes bankrupt. Of course, that won't help Nortel's disabled former employees who are not assisted by this federal legislation amendment.

The increase in the age of pension eligibility doesn't take effect until 2023, giving people plenty of time to prepare. As I stated before, Canadians have to stop whining on pensions. If it was up to me, I would have phased in the increase in OAS eligibility over five years and not waited till 2023 (exempting poorer Canadians).

Of course, I would have implemented draconian reforms on pensions, consolidating many smaller public pension plans into larger ones, just like they're doing in Ontario and BC. But the most important pension reforms were not in the budget. Harper's Conservatives are still banking on PRPPs, just like Quebec is taking the lead with VRSPs.

This is the biggest travesty of the budget which nobody is talking about. Instead of pandering to banksters and insurance hacks, we need to expand the CPP or create new large public defined-benefit plans to cover more Canadians adequately in their retirement. If the Conservatives or any other party really cared about pensions, they'd create a pensions Minister and place guys like John Crocker or David Denison in that position. They're both retired (Denison this summer) and can make a strong case for boosting defined-benefit plans for all Canadians.

Can hear the skeptics crying out loud: "Oh, but Leo, we can't afford DB plans for every Canadian." This is utter rubbish, a dangerous myth! We got enough brain power and experienced leaders to help us expand coverage for all Canadians. I am sure Bernard Dussault, Canada's former Chief Actuary, would relish the opportunity to be part of such a project and so would yours truly.

I'll tell you what we can't afford. We can't afford to wait any longer on meaningful pension reforms. The trend toward pension poverty continues unabated. Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), arguably the best defined-benefit plan in North America, sent me these comments on shifting people into defined-contribution plans:

There seems to be an underlying myth behind these discussions that defined contribution plans are cheaper than defined benefit plans. Actually, facts show that the reverse is true.

The cost of operating defined benefit plans such as HOOPP is a fraction of the cost of operating the typical DC plan. And switching from a DB to a DC plan doesn’t save the employer any money if the contribution rates remain the same.

Switching from DB to DC plans is really about risk transference. By switching from a DB to a DC plan employers are shifting the risk of future underfunding from themselves to the employee and ultimately to the social welfare system. Savings to the employer are only achieved by lowering the employers contribution rates.

Government employers should view the decision to shift from DB to DC differently than corporate employers. You could say that corporate employers are acting rationally by shifting from DB to DC plans. This allows them to shift risk off of their balance sheet onto the employee and the social welfare system.

However, if you are the government, you are simply shifting the risk from one bucket to another – from you the government as employer to you the government as the administrator of the social welfare system.

In fact this shift makes the problem worse. Due to the higher cost of administering DC plans, for the same contribution levels they produce lower pension incomes (a UK study found that they produce pension incomes which were 50% lower for the same contribution rates!) creating a greater strain on the social welfare system.

Front end contribution rates are a function of investment returns and the back end benefits. The front end costs can only be reduced by reducing the back end benefits. Who bears costs and risk are a function of plan design and these issues can be dealt with within a DB structure.
These are all excellent points. As pension deficits mount for U.S. and Canadian companies, the shift into DC plans from private and public entities will have a profound effect on the social welfare system.

I've long argued that pensions should be treated exactly like healthcare in Canada. Canadians deserve to have the same retirement privileges as public sector workers and their elected officials. By the way,
MPs' gold-plated pensions untouched by budget, no change before next election:
So much for sharing the pain.

Retirement just got harder for ordinary Canadians and for public servants, but the gold-plated pension plan enjoyed by members of Parliament has emerged virtually unscathed — at least for now — from Thursday's federal budget.

The budget promises only to begin moving "over time" toward making parliamentarians pay 50 per cent of their pension contributions and vaguely refers to further "adjustments" which won't take effect until after the next election in 2015.

"So far, the government's been pretty hard on ordinary Canadians and there's no evidence that they're willing to lead by example at all," said Gregory Thomas, federal director of the Canadian Taxpayers Federation.

For most Canadians under the age of 54, Thomas noted: "You've just had two years added on to your working life, you've just had your old age security benefits postponed by two years," yet "they don't say a word about the MP pension plan."

"We've been led to believe that this government is capable of providing leadership and making tough decisions but, if it is, there's no proof of that in this budget at all."

The federation has long crusaded against the parliamentary pension plan, under which MPs who've served a minimum of six years are entitled to start collecting what critics contend is one of the most generous pensions on the planet at age 55.

MPs enjoy pension benefits worth up to 75 per cent of their salary — and indexed to inflation — while ordinary Canadians are restricted by law to tax-sheltered pensions worth less than one-fifth of their annual pre-retirement income.

The federation estimates that Prime Minister Stephen Harper will be eligible to collect an annual pension of at least $223,500 by 2015. Pierre-Luc Dusseault, a rookie New Democrat MP elected last May at the tender age of 19, can retire from politics at 27 and still be eligible to collect an annual pension of $40,000 once he turns 55.

Unlike the pension plans most Canadians rely upon, the parliamentary pension fund is immune to market meltdowns. It is not invested in the markets and its interest rate is set by regulation and paid for by taxpayers.

And whereas most private sector plans require employees and employers to each pay 50 per cent of contributions to their pension fund, the government officially reports that MPs contribute just $1 into their plan for every $5.80 contributed by taxpayers. The federation maintains the real ratio is more like $1 for every $23.30 from taxpayers, once disguised interest and accounting sleight of hand is taken into account.

Public service pensions are more generous than what most Canadians can count on — worth about one-third of their annual pre-retirement income — but they're still not as cushy as MP pensions. It appears civil servants are going to have to pay more and wait longer to collect them.

Federal public servants currently pay 36 per cent of their contributions, with the government (that is, taxpayers) picking up 64 per cent. The budget says the Public Service Pension Plan will be adjusted "over time" to a 50-50 contribution ratio, as will pension plans for the Canadian Forces, RCMP and parliamentarians.

Finance Minister Jim Flaherty said the change in contribution ratio will be phased in, starting next year. A spokesman for the minister later said the 50-50 ratio will be fully implemented in 2016.

"It'll take some time to get there but that's the direction," Flaherty said, adding that there has to be more consultations because the changes will impact collective agreements with the public service.

As well, the budget says for those who join the federal civil service starting in 2013, the normal age of retirement will be boosted to 65 from 60.

An official said the savings from the changes to public service pensions will be in the ballpark of $500 million.

There is no such estimate for the savings anticipated from the "adjustments" to the MP pension plan. Officials said that's because the unspecified future changes will require consultation and legislation to implement.

Thomas said the ambiguity "makes you question the government's resolve and its ability to lead through a difficult economic period."

"Are they putting the country first or are they still trying to figure out how to end their days on Parliament Hill with the most public dollars possible?"

While they're still guaranteed a soft landing when they retire, MPs will have to get by for now with a bit less money for running their Parliament Hill offices. One day before the budget, it was announced that spending for the House of Commons will decrease by $30.3 million or 6.9 per cent, including $13.5 million less for MPs and House officers, $13 million less for House administration and $3.8 million less for committees, parliamentary associations and parliamentary exchanges.

The reductions are to be phased in gradually and fully implemented by 2014-15.

I've got no issue with public servants retiring at 65, but MPs with their snouts in the pension trough need to share some of their good retirement fortune with Canadians who elected them in office. In short, let's stop the charade and let's get serious on meaningful pension reforms.

Those of you wanting to see more coverage on Canada's Budget 2012 can watch this Global News report. Below, Canadian Press reporters Rob Russo and Bruce Cheadle say the document looks years down the road as Canada's economy gradually improves after the recession.

Thursday, March 29, 2012

Smaller Hedge Funds Best Larger Rivals?

Sarah Krouse of Dow Jones Financial News reports, Smaller hedge funds best larger rivals:
Smaller hedge funds have outperformed their larger rivals over the last 16 years, according to an exhaustive study of over 20,000 funds by a team at the Imperial College of London.

The Risk Management Laboratory at the Imperial College of London’s business school used figures from research providers BarclayHedge, EurekaHedge, Hedge Fund Research, Morningstar and Tass in a bid to confirm previously studied trends in the industry.

They presented their findings at panel event in London this week.

The combined database, which the centre plans to update several times a year, includes 24,749 unique hedge funds and 48,121 share classes, covering the period from 1994 to 2010.

It shows that funds with assets under management of less than $10m delivered average annual returns of 9.89%, while those managing between $250 to $500m returned of 4.84%. Funds with between $500m and $1bn had average yearly returns of 5.84% and those with more than $1bn in assets delivered 5.45%.

The same was largely true for alpha, or the excess return; funds with less than $10m in assets under management delivered alpha returns of 7.25% per year; those with $250m to $500m posted 1.59%; those with $500m and $1bn delivered 2.8%; and funds with more than $1bn had alpha of 1.58%.

Robert Kosowski, director of the Risk Management Laboratory who co-authored a paper on the merged databases, said: "When there is evidence of performance persistence, it seems to be driven by small funds, not large funds."

The industry as a whole ultimately added value over the last 16 years, researchers found, pointing to an annual average value-weighted return of 7.36%. The study also found that younger funds outperformed older rivals and that those with management incentives performed better than those without.

Kosowski underscored the challenges involved in hedge fund data such as reporting biases and missing information on assets under management, both of which can skew results and not paint a full picture of a given fund or the larger industry. He stressed the importance of using multiple databases in drawing conclusions.

Despite the number of funds and share classes covered by the data, the Risk Management Laboratory at Imperial College found that only 3.7% of all hedge fund share classes appeared in all five databases, highlighting the lack of consistency across various data sources. Nearly two thirds of all fund share classes were only covered by one database.

The researchers are still working on a total figure for the assets under management in the industry.

Experts speaking at the panel event this week attributed the stronger performance of younger funds to factors such as their ability to move quickly in and out of markets and the fact that their managers oversee a limited number of funds.

Jeroen Tielman, founder and chief executive of seeding firm IMQubator, said: “If you have one moment to prove yourself in the market, you’re going to do everything in your power to perform well."

Panellists nevertheless highlighted the challenge that smaller funds face in securing investments from institutional groups with more rigid risk management requirements, as these tend to favour firms with longer track records.

David Yim, director at KPMG, who works with firms that invest in hedge funds, said: “Established managers have a momentum. What it all boils down to is that they want a return on their investment given a certain risk appetite."

There is nothing new here. Academics are merely pointing out what industry practitioners have known for years, namely, that performance typically tapers off as hedge funds grow their assets under management (AUM) beyond a critical threshold.

Importantly, when hedge funds become large asset gatherers, hiring more sales staff than investment staff, their alignment of interests become distorted, and they're content collecting the 2% management fee, leaving the 20% performance by the wayside.

Of course, there are always exceptions. Bridgewater is the largest and one of the best hedge funds with a long, stellar track record. There are many other exceptional large hedge funds but the truth is the majority are large, lazy asset gatherers.

I've seen hedge funds go from $500 million to a billion to $10 billion in a matter of a few years and seen their performance plummet as assets mushroomed. Investors who rush into hedge funds should pay attention to how they grow assets under management and where the managers are aligning their interests.

Think about it, 2% on $10 billion, $20 billion or more is a hell of a lot of money. Large hedge funds can afford to hire top talent with that kind of dough. However, most of them are just slick marketing machines which over-promise and under-deliver.

If the industry as a whole adopted new rules where for example, pass $2 billion, no hedge fund is allowed to charge a management fee, then it would be interesting as large hedge funds would be forced to compete more fiercely and keep the focus solely on performance.

Don't hold your breath, however, as all hedge funds think it's their god-given right to keep charging 2 & 20 no matter how many AUM they obtain. It's a joke, and the irony in all this is that the smaller, hungrier fund managers, are being shunned by large institutions writing big tickets. The placebo effect of large hedge funds is alive and well, distorting the alignment of interests that originally gave hedge funds their competitive edge.

Interestingly, there are always new funds popping up, many of which are worth investing in. Bloomberg reports that Neal Shear, who spent 25 years at Morgan Stanley, and Jean Bourlot, former commodities head at UBS, are starting Higgs Capital Management LLP, a commodities hedge fund in London (don't know them but heard they're good).

In Canada, I know of many mangers who deserve seed capital. Montreal and to a lesser extent, Toronto, are pathetic markets for seeding new funds. It's a travesty and drives me crazy because foreign institutions are clueless on the amount of alpha talent we have in these cities and our own institutions fail to support our home grown talent.

There are however interesting developments even in Canada. The Globe and Mail reports that former star hedge fund manager Jean-François Tardif, who “retired” from Sprott Asset Management LP in 2009, is now back in the investment business. Mr. Tardif, who is in his early 40s, has been hired by First Asset Investment Management Inc. to run a new closed-end hedge fund to list on Toronto Stock Exchange in May. Jean-François is a great guy and I'd invest with him in a flash.

Another French Canadian investment "star" who recently announced the opening of his first hedge fund in Montreal is my friend, François Trahan of Wolfe Trahan & Co. The fund is scheduled to open next week and I wouldn't bat an eyelash to invest with François. I've known him since my days at BCA Research and tracked him as he ascended from Ned Davis, to Bear Stearns, to ISI Economics and finally to Wolfe Trahan & Co.

François is an exceptional strategist and I think he will be an equally exceptional hedge fund manager. Apart from understanding the importance of macro investing (read the book he co-authored with Kathy Krantz, a great gal, The Era of Uncertainty), he's a person with high integrity and pretty much one of the nicest guys you'll meet in the industry (most people who achieve his success are full of themselves!).

In his recent Seeking Alpha article, Investing During Major Bear Markets, Jim Puplava of Financial Sense mentions Trahan's research:

In fact, supplemental data from last week continue to support the case for a strengthening U.S. economy:

1. Unemployment claims: 355k: 4-year low
2. ISM Non-mfg PMI 57.3%
3. Vehicle production: + 19% q/q a.r. in 2Q
4. Vehicle sales: 15.0 m, a 4-year high
5. Mfg IP: + 0.8% in January
6. Consumer Credit $17.8 billion
7. Total payrolls rose by 227,000 in February

Even more critical to the economic recovery is the fact that general inflation remains subdued as reflected in the monthly ECRI Future Inflation Gauge, which remained unchanged at 101.4 in February. Francois Trahan at Wolfe Trahan maintains that in a zero interest rate environment, inflation has become the equivalent of the fed funds rate. A lower inflation rate means that consumers have more purchasing power than when the rate of inflation is rising.

Given the improving data on the economic front, it should come as no surprise that stock prices are up this year. Even more revealing is the performance of the various sectors within the S&P 500. As shown in the following table, those sectors that are outperforming the general index are the very sectors that would do well in an improving economy.

Given the above, the next logical progression of this data should be a continued improvement in corporate earnings. Current consensus earnings for the S&P 500 Index are $105.13, reflecting a growth rate of 8.61% over the previous year. What if earnings surprise on the upside? If the economic data point to an improving economy it would make sense that earnings follow suit. Also, keep in mind that estimates going into the year were conservative given the plethora of worries heading into the end of last year.

But skeptics abound in this market. Yesterday, I wrote about hedge funds snapping up commodity shares at quarter-end. Today I read that RAB Capital's flagship Special Situations hedge fund has cut its holdings in some commodity stocks after a rebound in markets this year.

Gregory Peters, global head of fixed-income research at Morgan Stanley, talks about the outlook for U.S. stocks, global investment strategy and Federal Reserve policy. He speaks with Tom Keene on Bloomberg Television's "Surveillance Midday." Note the cautionary tone.

I remain bullish on financials, commodities, tech, energy and think the current weakness is another buying opportunity. This "liquidity lull" is a pause and once the tsunami really hits, you'll likely see a melt-up unlike anything you've ever seen before.

Wednesday, March 28, 2012

Pension Reform: Is Bigger Really Better?

Alyshah Hasham of the Toronto Star reports, Pension reform: Is bigger really better?:

Ontario's big three in the public-sector pension fund world have combined assets of more than $200 billion. The new budget means a fourth could be joining the list.

The province plans to introduce a framework this fall to pool the investment management functions of smaller public-sector pension plans.

The management of assets could be run by an existing large public-sector fund — like the Ontario Teachers' Pension Plan, the Ontario Municipal Employees Retirement System (OMERS) or the Healthcare of Ontario Pension Plan (HOOPP). Or they could be run by a new entity altogether.

It's about time, says Keith Ambachtsheer, the director of the Rotman International Centre for Pension Management at U of T. The idea has been popping up since it was raised in a 1980's pension reform report that led to the creation of the Teachers' pension fund, he said. It even appeared in last year's provincial budget.

The reason it is taking wing now is perhaps because “it fits into the government theme of doing more with less,” Ambachtsheer said.

But is a bigger pension fund really better?

They're certainly more cost-effective to manage. Individual university plans, even big ones like the University of Ottawa, the biggest they'll get to is about $1 billion, says Tyler Meredith, research director at the Institute for Research on Public Policy and co-author of a recent study on pension reform.

That restricts the ability to reduce the size of management expenses. A decrease of 0.02 percentage points can have huge impact on the pension payments received, Meredith said. Large funds allow the hiring of in-house investment professionals, and can attract top talent.

“You can get the same job done internally at 10 per cent of the cost, so why wouldn't you do it?” Meredith said.

The other benefits lie in access opportunity and diversification, says pension and benefits lawyer Mitch Frazer.

“If you look at what some of our larger public-sector plans are doing, like the CPPIB (Canadian Pension Plan Investment Board) or Teachers' or OMERS, they're investing in infrastructure ... Teachers' owned the Leafs and associated enterprises,” he said.

Those aren't investments you can make with a $1 billion or smaller pension fund. They can also partner with other pension funds or financial institutions because they are recognized players, he says.

And a recent Economist article points out, politicians find Canadian pension funds, with their long-term horizons, to be “cuddlier partners.”

While larger firms may be slower to react in the short term, they can also be safer in the long term, says Frazer. The economic downturn in 2008 hit the Quebec Deposit and Investment Fund hard, but the fund has mostly recovered in less than four years, he said.

The nature of this proposed pension reform entity is still unclear, but it could be something like the BC Pension Corp. that quietly handles the municipal, college and public-service pensions, or the recently created Alberta Investment Management Corporation (AIMCo).

If so, the fund “could position Ontario to become a significant economic player,” said Meredith.

“It could provide access to capital markets, benefit the Ontario economy, and, if structured properly, be significant sources of capital for other kinds of public development such as infrastructure,” Meredith added.

Let me be clear on something, when it comes to pension reform, bigger is definitely better, but you still got to get the governance right or else bigger will turn out to be a bigger mess when the next financial crisis hits you.

Kudos to the Ontario government for introducing this new framework to pool functions of smaller public sector pension plans. Every single province in Canada, including Quebec, should follow Ontario (and BC's lead). Instead the Quebec government is touting VRSPs to self-employed and companies with more than five employees, a measure that is completely and utterly sub-optimal.

No DC plan, PRPP or VRSP can compete with a large, well governed DB plan. None. They are more expensive and cannot invest in the best managers across public and private markets, including top hedge funds. Let's stop pretending otherwise and get public policy on pensions back on track for the common good of all Canadians, not just those working in the public sector.

Below, Global News reports on tomorrow's budget. Finance Minister Jim Flaherty is trying to calm nerves before the federal budget is announced but the winds of austerity will be blowing our way too, and it could impact growth at the worst possible time.

Hedge Funds Snapping Up Commodity Shares?

Don't you just love end-of-quarter window dressing where funds sell their losers and buy the winners? Earlier today discussed how some hedge funds are booking profits after a bumper Q1, but let me go over where I think the action will be in Q2 and beyond.

First, spent my day reading more bad news on China, the latest from some analyst at Barclays who recently came back with some bad news:
Barclays analyst Gayle Berry recently visited China, and met with various industrial firms, and came back with some grim news: Things are weak, and it's not just a matter of the Lunar New Year.

Here is our summary of Berry's key points:

  • Demand for copper in China remains weak, and the outlook for the rest of the year doesn't look so great.
  • Some manufacturers cranked up production in January/February in anticipation of a rebound in Q2, but "demand has been softer than they expected."
  • Appliance demand is weak thanks to slow construction and poor real estate sales.
  • Copper inventories are rising.

Bottom line:

Overall, we believe Chinese demand in the short term is likely to disappoint before beginning on a recovery trajectory later in Q2. Subsequently, we think that imports will weaken until bonded stocks are run down to more normal levels, possibly in Q3 12. With the market already expecting a drop in Chinese imports, we doubt this alone would have a significant negative impact on LME prices.

That’s more likely to be determined by the market’s evaluation of how long imports will weaken for and whether it's the result of short-term dislocation or longer lasting core weakness. The LME backwardation meanwhile is likely to continue unless Chinese exports are big enough to begin offsetting the draws in LME inventories, in our view.

Nothing like spreading bad news on China's economy to create a rout in commodity stocks. Moreover, Morgan Stanley came out with its predictions on commodities:
Warm winter and excess production has hurt natural gas prices, while crude has been over $100 a barrel on account of oil supply risks stemming from Iran.

Now Morgan Stanley has updated its commodity predictions. Gold remains one of their top picks for 2012. Meanwhile, they have lowered their projection for natural gas prices by nearly 30 percent since they last published their commodities outlook in December last year.

Here are their forecasts for 14 key commodities (click here to view).

As if that wasn't bad enough, shares in U.S. coal companies slipped on Wednesday, one day after the government announced stricter emission regulations it is proposing for coal-fired power plants. That sent coal stocks, most of which are hovering around 52-week lows, sharply lower.

While everyone is bracing for a hard landing in China, I think smart money is going to be playing some oversold commodities shares and continue plowing into homebuilders, financials, tech shares and anything leveraged to global growth (like shipping). Admittedly, this is my hunch but by the time the data becomes public, it will be too late.

Importantly, don't get fooled by this end-of-quarter window dressing and scary, sensational stories warning of a hard landing in China. Lots of funds are underpeforming and they will chase high beta stocks higher in the second half of the year. It might be rocky as we shift into Q2, but if tomorrow's U.S. GDP numbers come in better than expected, it will propel this market higher.

Below are some key commodity stocks I'm watching carefully for a trend reversal. Some of these stocks have been heavily shorted in last few weeks (click on image to enlarge):

If the news out of China or Europe turns out to be better than expected and the U.S. recovery keeps humming along, expect a sharp turnaround in these stocks. But bear in mind, oversold can become extremely oversold so don't bet the farm on these commodity stocks.

As I stated above, I still like financials and some tech stocks but you have to pick your spots carefully. There are no free lunches on Wall Street where hedge funds, banksters, brokers, are all trying to steal your shares.

Gregory Smith, founder of Australian investment company Global Commodities Ltd., talks about the outlook for crude oil, precious metals and agricultural commodities. He speaks from Singapore with Rishaad Salamat on Bloomberg Television's "On the Move Asia."

Hedge Funds Booking Profits After Stellar Q1?

Lawrence Fletcher of Reuters reports, Hedge funds take profits after bumper Q1:

Hedge funds are cashing in some of their chips after enjoying a bumper first quarter, wary that a sudden change in market sentiment could see them take the sort of losses suffered in last year's volatile markets.

Hedge funds returned 5 percent in the first two months of the year, the best start to a calendar year since 2000 according to Hedge Fund Research, as the European Central Bank's 1 trillion euro ($1.3 trillion) cash injection boosted assets across the board.

Some star names recorded huge gains. Crispin Odey's Odey European fund gained 21.1 percent and Johnny de la Hey's Tosca fund rose 13.7 percent to mid-March, while Michael Hintze's $1.4 billion CQS Directional Opportunities fund was up 13.9 percent to end-February.

Many managers remain positive on markets, but in a number of cases have opted to trim their bets, influenced by sharp volatility last year during the euro zone debt crisis that saw the average fund lose 5.3 percent and some more bullish funds take much bigger losses.

"Over the last week or so we've actually seen (risk) come off a bit," said Paul Harvey, European head of sales in prime finance at Citi.

"We all want this rally to continue but we are all relatively cautious about the broader macroeconomic environment and the political environment, and uncertainty certainly prevails."

Many managers came into this year with low levels of risk, missing out on the start of the rally after underestimating the impact on markets of the ECB's so-called Long Term Refinancing Operations, designed to avoid another credit crunch.

As markets continued to rebound during the first quarter, however, a number of funds hiked their bets, in particular favoring the commodities and financials sectors, according to one fund of funds manager.

According to Citi's Harvey, equity long-short funds upped net exposure - the difference between bets on rising stocks and falling stocks - to 73 percent, and gross exposure - the sum of long and short bets - to 165 percent this quarter.

However, in some cases this has now come down. "We've seen some reductions but (I) wouldn't say (a) huge swing to risk off," said one prime broker who spoke on condition of anonymity.


CQS's Australian founder Hintze is among those to have struck a more cautious tone recently.

In his February investor report he wrote: "We remain broadly constructive on markets but are mindful of potential volatility that could arise due to the ongoing macro uncertainty."

Managers are worried the euro zone debt crisis could flare up again, that China's economic growth is slowing, and that tensions between Iran and the West could lead to further gains in the oil price that could reignite inflation.

David Stewart, chief executive of Odey Asset Management, told Reuters the firm remained bullish on equities, preferring them to credit.

But he added: "When the market has had a good run then you often trim a bit. We haven't changed our view. We know it's going to be difficult ... Equities are the right place to be ... The LTRO has been pretty favorable to equities."

Some funds are also beginning to look at put options as a way of protecting their portfolios from market falls, encouraged by the cheaper pricing of options thanks to a fall in volatility since the autumn. The VIX .VIX, a gauge of volatility, is down by two-thirds since early October, for instance.

"Some people who haven't used it historically (are looking at using options)," said Morten Spenner, chief executive of fund of funds firm International Asset Management. "As the pricing has come down because of the VIX, it's become more attractive for people to look at it.

"People are careful having made gains," he added. "Everyone will now agree that the situation does look more positive, but there are still quite a few things to solve."

Other hedge funds remain bearish. Tom Wilkes of Reuters reports, Hedge fund COMAC stays bearish despite rally:

Hedge fund COMAC Capital, the $5.2 billion macro fund run by Colm O'Shea, is bracing for a fresh round of turmoil in European markets, people familiar with the fund said, and is sticking to its bearish strategy despite losing out in this year's rally.

London-based COMAC, down more than 5 percent in the period up to mid-March this year, believes the flood of cheap central bank cash into parched markets is only a temporary fix for Europe's ills, and masks the region's poor economic prospects, these people said.

Most hedge funds are returning to winning ways in 2012 thanks to the rally in equity and bond markets and a bullish stance. The average hedge fund has risen 5.03 percent from the start of the year up to March 15, according to the HFRI Fund Weighted Composite Index.

Bullish funds have benefited from the European Central Bank's one trillion euro cash injection into the financial system and greater confidence that policymakers have finally stopped the Euro zone debt crisis from spiralling further out of control.

But some macro funds are positioning themselves for a new downturn in Europe, at the same time as they see an improved economic outlook for the U.S.

Many have bought options linked to volatility, which will rise in price if there is a resumption of the panic that racked markets for most of 2011, people familiar with the sector said.

"A lot of these funds think all this quantitative easing is just a temporary fix and the underlying problems are still there," one of the macro-investors said.

Macro funds make money by wagering how economic trends will play out across asset classes including in rates, currencies, commodities and equities, and are among the best-known.

Well-known funds in the sector include Brevan Howard, Moore Capital and Tudor Investment, as well as George Soros' Quantum Fund, where O'Shea used to work as a macro trader.

COMAC has made several successful calls in the past. It returned 5 percent in 2011 compared with a fall of more than 5 percent booked by the average fund.

It has returned an annualised profit of upwards of 8 percent since its 2005 inception, data seen by Reuters shows.

O'Shea, who read economics at the University of Cambridge, also performed well in 2008 after several successful bets including one on falling U.S. interest rates.

According to its website, COMAC invests across global markets to try and capture "directional market movements that commonly have a strong fundamental reasoning based upon economic and political analysis."

Investors looking for protection against volatile and uncertain markets have made macro funds among the most popular strategies this year.

In a recent survey conducted by Credit Suisse, investors said macro was the most sought-after strategy in 2012, while also predicting that they would be the best performing.

COMAC declined to comment.

So what is going on? On Monday I wrote that most hedge are capitulating, getting bullish on stocks. Is this about to change? I don't think so. While some funds are booking profits, most of them are underperforming, forced to play catch-up. The Dow Jones Credit Suisse Core Hedge Fund Indexes show that L/S Equity hedge funds were down 2.3% MTD in March. Most of these hedge funds got screwed shorting this market (click on image to enlarge):

But what about funds like COMAC? Are they right in warning that quantitative easing is a "temporary fix"? Bloomberg reports that European leaders signaled rising confidence that their region’s crisis is near an end, while Federal Reserve Chairman Ben S. Bernanke warned that a U.S. recovery isn’t assured.

While it's too early to claim victory, the US economy is well into recovery mode. As for Europe, they averted a crisis of confidence but they still have a lot of work ahead of them to tackle the debt and more importantly, unemployment crisis.

But the key point which I want my readers to understand, even if you're skeptical on quantitative easing, there is no denying that as global central banks pumped up the jam, it has helped banks shore up their balance sheets by reflating risk assets and we're seeing a pretty good US recovery right now. This isn't a "temporary fix", it could well be the early innings of a decent, albeit muted, economic recovery and a liquidity melt-up in stocks.

My point is simple, there is nothing wrong with taking profits, but stay vigilant as the dips will be bought hard and this thing can easily explode up. Of course, some think the opposite will happen.

Below, Jeremy Hill, chief operating officer of Societe Generale's U.S. research department, talks about hedge fund trades 'crowded' on risks, investor sentiment and strategy. Hill speaks with Deirdre Bolton on Bloomberg Television's "Money Moves."

Tuesday, March 27, 2012

Municipalities Betting on Pension Bonds?

More municipalities betting on pension bonds to cover obligations:
Struggling to pay employee pensions, local governments are increasingly borrowing money to cover their obligations — exploiting a loophole in federal law that allows them to issue taxable bonds without seeking voter approval.

Oakland took a bet on its pension fund that ended up costing the city an estimated $245 million — nearly a quarter of its annual budget. That hasn't stopped the city from looking to try its luck one more time.

The bets are being made using an exotic but increasingly popular financial instrument known as a pension obligation bond. Cities, counties and states use the bonds to take out high-interest loans from private investors to plug shortfalls in their employee pension funds.

If the pension funds make smart investments with the borrowed money, the returns can help pay the interest due to borrowers and sometimes even spin off some extra cash to pay pension costs. If they don't, the bonds can create additional costs for taxpayers, put the retirement funds of teachers and firefighters in jeopardy, and, in the worst case scenario, force municipalities into bankruptcy.

Municipal finance experts are sounding alarms about the practice, saying that local elected officials are taking unnecessary risk because they are afraid to anger voters by raising taxes. There is also the risk of instigating powerful public employee unions if pensions are cut.

"There are communities that just do not want to make the hard choices, even though it means the choices in the future will be worse," said Robert Doty, a municipal finance consultant in Sacramento. "They are just going to dig themselves deeper and deeper into a hole."

Oakland provides the clearest example of the risks and the allure of these bonds.

The city is credited with issuing the first pension obligation bonds in the 1980s. Another set of pension bonds the city issued in 1997 have lost Oakland $245 million, according to analysis by the city auditor. Those losses have helped push the city administration to propose more than $200 million of new pension bonds in the coming months.

"One would think they would have learned," said John Russo, the former city attorney who voted against the 1997 bonds when he was a City Council member and resigned last year because of disagreements over the city's budgeting. "This is a risk that may go horribly wrong."

Another California municipality to encounter problems after issuing pension bonds is Stockton. The city issued $125 million in pension bonds in 2007, a third of which promptly disappeared when the market crashed in 2008. But Stockton is still on the hook for the annual interest payments, some $6 million, or about 75% of the city's deficit this year. In late February, the city announced it was moving toward bankruptcy after determining it was unable to make the payments on these and other bonds.

Although local governments risk big losses from pension bonds, they carry profits with almost no risks for the law firms and banks that help arrange them. They aggressively market deals in which they get their fees up front, no matter what happens in the long term, according to several public officials.

"I was getting pitched the day after I arrived," said the chief financial officer of the University of California, Peter Taylor.

Since 2008 the dollar amount of bonds issued has gone up each year, rising from $1.4 billion in 2009 to $3.6 billion in 2010 to $5.2 billion last year, an analysis by The Times shows. With cities and states expected to encounter growing difficulty in funding their pensions, many insiders expect more municipalities to try them out.

Just in the last few weeks, proposals to issue the bonds have come out of Cincinnati; Fort Lauderdale, Fla.; Hamden, Conn.; and the Democratic mayoral candidate in San Diego, Bob Filner, who said he would use the bonds to help the city's budget crunch.

The argument for the bonds is almost always that they will fill a short-term budget hole and allow the city to maintain benefits for retirees. But market experts say the risks and long-term costs are frequently ignored.

Along with the interest rate payments and investment risks with which the bonds freight governments, they also provide another argument for opponents of public pensions, increasing the possibility that such benefits could be lost altogether.

"Municipalities find it attractive to think that there might be a free lunch — they can issue bonds and solve their problems," said Jeff Esser, chief executive of the Government Finance Officers Assn., which has issued an advisory cautioning its members against pension bonds. "Unfortunately there is no free lunch."

Pension obligation bonds are a product of the unusual way municipal pensions are funded. Unlike other divisions of local governments, which pay as they go, pension funds survive by taking annual payments from public employees and employers and investing that money to pay for future retirement benefits.

Some municipal finance officers realized in the 1980s that they could use these investment portfolios to do a form of Wall Street speculation that involves borrowing money at one rate with the hope of investing it and earning a higher rate.

Congress made it illegal in 1986 to issue normal tax-exempt municipal bonds for this type of speculation, but municipalities and their outside advisors realized they could get around this by issuing taxable bonds, like corporations. These bonds come with higher interest rates, but many local government officials have believed they could earn enough from investments to come out on top.

In California, Arnold Schwarzenegger lost a bid to issue pension bonds on the state level without voter approval when he was governor. But for most local governments, voter approval is not needed to issue the bonds because of their unique structure.

The bonds have worked out for some municipalities. Los Angeles County, for instance, issued $2.1 billion in pension bonds in 1994 that was promptly invested. In the boom years of the 1990s the value of the bonds shot up more than enough to pay off the cost of issuing them. But the current county treasurer, Marc Saladino, would never think of using them again.

"It's only by the grace of God that the deal worked out for us," Saladino said.

Many local governments have been willing to roll the dice because they have found themselves so far behind in funding retirement benefits for their employees.

The pension plan for California public school teachers currently has only 72% of the money that it estimates it will need to pay for the retirement benefits of the state's teachers, down from 90% in 2007, according to the Pew Center on the States. It is doing better than other states, such as Illinois, where the teachers' fund has only 48% of the money it will need, down from 63% before the financial crisis.

In Illinois, the state has struggled even to make the ongoing payments to the fund, much less make up the shortfall. For the last two years the state has issued billions of dollars of pension bonds just to pay the immediate contribution to the pension fund.

The state will shell out $1.6 billion — or 5% of the state's entire annual budget — just to pay off the interest on its pension bonds issued over the last decade, according to the Illinois Civic Federation. The bonds were issued with the hope of increasing the funding level of the pension fund, but that level has actually dropped.

"The intoxicating attraction of being able to borrow instead of making cuts in the budget is wiped out when you look at the costs in future years," said Lawrence Massal, CEO of the civic federation.

In Oakland, the proposed pension bonds would help make up the shortfall in a fund for retired police and firefighters — benefits the city does not think it can reduce. If the bonds are issued the city will be able to breathe easily, but not for long.

Critics of the bonds say that municipalities are better off paying pension costs as they arise.

Doty, the municipal finance advisor, said municipalities often turn to pension bonds to avoid dealing with problems created decades ago.

"They really should have been paying all along, that's really the bottom line," Doty said. "Now there is an unwillingness to make the hard decisions. So instead they penalize future taxpayers."
Reading this article just reminds me that US politicians are very similar to Greek politicians. In order to avoid making tough decisions which may offend their constituents, they find some loophole in the federal law to issue taxable pension bonds that do not require voter approval.

I am deeply distrustful of municipal governments everywhere. The amount of corruption going on there touches all facets of public finance, including pensions. This is why I urge Congress to roll all these municipal pensions into the large state plans which are managed better, more transparent and a hell of a lot more accountable (there are exceptions, of course).

I recommend the exact same thing here in Canada. Roll up all these municipal pension plans into the provinces' large public DB plans. The same for our university pension plans. Does anyone know details of where the cities and universities actually invest their pension assets? Are their investment policies, board minutes, and investments and liabilities all made public on a regular basis?

Below, a person from Sonoma County describes pension obligation bonds. When it comes to pensions, we need to consolidate and introduce reforms which will undoubtedly upset every stakeholder. There is no way around this reality. If compromises aren't made by all stakeholders, municipalities will keep issuing pension bonds until one day, it all explodes leaving taxpayers to foot the bill.

Monday, March 26, 2012

Hedge Funds Capitulating, Bullish on Stocks?

Nikolaj Gammeltoft and Whitney Kisling of Bloomberg report, Hedge Funds Capitulating Buy Most Stocks Since 2010:

Hedge funds trailing the Standard & Poor’s 500 (SPX) Index for the last five months are giving up on bearish bets and buying stocks at the fastest rate in two years.

A gauge of hedge-fund bullishness measuring the proportion of bets that shares will rise climbed to 48.6 last week from 42 at the end of November 2011, the biggest increase since April 2010, according to data compiled by the International Strategy & Investment Group. The Bloomberg aggregate hedge fund index gained 1.4 percent last month, lagging behind the Standard & Poor’s 500 Index by 2.65 percentage points.

Money managers struggling to catch up with the gains have contributed to the rally that pushed the S&P 500 up 27 percent since October as economic reports beat estimates. Market bulls say they are a continuing source of cash that can move stocks higher. Bears say capitulating hedge funds are further evidence that equities have risen too far, too fast as economic growth remains sluggish, warning that the pool of potential buyers is being depleted.

“It’s encouraged me to gradually increase my exposure to stocks,” Barton Biggs, founder of hedge fund Traxis Partners LP in New York, said in a March 23 phone interview, referring to an improving economic outlook. “The shift has occurred gradually in the six or so months since the beginning of October. I’d be inclined to raise my net long further because the potential to the upside would be greater” should the S&P 500 fall 5 percent to 7 percent, he said.

Biggest Shorts

Short bets reached a five-year peak in October 2008 just before the S&P 500 started a rally that has lifted it 107 percent over three years, according to data compiled by ISI and Bloomberg. Hedge funds trailed the index for six of the first seven months of that advance. Overall short interest reached 4.86 percent of outstanding U.S. shares in July 2008, according to data compiled by NYSE Euronext.

Companies with the most shares borrowed and sold by short sellers have led this quarter’s rally as gains forced bearish traders to repurchase them. Sears Holdings Corp. (SHLD) has returned 128 percent for the biggest gain in the S&P 500 as short interest fell to 8.8 percent of outstanding shares, the lowest since August 2010, according to New York-based Data Explorers. Bank of America Corp. (BAC) and Netflix Inc. (NFLX) have each increased more than 73 percent and seen a drop in pessimistic bets this year.

‘Maximum’ Bullish

ISI’s index, based on a survey of 36 mostly U.S. hedge funds with about $89 billion under management, tracks net exposure on a zero through 100 scale. Readings of zero show “maximum” short selling, while 100 means “maximum” bullish bets. At 50, hedge funds are deploying a “normal” ratio of long to short investments, according to ISI.

The S&P 500 slipped 0.5 percent last week to 1,397.11, the first decline since the five days ended Feb. 10, after manufacturing contracted more than forecast and China raised fuel prices. The benchmark gauge for U.S. equities is on track for the best first-quarter gain since 1998, according to data compiled by Bloomberg. Futures on the index advanced 0.2 percent at 8:21 a.m. in London today.

Investors placed $70.6 billion with hedge fund managers last year, pushing industry assets to $2.01 trillion, according to Chicago-based Hedge Fund Research. The total has risen another 5 percent in 2012 through February. Hedge funds are largely unregulated investment vehicles that aim to make money whether markets rise or fall. The fund managers, who may buy or sell any asset, charge annual management fees, traditionally 1.5 percent to 2 percent, and receive a portion of investment gains equal to 20 percent.

‘Missed It’

“These people have missed it again,” Philip Orlando, chief equity strategist at Federated Investors Inc., which oversees about $370 billion, said in an interview at Bloomberg headquarters in New York on March 20. “They’ve been unduly bearish in their outlook. That’s certainly come back to hurt them.”

While equities gained as the world’s largest economy began expanding in the second half of 2009, helped by President Barack Obama’s stimulus measures and the Federal Reserve’s easy money policies, it’s been the smallest post-recession recovery rate since at least the 1940s, according to Bloomberg data.

Bruce McCain, at KeyCorp in Cleveland, says that even though a slower-growing economy is better than a recession, the 27 percent gain in the S&P 500 since October isn’t justified and stocks will probably drop before they climb.

‘Too Much Enthusiasm’

“There should be a pullback, there’s been just too much enthusiasm,” McCain, who helps oversee more than $20 billion as chief investment strategist at the private-banking unit of KeyCorp in Cleveland, said in a March 22 phone interview. “One of the last parts of the rally is when people throw in the towel and buy into it, and there is that risk for the hedge funds right now.”

For Paulson & Co., the hedge fund founded by billionaire John Paulson, taking a more bullish stance on the U.S. economic recovery last year meant record losses. One of his largest funds declined 51 percent in 2011, prompting the manager to reduce risk just as markets stabilized. Since then, Robert Lacoursiere, the partner who oversaw the $23 billion hedge fund’s team of banking analysts, quit to start his own fund.

Trading volume has plunged this year, with about 768.44 million shares a day changing hands on the New York Stock Exchange in the 50 days through March 5, the least since 1999, Bloomberg data show. While bears say that’s an indication investors lack confidence in the rally, bulls say it means more money is available to be lured back to equities.

‘On the Sidelines’

“It’s been pretty painful to sit on the sidelines,” Walter Todd, who oversees about $950 million as chief investment officer at Greenwood Capital in Greenwood, South Carolina, said in a March 20 phone interview. “It’s one of the reasons we’ve gone as high as we have without correction. Any little pullback in the market has been bought. You’ll continue to see that with the hedge funds and others, there’s a lot of money that’s not in the market right now.”

Investors may be convinced to increase stock purchases after Fed Chairman Ben S. Bernanke raised his assessment of the economy this month and signaled he would keep benchmark rates near the record zero percent through late 2014. The easing has damped demand for the perceived safety of U.S. Treasuries, (USGG10YR) which lost 1.4 percent so far this quarter, compared with the 11 percent rally in the S&P 500. Equities haven’t beaten bonds by that much since the last three months of 2010.

U.S. Growth

Economists estimate the U.S. expanded 2 percent in the first quarter, five times the rate of a year ago, according to forecasts compiled by Bloomberg.

“The search for returns versus low yields on bonds is certainly helping drive the rally, and there is certainly a fear of having missed the rally that’s feeding on it, especially among hedge funds,” said Dennis Leibowitz, managing general partner at Act II Partners LP, a New York-based hedge fund that oversees about $400 million. “We have moved exposure up steadily since fall as a result of the settlement of European- related high anxiety and volatility, and improving U.S. economic numbers.”

The five-month stretch of trailing the S&P 500 is the second-longest in data going back to 2005. The longest was when hedge funds lost to the index for six months from September 2010 and February 2011, according to data compiled by Bloomberg. The equity index rallied 26 percent over that period, compared with an 11 percent advance for hedge funds.

Sears Rally

Sears, the department-store chain based in Hoffman Estates, Illinois, missed analysts’ average earnings estimates for seventh straight quarter and said it plans to close 62 stores in the first half of this year to cut costs. The shares are up 128 percent in 2012 after losing 56 percent last year.

Netflix shares gained almost seven times as much as the S&P 500 in 2012 even after consumers grew angry about a 60 percent increase in prices for the online and mail-order video-rental service and canceled subscriptions last year. The stock tumbled 79 percent from a high of $298.73 on July 13 to November last year. Short selling in the stock decreased to 8.1 percent of outstanding shares last week from 20 percent on Feb. 1, 2011, according to data compiled by Bloomberg and Data Explorers.

Bearish bets on Bank of America, the second-biggest U.S. lender by assets, fell to 1.2 percent from a two-year high in February. The stock has climbed 77 percent this year and topped $10 for the first time since August, pushed higher after the Charlotte, North Carolina-based company passed Federal Reserve stress tests.

“Hedge funds are at least part of the underlying strength in the recent move, and it has to do with not only buying stocks, but first and foremost covering,” Michael Holland, chairman and founder of New York-based Holland & Co., which oversees more than $4 billion, said in a March 22 phone interview. “It’s been a brutal time to be on the short side.”

Are hedge funds truly capitulating and buying up risk assets? Yes, they're dumping Treasuries in droves and chasing stocks at higher levels, fearing they'll underperform once again. The Dow Jones Credit Suisse Core Hedge Fund Indexes show that L/S Equity hedge funds were down 2.8% MTD in March. Most of these hedge funds got screwed shorting this market (click on image to enlarge):

Where did they go wrong? They basically underestimated the world's largest and most powerful hedge funds -- ie. central banks -- who pumped up the jam and unleashed a liquidity tsunami to help out the big banks who have been trading risk assets, profiting off money for nothing and risk for free.

The top hedge funds also participated in this rally, switching gears in Q4. Apart from tracking the quarterly 13-F filings of top hedge funds and long-only funds, I regularly look at weekly data from the WSJ's short interest highlights, showing me which stocks are being heavily shorted and which ones are experiencing a large decrease in short interest.

Sometimes stocks are being shorted for good reason, and other times it's blatant manipulation at its worst as brokers short to keep the price low, allowing their top clients to scoop shares on the cheap. Regardless, when a liquidity tsunami comes, most short-sellers cover, which is why it's important to pay attention to short interest on certain stocks in key sectors.

And what will happen for the remainder of the year? Market technicians are asking if there is any upside left in this market. I say yes, the rally in risk assets is for real, and investors waiting for a meltdown in stocks will be sorely disappointed. China is not heading for a 'hard landing' and there are still plenty of excellent opportunities in cyclical stocks related to China and global growth (aluminum, coal, copper, steel, shipping, mining and energy). As we head into Q2, this should be your focus, along with the strength in financials which will benefit from the US recovery.

Below, Christopher Westwood, head of asset management at Westwood Capital LLC, talks about pension plans investing in hedge funds. Westwood speaks with Deirdre Bolton on Bloomberg Television's "Money Moves." You know my thoughts on pensions investing in hedge funds, tread carefully, and always ask where are the customers' yachts?