Monday, April 2, 2012

Pensions Find Riskier Funds Fail to Pay Off?

Julie Creswell of the NYT reports, Pensions Find Riskier Funds Fail to Pay Off:
Searching for higher returns to bridge looming shortfalls, public workers’ pension funds across the country are increasingly turning to riskier investments in private equity, real estate and hedge funds.

But while their fees have soared, their returns have not. In fact, a number of retirement systems that have stuck with more traditional investments in stocks and bonds have performed better in recent years, for a fraction of the fees.

Consider the contrast between the state retirement fund for Pennsylvania and the one for Georgia.

The $26.3 billion Pennsylvania State Employees’ Retirement System has more than 46 percent of its assets in riskier alternatives, including nearly 400 private equity, venture capital and real estate funds.

The system paid about $1.35 billion in management fees in the last five years and reported a five-year annualized return of 3.6 percent. That is below the 8 percent target needed to meet its financing requirements, and it also lags behind a 4.9 percent median return among public pension systems.

In Georgia, the $14.4 billion retirement system, which is prohibited by state law from investing in alternative investments, has earned 5.3 percent annually over the same time frame and paid about $54 million total in fees.

The two funds represent the extremes, with Pennsylvania in a group of pension systems with some of the highest percentages of investments in alternatives and Georgia in a group of 10 with some of the lowest, according to groupings of funds identified by the London-based research firm Preqin.

An analysis of the sampling presents an unflattering portrait of the riskier bets: the funds with a third to more than half of their money in private equity, hedge funds and real estate had returns that were more than a percentage point lower than returns of the funds that largely avoided those assets. They also paid nearly four times as much in fees.

While managers for the retirement systems say that a five-year period is not long enough to judge their success, those fees nevertheless add up to hundreds of millions of dollars each year for some of the country’s largest pension funds. The $51.4 billion Pennsylvania public schools pension system, for instance, which has 46 percent of its assets in riskier investments, pays more than $500 million a year in fees. It has earned 3.9 percent annually since 2007.

Whether the higher fees charged by private equity firms and hedge funds are worth it has been hotly debated within the investment community for years. Do these investment entities, over an extended period of time, either offset the wild swings in assets during rough patches of the market or provide significantly higher gains than could be found in less-expensive bond and stock investments?

“We can’t put it in Treasury notes and bonds; that’s just not making any money,” said Sam Jordan, the chief executive of the Austin Police Retirement System in Texas.

James Wilbanks, executive director of the Oklahoma Teachers Retirement System, which has largely stayed with stocks and bonds, said that pension funds were obligated to take a cautious approach. “We all heard the stories about institutional funds that had more than half of their assets in private equity in 2008” and then had to sell, he said.

While both sides of the debate can point to various studies, the topic is taking on a sharper focus as more funds embrace the riskier strategy. By September 2011, retirement systems with more than $1 billion in assets had increased their stakes in real estate, private equity and hedge funds to 19 percent, from 10.7 percent in 2007, according to the Wilshire Trust Universe Comparison Service.

Public retirement systems are struggling to earn sufficient returns with interest rates near record lows and more and more workers qualifying for retirement. Their pension costs are growing fast, but state and local government returns are not keeping up.

A new study by the Government Accountability Office raised questions about how some of the riskier investments performed for public and private pension funds during the financial crisis. Meanwhile, some public retirement systems that increased their stakes in those investments are trying to curb those costs.

Calpers, which has earned 3.4 percent annually over the last five years, is pushing the managers of the funds for lower fees as well as reducing the number of outside managers it uses to try to bring costs down.

“I think it’s part of our job as public fund managers to do our best to drive a better bargain,” said Joseph A. Dear, the chief investment officer for Calpers.

Mr. Dear cautioned that there were big differences in how various alternative investments performed during the financial crisis.

He said that Calpers’s investments in real estate had been “a disaster” and that its hedge fund investments had not met their benchmarks and were under review. But he said that its private equity holdings had easily beaten public stock returns over the last decade.

“Over the longer term, that kind of outperformance represents real skill, not luck, and it’s worth paying for,” he said.

Heads of pension funds across the country feel trapped. Lower-risk bonds, like 10-year Treasury notes with a yield of around 2 percent, simply will not fill the gaps many systems face between what they have and what they owe retirees.

The Austin Police Retirement System, for example, moved 46 percent of the $505 million it oversees into alternative investments after the 2000 collapse of technology stocks produced steep losses.

However, the fund’s choice of investments — real estate in places like Las Vegas and Florida — did not provide much refuge when that bubble burst.

“Vegas was in a boom time,” Mr. Jordan, the fund’s chief executive, said. “Snowbirds were moving there from the Midwest. People were saying at one time it was going to get bigger than New York. Then the bust happened, and we owned some single-family developments, subdivisions, and there’s no one living in those.”

The fund has returned 2.5 percent annually over the last five years. Mr. Jordan still believes that over many years those investments will pay off, he said.

To be sure, it has been tough to find robust returns in any markets over the last five years. While the median return for private equity investments held by public pension funds was 7.2 percent annually, hedge funds returned only 2.74 percent, according to Wilshire TUCS. Likewise, global bonds earned 6.99 percent while global equities rose 3.68 percent.

Despite their tepid returns, retirement systems that have bet big on riskier investments are paying a hefty tab. While funds with little stakes in hedge funds and private equity pay an average of 17 cents on every $100 invested, funds with large stakes pay 77 cents.

The Pennsylvania state retirement system, which has about 46 percent of its money in alternative investments, paid those managers 77 percent of the system’s total $195 million in fees last year. Last fall, the system replaced the two consulting firms that had promoted that strategy. Over the last five years, its annual returns of 3.6 percent lagged behind its peers’.

In a series of e-mails, Pamela Hile, a spokeswoman for the Pennsylvania fund, said that the fund had made many new alternative investments from 2004 to 2007. Some of these entities, like venture-capital funds, often have negative returns in the early years as that money is invested, she said.

Noting that pension funds have time horizons that stretch into decades, Ms. Hile added that the retirement system had outperformed its 8 percent target over the last 25 years, with an 8.8 percent annual return.

Still, the allure of the riskier investments remains strong, even among public pension funds that without them have still performed better than other funds.

The Oklahoma Teachers Retirement System, which has posted returns of 5.5 percent over the last five years through a mix of stocks and bonds, is putting 10 percent of its fund into private equity and real estate funds.

When asked about the higher fees, Mr. Wilbanks, the fund’s executive director, said, “We believe the outperformance from moving into these categories can justify the additional fees.”

It's simply mind-blowing reading articles like this but I'm hardly shocked. Most U.S. public pension funds don't have a clue of what the hell they're doing when investing in private equity, real estate and hedge funds.

At the end of the day, all this nonsense boils down to poor governance. In the U.S., they pay pension fund managers monkey salaries and that's why they get monkey results. Worse still, their fiduciaries take a cover-your-ass approach, relying entirely on their brainless pension consultants who've never invested a dime in alternatives, don't understand the risks and don't understand the strategies to gauge whether the fees are worth it. They also don't understand how to structure a portfolio of alternatives, how they fit in the overall portfolio and how they're highly correlated to traditional asset classes.

When you scrutinize the performance of hedge funds and private equity funds, you'll quickly recognize that most of them are glorified asset gatherers who are NOT aligning their interests with pension funds and their stakeholders. It's even worse with funds of funds that charge an extra layer of fees. But some investors are realizing they're getting eaten alive on fees and others are completely re-questioning their entire approach on alternatives.

In Canada, public pension fund managers are properly compensated and they do not pay external funds for strategies they can replicate in-house. They pay experts to do direct deals in real estate, private equity, infrastructure and they'll have internal teams in public markets to generate absolute returns.

Importantly, the large and sophisticated Canadian pension funds will only pay external managers for alpha they cannot reproduce internally. And even then, they use their size and clout to lower fees, making sure they get the best possible deal.

Last week, I discussed why in this environment it makes sense to focus on smaller hedge funds. Sure, a handful of large hedge funds fared well in 2011, but the majority failed to deliver absolute returns and couldn't even beat the market. Last year was indeed the great hedge fund humbling.

I've been critical of alternatives because I know first-hand the amount of nonsense that is going on in this overhyped industry. Too many pension fund managers are enamored, intimidated by "star" managers in this space and they get hoodwinked into investing in 'brand names" without understanding the risks of the strategy and the correlation with other asset classes.

You could put Ray Dalio, Jim Simons, Alan Howard, Ken Griffin, Steve Cohen, David Bonderman, John Grayken, Tom Barrack or any other "elite" manager in the alternatives space in front of me and I'll grill them just as hard, if not harder, than I'd grill someone else trying to raise money. Couldn't care less if George Soros was in front of me, if you want to manage pension money, you'd better answer all my questions and don't get cute with me or else I'll crucify you!

You don't have to be an asshole when grilling managers but you have to do your job or else you're going to get burned. And doing your job means knowing when to pull out and knowing when to stay in. How many investors (erroneously) rushed out of Citadel Advisors after they got clobbered in 2008? I would have doubled-down and this isn't with the benefit of hindsight. I even wrote about it on my blog back then.

Most investors panicked and pulled out at the worst possible time without understanding why the fund experienced sharp losses. Since then, Citadel has recouped nicely as their main hedge funds cleared their high-water mark, allowing them to charge performance fees once again.

But for every Citadel, there are thousands of charlatans and snake-oil peddlers. It's truly disconcerting watching pension funds gunning for higher yields chasing after alternatives managers over-promising and under-delivering. Again, the biggest problem in the U.S. is poor governance, which means you get what you pay for.

There are of course exceptions. CalPERS, CalSTRS, MOSERS, and a few others stand out in my mind but the bulk of U.S. pension funds are poorly governed. For example, Chris Tobe sent me an article on Maryland paying excessive fees for currency management to reduce volatility. For pure currency hedging, they are better off using Montreal's Fjord Capital. I guarantee you they wouldn't have gotten raped on fees and they would have received much better results.

Let me once again make the case for seeding hedge funds in this environment. There are many frustrated prop traders at big banks and brokerage firms that see the writing on the wall as Basel III rules come into effect. They want out of these shops because most of them are sick and tired of the bullshit politics, and I don't blame them.

But only a handful will survive and thrive on their own. As one commodities trader told me: "Many of the guys that trade at prop desks trade on flow from their clients. They have a separate absolute return book but their profits are intertwined with the flow trades from clients' trades. Once that is taken away from them, very few can generate alpha consistently on their own. When they lose money, the psychological effect overwhelms them and they realize they can't make it on their own."

He's absolutely right which is why I now recommend seeding new talent through an experienced fund of funds like PAAMCO or Blackstone. There are others who are less well known but equally excellent and know how to weed out true talent from bozos looking to collect 2 & 20 for leveraged beta. When it comes to seeding, it may be worth taking a fund of funds approach but you still need to negotiate carefully on fees and terms so that you benefit if one of the funds succeeds.

Importantly, investors need to start thinking outside the box when it comes to alternatives or else they'll get creamed on fees and underperform over the long-run. I'm convinced of this.

Below, embedded some Bloomberg interviews on markets discussing a range of views. All worth watching but I maintain that this liquidity rally isn't over and that markets will keep grinding higher in Q2. Pay attention to some commodity and energy shares which got trounced in Q1 as investors brace for a hard landing in China.




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