Monday, April 30, 2012

OMERS Launches Giant Infrastructure Fund?

Greg Roumeliotis of the Globe and Mail reports, OMERS, Japanese partners launch infrastructure fund:
One of Canada’s largest pension plans teamed up on Thursday with Japan’s pension funds and some of its major conglomerates to help raise $20-billion (U.S.) for the world’s largest infrastructure fund to invest in assets such as roads and airports.

While a handful of the world’s biggest pension funds have the capacity to lead their own investments in infrastructure assets, the initiative represents an unprecedented effort to cut out asset managers as middle men in infrastructure investment.

Ontario Municipal Employees Retirement System (OMERS) said on Thursday it, along with Japan’s Pension Fund Association and a consortium led by Mitsubishi Corp., Japan’s largest trading house, had committed a total of $7.5-billion toward the new fund.

Infrastructure funds have traditionally been sponsored by investment banks, private equity firms and independent asset managers. If successful, the new fund could have major implications for the infrastructure asset management industry.

Much of the world’s infrastructure is struggling to meet the needs of a growing and aging population. The Organization for Economic Co-operation and Development estimates $53-trillion of investment, equivalent to an annual 2.5 per cent of global gross domestic product, will be needed to meet demand over the coming decades.

Dubbed Global Strategic Investment Alliance (GSIA), the new fund will invest in assets such as railways, ports and gas pipelines that have a value of more than $2-billion each and are located primarily in North America and Europe.

The initiative is led by OMERS, which administers the pensions of 420,000 public sector employees in Ontario such as police officers, fire fighters and municipal workers, and has more than $55.1-billion in net assets under management. It’s infrastructure arm, Borealis, is a serial acquirer of infrastructure assets and its portfolio includes the Detroit River Rail Tunnel linking Michigan to Ontario and a high-speed rail line in Britain.

“Based upon the feedback in the market, we anticipate welcoming a number of other forward-thinking pension plans and other long-term institutional investors from around the world into the GSIA over the next 12 to 18 months,” Jacques Demers, strategic investments chief executive for OMERS, said in a statement.

OMERS has committed $5-billion to the fund, Japan’s Pension Fund Association has committed $1.25-billion, and Mitsubishi’s consortium, which includes Mizuho Corporate Bank Ltd. and Japan Bank for International Cooperation, has also committed $1.25-billion. GSIA’s fundraising target is $20-billion.

Infrastructure has emerged as a separate asset class to private equity in the last decade, offering lower returns but also stable cash flows that are hedged against inflation and are underpinned by physical assets such as roads and pipelines.

Infrastructure typically has a longer investment horizon than private equity, which tends to flip assets within three to seven years, and so it appeals to pension funds looking to match their long-term liabilities with long-term assets.

But the developing world sees little of such infrastructure fund investment. Political risk and patchy regulation often drive pension funds to skip on emerging markets, despite their attractive demographics, for the safety of infrastructure assets in Europe and the United States, which have a track record. GSIA will be no different.

Benefits Canada also reported on this new fund:

OMERS has joined with two Japanese partners in officially launching a US$7.5-billion global investment fund.

The newly minted Global Strategic Investment Alliance brings together the investment arm of OMERS, Japan’s Pension Fund Association (PFA) and a consortium led by Mitsubishi Corp.

Initial commitments include US$5 billion from OMERS and US$1.25 billion each from PFA and Mitsubishi-led Japan Infrastructure Investment Partners LP.

“We’re very pleased to be partnering with these sophisticated investors in pursuit of high-quality, large infrastructure investments that we can own over the long term,” said Jacques Demers, president and CEO of OMERS Strategic Investments.

“Based upon the feedback in the market, we anticipate welcoming a number of other forward-thinking pension plans and other long-term institutional investors from around the world into the GSIA over the next 12 to 18 months.”

That would being in billions of dollars more in commitments to the fund, he said.

The GSIA’s goal is for like-minded, long-term institutional investors in North America, Europe, Asia-Pacific and the Middle East to work together in pursuit of attractive, large-scale infrastructure investment assets, mainly in North America and Western Europe, OMERS said in a release.

All GSIA investments will be originated and managed by OMERS’ infrastructure investment arm, Borealis Infrastructure. Administrative support services will be provided by Rosewater Global, an OMERS affiliate.

You can read the OMERS press release here. OMERS' Borealis Infrastructure is a leader in infrastructure and this deal will allow them to compete directly with investment banks and private equity firms bidding for global infrastructure assets. By cutting out the middle man, OMERS will cut down fees and focus on investing in long-term assets that are better suited for pensions than for private equity firms or banks.

If I were a mid or large pension fund looking to invest in infrastructure, I would steer clear of infrastructure bonds (the latest investment bubble) and contact the folks at Borealis to see if I can be part of this new fund.

Importantly, when it comes to infrastructure, many pension funds don't have a clue of the risks involved and are being preyed on by financial sharks peddling all sorts of nonsense where they're completely mispricing risk. Buyers beware, infrastructure assets are fraught with risks and you're better off investing with experts who know what they're doing than investing in bonds or some fund of funds that will eat you alive in fees.

OMERS isn't the only Canadian pension fund investing in infrastructure, but it is the largest infrastructure investor in North America. Other Canadian pension funds are snapping up infrastructure assets. The Canada Pension Plan Investment Board (CPPIB) recently announced that it has entered into an agreement to acquire significant minority stakes in five major Chilean toll roads from the Atlantia Group.

In November, the Alberta Investment Management Corporation (AIMCo), acquired a 50% stake in Grupo SAESA, a regulated electricity transmission and distribution company in Chile. The other 50% stake is owned by the Ontario Teachers' Pension Plan.

AIMCo posted an excellent white paper on benchmarks for unlisted infrastructure assets (part 1). Leo de Bever, AIMCo's President and CEO, was one of the first investors in this asset class and this white paper written by Jagdeep Singh Bachher, Ryan J. Orr, and Daniel Settel is excellent, going over all the benchmarks used by Canadian pension funds for unlisted infrastructure, explaining in detail the diversity in these benchmarks (click here to read it).

The authors note the following:
At AIMCo, the view is that “infrastructure shouldn’t just be another form of equity. It should be a somewhat higher return, somewhat higher risk substitute for real return bonds.” The emphasis is on finding the relatively small subset of “unrisky” projects that generate predictable, long-term, inflation linked cash flows with low volatility. These so-called “core” infrastructure investments offer a sort of holy grail, generating equity-like returns with bond-like risks and serving as a first-order proxy for long-dated liabilities.
And on the various benchmarks used for unlisted infrastructure, they conclude that "different benchmarks produce quite different return expectations and volatility levels."

As I stated, infrastructure is an excellent asset class for pensions but it isn't "riskless" and if investors don't know what they're doing, they're better off investing in listed infrastructure companies to gain exposure to the 'beta' of the asset class, recognizing full well that this isn't a proxy for unlisted infrastructure nor as efficient as matching liabilities with long-duration unlisted infrastructure assets.

Below, British Chambers of Commerce Director General John Longworth talks about the outlook for the U.K. economy and the need to build up infrastructure. He speaks with Manus Cranny on Bloomberg Television's "Last Word."

Sunday, April 29, 2012

A Global Game Changer?

Joe Weisenthal of Business Insider reports on Hugh Hendry's latest letter, It Looks Like America Is 'Creating Yet Another Historic Turning Point':
We wrote yesterday about how how Hugh Hendry is back with his first big shareholder letter since 2010.

The gist is that Hendry is more bearish than ever on China, and that his favorite way to play it remains credit default swaps on China-exposed Japanese corporate names, which are still up to their necks in debt.

He doesn't write much about the US, but we wanted to highlight his bullish commentary...

This might be the year everyone else notices this; the year panic over Chinese economic growth comes to replace the market's morbid fascination with the travails of the European continent and the year in which we see that the US is not giving way to China in terms of global economic leadership. There is a near consensus that China will supplant America this decade. We do not believe this. We are more bullish on US growth than most. The momentous nature of recent advances in shale oil and gas extraction and America's acceptance of the unpleasantness of debt and labour price restructuring looks to us as if it is creating yet another historic turning point.

As we just noted, he's not the only one making this bullish argument. It does seem as though this is becoming a new conventional wisdom, that the best path forward for the US is revolves around the exploitation of domestic natural resources (such as those in Williston, North Dakota).

Last month we noted how economists from Citi said that the domestic energy story had the potential to turn the US into the next Saudi Arabia, sparking a new industrial revolution.

More and more, people aren't just bullish on domestic energy, but think this is going to be BIG. Like nation-changing big.

Zero Hedge published Hugh Hendry's entire letter on their site. I partially agree with Hendry. While I'm not bracing for a hard landing in China, I don't believe that China will overtake the US economy anytime soon, not even in the next 50 years. The faulty logic of many who believe so is that they wrongly extrapolate current growth rates to reach such conclusions (go back to read my comment on Galton's Fallacy and the Myth of Decoupling).

Those of us who understand economics understand that the US economy remains the engine of global growth and will remain so for many decades to come. Sure, there are serious structural problems, but at the end of the day, the US economy remains one of the most productive economies in the world. And economists all agree on this point: it's productivity growth that ultimately determines the wealth of a nation.

One of the most incredible revolutions occurring right now is the massive drop in energy prices, driven in large part by the historic drop in natural gas prices. Alexandra Marks of the Christian Science Monitor wrote an interesting comment, With all this natural gas, who needs oil?:

Natural gas has suddenly become almost everyone's favorite chassis for building an energy independent future. Many people on both sides of the drilling divide view the current abundance of the low-cost fuel as a "global game changer" – an energy source that will help wean the United States off Mideast oil, alter the nation's foreign policy, spur jobs and boost the economy, and reduce greenhouse gases.

President Obama has pledged to "take every possible action to safely develop this energy." Mitt Romney calls the domestic gas "a godsend." Energy tycoon T. Boone Pickens, an early natural gas booster, contends it's "obvious" that Washington should enact policies to encourage natural gas production and use throughout the economy.

"Do we have to take advantage of this?" asks Mr. Pickens, with his characteristic Texas Panhandle pragmatism. "Well, if you don't, you're going to go down in history as the biggest fools that ever came to town."

Indeed, as one executive declared to the NYT, Natural Gas is on a Roll:

A “perfect storm” of economic and regulatory factors is driving major United States utilities to rapidly switch from coal to natural gas as an electric power source, the top executive of one of the nation’s largest utilities said on Thursday.

Nicholas K. Akins, chief executive of Ohio-based AEP, said the company plans to retire 5 of its 25 coal-burning plants and shut down coal-powered units at other plants it owns in a shift that collectively means the elimination of about 5,000 megawatts of capacity. The result will be that by 2020, only about half of the power AEP produces will come from coal, down from about 67 percent last year.

The surge in domestic production of cheap natural gas, largely yielded by the rise of the controversial technique of forcing gas out of shale through hydraulic fracturing, has been a big factor in this shift. A series of new environmental regulations and pressure from environmentalists are also leading major utilities to either shut down older plants or spend billions of dollars to upgrade them.

Mr. Akins estimated that the industry would have to spend about $300 billion through the end of the decade to expand natural gas power generation capacity or retrofit older coal-fueled plants so they can meet new environmental standards — investments that it is asking regulators to allow it to pass on to its customers, at least in part, which total five million accounts in 11 states.

Renewable energy is expected to contribute a larger share of power to AEP’s mix by 2025, Mr. Akins said, but perhaps not as much as expected because of a decline in federal subsidies and continuing repercussions from the bankruptcy of Solyndra, the California solar manufacturer that collapsed last year despite receiving a $535 million federal loan guarantee.

And the once-anticipated nuclear power renaissance will probably not materialize, he added, in view of the Fukushima disaster in Japan last year.

Domestically, coal mining will be the hardest hit by this historic shift, he said. Last year alone, the amount of electricity produced by AEP’s gas-powered plants jumped 24 percent, with most of that resulting from a drop in production at coal plants.

“Our industry is in the midst of an extraordinary period of transformation and investment which will affect how we produce and delivery electricity — and what you pay for it — for decades to come,” Mr. Akins said in his remarks before the United States Chamber of Commerce,

At the Southern Company, another major coal-burning utility, natural gas is now responsible for 46 percent of its electricity, up from 16 percent four years ago. That translates into about 45 million tons of coal slated to be burned this year by Southern, down from 80 million tons in 2007, Southern’s chief executive, Tom Fanning, said in his own remarks on the topic on Wednesday.

Mr. Akins said he was somewhat concerned that the nation may end up too reliant on natural gas, particularly given the history of price volatility of natural gas. The price has dropped from $10.8 per thousand cubic feet at the wellhead as of July 2008 to $2.89 as of January.
I happen to think nat gas prices are bottoming and will head up over the next year, but there is no denying that cheap, abundant nat gas has hit shares of coal and solar stocks extremely hard allowing some well-known short-sellers like Jim Chanos to profit.

From a trading perspective, I don't see natural gas displacing US coal and think the selloff in some coal shares is way overdone, fueled by fears of a hard landing in China and the historic drop in nat gas prices. But keep in mind in this wolf market dominated by elite hedge funds using high frequency trading multi-million dollar computers, oversold can become extremely oversold, so tread carefully (Note: I am bullish on nat gas, coal, steel, oil and oil servicing and pipeline shares).

Finally, a Greek-Canadian friend of mine living in Israel now sent me an interesting Hareetz article, Greece, Cyprus to advance Israeli power line to Europe (h/t, Jimmy):

Greece and Cyprus have agreed to an Israeli request to lay a power cable to Europe via the two Mediterranean nations, their electricity authorities stated yesterday.

The 2,000-megawatt cable, dubbed the EuroAsia Interconnector project, would ensure that nations including Greece, Cyprus, Israel and others in southeast Europe and the Mediterranean basin have a regular power supply.

Israel has faced soaring power prices since losing its supply of Egyptian natural gas a year ago, following the revolution there. The supply became unreliable following the fall of Egyptian President Hosni Mubarak. This week, Egypt announced that it was halting gas exports to Israel altogether.

Meanwhile, Israel has been drafting emergency plans to address expected power outages this summer.

Cyprus for its part has been facing severe power shortages since a disaster at a production plant last year. Following the incident, local authorities had to bring old plants back online in order to meet local needs.

Also, Europe as a whole is expecting power shortages in the wake of Germany's decision to shutter all of its nuclear power plants following Japan's Fukushima disaster.

The Israel-to-Europe cable will be built by the Israel Electric Corporation and PPP Quantum Energy, which is controlled by the Greek power utility and Cypriot companies. Israel and Cyprus signed an accord to lay the underwater cable in March. Yesterday's announcement was the official one.

This is the first stage in a process that would bring Israel electricity from mainland Europe.

At 540 nautical miles (1,000 kilometers ) long and lying at a maximum depth of 2,000 meters, the cable would be the longest in the world.

I have long argued that Greece, Cyprus and Israel need to work together on all fronts, especially to secure their vital energy needs. I see the Greek-Cypriot-Israeli ’energy axis’ as a positive development for the region and for Europe as a whole.

Is natural gas a 'global game changer'? It already is leading to a renaissance of American manufacturing and will help many European nations struggling with competitiveness to lower their energy costs. The implications of this structural shift are profound and investors better be on the right side of the trade.

Friday, April 27, 2012

Money, Power and Wall Street: Parts 1 & 2

Since 2008, Wall Street and Washington have fought against the tide of the fiercest financial crisis since the Great Depression. What have they wrought?

In a special four-hour investigation, PBS FRONTLINE tells the inside story of the struggles to rescue and repair a shattered economy, exploring key decisions, missed opportunities, and the unprecedented and uneasy partnership between government leaders and titans of finance that affects the fortunes of millions of people around the world.

Below, watch Parts 1 & 2 (or on your tablet). Have a great weekend!

Will Spain Kill the Bull Market?

You knew it was only a matter of time before some credit agency downgraded Spain right before the weekend. On Thursday, Standard & Poors cut Spain's sovereign credit rating to BBB+ from A on concern the nation will have to provide further fiscal support to the banking sector as the economy contracts.

The assertion that Spain will need a major banking bailout due to a surge in defaults was derided yesterday as nonsense by Banco Santander Chief Executive Officer Alfredo Saenz:
“Mortgages get paid in good times and in bad,” he said in a news conference at the bank’s headquarters outside Madrid. “Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid.”

There’s more at stake than the credibility of the CEO of the country’s largest lender. If he’s right, investors betting against his bank and the country will lose. If he’s wrong and delinquencies rise, that will weaken the nation’s banks as Spain’s Prime Minister Mariano Rajoy seeks to restore the recession-hit economy. Concern about Spanish lenders already has helped push the country’s 10-year borrowing costs to about 6 percent, adding to concern that borrowing costs may reach levels that prompted bailouts for Greece, Ireland and Portugal.

Saenz’s comments underscore a growing gap between Spanish banks’ statements about the mortgages they hold and forecasts such as those by the JPMorgan analysts for further losses as unemployment exceeds 24 percent. Santander said the ratio of defaults on its home loans fell in the first quarter, while the Bank of Spain said it’s still below 3 percent nationally.

Bloomberg reports that Spanish Economy Minister Luis de Guindos expects foreign investors and real-estate funds to help offload property assets from banks’ balance sheets and ruled out using public funds to shore up the industry:

“A third-party partner is going to enter into this asset management company if the valuation is the correct one,” said Guindos, 52, in an interview in Madrid late yesterday. The government “will set the general rules to do that but without any kind of subsidy. We are not going to put in any money.”

Less than three months after tightening rules to force lenders to recognize deeper real-estate losses, Spain is seeking new ways to convince the bond market that bank losses won’t overburden public finances. De Guindos was speaking just hours before Standard & Poor’s cut Spain’s credit rating to within three steps of junk and data showed the nation’s unemployment rate surged to 24.4 percent, the highest in 18 years.

I can see bond vigilantes and elite hedge funds salivating at the prospect that Spain will be the next Greece, but let me assure you that no matter how bad things are, Spain isn't Greece and speculators trying to profit off some major Spanish calamity will end up getting badly burned.

And as I wrote in my comment on the stay-liquid-and-wait strategy, I doubt we'll see a repeat of summer 2011. Nevertheless, the macro headlines will paralyze many jittery investors who remember the insane deleveraging that took place in Q3 2011. They will be the ones underperforming once again in 2012.

Having said this, there are serious structural problems that are not being addressed. Spain's economy is extremely weak as unemployment soared to 24.4 percent, the highest in 18 years:

The jobless rate advanced in the first quarter from 22.9 percent in the previous three months, the National Statistics Institute in Madrid said today. Unemployment was higher than the median estimate of 23.8 percent forecast in a Bloomberg survey of three analysts. Spain’s inflation rate rose in April to 2 percent from 1.8 percent, a separate report showed today.

Surging unemployment rates from Spain to Italy and Greece are threatening to derail efforts to quell the region’s debt crisis and keeping bond yields close to record levels relative to benchmark German bunds. Spain is home to more than a third of the euro-area’s jobless and more than half of young people have no work, sapping government tax revenue. Spain will miss its 2012 budget deficit target as its economy contracts, the government said on March 2.

The yield on Spain’s 10-year benchmark bond has risen about one percentage point since early March to 5.99 percent today, approaching the 7 percent level that helped force Greece, Ireland and Portugal into bailouts.

The depression conditions southern European nations face right now is a testament to the monumental failure of savage austerity.

Let me repeat what I and many other economists much smarter than me have been telling policymakers, the developed world suffers from an unemployment crisis and the debt problem will only get worse unless policymakers first address the growth part of the equation.

This why Nobel Prize-winning economist Joseph Stiglitz said Europe is in a “dire” situation as a focus on austerity pushes the continent toward “suicide":

If Greece was the only part of Europe that was having austerity, authorities could ignore it, Stiglitz said, “but if you have U.K., France, you know all the countries having austerity, it’s like a joint austerity and the economic consequences of that are going to be dire.”

While euro-area leaders “realized that austerity itself won’t work and that we need growth,” no actions have followed and “what they agreed to do last December is a recipe to ensure that it dies,” he said, referring to the euro.

“The problem is that with the euro, you’ve separated out the government from the central bank and the printing presses and you’ve created a big problem,” Stiglitz said, adding that “austerity combined with the constraints of the euro are a lethal combination.”

The economist said he sees a core euro area of “one or two countries” made up of Germany and possibly the Netherlands or Finland as the “likely scenario if Europe maintains the austerity approach,” he said. “The austerity approach will lead to high levels of unemployment that will be politically unacceptable and will make deficits get worse.”

Youth unemployment in Spain has been at 50 percent since the crisis in 2008 with “no hope of things getting better anytime soon,” said Stiglitz, who is a professor for economics at Columbia University. “What you are doing is destroying the human capital, you are creating alienated young people.”

To push for growth, European leaders could refocus government spending to “fully utilize” institutions like the European Investment Bank, introduce taxes to improve economic performance and use balanced budget multipliers, he said.

If Keynes were alive today, he'd be horrified at the gross negligence on the part of European policymakers who are sacrificing the next generation in the name of ideology. Sooner or later, Merkel et al. will realize that the only long-term solution to this crisis is to adopt Soros' proposals to create and back a fully functional eurobond market.

Procrastination and more political dithering will bring about more economic hardship and fuel more resentment, empowering extreme left-wing and right-wing parties. It's already happening in many European nations. The rise of extremism is the ultimate threat not only to markets and the global economy, but to world peace and prosperity.

Below, Spanish Economy Minister Luis de Guindos discusses the European sovereign-debt crisis, Spanish banks and the outlook for the economy. He spoke yesterday in Madrid with Bloomberg's John Fraher.

Also, Bloomberg's Mike McKee and Sara Eisen report that the problems of Spain are not extending to Europe as a whole and deepening the debt crisis, but concerns remain. They speak on Bloomberg Television's "Inside Track."

Thursday, April 26, 2012

Social Security Slated to Run Dry in 2033?

On Monday, Social Security Board of Trustees released its annual report on the financial health of the Social Security Trust Funds:
The combined assets of the Old-Age and Survivors Insurance, and Disability Insurance (OASDI) Trust Funds will be exhausted in 2033, three years sooner than projected last year.

The DI Trust Fund will be exhausted in 2016, two years earlier than last year’s estimate. The Trustees also project that OASDI program costs will exceed non-interest income in 2012 and will remain higher throughout the remainder of the 75-year period.

In the 2012 Annual Report to Congress, the Trustees announced:

  • The projected point at which the combined Trust Funds will be exhausted comes in 2033 – three years sooner than projected last year. At that time, there will be sufficient non-interest income coming in to pay about 75 percent of scheduled benefits.
  • The projected actuarial deficit over the 75-year long-range period is 2.67 percent of taxable payroll -- 0.44 percentage point larger than in last year’s report.
  • Over the 75-year period, the Trust Funds would require additional revenue equivalent to $8.6 trillion in present value dollars to pay all scheduled benefits.

“This year’s Trustees Report contains troubling, but not unexpected, projections about Social Security’s finances. It once again emphasizes that Congress needs to act to ensure the long-term solvency of this important program, and needs to act within four years to avoid automatic cuts to people receiving disability benefits,” said Michael J. Astrue, Commissioner of Social Security.

Other highlights of the Trustees Report include:

  • Income including interest to the combined OASDI Trust Funds amounted to $805 billion in 2011. ($564 billion in net contributions, $24 billion from taxation of benefits, $114 billion in interest, and $103 billion in reimbursements from the General Fund of the Treasury—almost exclusively resulting from the 2011 payroll tax legislation.)
  • Total expenditures from the combined OASDI Trust Funds amounted to $736 billion in 2011.
  • Non-interest income fell below program costs in 2010 for the first time since 1983. Program costs are projected to exceed non-interest income throughout the remainder of the 75-year period.
  • The assets of the combined OASDI Trust Funds increased by $69 billion in 2011 to a total of $2.7 trillion.
  • During 2011, an estimated 158 million people had earnings covered by Social Security and paid payroll taxes.
  • Social Security paid benefits of $725 billion in calendar year 2011. There were about 55 million beneficiaries at the end of the calendar year.
  • The cost of $6.4 billion to administer the program in 2011 was a very low 0.9 percent of total expenditures.
  • The combined Trust Fund assets earned interest at an effective annual rate of 4.4 percent in 2011.

The Board of Trustees is comprised of six members. Four serve by virtue of their positions with the federal government: Timothy F. Geithner, Secretary of the Treasury and Managing Trustee; Michael J. Astrue, Commissioner of Social Security; Kathleen Sebelius, Secretary of Health and Human Services; and Hilda L. Solis, Secretary of Labor. The two public trustees are Charles P. Blahous, III and Robert D. Reischauer.

Following the press release, a lot of misinformation was spread. Mark Miller of Reuters reports, Is Social Security really "exhausted?" Not at all:

It's rare to see a federal official publicly beg reporters to get a story right, but the commissioner of the Social Security Administration seemed ready to get down on his hands and knees at a Monday press briefing. Michael Astrue was cautioning journalists not to scare the public about the meaning of the word "exhaustion."

"Please, please remember that exhaustion is an actuarial term of art and it does not mean there will be no money left to pay any benefits" he warned in issuing the trustees' annual report on the financial health of the Social Security program.

"After 2033, even if Congress does nothing, there will still be sufficient assets (from payroll taxes) to pay about 75 percent of benefits. That's not acceptable, but it's still a fact that there will still be substantial assets there," Astrue insisted.

This year's report shows some acceleration of the drawdown of Social Security's vast trust fund reserves. Absent Congressional action, the trust funds of the retirement and disability programs are expected to be exhausted in 2033 as baby-boomer retirements accelerate - three years sooner than projected a year ago.

But Astrue went out of his way to emphasize that the program is far from broke. Social Security took in $69 billion more than it spent last year, according to the report, when you include tax receipts and interest on bonds held in the Social Security Trust Fund (SSTF). The SSTF had reserves of $2.7 trillion last year.

Yet the press plowed right ahead with stories warning that the Social Security retirement program is running out of money. "There won't be much money left for you" after 2033, warned a public radio reporter - a line that pretty well summed up the coverage and nearly forced me to run my car into a ditch.

Americans need to get this right, because Social Security is the primary source of retirement security for most Americans - and it will be even more important in the future as we continue to dig our way out of the rubble of the Great Recession.

So, what's really going on with Social Security?

1. Social Security isn't running out of money.

The long-range actuarial shortfall is projected to be 2.67 percent of taxable payroll - in other words, 2.67 percent of all the earnings subject to Social Security contributions. That's a modest shortfall - and it fluctuates over time due to economic cycles and changes in assumptions about growth in taxable earnings. For example, the projected year of SSTF exhaustion was as far off as 2042 in 2003 in the wake of the dot-com bubble; it was as close as 2029 in 1994 due to changed expectations about real wage gains.

2. Yes Virginia, there is a Trust Fund.

Social Security's critics love to argue that the SSTF is a myth, but it's not. Although Social Security was designed as a pay-as-you-go program, every penny it receives is credited to the SSTF, which has been building enormous reserves following benefit cuts enacted in 1983.

The Trustee report confirms - again - that the surplus funds are invested in "special issue Treasury bonds" and that they are "full faith and credit" obligations of the government to Social Security. Since Social Security can't borrow money by law, it uses those reserves to pay benefits whenever cash on hand runs short.

3. This year's news is not about our aging population.

The accelerated SSTF exhaustion date stems from two factors: a 1.6 percent drop in taxable earnings due to the ongoing depressed economy, and a 3.6 percent cost-of-living adjustment awarded for this year.

Our aging demographics do play a role in the longer range imbalance after 2033, because we have not raised revenue sufficient to match the projected growth in our retired population.

"The choice is to either reduce benefits 25 percent, or raise revenues 33 percent to adapt," says Steve Goss, chief actuary of the Social Security Administration. Making reforms sooner rather than later would allow for a more gradual phase-in, giving the public plenty of time to plan and adjust accordingly.

I'm in favor of a modest, graduated payroll tax increase. Social Security benefits are modest, averaging $1,230 per month this year. It's the main source of income for most people over age 65 - more than half for nearly one in two married couples and two in three unmarried individuals, according to the National Academy of Social Insurance.

A gradual increase in payroll taxes over the next decade would eliminate a sizable portion of the imbalance; another approach is to lift or remove entirely the cap on wages subject to payroll taxes, which currently is set at $110,100.

Perhaps that won't be too exhausting an idea for Congress and the media to embrace.

I think it makes perfect sense to entirely remove the cap on wages subject to payroll taxes but don't count on any reforms taking place in an election year.

What is most troubling is the irresponsible coverage from the media. A similar situation happened here in Canada last week when Jim Leech, President and CEO of the Ontario Teachers' Pension Plan, spoke in Hamilton.

Some pension analysts harped on the media coverage stating that Mr. Leech was offering a dose of reality, The Alliance for Retirement Income Adequacy (ARIA), produced a fact sheet dispelling myths surrounding Ontario Teachers' Pension Plan.

In fact, if you read his speech carefully, he didn't warn of any crisis. Quite the opposite, he explicitly stated: "Let me stress that Teachers’ is not in any short term financial crisis. We have over $117 billion in assets and can pay pensions for decades without any changes."

Jim Leech then went on to vigorously defend defined-benefit (DB) plans (added emphasis mine):
Let me return for a moment to the DB-DC debate and sound a word of caution: We must not allow “pension envy” to define that debate. There is a danger that this could happen, however, as the private sector increasingly moves toward Defined Contribution plans - and away from the Defined Benefit model - saying it is unaffordable.

The truth is that DB Plans are far better vehicles for pension saving. I know that this flies in the face of conventional wisdom, but it is true.

A report by the US National Institute on Retirement Security finds that there are four main reasons for this:
  • Individuals in a DC Plan must plan to live a long life – out to the maximum on the actuarial table, as you don’t want to run out of money part way through your retirement! Because individuals can’t pool longevity risk, like DB plans do, they’re forced to accumulate more in their DC plan than would be necessary to fund an equivalent DB plan, which can be based on actuarial averages.
  • Because DB plans are ageless, they can perpetually maintain an optimally balanced investment portfolio. Individuals, on the other hand, must downshift dramatically in order to lower their risk/return as they age. Transaction costs of such rebalancing are very high.
  • By pooling their savings in a DB Plan, the participants can afford to engage professional investment advisors – something that the average worker with a DC Plan or RRSP cannot afford. When I compare the returns I have realized in my own self-managed RRSP with those of Teachers’, I know I could use some expert advice.
  • DC Plans and RRSPs are usually invested in retail products that carry large administrative fees – sometimes as high as 2% per annum. Contrast that with the cost at Teachers’ of only 25 basis points. The extra 1.75% over a working lifetime is a huge cost - amounting to just under 40% of the total funds you could have for your retirement.
The social costs that the private sector’s shift to defined contribution plans will impose in the future have not been widely acknowledged. Members of such plans will likely retire with inadequate retirement incomes.

Their combined individual defined contribution shortfalls will likely dwarf any potential valuation shortfalls of defined benefit plans, possibly imposing obligations on future governments (read: taxpayers) for further retirement income assistance.

So, we as a society are in a pickle: Defined Benefit plans are being terminated and replaced by Defined Contribution plans which are inadequate.

But a wholesale shift from pure DC to pure DB is not a panacea, either.

It’s time to take a look at a hybrid model.

The recent market chaos should be a wake-up call to everyone – companies, governments and citizens – that our current pension system needs to be overhauled.
The recent market chaos should indeed be a wake-up call to policymakers that our current pension system needs to be overhauled. But politicians worried about being elected will put off any drastic reforms until some catastrophe strikes.

As for U.S. Social Security, it is on sound footing but it too needs reforms, including a possible shift away from the current model to investing in public and private equities much like the Canada Pension Plan. In fact, 10 years ago, Mark Sarney and Amy Prenata of Social Security wrote a paper on this topic. If Social Security does adopt a CPP model, it needs to also adopt their governance.

Bernard Dussault, Canada's former Chief Actuary, shared these comments with me:
I can hardly believe the optimistic views expressed on the OASDI such as "After 2033, even if Congress does nothing, there will still be sufficient assets (from payroll taxes) to pay about 75 percent of benefits. That's not acceptable, but it's still a fact that there will still be substantial assets there," Astrue insisted." Gee! Payroll taxes are not assets, they are income. And a 25% pay-as-you-go shortfall is no case for any complacency.

Because of that complacency, the OASDI was not reformed in the mid-1990s as was the CPP by accelerating the required increases in contribution rates so that the investment earnings on the resulting additional fund can help reducing the contribution rate. It is now too late to do that because the aging of the population has now reached a point where the OASDI contribution rate (12.4%) would need to be increased to more than the paygo contribtion that is now close to 18%.
Below, PBS News Hour's Ray Suarez, Nancy Altman of Social Security Works and the Heritage Foundation's David John discuss its long-term health of Social Security amid a retiring baby boomer population and a weakened economy. Transcript is available here.

Wednesday, April 25, 2012

Why Are Hedge Funds So Gloomy?

Svea Herbst-Bayliss of Reuters reports, Hedge fund managers a gloomier lot in 2012-survey:

Faced with new regulatory oversight, fierce competition for investment dollars, and uncertain markets, nearly half of the hedge fund industry is bracing for a difficult year, a survey shows.

Accounting, consulting and audit firm Rothstein Kass found that 47.5 percent of managers said 2012 will be "difficult" or "somewhat difficult", making for a noticeably gloomier outlook from a year ago when only 32.3 percent of respondents said they expected 2011 to be a tough year.

One surveyed manager warned that bigger funds may fail to meet their investors' expectations. Another manager said that the pressure to perform is on in 2012.

"We are in a new world," said Howard Altman, Rothstein Kass' co-chief executive officer, adding "I t is a time of inflection for the industry with registration and how difficult it is to raise to capital."

As of March 30, all but the smallest hedge funds are required to register with the U.S. Securities and Exchange Commission, providing the agency with more information about the funds' investment philosophies and operations and giving regulators a closer look at who is doing what in the $2 trillion hedge fund industry.

Rothstein Kass surveyed 400 hedge fund managers in January and will release the findings of the survey on Wednesday. Reuters obtained a draft of the report.

One year after sounding an optimistic tone in early 2011, but losing 5 percent on average for the year, the $2 trillion industry has adopted a darker outlook.

Gone are the days where traders could quickly raise millions to launch their own funds, said respondents, adding that raising money is now one of the industry's biggest concerns.

Indeed, 79 percent believe that finding a deep pocketed seeder who will commit capital in exchange for a chunk of the firm is critical to a successful launch this year.

Still nearly half of the polled managers expect to see more competition this year with 48 percent expecting that the pace of hedge fund launches will pick up this year, the survey found.

At the same time with many funds still reeling from the 2008 financial crisis and lasting fears about Europe's debt crisis and growth in the United States which contributed to losses, managers expect to see more funds liquidate.

Like last year, pension funds, endowments and family offices are seen as the main source of funding for hedge funds as many of these institutional investors try to make up for past poor investment returns by adding hedge funds into the portfolio.

Six years ago when Rothstein Kass first put out its annual survey, only 20 percent of the managers expected institutional investors would become the dominant source of capital.

And with more funds chasing investment dollars, one out of every two managers said fund raising and marketing is the single biggest concern for 2012. Indeed 90 percent of the respondents said they expect competition for assets to increase in 2012.

Not surprisingly, raising money is especially hard at smaller funds with many managers saying they feel investors generally prefer to invest with bigger funds. During the last three months of 2011, investors sent less than $7 billion of new money into hedge funds with most of it going to firms that managed at least $5 billion, industry data show.

"One of the frustrations we sense is that emerging managers needing to fight above their weight class," Rothstein Kass' Altman said. "You are dealing with an industry where the top 250 funds control the bulk of the capital."

Even though it will be tough, 66.2 percent of the respondents said they want to boost their capital by 25 percent or more, the survey found.

One of the ways to attract more institutional investors may be to be more conciliatory, respondents said, with 72 percent expecting hedge funds to offer special terms to pension plans and sovereign wealth funds this year.

Please read my last comment on hedge funds fighting back. There is no question that institutional investors prefer larger funds, all part of the 'placebo effect' of large hedge funds. The irony is that smaller hedge funds typically outperform their much larger rivals.

To be sure, some of the biggest hedge funds have earned their asset growth through stellar performance. Global macro funds like Bridgewater and Brevan Howard are two of the biggest and best hedge funds so it doesn't surprise me that Brevan Howard is cashing in on its popularity.

But buyers beware, when I see the world’s biggest publicly traded hedge-fund manager as a likely takeover target, I start getting nervous. And if that doesn't phase you, how about Red Kite's announcement to open up a $1 billion long-only metals fund. You read that right, a LONG-ONLY metals fund!!!

In some ways, it feels like 2005-2006 all over again except this time, underfunded pension funds and other institutional investors are going all-in on hedge funds and other alternative investments.

So cheer up dear hedgies, Apple crushed Street targets, the world isn't coming to an end and you can still ride the big beta wave higher, for now. Just make sure you're not adopting a stay-liquid-and-wait strategy because if that's your game plan, you'll woefully underperform again in 2012.

You can watch Reuters Fred Katayama's interview with Rothstein Kass co-CEO, Howard Altman, here. Below, "BWest Byte" Bloomberg's Emily Chang and Jon Erlichman discuss Apple's cash pile.

Tuesday, April 24, 2012

Beaten Down Hedge Funds Fight Back?

Lawrence Fletcher of Reuters reports, Managers pocket 28 percent of hedge fund profits:

Hedge fund managers pocketed 28.1 percent of profits generated by their funds over the past 18 years, new research from London's Imperial College found.

The research, commissioned by KPMG and hedge fund industry body the Alternative Investment Management Association, found investors' share of annual profits delivered by hedge funds from 1994-2011 was 71.9 percent.

It also found funds delivered an average annual return of 9.07 percent from 1994-2011, compared with 7.27 percent from global commodities, 7.18 percent from stocks, and 6.25 percent from global bonds.

"This research ... disproves common public misconceptions that hedge funds are expensive and do not deliver," said Rob Mirsky, head of hedge funds at KPMG in Britain.

The study, which assumed average hedge fund fees of 1.75 percent and performance fees of 17.5 percent, followed the publication in January of 'The Hedge Fund Mirage' by fund manager Simon Lack.

The book, which prompted a swift rebuttal from the hedge fund industry, said hedge fund managers themselves had earned 84 percent of returns delivered by their funds from 1998-2010.

The study found a relatively high level of correlation between hedge funds and global stocks, particularly during recessions.

The findings come after a 2011 in which funds lost money as markets fell on worries over the euro zone debt crisis and a first quarter of 2012 in which a market rebound has fuelled a resurgence in fund performance.

Correlations between hedge funds and global stocks were 0.87 during recessions and 0.77 outside recessions. A score of 1 indicates a perfect correlation.

The highest correlation was between equity hedge funds - one of the most popular strategies - and global stocks during recessions at 0.91.

You can read AIMA's study, The value of the hedge fund industry to investors, markets and the broader economy, by clicking here. Sam Jones of the FT also reports, Hedge fund industry fights criticism:

The hedge fund industry has never been bigger.

According to figures released last week, hedge funds now manage more than $2.13tn in assets on behalf of their clients. Gone too are the merely superwealthy: the majority of hedge fund investors are now pension funds, insurance companies or other sophisticated institutions.

But this does not mean that hedge funds are better. Last year was the second-worst year for hedge funds on record. The average fund manager lost 5.25 per cent in 2011, a drawdown only worsened in 2008. The post- crisis world has been unkind.

Indeed, for many, such numbers underscore an unpleasant truth: hedge funds are expensive follies

The criticism is not new, but in recent months, fuelled by the performance dip and a number of high-profile losers – John Paulson’s damaging 51 per cent loss, the industry’s worst ever in absolute terms, for example – it has been growing in volume.

Simon Lack, a former JPMorgan banker, has become one of the hedge fund industry’s most vocal critics thanks to his book, The Hedge Fund Mirage, which has enjoyed popularity beyond the rarefied hedge fund enclaves of Mayfair and Connecticut. Last year was the ninth consecutive year that a simple 60:40 stock and bonds portfolio outperformed the average hedge fund, according to Mr Lack.

Even the very notion of hedge funds as “alternatives” in any investor’s portfolio is beginning to come into question. Since 2008, the average hedge fund’s performance has very closely mirrored that of equity markets, apparently giving lie to the promise of de-correlated returns.

Faced with such challenges, the industry is keen to fight back.

The Alternative Investment Management Association is today set to release data, drawn up in conjunction with KPMG by academics at Imperial College, that it hopes will draw a line under the debate.

Hedge funds have, on average, returned 12.61 per cent annually, the research will show: 3.54 percentage points of which is skimmed off by managers as fees, leaving investors to pocket an average 9.07 per cent annual return.

The numbers are hardly of the sensational, shoot-the-moon, type that the hedge fund industry is perhaps best known for, but they are consistent, and they are better than most other asset classes, Aima says.

“This analysis covers 17 years and demonstrates that over that period hedge funds significantly outperformed traditional asset classes,” says chief executive Andrew Baker. “Of course, during that timeframe there will have been individual years when hedge funds were outperformed, but this research looks at the bigger picture.”

A 60:40 stock and bond portfolio may well have done better than hedge funds in recent years, but an equally split hedge fund, stock and bond portfolio would have done the best, the research notes.

According to Robert Kosowski, director at Imperial College’s Centre for Hedge Fund Research, the quality of the returns hedge funds deliver also stands out.

Data analysed by Mr Kosowski show an annual “alpha” – an industry buzz­word that refers to the returns delivered by a manager’s skill rather than extraneous forces such as leverage or market direction – of slightly more than 4 percentage points.

Only 1.32 percentage points of hedge fund returns above a passive benchmark are, meanwhile, due to beta, or market risk factors, according to the research.

The question, as always, however, remains how such returns can be accessed. The average hedge fund does not exist in practice, and there are plenty of managers whose skills may not prove all that they seem.

“There are high-profile blow-ups or losers in just about every asset class you can invest in,” Robert Mirsky, head of hedge funds at KPMG, nevertheless points out. “Hedge funds are no better or no worse, from that point of view.”

More critically, perhaps, the Aima research comes as part of a broader drive at Imperial College to map, for the first time, an accurate “index” of hedge funds.

Traditional indices – of which there are several – are consistently criticised for overstating hedge fund returns.

Funds that implode or suffer negative performance may simply stop reporting figures to the databases, for example, flattering the picture of the industry as a whole, a phenomenon known as survivorship bias.

“Survivorship bias gets a lot of attention,” says Mr Kosowski.

“Some funds drop out because they have bad performance, but some funds also drop out because they have good performance,” he says. “The two actually cancel each other out.”

The hedge fund industry’s fiercest critics may not be silenced by such findings. But with most hedge funds already having made significant gains so far this year – and enthusiasm for hedge funds from big institutional investors remains undimmed – the industry may not actually need them to be.

Undimmed? That's an understatement! After the great hedge fund humbling of 2011, leaving most managers on the ropes, enthusiasm for hedge funds is now off the charts.

Bloomberg reports Japanese pension funds plan to boost investments in alternative assets even after the fallout of AIJ Investment Advisors Co., which just confirms the insatiable institutional appetite for hedge funds and other alternative investments.

But as I mentioned last Friday in my comment on record hedge fund assets and food stamps, now more than ever, investors need to be vigilant on all hedge funds, including "superstar" managers. Far too many investors are falling for the 'placebo effect' of large hedge funds, erroneously believing that if they shove billions into large brand names, they'll fare better during the next downturn.

Nothing can be further from the truth. What is going on right now is hedge funds (and other funds) are riding the big beta wave in markets, a wave that has more upside as many investors are still caught in a stay-liquid-and-wait mode.

The real value of hedge funds will come when the next crisis hits and the large asset gathering marketing con artists running their Malakia Capital Management are exposed for what they truly are while true real alpha generators keep delivering real alpha, earning their performance fees.

The AIMA study brings up good points but it doesn't disprove Simon Lack's claims. He's absolutely right to ask where are the customers' yachts?

Fed up with high fees, some institutions are chopping down hedge fund fees. Moreover, as Caroline Linanki, editor of Nrpn (Nordic region pensions and investment news) reports in the FT, a growing number of sophisticated investors are learning to harvest hedge fund return sources without high fees:

A growing understanding of the composition of hedge fund returns is letting investors capture the return streams of hedge funds through systematic exposure to persistent risk premia (returns above the expected risk-free rate of return). This provides investors with diversification away from equity market risk in a low-cost, liquid and transparent manner, but without the downsides of investing in a hedge fund.

For a long time, hedge fund returns were believed to derive purely from manager skill and clever investment decisions based on active management. However, the academic literature has identified that it is not so much skill as exposure to certain return sources that can explain the majority of returns in certain hedge fund styles.

These alternative risk premia, the beta, or market components of many hedge fund strategies, can now be accessed through far more transparent structures than the typical black-box strategy that comes with hedge fund investing.

“There are a number of persistent risk premia that are uncorrelated to traditional beta,” says Yazann Romahi, executive director, global multi asset group at JPMorgan Asset Management. “A lot of these are typically exploited by hedge fund managers, but wrapped up in illiquid, expensive and opaque vehicles. But there’s nothing fundamentally illiquid about the underlying investments themselves or the underlying risk premia.”

The proponents of alternative risk-premia investing believe the attraction lies in the genuinely uncorrelated returns that it offers.

“The domination of equity market risk is a significant theme for institutional investors across the world and this is one way of reducing it in the portfolio,” says Antti Ilmanen, managing director at AQR Capital Management. “For many investors there is a huge correlation in portfolio returns and equity market movements. And diversifying into hedge funds doesn’t work. Over the last 10 years, the correlation of major hedge fund indices with global equities has been 0.77-0.88 per cent.”

Rather than trying to make money from active investment decisions, alternative beta is about systematic ways to capture the common risk factors behind hedge fund strategies. In other words, instead of timing or trying to forecast the market, it is about systematically harvesting the return sources over time.

PKA, the DKr160bn ($28bn) Danish administration company for five pension funds, and AP2, the SKr216.6bn ($32.1bn) Swedish national pension fund, are two of the pioneers in this area.

Both are in the process of implementing portfolios that look to capture alternative risk premia. The pension funds have been driven by the search to diversifying equity market risk but also share a fundamental scepticism about hedge funds.

PKA’s project to set up a portfolio of risk premia is an isolated equity project and is looking to both capture traditional and alternative risk premia in equity markets. AP2 has taken a different approach and is looking to implement a multi-asset class portfolio of alternative risk premia.

For AP2, capturing alternative risk premia is seen as a way to give the fund cheap exposure to valuable systematic risk factors rather than chasing expensive alpha.

“It’s not that we think alpha doesn’t exist. But it would be naïve to think that alpha would be cheap. By definition, there must be a shortage of pure alpha, so it will be expensive. And it’s also difficult to identify those managers and then knowing if the alpha will persist,” says Tomas Franzén, chief investment strategist at AP2.

The growing interest in alternative benchmarks and investing along risk premia in the long-only space is a related discussion. Both traditional and alternative betas are the result of exposure to systematic risks in capital markets, but alternative beta is more complex. While traditional risk premia can be captured by long-only investing, capturing alternative risk premia requires short-selling, leverage and the use of derivatives. However, long/short risk premia and factor indices are starting to emerge.

An important distinction is the difference between hedge fund replication and alternative beta strategies. While the latter is a bottom-up collection of strategies, hedge fund replication has come to mean top-down replication of hedge fund indices.

“I think the industry has been sent off on a tangent because of the hedge fund replicators. Ironically they delayed the growth of the industry,” says Mr Romahi. “We’re not replicating indices. Our aim is to take out the traditional beta and concentrate on the factor exposure. What’s important is whether we can use the common-factor risk exposures in hedge funds and invest like they do. It’s a subtle but very important difference.”

And crucially, as Mr Ilmanen points out, hedge fund replication strategies will replicate the high correlation with equity markets. “We should instead try to do what’s good in hedge funds – which is the alternative beta part – and come up with a combination of alternative beta strategies that doesn’t have 0.8 correlation but 0.2 correlation to equity markets,” says Mr Ilmanen. However, not all investors are convinced of the existence or persistence of alternative risk premia. One of them is the €31.9bn Finnish pension company Varma, the Nordic region’s largest hedge fund investor with 11 per cent of assets allocated to the asset class.

“We’ve been following the development of the alternative beta space for years,” says Jarkko Matilainen, director of hedge funds at Varma. “There are three strategies where we can easiest argue that there is some alternative beta and where I think it’s applicable: merger arbitrage, convertible arbitrage and trend-following strategies.

“I have difficulty buying the argument that other strategies are capturing alternative beta,” he says.

He is also not convinced that having a systematic exposure to these risk premia is the best approach.

“For me, it’s simple. I don’t want to be invested in convertible arbitrage or merger arbitrage all the time, only when the risk premia is high. Those strategies are quite commoditised and I’m not sure if there’s any risk premia left or if there is enough all the time. You should look to time it rather than participate the whole time. We have outsourced a large part of the timing decisions to the multi-strategy hedge fund that we are invested in,” he says.

But Mr Matilainen does not close the door completely on Varma’s prospects of using alternative beta strategies.

“If alternative beta can be replicated in a reasonable and rational manner then maybe it would be interesting for us. It could also be used as a liquid way to gain exposure if we wanted to make quick changes in strategies,” he says.

Widespread adoption of alternative beta investing would be likely to pose a threat to the traditional hedge fund model. If a significant part of hedge fund returns is beta and not skill, can the industry really justify the existing high fees?

Mr Franzén is clear. “Hedge funds have a fee structure appropriate for true alpha generation while most returns come from systematic risks. We want to get paid for taking systematic risk, not pay for it,” he says.

Mr Ilmanen says an increased understanding of alternative beta is offering investors a weapon when trying to negotiate better fees.

“It’s easier for the hedge funds to charge 2 and 20 when it’s all mystical and magical. When you explain and demystify the returns, it pretty much leads you to lower fees and that’s not in the interest of the industry,” he says.

Mr Franzén agrees: “There are various stakeholders within this discussion and parts of the asset management industry do not want to hear about this. In the end, it comes down to evaluating a business model. If everyone started arguing along these lines, large parts of the hedge fund industry would have problems with their business model.”

I'm not a big believer that "alternative beta" is the way to go. Let's be brutally honest, even if you can capture some of the risk premia in some hedge fund strategies, what exactly are you capturing?

Also, no matter how good you are, you'll never come close to beating top multi-strategy hedge funds which are the best of the best at dynamically allocating across alpha strategies. Investors chasing 'smart beta' should read this previous comment of mine.

Sophisticated Canadian, Dutch and Danish pension funds are properly compensating their managers to deliver internal alpha across public and private markets. They will only go to outside managers and pay fees for alpha they can't replicate internally. And the very best pension plans like ATP and HOOPP hardly use external funds and don't need to bother with "alternative beta" because they have mastered the intelligent use of derivatives to manage their assets and liabilities.

Other top global pension plans like Ontario Teachers' delivered stellar results in 2011 by producing alpha through internal and external managers. And some top global pension funds, like APG, changing without regret, are adopting innovative internal and external strategies like seeding top alpha managers.

I cannot overemphasize the importance of seeding alpha managers in this environment. If done properly, using selective fund of funds, institutions will get better terms (not just lower fees) and a better alignment of interest as smaller hedge fund managers typically outperform their much larger rivals.

Will end my comment by making another shameless plug for Quebec's absolute return funds and ask you to please read that post carefully, including the update at the end. If you require more information, contact me directly at

Below, Ken Heinz, president of Hedge Fund Research Inc., talks about the performance of global hedge funds. He speaks with Linzie Janis on Bloomberg Television's "The Pulse." And Philip Vasan, head of prime services at Credit Suisse Group AG, talks about the outlook for hedge funds and global markets. He speaks with Erik Schatzker, Stephanie Ruhle and Scarlet Fu on Bloomberg Television's "InsideTrack."

Monday, April 23, 2012

Ontario Teachers' CEO Offers Dose of Reality?

Bill Tufts, Founder and Executive Director of Fair Pensions For All, sent me a media release, Teachers' Pension Plan CEO offers dose of reality to taxpayers:
Ontario taxpayers received a painful dose of honesty from the Ontario Teachers’ Pension Plan President and CEO Jim Leech last week as he admitted the funding formula is broken beyond repair and that “revolutionary” changes to pensions are needed.

Leech spoke at a fundraiser in Hamilton on Thursday, after a decidedly brutal assessment of the Teachers’ Plan in the Hamilton Spectator the day before.

Leech pointed out that the plan’s current formulas were based on a 1970 actuarial report that assumed teachers would work for 27 years and retire for 20. As of 2012 teachers are indeed working for 27 years, but they are retiring for 30.

“There is no defined benefits plan ever conceived that you would draw from much longer than you paid in,” he said. “It mathematically doesn’t work.”

Documents released this month by the OTPP reveal that the fund had a $45.49 billion deficit as of the end end of 2011.

Previous statements had listed the fund deficit variously at $17 billion (2010), and $5.2 billion (2011). New accounting rules known as “pension relief smoothing” allowed funds to restate the true losses from 2008 by amortizing them over 5 years. This has tended to hide deficits from view.

The OTPP is recognized as one of the most successful plans in the world, with the highest 10-year returns worldwide, according to CEM Benchmarking. The fund earned an 11.2% return in 2011. Despite these outstanding returns, Leech admitted the fund has had a yearly shortfall for the past 10 years, because benefit payments drastically outrun contributions. He joined the pension fund in 2001 and has been President since 2007.
“There are now 1.5 working teachers for every retiree,” explained Leech. “In 15-20 years it will be 1:1. It was 10:1 in 1970 and 4:1 in 1990. As the signs came in that the assumptions were wrong, the change weren’t made.”

Pension contributions may vary, but benefits are guaranteed for life by taxpayers, in partnership with the fund. Leech suggested that solutions might include a change in the indexing of pensions and an adjustment to retirement ages.

The current Ontario budget recommendations make no mention of taxpayer’s liability for the fund, or other public sector funds such as the Ontario Municipal Employees Retirement (OMERS) fund, which recently declared their accumulated deficit as $9.2 billion. OMERS members have seen their contributions (matched by taxpayers) increase from 4% in the 1970s and 5.5 - 6.5% from 1978 to 2010, to as high as 14% today.

From 1998 to 2002 workers in Ontario took a “contribution holiday” and paid absolutely nothing towards their pensions, while increasing benefits and relaxing qualification rules.

It is currently estimated that the combined deficit for all taxpayer guaranteed public sector pension plans is more than $300 billion. This figure is not included in current government debt figures.

Last year Ontario taxpayers contributed approx. $1.4 billion to the Teachers’ Fund in regular contributions, plus an additional $522 million in top-up payments to be allocated towards the $44 billion shortfall.

This top-up payment is now annual, and expected to increase to $1.2 billion by 2014.

The total pension deficit reduction payment made by taxpayers to the four largest Ontario government worker’s plans was $2.4 billion last year.
Here are the five questions asked to Jim Leech by Meredith MacLeod of the Hamilton Spectator:

1. There is a lot of angst about the future of pensions. Do you share that concern?

Certainly pensions have become the subject du jour for the last year or so. I think it’s a function of the baby boomers reaching that golden age and probably aggravated by the recession which affected people’s nest eggs. There is angst and concern for people about whether they’ll have enough money to last them, pay for health care and maybe long-term care if it’s necessary. The majority of Canadians haven’t saved enough to provide for themselves. We have to face that. Coupled with that, we’re all living longer.

2. What are the current challenges facing the Ontario Teachers’ Pension Plan?

A 1970 actuarial report for the teachers’ pension plan made the assumption that teachers would work for 27 years and retire for 20. He was right about the 27 years of working but teachers are now retiring for 32 years. He didn’t do anything wrong, that was the best information at the time. But we’ve stopped smoking, we’re getting fit, we’re eating better and medical science is coming up with all the answers.

There are now 1.5 working teachers for every retiree. In 15-20 years, it will be 1:1. It was 10:1 in 1970 and 4:1 in 1990. That’s a challenge and it’s driven by the fact the profession isn’t growing. The ranks of teachers aren’t doubling and retirees are living longer … There is no defined benefits plan ever conceived that you would draw from much longer than you paid in. It mathematically doesn’t work.

3. What are the solutions to those challenges?

A number of plans, corporate, private plans are built on erroneous assumptions. As the signs came in that the assumptions were wrong, the changes weren’t made when they could have been evolutionary. Now, the changes have to be revolutionary.

It’s the same with every plan, the economic uncertainty we see means the inability to project with any degree of certainty about returns going forward means we need to be conservative or we are putting everyone at risk. Everybody knows we can’t solve this simply through investment returns. We’ve had the best returns in the world in the last 10 years and we’re still facing a shortfall. We will be the model. Our sponsors (Ontario Teachers’ Federation and the Ontario government) in the past have used conditional inflation protection so that when returns are low, the increases for inflation are suspended … Our sponsors are also looking at retirement ages for a better demographic balance.

4. Do Canadians need to change the way they think about retirement, especially those who don’t have workplace pensions?

There was a study done by David Dodge about a year and a half ago which found that if you want to earn 60 to 65 per cent income replacement for retirement, over 30 to 35 years of working you have to save 15 to 20 per cent each and every year. I’m not sure everybody is doing that … People have to take more responsibility. And we really think the move from defined benefit to defined contribution by many companies is a dumb-headed move. It will end up costing our society much more … We need something in the middle where an amount is guaranteed and then laid on top is something that’s more reflective of what the market is doing.

5. What do you think of the federal government’s recent change to the Old Age Security which bumps eligibility from 65 to 67?

The changes are necessary. As long as the saving period is long enough, it’s fair. It would be unfair to tell someone coming to the last yards of a marathon, “By the way, we’ve added four more miles.” But if you extend it 50 yards, they can probably handle that. I think we’re going to have to see more changes like that.

As I stated in my comment covering Ontario Teachers' 2011 results, even if Teachers' keeps delivering stellar results over the next decade -- no easy feat in these schizoid markets -- investment returns alone will not cover the plan's structural deficit.

The long-term viability of Ontario Teachers' Pension Plan and any other defined-benefit plan rests on getting the governance and funding right. Teachers' sponsors have to sit down and make tough decisions which include raising the retirement age, increasing contribution rate, and cutting cost-of-living-adjustments.

This might not seem fair to young teachers entering the work force and I can understand them. Think of it as an inverse pyramid where younger teachers will be forced to pay more into their pension plan to cover the deficit and benefits to an increasing number of teachers who are retiring. It seems unfair but the truth is that funding formula was never adjusted to reflect the demographic shifts Jim Leech is referring to.

Having said all this, at the end of the day, Ontario's teachers are lucky to have some of the best pension fund managers in the world managing their plan's assets. I can say the exact same thing about members of the Healthcare of Ontario Pension Plan (HOOPP), the best defined-benefit plan in North America, remaining fully funded and leading its peers in 2011.

I also don't think it is useful to harp on Ontario Teachers' deficit as they're still 94% funded, which is excellent compared to other Canadian and US plans. The problem is they're facing stiff structural headwinds and are communicating their concerns openly with their plan members, which is exactly what they should be doing.

Finally, I like what Leech said about the shift from defined-benefit to defined-contribution from companies as being a "dumb-headed move". The real pension experts know that if governments are going to tackle the pension crisis now, they need to stop ignoring the obvious fix for pensions.

UPDATE: Jim Leech Responds

Jim Leech, President and CEO at the Ontario Teachers' Pension Plan, sent me these comments after reading my post (added emphasis is mine):
Read your blog today and was horrified at Mr Tuft's numerous misquotes/representations from my speech last week in Hamilton where I said that revolutionary changes were NOT required (speech is available here).

Thank you for pointing out some of the obvious points.

Fear mongering, especially when it is based on misinformation, is irresponsible. What people need is facts, in context:

1. Our sponsors are working together productively on long term solutions that will allow our plan to adapt to its environment. It's the plans who are not doing this that you need to worry about.
2 Smoothing is used throughout the pension sector not just for losses, but also for gains. This shields members and taxpayers from unnecessary short term contribution rate and benefit volatility. In our case smoothed gains actually exceed smoothed losses at this point in time.
3. Mixing funding valuations and financial statement valuations is amateur.
4. The context for revolutionary change is aimed at those who don't take steps now and insist on unrealistic assumptions in the 8% range while maintaining unaffordable benefits
I thank Jim for sharing his thoughts with my readers and agree 100% with him. Please read his entire speech carefully and once gain, listen to his comments below discussing 2011 results.