Sunday, September 30, 2012

Retail Investors Falling Dangerously Behind?

Jilian Mincer and Steven C. Johnson of Reuters report, Mom and pop investors miss out on stock market gains:
Stocks have more than doubled since the financial crisis and are closing in on a five-year high, but many Main Street investors have been absent from the party - especially those with the least saved.

Those who missed much of the rally did so because they reduced equity exposure after the benchmark S&P 500 index plummeted 57 percent between late 2007 and March 2009, according to an analysis by Reuters of mutual fund flows and changes in assets held in retirement accounts. Investors with the smallest savings typically saw the lowest percentage recovery in returns.

And while some have returned to the stock market during the subsequent rally, plenty of small investors remain on the sidelines.

"This is the most uncelebrated bull market in history," said Tony Ferreira, managing director at Cogent Research, which provides research and consulting for large fund managers. "In the old days, people would be jumping on the bandwagon, but nobody's chasing equity performance this time. Many people are still scared to wade back into the water."

If the equity upswing continues, some economists fear it could leave middle class Americans financially unprepared for retirement and widen the growing income disparities between rich and poor, which the U.S. Census Bureau said grew sharply in 2011.

It could also complicate President Barack Obama's chances for re-election, with some voters not having enjoyed much of a wealth effect from the stock market's 3-1/2-year rally.

To be sure, plenty of Americans have seen the balances of their 401(k) retirement accounts bounce back since the financial crisis as inertia kept many from abandoning stocks when the market crashed.

But things are hardly like they were during the bull market in the 1990s, which turned many retail investors into addicts for the latest Internet stock offering.

According to figures from Cerulli Associates that are based on analysis of Federal Reserve data, those with less than $100,000 in investable assets on average had $17,975 at the end of 2011, down 9 percent from $19,732 at the end of 2007.

In contrast, those with $500,000 to $2 million saw a 7 percent uptick to $966,948 from $903,219.

The vast majority of U.S. households - 87 million of the almost 119 million in 2011 - have less than $100,000 in assets, according to the data.


Investment advisers say stock market plunges in 2000-2002 and 2008-2009, the housing bust, a weak economy and a steady stream of Wall Street scandals have helped sour people on stocks and push them toward the perceived safety of bonds and cash.

Typically when the market doubles after hitting bottom investors return, said Jeffrey Mortimer, director of Investment Strategy at BNY Mellon Wealth Management in Boston.

But not this time. "They're still not back, and they'll unfortunately miss a rally," he said.

Investors didn't dump all their stocks during the crisis, but fewer households now hold equities than a decade ago, according to the Investment Company Institute, a U.S. mutual fund trade organization.

"The vast majority of people have some equity holdings in their 401(k) plans," said Brian Reid, chief economist at the ICI, but fewer are willing to take above-average or substantial risk than they were in 2008, before the market plummeted.

After climbing to 53 percent in 2001, equity ownership in individual stocks, mutual funds, ETFs and variable annuities fell to 48.2 percent in 2008 and 46.4 percent in 2011.

In another sign of how many investors have missed out on the recovery, they have pulled $235 billion out of U.S.-domiciled equity mutual funds, considered a proxy for retail investors, since 2007, data from Thomson Reuters' Lipper service shows.

Of that amount, some $53 billion has come out since last October, the bottom of a two-month selloff sparked by crisis in Europe and the loss of the United States' top credit rating. During that stretch, the benchmark Standard & Poor's has gained 28 percent, the Dow industrials 24 percent.

For the broad investing public, "it's been five solid years of steady outflows from equities and inflows into bonds," said Liz Ann Sonders, chief investment strategist at Charles Schwab & Co, which oversees $1.6 trillion in client assets. "Even 3-1/2 years into this bull market and the gains we've seen since June, it has not turned that psychology around."


Investors who left the market at the end of 2008 or early 2009, paid a high price.

Fidelity Investments found that individuals who had been investing for at least 12 consecutive years in their 401(k) plans but pulled out of equities in late 2008 or early 2009 had an average balance at the end of June 2012 of $167,000, compared with a $212,000 balance for those who didn't.

"The average investor tends to chase returns when things are going well and bolt when things are going poorly," says Drew Kanaly, CEO of Kanaly Trust Co in Houston.

To be fair, even advisers for the very wealthy - people with a few million dollars in assets - have lately been doing "a lot of hand-holding and education" for clients who were scarred by the 2008 crash, said Lori Heinel, head of investment services and chief investment strategist at Oppenheimer Funds.

"But some of these investors may just want to preserve capital. They don't necessarily have to see it grow," she said. "I'm more concerned about the average investor with a 401(K) balance that's less than $100,000."

Indeed, if average investors don't recover some appetite for risk, it could leave more Americans financially under prepared for retirement.

According to the Employee Benefit Research Institute, the median balance was $58,000 for workers 55-64 with a 401(k) retirement plan at the end of 2010. The median for all 401(k) participants that year was $17,686.

About 60 percent of workers and or their spouses had less than $25,000 in savings and investments excluding their homes and pensions, according to EBRI's 2012 Retirement Confidence Survey, which was released in May.

And it's not just baby boomers that are at risk.

A recent Cogent Research report found that risk aversion among all age groups has been on the rise since 2006, including Generation X and Y, who have lived through a number of market collapses.

But while bonds have provided solid returns in recent years, thanks to low inflation and the Federal Reserve efforts to hold down interest rates, advisers say a long-term strategy based on bonds and cash may be riskier than stocks.

Bank accounts and money market funds currently pay next to nothing and a 10-year bond is yielding little more than 1.6 percent.

"If you have a 401(K) or an IRA, you have to be invested in risk assets in order not to outlive your money," said Barry Ritholtz, director of equity research at Fusion IQ. "There's simply no way to get to retirement without some sort of participation in the market. Unless you have $10 million, and maybe even if you do, you have to outpace inflation."

Investors, though, seem to be in no hurry to climb the so-called wall of worry. Now, many fear gridlock in Congress after the election could trigger massive automatic spending cuts and tax increases, bringing on another recession in 2013.

The American Association of Individual Investors reported on Thursday that bullish sentiment - based on whether investors expect stock prices to rise over the next six months - declined in its latest weekly survey to 36.1 percent.

It has now been below the historical average of 39 percent for 25 out of the past 26 weeks, and many of those responding expressed frustration about the political uncertainty.
Clearly the scars of 2008 are still fresh in the minds of many retail investors who got wiped during the financial crisis.

The article also demonstrates that America's 401(k) nightmare is far from over. The majority of households are financially under prepared for retirement, which means either people will have to work longer, or more likely, they will require some form of social assistance to survive in their golden years.

Bearing this in mind, I was actually impressed to read this Bloomberg article, California Is First to Offer Private-Pension Management:
California Governor Jerry Brown signed a law that permits as many as 6.3 million private workers without a pension plan to set aside retirement money for management by the state.

It is the first state-run pension program for non-government employees and may add as much as $6.6 billion to funds managed by the California Public Employees’ Retirement System, the biggest U.S. pension. Calpers, as the fund is known, has assets of $242 billion.

The law is aimed at businesses with five or more employees that don’t offer pensions or 401(k) savings programs. The law requires companies to contribute 3 percent of a worker’s salary to a retirement account. Workers will be enrolled in the program unless they choose to opt out.

About 6.3 million Californians, most of them making less than $46,420 a year, aren’t covered by an employer-provided retirement plan, according to a June 2012 study by the Labor Center of the University of California, Berkeley.

The measure was opposed by the California Chamber of Commerce and Republican lawmakers.

The law won’t automatically entrust the new retirement accounts to Calpers. Rather, the fund, which manages benefits for 1.6 million public employees, retirees and beneficiaries, will bid for the asset-management business in a process to be overseen by an investment board headed by the state treasurer. Private firms may compete to manage all or part of the money.
At least California is doing something to help private workers be better prepared for retirement. The benefits of having CalPERS manage their pension savings are huge because they can lower fees and invest across public and private market asset classes, reducing the volatility of returns.

Still, this isn`t a defined-benefit plan and workers can opt out at any time. The sad fact is far too many Americans are falling behind, ill-prepared for retirement.

Below, Daily Ticker's Henry Blodget interviews economist Teresa Ghilarducci on why America`s retirement system has failed. In a New York Times Op-Ed published in July, Ghilarducci argued that the current retirement savings model is "ridiculous" and failing middle-class Americans.

Saturday, September 29, 2012

MPs Back Hike in Pension Contributions?

CBC News reports, Conservatives back hike in MP pension contributions:
The Conservative caucus has accepted a government proposal that would ease the burden on taxpayers by more than tripling how much members of Parliament and senators kick into their pension plans, CBC News has learned

Currently, MPs and senators contribute around $11,000 a year to their own pensions, while taxpayers add about $64,000 for each pension plan.

Under the proposal, it would be a 50/50 split, CBC's national affairs editor Chris Hall reported.

A 50/50 contribution split would bring the parliamentary pension plan in line with changes being implemented for the federal public service.

If the pension plan's benefit levels do not change, politicians may need to contribute close to a quarter of an MP's current salary to meet taxpayers halfway. At current benefit levels, parliamentarians would have to contribute around $38,000 a year, a jump of more than $25,000 from what they pay now.

Alternatively, the benefits payable could become less generous.

Hall said it's still unclear whether eligibility rules could change, such as increasing how long MPs will have to serve from six years to eight, or if they will have to collect their pensions later at age 60, as opposed to 55.

A change in eligibility rules could also affect the amount serving parliamentarians need to contribute to the plan.

The pay freeze on MPs and senators salaries may end, but it's unclear how much salaries might rise to compensate for greater pension contribution requirements.

The changes are expected to take effect in the next Parliament, affecting MPs and senators who start in 2015 and beyond. Those already serving would not see their pension eligibility change.
Contribution disparities under current plan

A study by the C.D. Howe Institute last January found that in 2011, the taxpayers' share of contributions to the plan was more than six times the amount paid by MPs into the plan.

Numbers released last June by the Canadian Taxpayers' Federation tallied an even greater disparity in who bears the brunt of the costs: the taxpayer watchdog believes the public contributes more than $24 for every $1 contributed by MPs.

Under the current system, parliamentarians contribute seven per cent of their gross salaries to the pension plan. The pension pays out three per cent of this average of their best salary per year of service.

Many observers consider the current pension payouts very generous. Each MP makes just under $158,000 a year and after six years of sitting in the House, each qualifies at age 55 for a pension based on the average of his or her best five years of salary.

Assuming the minimum six years of service at the current $158,000 annual salary, a backbench MP stands to receive a pension of more than $28,000 a year.

Long-serving parliamentarians or those who earned higher salaries, such as cabinet ministers, receive much more.

Figures from 2011 suggest there are 59 former MPs and senators who receive more than $90,000 a year each. The average annual pension is $60,599 for former members of the Senate and $55,102 for former members of the House of Commons.

The parliamentary pension scheme changed significantly in the early nineties. Not every former MP, or senator or their survivors receives benefits at these levels. Sixty former parliamentarians, or spouses and dependents of former parliamentarians, received benefits of less than $15,000 in 2011.
The new rules for funding parliamentarians' pensions make sense. There has been a lot of pressure from groups representing Canadian taxpayers to change the current system where MPs have their snouts in the pension trough.

Another reason behind this move is that the Conservatives are preparing to introduce sweeping changes to federal public sector pensions. In the next few weeks, we will learn about new proposals that change eligibility rules, benefits and possibly an introduction of a defined-contribution plan for new employees entering the federal civil service (stay tuned).

Of course, as the pay freeze on MPs and senators salaries ends, they will likely vote in higher salaries to offset some of the higher pension contributions. Moreover, as the article mentions, it is unclear whether  the eligibility rules change.

I'm not against giving MPs decent salaries and good pensions. I think if someone serves in public office, they are taking a big risk and we should reward them for doing so. It's also important to remember that not all MPs get pensions:
While few would dispute that the pensions provided for MPs are generous, one former MP cautions it would be a mistake to run for office simply for the pension.

A six-year minimum eligibility means MPs have to win at least two elections — possibly more in a minority government situation.

Former Liberal MP Glen Pearson says that those who have a career before going into politics have to decide whether to give up their highest-earning years to serve the public.

Of course, a winning candidate for federal office immediately earns a salary far beyond that of most Canadians for the years they're in Parliament — just under $158,000 a year (the average family income in Canada in 2010 was $76,600, according to Statistics Canada).

But if they don't make it beyond one election, they've lost out on their highest earning years in their previous career, Pearson points out.

Pearson won a byelection in London, Ont. on Nov. 27, 2006. He was defeated by Conservative MP Susan Truppe on May 2, 2011, giving him four and a half years in office.

Pearson, who is now too old to return to his previous career as a firefighter, often runs into former constituents who refer to what they assume is his huge pension.
Felt it was 'very much worth it'

"I think people don't realize that when somebody leaves another thing to go into politics, they're actually leaving a whole other livelihood behind, a pension scheme they might have been in, or money that they were making from another job. So you sometimes come back and you've actually taken a hit for being in politics," Pearson said.

"I did think about that, but because I was being asked to run for reasons that had to do with Africa and [the Canadian International Development Agency] and things that I really, really believed in, I felt I would take that chance. And I knew there was a chance that I would not get to the six-year stage. Absolutely, I knew that. But for that cause I felt that it was very much worth it, and for representing me and my constituents."

After they've hit six years in the House, MPs qualify at age 55 for a pension based on the average of their best five years of salary.

Assuming the minimum six years of service at the current $158,000 annual salary, a backbench MP stands to receive a pension of more than $28,000 a year.

The pensions are mostly funded by taxpayers. The Conservative government is planning to reform the pensions by having MPs contribute more.

Long-serving parliamentarians or those who earned higher salaries, such as cabinet ministers, receive much more.

Figures from 2011 suggest there are 59 former MPs and senators who receive more than $90,000 a year each. The average annual pension is $60,599 for former members of the Senate and $55,102 for former members of the House of Commons. Some MPs are elected young and are well positioned for a career after Parliament — with the added comfort of that pension.
Some will qualify before they are 30

Conservative MP Pierre Poilievre, for example, was first elected June 28, 2004, a few weeks after his 25th birthday. At 33 years old, he has already qualified for the MP pension. The same goes for House of Commons Speaker Andrew Scheer, who was elected the same day and at the same age. There are usually a handful of young MPs elected after each trip to the polls, but the May 2011 election saw a whole crop of New Democrat MPs in their early 20s take seats in the House. If re-elected, they would be set to hit their six-year eligibility and qualify for the pension before any of them hit their 30th birthday.

For those who go on to a career after politics, there are sometimes lucrative consulting jobs available (Pearson says they didn't interest him, so he's a volunteer director at the London foodbank).

But it's not the case for everyone.

Pearson, who is recovering from major surgery to remove a benign tumour from his stomach, says he's happy to have time to spend with his wife and seven children. But the fact that three of them will be in university in the next six years caught him up on election night.

"That was very much on my mind," he said.
Finally, as MPs change their pension rules, many Canadians are very worried about their pensions. Earlier this week, the Vancouver Sun reported that Canadians feel increasingly vulnerable about pensions:
Years of volatile stock markets and low interest rates have made Canadians feel vulnerable about their retirement and they're looking to their pensions, a new report by Towers Watson suggests.

"Employees are willing to sacrifice cash pay, bonus opportunities and to a lesser extent paid time off to secure and increase their retirement benefits," the report said.

"The increased appeal for security is also affecting the factors that employees look for in a job."

Companies have been switching from defined benefit pension plans to defined contribution plans because of the risks inherent in promising to pay a regular monthly benefit years in the future.

However the report said defined benefit plans are attractive for companies that want to attract and keep employees.

The report said base pay and job security were top factors for taking a job among employees of all ages, but many are attracted to the security of their retirement.

"The appeal for security is particularly evident among employees with a defined benefit plan, which supports that these programs are an effective attraction and retention tool," the report said.

The survey by the pension consulting firm found a third of Canadian workers would give up part of their current compensation in return for improved security in retirement.

Towers Watson also said one in four would forgo a bonus in exchange for additional retirement benefits.

The report suggests that 50 per cent of those surveyed with a defined benefit pension plan identified their retirement program as a key reason for joining their current employer.

That compared with 30 per cent of those with a defined contribution plan or group RRSP.

And once employees have been hired, pension plans play an even larger role in why workers will stay with a company.

Depending on age, between 62 per cent and 71 per cent of Canadian workers in a defined benefit plan cite their retirement program as a compelling reason to remain with their current employer.

That compared with between 30 per cent and 50 per cent of those with a defined contribution plan.

Towers Watson surveyed 1,577 full-time workers for private sector companies with at least 1,000 employees.
You can download the complete Towers Watson survey by clicking here. The survey highlights are also posted on Towers Watson's site:
  • Canadian workers look to their employers to help them prepare for retirement and identify personal savings, employer-sponsored retirement plan(s) and social security benefits as their top three expected sources of retirement income. While a majority of Canadian respondents are satisfied with their retirement plan, satisfaction tapers off among older workers.
  • A significant percentage of employees are not satisfied with employer-provided retirement information and tools. Although reactions vary, Canadians find face-to-face advice and web-based tools most effective and traditional mailings least effective.
  • As financial insecurity has become widespread, Canadian workers are increasingly interested in a secure rewards package with retirement benefits they can count on. Many respondents would trade off pay increases in exchange for guaranteed or more generous retirement benefits. Older Canadians — especially those with defined benefit (DB) plans — are most willing to surrender pay, bonus opportunities and, to a lesser extent, paid time off (PTO) for a larger and more secure retirement benefit. Canadians of all ages are also willing to relinquish control over investing their retirement assets in exchange for a guaranteed retirement benefit.
  • Canadian workers’ greater appetite for security is affecting their employment decisions. The survey shows a similar shift in the U.S. regarding the attraction and retention powers of retirement programs, particularly among DB plan participants. Canadian DB plan participants of all ages identify their retirement plan as an important reason for taking and remaining at their current job. Both younger and older employees ranked their DB plan as one of their top four reasons for taking their current job, along with job security, base pay and health care benefits.
  • This research shows strong evidence that DB plan sponsors have more stable workforces than organizations with only a defined contribution (DC) plan or group registered retirement savings plans (GRRSPs). DB plans are particularly effective at attracting security-minded workers who view their job as potential career employment. Employees expect their organization’s retirement plan to help them prepare for retirement.
Canadian MPs and companies should take note of this important survey as it clearly demonstrates that Canadians are feeling increasingly vulnerable about their pensions and given a choice, they prefer the security of a defined-benefit plan.

Below, CBC's Chris Hall reports on how the Conservative caucus has accepted a government proposal that will dramatically increase the amount MPs and Senators contribute to their pension plans.

Friday, September 28, 2012

Landmark Settlement for Pensions?

Richard Blackden of the Telegraph reports, European pension funds among victors as Bank of America reaches $2.4bn settlement over Merrill Lynch:
America’s second-biggest bank struck a deal with investors to end a near four-year legal battle that was destined for trial in a New York court next month.

PGGM, which helps manage €125bn (€100bn) in the Netherlands, and AP4, one of Sweden’s state pension funds, are among those who had led the litigation in Manhattan.

Analysts said the deal will likely result in a third-quarter loss for BoA after it set aside $1.6bn to help fund the payout. Brian Moynihan, the bank’s chief executive, insisted that the agreement removes the “risk and uncertainty” that a trial would have involved.

“They’ve decided this on the courthouse steps,” said Roy Smith, a professor of finance at New York University. “They decided that they really didn’t want to face a jury trial.” The lawsuit, filed just weeks the $18.5bn acquisition of Merrill was sealed in January 2009, alleged that BoA failed to disclose the mounting losses that Merrill was facing.

According to the suit, BoA should have disclosed the deterioration in Merrill’s financial health between October 31, 2008, when the deal was first formally put to shareholders, and December 5, 2008, when investors were required to approve the purchase.

Weeks after buying Merrill, BoA took a $20bn injection from US taxpayers as Merrill’s losses for the final three months of 2008 spiralled past $15bn. It also controversially paid out millions in bonuses to Merrill bankers.

Shares in BoA fell 1.5pc in afternoon trading on Friday as investors took fright at the scale of the settlement.

“This settlement is far larger than we expected given the weak merits of such suits and historical precedence,” said David Trone, an analyst at JPM Securities. “BoA is attempting to rebuild its capital base, and these hits will essentially erase the past six months of progress.”

BoA denies the lawsuit’s allegations.

The agreement also underlines the legacy of litigation left by former chief executive Ken Lewis’s deal-making. Besides agreeing to buy Merrill the day before Lehman Brothers filed for bankruptcy, Mr Lewis engineered the purchase of Countrywide, once America’s biggest mortgage lender, for $4bn in January 2008. The bank has faced a wave of lawsuits from Countrywide customers alleging the lender mis-sold them mortgages.

In the face of the mounting legal threats he inherited, Mr Moynihan last year hired Gary Lynch, the former head of enforcement at the Securities and Exchange Commission, to help resolve them. Although Merrill has proved a much better acquisition than Countrywide, billionaire investor Warren Buffett has said that the bank paid a “crazy price” for Merrill.

As part of Friday’s settlement, BoA also agreed to make improvements to its corporate governance. “We had a duty as a long-term investor to be active in this case,” said Mats Andersson, the chief executive of AP4.

The lawsuit was the first time that both AP4 and PGGM had been lead plaintiffs in a class-action lawsuit in the US. The settlement is the eighth-biggest for such legal action. A pension fund for teachers in Texas and two public pension funds from Ohio were the other lead plaintiffs.
Mark Cobley of Financial News also reports, Bank of America settles with pension funds for $2.4bn:
Bank of America has agreed to pay $2.4bn to settle a class-action lawsuit over its 2009 acquisition of investment bank Merrill Lynch - one of the four largest legal settlements of its type in history, according to one of the lead plaintiffs.
As well as paying the money, the bank has agreed a series of corporate-governance improvements, including subjecting future M&A decisions to a special board committee and conducting an annual "say on pay" vote for shareholders.

Bank of America was sued in 2009 by four big public pension funds, with others able to join the lawsuit subsequently. They complained that the bank and its directors had made misleading statements about the financial health of Merrill Lynch before the acquisition, encouraging shareholders to vote for the deal.

Bank of America said in its statement it "denies the allegations and is entering into this settlement to eliminate the uncertainties, burden and expense of further protracted litigation".

The lead plaintiffs comprised three US plans - the State Teachers Retirement System of Ohio, the Ohio Public Employees' Retirement System and the Teacher Retirement System of Texas - and two European funds, the Dutch healthcare workers' scheme PfZW and the Swedish state fund AP4.

They accused Bank of America of omitting to mention "mounting losses of billions of dollars that Merrill Lynch had suffered before the vote by shareholders [in December 2008]", according to a statement from PGGM Investments, which manages the PfZW fund, this afternoon.

PGGM also referred to "an undisclosed agreement in which Merrill Lynch gave the possibility of accelerating the amount of $5.8bn in bonuses to be paid for the completion of the acquisition, despite the enormity of the losses."

According to the investors, this meant they voted to approve the deal without understanding the true financial position of Merrill Lynch. When the deal was completed and the full picture revealed, Bank of America's share price fell, meaning its shareholders suffered unfair losses, they claimed.

The out-of-court settlement has been agreed by the parties on the eve of the commencement of a jury-trial over the claim, which would have begun on October 22. The settlement must now be reviewed and approved by the US District Court for the Southern District of New York, where the class action is pending.

Bank of America said the $2.4bn payment would be met out of an existing fund it has put aside to pay for litigation costs, plus further expenses to be recorded in the third quarter of 2012, which will mean it will record a one-off charge totalling $1.6bn for the three months ended September 30.

Eloy Lindeijer, chief investment officer at PGGM Investments, said: "We believe the settlement represents a landmark recovery for Bank of America shareholders who voted on the acquisition without complete and accurate information."

This is a huge settlement and Eloy Lindeijer, CIO at PGGM Investments, is absolutely right, the settlement represents a 'landmark recovery' for Bank of America shareholders who voted on the acquisition "without complete and accurate information."

The fact that Bank of America decided to settle a month before it goes to trial just means they knew they had a poor chance of winning this case. The Merrill deal was ill-timed and just stupid on the part of Ken Lewis, the bank's former CEO. Brian Moynihan, the current CEO, is just cleaning up the mess and laying this suit to rest.

Longer term, this settlement is a win win for both parties. Plaintiffs recovered some of their losses and Bank of America can move on and focus on more important things like collateral transformation.

Below, Bank of America, the second-largest U.S. bank by assets, said it agreed to a $2.43 billion settlement with investors who suffered losses after the lender purchased Merrill Lynch. Deirdre Bolton reports on Bloomberg Television's "In The Loop."

Thursday, September 27, 2012

A Hobson’s Choice for Europe?

Tom Hirst of Mindful Money opines, Popular unrest in Spain could push Europe into a dangerous new phase (h/t, Yanis Varoufakis):
The eruption of popular unrest in Spain and a rising threat of Catalan secession could push Europe into a dangerous new phase. While central bank action may have calmed the bond markets in recent weeks, it has done little to alleviate the consequences of harsh austerity on the populations of struggling states.

Where one country in a monetary union is running a current account surplus, it is a good bet that a large part of it is being funded by deficit spending from other member states. If there is then a market disruption those countries with a deficit can quickly get into trouble unless they are able to rebalance their economy.

The narrative fits neatly for countries such as Germany and Greece. Between 1997 and 2007, GDP growth in Greece averaged 4% - around twice the average for the region as a whole. This impressive growth rate was financed through low borrowing costs provided by the apparent security of the monetary union and allowed the country to run up huge government borrowings.

In turn it facilitated the increased consumption of, among others, German exports at a higher rate than would otherwise have been possible. However, it also increased the fiscal vulnerabilities of the Greek state so that it was ill prepared when the financial crisis struck and it became difficult to meet its spending commitments.

Unfortunately, while the Greek example may be a useful parable for proselytisers of austerity the case of Spain does not fit the pattern so neatly. As Paul Krugman, Nobel-winning economist and columnist for the New York Times, wrote in April:
"In a way, it doesn't really matter how Spain got to this point - but for what it's worth, the Spanish story bears no resemblance to the morality tales so popular among European officials, especially in Germany. Spain wasn't fiscally profligate - on the eve of the crisis it had low debt and a budget surplus. Unfortunately, it also had an enormous housing bubble, a bubble made possible in large part by huge loans from German banks to their Spanish counterparts. When the bubble burst, the Spanish economy was left high and dry; Spain's fiscal problems are a consequence of its depression, not its cause. "

The point is not that Germany alone was at fault for creating the Eurozone's crisis. Indeed the allocation of blame ignores the interconnectivity that provided the conditions for the crisis. The failure to frame solving the fiscal woes of Southern European countries as a common cause, however, is having real-world implications and is driving fractures in the union ever deeper.

The human condition

A principle failure has been the inability of Eurozone politicians to communicate with their electorates. How opposed would German taxpayers be to fiscal transfers for struggling member states if they were told that a disorderly break up could cost Germany around €1,000 billion in write downs?

Moreover in countries where the need for fiscal consolidation is considered urgent a demonstration of support by European partners could go a long way to assuaging the rising tide of anger against government reforms. Even if politicians deem it accurate, There Is No Alternative neither appears a particularly democratic way to justify policy decisions nor a compelling argument for having almost a quarter of the working-age population out of a job.

This looks to be what is currently playing out in Spain. With the unemployment rate running at 24.6%, news today that the economy is expected to contract in the third quarter of 2012 will make for grim reading. After images of police firing rubber bullets at protestors in Madrid yesterday, who had taken to the streets to protest the "kidnapping of democracy", it seems the mood of the country is turning from indignant to angry.

Adding to Prime Minister Mariano Rajoy's woes, the inability of the government to address the concerns of its citizens has allowed Artur Mas, the Catalan President, to piggyback on hostility to press for greater independence for Spain's richest region. It may be populist politics but Mas is simply exploiting the democratic gulf opening up between elected officials and voters in Europe.

Failure to address the democratic deficit alongside the fiscal one will only increase the likelihood of these types of situations occurring. Across the crisis-hit region anti-austerity parties have been gaining ground, many of which have attempted to use nationalist rhetoric to stoke hostility against the Euro project. Here the European Central Bank (ECB) cannot come to the rescue without a political mandate.

What needs to be done

Firstly, a campaign is required to candidly explain to the public what the consequences of a Eurozone collapse would be and allow them to vote on it. If they decide that it is a risk they are willing to take then they can choose either to continue with current policies or begin a discussion on a route to a more orderly dismantling of the monetary union.

If, however, the majority wish to remain part of the euro then this would provide the democratic mandate to institute thoroughgoing reforms necessary for its long-term survival. These would have to include removing the conditionality from the ECB's Outright Monetary Transactions to cap borrowing costs as well as some form of fiscal transfer from core to periphery.

Only then would a comprehensive package, such as Yanis Varoufakis and Stuart Holland's Modest Proposal for Resolving the Eurozone Crisis, become plausible.

Contrary to what eurosceptics assert, it remains possible for structural weaknesses to be addressed and a democratic solution reached without the full or even partial destruction of the single currency. Yet, as the situation in Spain demonstrates, for policymakers to achieve this political timidity is no longer an option.
That article prompted this response from Yanis Varoufakis, A Hobson’s Choice for Europe?:
Tom Hirst, of Mindful Money, has posted a thoughtful piece on the Euro Crisis, with special emphasis on the deathtrap that Spain is now in.
His analysis of the situation is spot on: so far, Europe’s responses to the Crisis have been piecemeal, disconnected from one another, and based on the denial that this is a Systemic Crisis (that requires a systematic approach) rather than a Greek Crisis that is separate from the Irish Crisis which is different to the Spanish Crisis etc.
His apt conclusion is that: “The failure to frame the solution to the fiscal woes of Southern European countries as a common cause…is having real-world implications and is driving fractures in the union ever deeper.”

In the last section of his article, Tom addresses “What Needs To Be Done”. Here is his verdict:
“Firstly, a campaign is required to candidly explain to the public what the consequences of a Eurozone collapse would be and allow them to vote on it. If they decide that it is a risk they are willing to take then they can choose either to continue with current policies or begin a discussion on a route to a more orderly dismantling of the monetary union.
If, however, the majority wish to remain part of the euro then this would provide the democratic mandate to institute thoroughgoing reforms necessary for its long-term survival. These would have to include removing the conditionality from the ECB's Outright Monetary Transactions to cap borrowing costs as well as some form of fiscal transfer from core to periphery.
Only then would a comprehensive package, such as Yanis Varoufakis and Stuart Holland's Modest Proposal for Resolving the Eurozone Crisis, become plausible.
Contrary to what eurosceptics assert, it remains possible for structural weaknesses to be addressed and a democratic solution reached without the full or even partial destruction of the single currency. Yet, as the situation in Spain demonstrates, for policymakers to achieve this political timidity is no longer an option.”

I could not but agree with the general thrust here. But I do have one significant qualm. Tom seems to be assuming that a referendum on the Eurozone will be couched as a choice between (a) the current policies and (b) a rational alternative that would transform the Eurozone from an unsustainable to a viable currency union. Alas, this would require a German leadership that wants to resolve the Crisis and is prepared to bind Germany irreversibly to this re-designed currency union.
And here is the rub: The very reason this awful Crisis was allowed to go on and on and on is that Germany’s elites have not resolved to do this. Indeed, if anything, they are shifting in the opposite direction, especially now that the Bundesbank has become the de facto champion of a Eurozone breakup. Thus, if a referendum is put to the German people, it will resemble more of a Hobson’s Choice, than any real dilemma on Europe’s future.
Now, I don't agree with Varoufakis on many issues, including the Modest Proposal he and Stuart Holland put forth to deal with the euro crisis (read Andreas Koutras' critique).

Moreover, unlike Varoufakis, my problem with reforms in Greece isn't with austerity per se, but how austerity was implemented in Greece. Instead of chopping Greece's bloated public sector in half (or more) when the crisis began, leaving the rest intact, Greek politicians vying for votes from powerful and corrupt public sector unions, all bent over backwards to appease these unions, effectively condemning the entire population so a bunch of inefficient civil servants can keep their jobs.

Importantly, don't listen to Greek reporters and left-wing academics on the public sector unions' payroll lamenting that the 'troika is milking their country dry' or that tax evasion is Greece's biggest problem. This is pure rubbish. The biggest threat to the Greek economy is a public sector monstrosity that's the result of decades of political bribery from both major parties, promising 'jobs for life' to buy votes. (A friend of mine said it best: "Greece needs a Margaret Thatcher". Couldn't agree more.)

But one place where I do agree with Varoufakis is that  Germany's elites have not resolved to stem the growing crisis in a systematic way. Part of the reason why is that for Germany, the euro crisis is a mixed curse:
For Germany, the European crisis (formerly the debt crisis) was always a mixed curse. German taxpayers found themselves on the hook for a string of sovereign bailouts. On the other hand, the crisis sent the euro into the toilet and that was good news for German exports and job creation.

Before the crisis began in earnest in late 2009, with Greece’s admission that it had lied about its debt load, the euro was trading at about $1.60 (U.S.). Since then, it has been downhill for Greece, Ireland, Portugal, Spain and France. Ditto the euro. It went from a high of about $1.60 to a low, in July, of about $1.20 – a 25-per-cent fall.

German exports, from BMWs for Russians to machine tools for Chinese factories, duly surged and the jobless rate went in the opposite direction. At one point earlier this year, German unemployment went as low as 5.4 per cent – the best reading in decades. It has been rising in recent months, but, at 6.8 per cent, remains far below 11.2 per cent for the euro zone as a whole and a quarter of Spain’s grisly jobless rate of 25 per cent, and rising.

As a bonus, the capital flight to safety pushed Germany sovereign bond yields into free-money territory. On Monday, the 10-year bond was at 1.7 per cent. Only Japanese yields are lower.

Sadly for German exporters, the euro has been on tear. The rally started in August, when European Central Bank boss Mario Draghi said the ECB “will do whatever it takes” to spare the common currency from oblivion. It gained momentum about 10 days ago, when Mr. Draghi announced the relaunch of the ECB’s sovereign bond buying program (with the European bailout funds at the bank's side). It gained even more momentum last week, when Germany's constitutional court rule in favour of the new rescue fund, known as the European Stability Mechanism, Dutch voters endorsed broadly pro-European parties and Greek officials signalled that the European Union might give Greece a bit more time to meet its bailout conditions.

All the good news hit the euro short sellers like a cluster bomb, and they got it again when the U.S. Federal Reserve late last week unveiled its third quantitative easing onslaught, the so-called QE3. The euro went above $1.31 on Friday, though dollar weakness certainly helped to propel the euro's run. Since July, the euro has gained more than 9 per cent. The euro is also at a four-month high against the yen.

On Monday morning, the euro fell marginally and currency strategists were busy wondering whether the euro had temporarily peaked out, was set for a new plunge or might even rise as the open-ended QE3 program weighs on the dollar. To be sure, a renewed euro zone crisis, such as a Spanish sovereign bailout on top of the €100-billion Spanish banking bailout, could send the euro swooning again. But only the bravest currency speculators would ramp up their euro short positions today. The euro could equally rise to $1.33 or higher.

German exporters will be the keenest euro watchers. The weak euro has been a godsend to them. German exports are near their all-time highs of May, 2012 while Japanese exports have plummeted in recent years, thanks to the enormous depreciation of the euro against the yen.

With the euro powering forward, you can bet that German exports will fall somewhat, and that Germany's jobless rate will not. You can also bet that Germany’s manufacturers and exporters will put pressure on chancellor Angela Merkel to keep the austerity campaign intact in the weakest countries, all the better to keep the currency tension intact. A de-stressed euro zone that sends the euro soaring might be good news for Japan, not so for its great export rival Germany.
There is much truth to this but the reality is that German political posturing has reached its limits and now threatens the global recovery, core European countries, including Germany itself.

David McWilliams of the Irish Independent warns, Prepare for titanic struggle as Draghi turns euro into lira:
Well that didn't last long, did it? The financial market euphoria, which greeted the announcement that the ECB would buy bonds in unlimited quantities, has melted away. In its place, the realisation that Europe's economy is weakening quickly is puncturing short-lived optimisms.

Yesterday, we had more evidence from Germany that business confidence is ebbing more quickly than anyone anticipated. The IFO index of businesspeople's expectations about the future has now fallen for the fifth consecutive month.

The rolling recession, which started with the collapse of Lehman, initially affected highly leveraged countries like Ireland, Iceland and Greece, then mutated into a slump in Spain and Italy and it is now moving in a crashing wave to the core of Europe. Affecting France at the beginning of this year, it is now being felt in the industrial powerhouse of Europe, Germany.

Until recently, China's demand for German exports -- particularly heavy machinery, which Germany excels at -- kept order books healthy. But now Chinese demand is not there any more as its exports and economy weaken. The real fear in China is that it will prove to be the mother of all property bubbles, which will burst.

This is its own fault because, as money flooded into China, the revenue from its exports should have caused the Chinese currency to rise. But the Chinese didn't allow this to happen and they allowed the local money supply to grow, providing cheap loans for speculation on property. Now the result isn't just ghost estates, but entire ghost cities of unsold apartments.

All this is having an impact on Germany. The economy that was once a powerhouse may well prove to be regular after all. The slowing in Germany will cause a renewed crisis in the eurozone because Germany, as well as being an exporter, is an importer and France and Italy are her main clients.

As always happens when there is a slowdown, the least competitive supplier loses. This will put the spotlight again on Italy and, for the first time in the crisis, on France.

If growth stumbles again, the inconsistencies in France will become more evident. France is a country which has been running a budget deficit for years, but in recent times it has also been running a current account deficit.
Of more concern is that France is a country that has proved itself incapable of even the most modest reforms to its labour market. This inflexibility will prove to be highly damaging if it has to seek ECB assistance (as Spain will definitely require and Italy is likely to need). In short, France is Europe's Achilles heel and, next year, we should expect more financial fireworks as the French bondmarket is sold by investors.

This cyclical slowdown is coming in a German election year when the hostility between the German Bundesbank and the ECB's Italian leadership will be difficult to conceal.

You know the world is in a strange phase when the Pope is a German and the head of the central bank is an Italian. But just how Italian, is now dawning on many in Germany. Make no mistake about it, Mario Draghi is turning the euro into the lira because he realises that in order to survive, the euro needs to look and feel much more like the lira than the Deutschemark.

Whatever the Germans were expecting when they reluctantly gave up their Deutschemark, they sure as hell weren't expecting the lira. But this is what they are getting.

As growth wanes, open war is likely to erupt between the Bundesbank and the ECB in a philosophical as well as economic confrontation.

The Germanic view of money, exemplified by the Bundesbank, sees money as a 'common good', protected by treaties and laws and it is a common good that no government or institution owns: the economy adapts to money, not the other way around.

The alternative school of thought, exemplified by Mario Draghi, views money as a tool: the state or institutions have a responsibility to use money to achieve desired outcomes, such as full employment, or economic growth, or saving the euro.

Thus we are set for a titanic struggle in Europe and the trigger for this struggle will be a crisis in France, where faltering growth will force it into an economic adjustment, which the country is simply incapable of effecting.

Europe's economic problems are: too much debt, too little growth and a lack of coherent political leadership.

None of these issues has been addressed by what is in effect monetary financing through the back door announced by the ECB two weeks ago. These problems will resurface in 2013 and, when they do, expect the next move from Draghi in 2013 to be printing of more money as the gradual but unambiguous "lira-isation" of the euro continues.

This is good for us because our major trading partners are Britain and the US, so anything that weakens the euro is good for Ireland. In addition, the bank debt deal will be supported by Draghi and we should play to this audience and for his affection in the months ahead.

But the question for the euro is how long Germans will tolerate the debasing of a currency that they intended to be as least as strong as the Deutschemark. In the past few days, the financial markets are suggesting that the Germans will not remain sanguine forever.

In the next few weeks, economists and analysts at large banks and pension funds will be locked in meetings trying to figure out what is likely to happen next year and how to position their funds accordingly.

Looking at the recent numbers, we are likely to see recessionary conditions in core Europe in 2013. Before the end of the year, Greece will need another bailout and Spain will be bounced into an IMF/EU programme.

But the big story for 2013 is likely to be France and the row, in a German election year, between Germany and the rest as the euro morphs from a mini-Deutschemark to a mini-lira under the eye of Mario Draghi.
Germany has little choice and will allow the "lira-isation" of the euro to continue as it will help bolster its exports (outside Europe) and loosen financial conditions in struggling periphery countries.

I'm actually part of a minority who think that Europe will eventually come out of this mess much stronger, but I do fear the current disjointed and piecemeal approach can easily devolve into further social unrest as unemployment soars to dangerous levels. At that point, we won't be discussing a Hobson's choice for Europe but a Hobbesian state of nature which will send Europe back to the Middle Ages, threatening global stability and prosperity.

Below, John Taylor, founder and chief executive officer of FX Concepts LLC, talks about the euro, the Swedish krona and the impact of central bank policies on the currency market. He speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "Market Makers."

Wednesday, September 26, 2012

Harvard Betting Big on Timberland?

Michael McDonald of Bloomberg reports, Mendillo Returns to Farms as Harvard Vies for Ivy Rebound:
Jane Mendillo, who took over as head of Harvard University’s $32 billion endowment four years ago, is still searching for an edge.

While Harvard has recouped about half of the $10 billion it lost after global financial markets collapsed in 2008, Stanford, Columbia and Princeton universities have been posting bigger gains. Colleges are preparing to report modest returns for the year ended June 30 after the Standard & Poor’s 500 Index posted only a 3.1 percent gain.

“People are competing for outsized returns and there are fewer and fewer of them available,” said Brad Barber, a finance professor at the University of California, Davis. “The best and brightest might be able to find something.”

Endowments and foundations had the worst returns of any class of institutional investor, gaining just 0.37 percent for the year through June, Wilshire Associates said in an Aug. 6 report. Harvard will post results in the coming weeks. Princeton President Shirley Tilghman said last week her school’s endowment probably earned zero to 5 percent on its investments in the period, down from 22 percent a year earlier.

As Mendillo seeks to return the world’s richest school to the top of the performance charts, she’s revisiting a strategy she pioneered more than a decade ago: buying timberland. That proved profitable for Cambridge, Massachusetts-based Harvard after it bought and sold forests in the U.S. Now Mendillo is expanding the approach globally while capping private-equity funds and other alternative assets in the U.S.
Forests, Farms

In April, Mendillo flew to Brazil where she boarded a turboprop plane in Brasilia, the inland capital, and headed deep into the countryside to inspect tree plantations the university has bought. Since she took over the endowment in July 2008, Harvard’s holdings of forests, farms and other natural resources in Brazil as well as in New Zealand and Romania have grown to about 10 percent of the portfolio -- more than $3 billion -- and she wants to add more.

“What I want is properties that produce something that the world is going to want more of, and the increase in the supply is difficult,” Mendillo, 53, said in an interview earlier this year in the Federal Reserve Bank building in Boston where Harvard Management Co. has its offices. “Timberland is the perfect example.”

The push into farms and forests follows a boom in commodity prices led by the growth of China and other emerging economies. Yale University disclosed for the first time last year it had 8.7 percent of its $19.4 billion endowment invested in natural resources. A study by the National Association of College and University Business Officers showed the average allocation by colleges in fiscal 2011 was 5 percent, up from 2.2 percent in 2008.
Direct Investment

Harvard stands out among universities because, in addition to the size of the deals it does, it’s one of the first to directly buy such properties outside of the U.S. -- as opposed to investing in shares through other funds -- and actively manage them, said Jack Lutz, an economist at Forest Research Group in Rowley, Massachusetts.

“Harvard goes into places no one else goes into,” said Lutz, who previously worked for the Hancock Timber Resource Group, the world’s largest timberland manager for institutional investors. “They’re willing to accept more risk than most.”

It was Harvard’s early and enthusiastic embrace of alternative assets such as private equity and hedge funds that turned it into one of the top performers among endowments, with a 20-year return of 12.9 percent through 2011. Yale is the 20- year leader with 14.2 percent. Since the credit crisis, when the Harvard lost 27 percent on its investments in 2009, Mendillo has been cutting leverage and trying to sell stakes in private equity funds that no longer produce top returns.
Columbia Tops

As financial markets have recovered, Harvard generated investment returns of 11 percent in 2010 and 21.4 percent last year. New York-based Columbia had the strongest recovery in those two years, with returns of 17 percent and 24 percent, followed by Princeton in New Jersey, and Stanford, near Palo Alto, California. Over 10 years, Harvard ranks fourth among the Ivy League’s eight schools with an average gain of 9.4 percent.

Harvard’s stake in natural resources has stood out over this period, gaining 19 percent in 2011, and 13 percent over the past 10 years. In contrast, investments in private-equity managers such as Boston’s Bain Capital Partners LLC that once fueled the university’s gains, producing an annual average return of 24 percent over the past 20 years, returned 7 percent in the past decade.
Harvard’s Bet

“The question is whether they are better than average investors,” Steven Kaplan, a finance professor at the University of Chicago’s Booth School of Business, said in an interview. “To do that effectively you have to have some advantage, whether it’s better information or better access. That’s a bet she’s making.”

The university has regained its financial footing since the crisis when investment losses and a cash crunch forced it to postpone a 50-year expansion plan begun in 2007 that included 10 million square-feet of new space in Boston across the Charles River from the main campus. President Drew Faust, who declined to comment for this story, said in June that construction of the $1 billion centerpiece science center would resume.

After being forced to cut about 50 positions in the wake of the 2009 crisis, Mendillo is also expanding her staff of about 200 as she seeks to recreate the juggernaut fashioned by her mentor, Jack Meyer, during his 15 years at the helm. She rose through the ranks under Meyer, starting out as an insurance and steel industry analyst at the endowment in 1987 before leaving in 2002 to run the endowment at Wellesley College, 14 miles from Harvard.
U.S. Timber

A mother of two, Mendillo graduated from Yale University with a degree in English literature in 1980, joining the investment office there before Yale hired its longtime manager David Swensen. She got an MBA from Yale and moved to Boston to work at Bain & Co. in 1984, around the same time the management consultant company spun off the private-equity firm that Republican presidential candidate Mitt Romney once ran.

Her conviction in natural resources dates back to 1997 when as a vice president she recommended the endowment buy timberland in Oregon, Washington and later Pennsylvania. U.S. paper companies had been selling their forests for years as they sought to generate cash amid competition from overseas, finding buyers in pension funds and other institutions.
‘Harvard’s Strength’

The endowment had the cash that paper companies needed, said Meyer, who resigned in 2006 to start the hedge fund Convexity Capital Management LP in Boston. It didn’t have to squeeze the assets for income and it had the expertise to do the complicated deals and ultimately manage the holdings, he said. Harvard sold all the U.S. properties at a substantial profit.

“That fell right into Harvard’s strength,” said Meyer, who left amid criticism from Harvard alumni that some endowment employees were paid too much. “It’s a big advantage having this internal team that can pay attention to these details.”

The success galvanized Harvard Management, which added specialists such as Andy Wiltshire, a New Zealand native who worked in the forest service there and joined the endowment in 2001. He came from GMO Renewable Resources, the forestry affiliate of Grantham, Mayo, Van Otterloo &; Co., the Boston- based firm co-founded by Jeremy Grantham that manages about $100 billion.

Wiltshire, who was promoted to head of alternative assets including natural resources at Harvard in 2008, was the university’s highest-paid employee in 2010, earning $5.5 million. Mendillo received compensation of $3.52 million.
Romanian Forests

Harvard also hired Grantham’s son, Oliver Grantham, who is a senior vice president on the natural resources team. His father is a well-known advocate for investing in natural resources on the belief that population and economic growth in countries such as China will push up commodity prices.

In the past decade, Harvard turned its attention overseas. In 2004, it outbid CITIC Group Corp., a Chinese finance and real estate company, for the cutting rights to New Zealand’s Kaingaroa pine plantation forests. The next year, Harvard began buying forests in Romania, and owns almost 100 percent of a company that’s among the largest private holders of timberland there, with 35,000 hectares valued at $100 million.

The endowment’s global reach also extends to South Africa, according to Mendillo, whose husband runs a company that advises on so-called green investing, and was an assistant Massachusetts secretary of environmental affairs. In 2010, the fund paid $28 million for a dairy farm in New Zealand.
Timber Expertise

“It takes expertise to execute in this area,” said Mendillo, who made a rare public appearance in July in New York at an investor conference and talked about her new strategy. “A lot of other investors don’t have the expertise, don’t have the team to go out and look at individual timberland or other natural resources and decide what they think are the higher- potential or higher-risk situations.”

Mendillo also said that in the next five years or so there may be opportunities to buy natural resources again in the U.S., where it can take at least three times as long to grow trees for harvest as it does in more temperate climates such as Brazil.

While she confirmed some of the investments that have been reported in local news accounts in New Zealand and Romania, the university in general doesn’t comment on its endowment holdings. Because Harvard is a nonprofit institution, it is only required to disclose publicly traded investments, which amounted to less than $1 billion in the second quarter.
‘Black Box’

Some in the Harvard community are skeptical. Students representing the coalition Responsible Investment at Harvard wrote a letter to the Harvard Crimson in December criticizing the school for making investment decisions “in a black box, removed from the input and examination of Harvard community members.” They also called for a more socially responsible investment fund and divestments from companies such as Alpha Natural Resources, a coal producer.

At the same time environmentalists and development experts have ramped up criticism of the rush of large institutional investors including private-equity funds buying agricultural land to develop export crops, primarily in poor regions of the world. A World Bank report last year found there have been an unprecedented number of large-scale farmland deals in recent years, primarily in Africa, with questionable benefits to the local population.

If greater returns are “going to come at the expense of environmental degradation and social harm, then I don’t think it is worth it,” said Joshua Humphreys, a fellow at the Tellus Institute. The Boston-based nonprofit research firm advocates for sustainable economic development.
‘Environmentally Driven’

In April, a group of activists wrote a letter to Faust condemning Harvard Management’s participation in a global agricultural-investing conference in New York, saying it promoted corporate management of farms, which leads to hunger, rising food prices and environmental degradation such as monoculture forests that destroy native habitats.

While Mendillo won’t discuss details of the university’s investments, she said they’re all done on a sustainable basis.

“We have a very high conviction that if we create value in the portfolio by increasing the health of the forest, increasing the forest itself, allowing it to mature while we hold it, we’re going to be able to sell at a better price,” she said. “It’s economically and environmentally driven.”
Harvard's push into natural resources which includes farmland and timberland is fraught with political and reputation risks. I can understand the student backlash even though I think some of it is misguided and unwarranted.

First, endowment funds are notoriously secretive. Ivy League schools compete for the best and brightest staff and students. They rely on hefty gains from their endowment funds to meet their university's expansion projects and to attract and retain top students and professors. (Do I agree with this ultra-secretive governance model? Absolutely not but it will never change unless another huge disaster hits them hard).

Second, and equally important, students tend to base their decisions too much on emotion and idealism, not whether it makes good investment sense to invest in a company. For example, calling for divestments from companies such as Alpha Natural Resources, a coal producer, is just stupid (I am long US coal stocks and know that top funds are accumulating these and other cyclicals).

Third, Harvard's push into timberland is not revolutionary. Here in Canada, some large pension funds have been allocating to these assets since early 2000s, diversifying their portfolio and hedging for inflation down the road. A year ago, AIMCo's Timber Group wrote an excellent white paper on Timberland Investment. Institutional investors looking to familiarize themselves with this asset class should read this paper.

Last June, I covered the sale of TimberWest to PSP Investments and bcIMC, two large Canadian public pension funds. In fact, PSP Investments’ Renewable Resources group was created in June 2011. The group invests globally in timberland, agriculture and related opportunities via direct investments or partnerships. The initial target weighting is 2% of the Policy Portfolio with the intention of increasing it in the coming years.

Am I impressed with Harvard's push into timberland? Not really. It's just another illiquid asset class, with interesting attributes and many potential pitfalls. I am also a little concerned with the fact that they're going direct as these are complicated investments to manage directly. Think Yale and others are taking a wiser approach going through specialized funds (PSP and bcIMC bought a company that specializes in timberland).

One other thing that struck me from the article above is how Mendillo has been cutting leverage and trying to sell stakes in private equity funds that no longer produce top returns. Many endowments, including Princeton, are also cutting back on private equity funds that are not performing up to snuff. Pretty much confirms there is a changing of the old PE guard.

Below, Jane Mendillo, Harvard Management Company CEO, shares her perspective on why she believes natural resources is the single, best investment play.

And Michael Burry, founder of the Scion Capital, which he ran from 2000 until 2008 before closing it to run his own money, discusses why he is bullish on farmland and gold.

Tuesday, September 25, 2012

New Rules to Ease Pressure on Nordic Plans?

Sophie Baker of Financial News reports, Dutch pensions thrown lifeline by government:
The Dutch Cabinet has sent a letter to Parliament outlining a new framework that could alleviate the need for the country's pension schemes to carry out “unprecedented” benefit cuts.

The "September Pension Package" has been developed by the Cabinet and the Dutch regulator, De Nederlandsche Bank.

In a letter to the Lower House of Parliament, State Secretary Paul de Krom, the minister of social affairs and employment, said the measures put plans on “a more manageable and balanced footing”.

In February, DNB warned that 103 of the Netherlands’ 454 pension funds were facing cuts to benefits by the end of next year, because they were falling far below their funding targets.

DNB requires that pension funds have a funding ratio of at least 105%. Falling below that means they must submit a recovery plan to the regulator, detailing how they will get back to the threshold.

At the time, benefits were expected to be slashed by an average of 2.3%, with 34 of the funds looking to cut by over 7%.

The latest data from DNB shows that the average scheme in the Netherlands is 97% funded.

The package of measures will “put their financial position back in order in an accelerated and responsible manner”, according to a statement published on the Dutch government's website.

The proposals are designed to prevent unnecessary increases in pension contributions next year and will enable funds to spread the inevitable pension reductions across several years. Reductions in benefits paid will be capped at a maximum of 7% per year.

DNB will also adjust the actuarial interest rate for pension funds, using an amended method to determine the pension liabilities in 20 to 60 years’ time. This, said the letter, will make the interest rate less sensitive to fluctuations in the markets.

In the letter, Krom said: “The package means that for 2013 curtailments can be restricted to what was announced at the beginning of this year.”

However, he said that while the measures will have a beneficial impact on the funding ratios, some funds are in “very poor financial shape” and “will probably have to make further curtailments after 2013”.
In their article, Maarten van Tartwijk and Tommy Stubbington of the WSJ report, Netherlands to Ease Pressure on Pension Funds:
The Netherlands Monday announced new rules for pension funds, bringing them into line with similar investments in the insurance sector to firm up portfolios under stress from the unprecedented rally in long-term bonds.

The proposed rules, presented by the Dutch ministry of social affairs, are part of a package of measures to improve the financial position of an industry that manages more than EUR800 billion in assets.

Given that clout, the measures could hit demand for long-dated government debt, both in the Netherlands and other European countries seen as safe investments. The proposals, which still have to approved by Dutch lawmakers, would take effect in 2013.

A key element of the package is that pension funds will be allowed to use a more favorable benchmark to calculate their liabilities, which would help their capital buffers. The government also proposes giving them more financial breathing space by allowing them more time to cut benefit payments to pensioners.

The industry's funding position has sharply deteriorated over the past few years as the European sovereign debt crisis has prompted investors to snap up the bonds of Europe's safest havens, such as the Netherlands and Germany, lowering their rates of return.

That has crimped pension funds as these are effectively forced to own such bonds to meet benchmarks set by regulators.

The Dutch central bank, the industry supervisor, last week reported that 231 pension funds had a capital shortfall. Many funds have threatened to cut pension payments if their situation doesn't improve.

Recent measures announced to ease similar pressures on the Dutch insurance industry--coupled with similar moves in Denmark and Sweden--have eased the downward pressure on long-term bond yields somewhat.

The extra yield demanded by investors to hold 30-year Dutch debt compared to its 10-year equivalent has climbed to around three quarters of a percentage point from around half a percentage point before the insurance measures were announced in early July.

Pension funds and insurance providers must balance their investments against their liabilities--payouts to pensioners or policy holders that stretch decades into the future.

Right now, that balance is often calculated using a formula based on long-term interest rates. When these are low, liabilities are discounted less, requiring investors to hold more assets, and therefore buy greater piles of these low-yielding bonds.

The proposal is in line with the plan presented by the Dutch central bank in early July to ease the burden on insurers. Instead of basing the discount rate on interest-rate swaps--financial derivatives that price expectations of future interest rates--the proposals would apply a more steady, and higher, rate for ultra-long maturities where rate expectations are uncertain and volatile.

Confirmation that a similar move is in the pipeline for the large Dutch pension sector is likely to fuel this pickup in longer-term yields.

"We believe that further steepening is on the cards with some pension funds probably unwinding [positions in the swaps market]," said Rainer Guntermann and Peggy Jaeger, interest rate strategists at Commerzbank.

Such a trend in the swaps market would likely be echoed in the bond market, as higher long-term interest rate expectations make longer-dated bonds less attractive.

So Dutch regulators caved in and will allow pension fund managers to use some blended rate rather than a market rate based on long-term bonds to value pension fund liabilities. The Dutch bond market is small, so any move like this will mean a selloff in the long end, steepening the curve.

Still, it's important to put this in context. Dutch pensions are among the best OECD performers:
Dutch pension funds were among the best performers in the OECD countries last year, according to a new report by the Paris-based organisation.

Pension fund assets in OECD countries booked an average negative return of -1.7% in 2011, but Dutch funds booked an increase of 8.2%.  

Denmark was the best performer with 12.1% and Australia was third with 4.1%.

Dutch pension fund assets were equal to 138% of the GDP, the highest ratio among the OECD countries. On average, pension fund assets were 67.3%. Iceland had the second-highest ratio at 128.7%.

The Dutch move follows similar changes in Denmark and Sweden. In June, Frances Schwartzkopff and Christian Wienberg of Bloomberg reported, Denmark to Ease Pension Rules to Reduce Liability Burden:
Denmark’s government agreed to ease rules for the country’s pension firms to help reduce their liabilities as record-low bond yields inflate the value of their obligations.

Pension companies and life insurers will be allowed to raise the discount rate they use to calculate their liabilities to better reflect long-term growth and inflation prospects, the Business and Growth Ministry in Copenhagen said in a statement late yesterday. The decision sent yields on longer-maturity bonds soaring as the industry’s need to buy up debt assets to match their pension obligations was reduced.

“The demand for duration isn’t as strong as before,” Henrik Henriksen, chief investment strategist at Copenhagen- based PFA Pension A/S, Denmark’s second-largest pension fund with about $50 billion in assets, said in an interview. “Looking especially at the 30-year point, there’s less demand for 30-year bonds due to the new rate curve.”

The Danish move follows similar changes in Sweden, where 10-year yields surged 30 basis points on June 7 after the country’s regulator put a floor on the discount rate pension funds use to calculate liabilities. Nordic pension funds had come under pressure to increase their asset purchases as the region’s haven status from the debt crisis sent bond values higher and swelled the value of their liabilities.
‘Unusual Conditions’

“It’s key that companies have the possibility to create the best possible returns for pensioners in the future and rules and guidelines shouldn’t press companies to make short-term investment decisions due to unusual conditions in the capital markets,” Business and Growth Minister Ole Sohn said in the statement.

The yield on Denmark’s 3 percent note due 2021 surged eight basis points to 1.4 percent as of 11:51 a.m. local time. Denmark’s 30-year yield jumped 13 basis points to 2.08 percent. Yields on bonds sold by other governments perceived as havens also rose. Borrowing costs on Germany’s 2022 bond gained nine basis points to 1.51 percent, while similar-dated yields on Dutch debt increased six basis points to 2.04 percent.

The rate on 30-year swaps in euros climbed 11 basis points to 2.21 percent, widening the difference in yield, or spread, with 10-year swaps by 10 basis points to 28 basis points.
Euro Swap

“Obviously this affects Danish rates but, it is even affecting the much bigger and more liquid euro-swap market,” Anders Schelde, chief investment officer at Nordea Life & Pension, a unit of Nordea Bank AB, said in an interview. “That is most interesting.”

Even after today’s moves, Denmark’s 10-year bonds yield about 12 basis points less than similar-maturity German debt. The central bank has said it is ready to cut policy rates below zero in an effort to defend the krone’s peg to the euro and offset a capital influx.

“Denmark is still a safe haven, but the demand from the pension funds in Denmark, which were forced by regulation to buy government bonds, has eased,” Henriksen at PFA said. “Denmark is still fundamentally a strong case and people would still prefer to invest in Denmark compared to a lot of other eurozone countries.”

The Nordic country will have public debt equivalent to 40.9 percent of gross domestic product this year, compared with an average of 91.8 percent in the 17-member euro area, the European Commission said on May 11.
More to Come

The government of Prime Minister Helle Thorning-Schmidt on May 25 predicted a smaller budget deficit for this year than announced in December and the shortfall will shrink to 1.7 percent of GDP next year, well within the European Union’s 3 percent threshold, it said then.

The government’s decision to ease pension rules, signaled last week, “will reduce the industry’s need to purchase long interest-bearing assets and will lead to higher yields and a steeper curve for maturities longer than 20 years,” Nordea analyst Mik Jorgensen said in a note to clients today.

Other nations are also looking into easing pension rules. In Finland, the parliament votes today on combining pension funds’ insurance risk and investment risk buffers into a solvency capital buffer, meaning pension funds won’t be forced to sell investments that drop in value to comply with solvency rules.

In the Netherlands, the government proposed on May 31 that retirement funds be allowed to calculate financial buffers on expected long-term interest rates, making them less reliant on daily interest rates.

The changes to the Danish pension system also seek to enable companies to phase out guarantees to their customers and instead offer products that track market values, the government said.
Some pension analysts will grumble that these changes are too lenient, but the Dutch, Danes and Swedes aren't stupid, if they're making these changes, it's because they cherish their pensions and want to keep them strong and healthy for as long as possible.

It's obvious that historic low rates exacerbated by the euro crisis have been too taxing on their liabilities. But I shudder to think what would happen if US  plans had adopted similar strict pension regulations over the past decade as those enforced in these Nordic countries. Most US plans would be insolvent, shut down and taken over by the government.

At the end of the day, the Dutch and Danish plans are among the best in the world precisely because they have been matching their assets and liabilities very carefully for years, long before anyone else. These new rules won't change this. They provide some leeway in a historically low interest rate environment, but good governance and the ALM approach are still the driving forces behind the success of their pension systems.

Below, an Opalesque interview with Jeroen Tielman, founder of  IMQubator, a Dutch emerging manager seeding fund that connects institutional investors with emerging asset management talent.

Great interview, listen carefully as Tielman gives insight into IMQubator’s seeding model, which seeks to address escalating investor concerns over lack of liquidity, inadequate transparency, fee structures, and governance structures that overwhelmingly benefit managers.

The main weakness of IMQubator's seeding model is that they force managers to move to Amsterdam, severely limiting their options. In this day and age, this is simply not necessary.

Monday, September 24, 2012

The Oracle of Ontario?

Julie Segal of Institutional Investor reports, The Oracle of Ontario:
Jim Leech, the 65-year old CEO of the C$117 billion ($118.2 billion) Ontario Teachers’ Pension Plan, is hard to rattle. He comes from a family of generals, attended the Royal Military College of Canada and became a captain in the Canadian Army before going into business. True to a childhood steeped in military discipline, Leech is a hard-core believer that emotion should have nothing to do with investing. But the sale last month of Toronto-based Ontario Teachers’ majority stake in Maple Leaf Sports + Entertainment, which owns the Toronto Maple Leafs hockey team as well as the arena where they play, might have stung. After all, the Leafs are to Toronto what baseball’s Yankees are to New York.

Except the Yankees have won 27 World Series championships; the Leafs haven’t captured hockey’s Stanley Cup since 1967 and haven’t made the playoffs since 2004.

Leech might have felt the Leafs were experiencing one more painful loss when the pension fund sold its stake. But the Ontario Teachers’ CEO, and his predecessors who made the investment 18 years ago, have long recognized that the pension plan could make a good profit from the Leafs whether the team won or lost. The Leafs sell out every home game, and their die-hard fans spend a lot of money following them. Ontario Teachers pocketed about C$1 billion in profit from its investment to help pay the 300,000 teachers who are covered by the fund.

The success of the MLSE deal — and, more important, of Ontario Teachers’ portfolio overall — hinges on the unique governance structure that was set up at the plan’s founding in 1990. Teachers in Ontario have been earning pensions since 1917, but the fund itself was going broke by the late 1980s. The government and the Ontario Teachers’ Federation named Gerald Bouey, former governor of the Bank of Canada, to lead the initiative to replace the sleepy government agency that had managed the fund with a nonprofit private corporation. Ontario Teachers was set up with an independent board that delegates all investment decisions to its CEO. The laid-back Leech gets passionate when he talks about how elected officials, bureaucracy and, certainly, emotion shouldn’t touch Ontario Teachers’ investment decisions, even when they concern unionized teachers and the politicized rhetoric surrounding pensions.

“It’s run like a business,” says Leech during an interview at his office in the North York section of Toronto, Canada’s financial capital. “There is subtlety in that: The board has the power to delegate through the CEO,” Leech says emphatically, meaning the trustees do not get involved in investment decisions.

Running Ontario Teachers like a business might seem like a no-brainer, but that’s not the way most public pension funds operate. They’re often managed more like creaky political machines, whose boards have to approve investments and asset allocation changes, and whose chief investment officers come and go at the whim of elected officials. And, like the Maple Leafs, many of them are on a losing streak as they face meager future returns, falling tax revenue, dramatically rising life expectancies for their beneficiaries and political pressure, particularly in the U.S., to significantly pare benefits.

What Leech oversees, and what Ontario has built over the past two decades, is an in-house asset manager that primarily depends on its own well-paid professionals to make direct investments, rather than hiring expensive consultants and outside firms to do the job. Other Canadian plan sponsors, such as the Canada Pension Plan Investment Board and Caisse de dépôt et placement du Québec, which each manage more than C$165 billion in pension assets, also employ a direct approach.

It’s a model hard to argue with. Since the beginning Ontario Teachers has earned an average of 10 percent annually. Even APG Asset Management, which runs the biggest Dutch pension fund and has been lauded for its cutting-edge investing, has returned only 7 percent a year since 1993. According to Santa Monica, California–­based Wilshire Associates, the median annualized return for U.S. public pension funds was 6.32 percent for the ten years ended June 30, 2012. Ontario Teachers earned 8 percent a year over the decade ended December 31, 2011 (the most recent time period available). No wonder its approach is being emulated, if not downright copied, by investors around the globe. Sovereign wealth funds and pension funds have been flying to Canada and knocking on Leech’s door to learn how the Oracle of Ontario does it.

“It’s corporate governance 101,” says Lawrence Schloss, who visited Leech in July 2010, shortly after being named deputy comptroller for pensions and CIO of the $120 billion New York City Retirement System. “Everyone has to agree that this is the job of the trustee, this is the job of management, then figure out what’s the mission statement, what risk do we want to take, our return objectives, how to execute. It’s the Constitution. In Ontario that’s black-and-white.”

Ontario Teachers is Canada’s largest single-profession pension plan and was set up as an independent organization by the Ontario government and the Ontario Teachers’ Federation. Each appoints four board members and agrees on a chairman: now Eileen Mercier, former CFO of Canadian forest products company Abitibi-Price. To take the business of investing out of the political sphere, the board delegates authority to invest wholly to the CEO, and Leech delegates to his team.

Leech’s right-hand man is chief investment officer Neil Petroff, who joined Ontario Teachers in 1993, one of the plan’s first 25 employees and only its second CIO. Wayne Kozun oversees C$51.7 billion in public equities, including a separate group for relationship investments — essentially, a quiet activist team. Ronald Mock runs a C$55.8 billion fixed-income portfolio. Jane Rowe was hired in 2010 to take over Teachers’ Private Capital after her predecessor Erol Uzumeri left to form his own firm. TPC was created in 1991, invests directly in private companies as well as funds and is one of the largest private equity groups in the world. The unit has generated an internal rate of return of 19.3 percent; if it were on its own, it would rank in the top quartile against peers in the private equity world.

Stephen Dowd runs the C$8.7 billion direct infrastructure group, launched in 2001 to invest in airports, electrical power generation, water and natural-gas distribution, among other systems. Pension funds around the world are just now trying to increase their infrastructure investments as an alternative to bonds and to protect against inflation. The team at Ontario Teachers is pragmatic: It supplements its direct investing with outside funds when it doesn’t believe it can develop its own talent in a particular sector or country cost-effectively.

Ontario Teachers, which has 838 employees, took its time in creating the approach now known as the Canadian model. It single-handedly developed the equity derivatives market in Canada as a way to swap out of government debentures, which were its only asset when it was founded. Another milestone came in 1996, when Ontario Teachers made a huge bet that active management would be the path to outsize returns. Its value approach protected against much of the damage others suffered from the 2000 bear market. In 2000 it made a bold move, acquiring all of Cadillac Fairview Corp., a real estate company that operates as a wholly owned subsidiary, after Goldman Sachs Asset Management backed out of a restructuring deal at the last minute. The purchase made Ontario Teachers the first pension plan to own an operating real estate development management company. Now Cadillac CEO John Sullivan runs C$15 billion in real estate for Ontario Teachers.

In 2004, Ontario Teachers sent its senior management team to South Africa, the first of two trips to gather information on emerging markets, in a project dubbed Atlantis. In 2006 the team visited Brazil. It was then that the plan consummated a deal to work with Brazilian mogul Eike Batista. Recently, it teamed up with activist hedge fund Jana Partners and successfully pushed media conglomerate McGraw-Hill Cos. to restructure. The only other pension plan to do something similar is Alberta Investment Management Co., run by Leo de Bever, an émigré from Ontario Teachers who is trying to build a direct model in Edmonton (see sidebar, right).

“Ontario Teachers stands out for its commitment to shareholder value creation and its entrepreneurial and commercial mind-set,” Jana founder Barry Rosenstein says. “That’s what made them a great partner in our McGraw-Hill campaign.”

Public pension funds, which control $3 trillion of assets in the U.S. alone, have been playing a more active role in capital markets, and that role is set to expand exponentially in the coming years. Direct investing is real-world economics. When a pension fund hires a firm like Blackstone Group, it typically pays a 2 percent management fee plus 20 percent of any profits. Public pension funds have the scale to hire talent and can save on the huge costs associated with investing through an intermediary. With the prospect of skimpy returns and interest rates at historic lows, funds need all the help they can get to minimize the amount taxpayers will have to shoulder to make up for any shortfalls. But it’s not just about the fees; it’s also about control. By investing directly, TPC head Rowe gets calls from banks and CEOs about every potential deal in Canada.

Power is shifting toward investors, not just because of the tantalizing allure of the Canadian model. Public pension funds are displacing Wall Street as the new power brokers simply because they have the capital: the ability to fund new businesses, bridges and corporate expansion. In an effort to save the world from another financial crisis, regulators have forced banks to increase capital, reduce leverage and risk exposure, and — as former Citigroup head Sanford Weill now proposes — possibly even prepare to break up. Pension funds and other asset owners are eagerly jumping into the void. Plan sponsors are going directly to organizations that need capital and making deals. Wall Street will have to adapt to the newfound power of asset owners — not easy when profits from deal making, bond trading and IPOs are already under pressure.

Public funds are rightly salivating over Ontario Teachers’ returns and independent approach. Exceptional investing can help mitigate the pension crisis. Since inception Ontario Teachers has added C$53 billion to the plan’s size through its active management. “People ask what that means to them,” says CIO Petroff, explaining that pensioners often believe their contributions are funding their retirement incomes. “But 75 percent of the fund is made up of investments. Only 25 percent is from contributions.”

That’s not to say that governments and unions can simply invest their way out of their problems. Ontario Teachers itself still has a C$9.6 billion shortfall. But by delivering great investment returns, Leech has gained credibility with his beneficiaries and has argued for changes that stand in stark contrast to other plans. In fact, the plan uses a discount rate, which determines the value of future liabilities, that is among the lowest in the world. At just 5.40 percent, the rate makes Ontario Teachers’ promises for the future appear more onerous than others’, preventing the plan from kicking any problems into the future. It also helps that the government and the union are equal partners in this. Last year, for instance, teachers agreed to increase their contributions by 1.1 percent by 2014, and pensioners who retired after 2009 will receive slightly smaller cost-of-living increases for the next three years.

The Canadian model won’t work for everyone. Funds need to be large enough to throw their weight around the investing world, investment professionals have to be compensated in line with what they would make in the private sector— even if that generates some combative headlines in the local press — and trustees, the media, unions and the public need to understand that there will be good years and bad ones. What’s more, Ontario Teachers developed its model over 20 years and has benefited from being an early investor in asset classes that others are now chasing. “It’s a long-term journey,” says Uzumeri, the former head of TPC who left to co-found private equity fund Searchlight Capital Partners, which operates out of London, New York and Toronto. “You need the right governance, the delegation of authority to the investment managers, the tolerance for risk and the right compensation. Without that, the four-legged stool tips over.”

Some public pension funds in the U.S. have done direct investments, but they have been the exception, not the rule. The California Public Employees’ Retirement System and the California State Teachers’ Retirement System both do direct investing in areas such as real estate, private equity co-investments and, more recently, infrastructure. These direct investments are cyclical, however. During bull markets, when all investment values are rising, boards will endorse these approaches. During stressed markets, such as 2008, trustees often have retrenched, reasoning that specialized money managers are a better bet. Sometimes it just comes down to paychecks.

“If you can’t offer compensation to attract and retain experienced people it’s very difficult to compete,” says Mark Weisdorf, CEO of Infrastructure Investments for J.P. Morgan Asset Management and former head of Private Markets at the Canada Pension Plan Investment Board.

THE DIRECT-INVESTING MODEL ISN'T NEW. ENDOWMENTS and foundations, particularly in the U.S., have been among the most sophisticated investors, setting up independent asset management companies and investing early in private equity, real estate, infrastructure and hedge funds. In 1985, Yale University hired David Swensen, a former Ph.D. student of Nobel Prize–winning Yale economist James Tobin, to take over its endowment. Swensen quickly identified hedge funds and private equity as opportunities and moved the portfolio into them. By the 1990s one fifth of the portfolio was in hedge funds.

Then came Harvard University. Jack Meyer, hired to manage the endowment in 1990, built a similar portfolio during his years as CEO of Harvard Management Co. before leaving in 2005 to start a hedge fund. Swensen and Meyer did things differently, however: Swensen used the best outside managers, while Harvard at one time ran as much as 85 percent of its assets in-house, prompting criticism from professors and others about the risk the university was taking and the outsize paychecks being handed to in-house investment staffers. Great returns couldn’t overcome the negative spotlight, and Harvard partly retrenched.

Public pension funds have long existed in the government sphere, subject to politics, the vagaries of state finances and the agendas of unions. Larry Cary, an attorney representing Transport Workers Union Local 100 and a former trustee for NYCERS, has advised against adopting a model like Canada’s, saying the move would hand assets over to Wall Street types, a not-so-popular group in the aftermath of the financial crisis. Cary was unswayed by arguments that New York City already pays $400 million in fees to intermediaries and that managing investments in-house could redirect some of those fees from Wall Street back to the fund. Most pension plans need that kind of help. According to the Center for Retirement Research at Boston College, public pension funds in the U.S. are 24 percent underfunded. That’s money that will ultimately have to come from somewhere. If taxpayers don’t cover the shortfall, employees will have to contribute more or investments will have to generate better returns.

Leech joined Ontario Teachers as head of private equity and infrastructure in 2001 after 25 years in business. He had been CEO of Unicorp Canada Corp., one of Canada’s first public merchant banks, and Union Energy, then one of North America’s largest energy and pipeline companies. He had led two start-up technology companies in the 1990s. Leech was ready to retire, but Claude Lamoureux, Ontario Teachers’ first CEO, and Robert Bertram, its first CIO, called and offered him the opportunity to expand the fund’s still-nascent private investing platform. They wanted his experience in M&A and business-building. Leech grew the group from eight to 50 people and from about C$1.75 billion to C$20 billion in assets.

Ontario Teachers launched its Atlantis program in 2004. It wanted to expand into emerging markets, but it also wanted to do its own research. In 2006 the investment management team went to Brazil and met as many people as possible. Ontario Teachers partnered with Batista and provided money for several of his public ventures, including a C$1.1 billion stake in oil company OGX Petróleo e Gas Participações. The plan also took a position in what public equity head Kozun calls the Goldman Sachs of Brazil: BTG Pactual.

Leech became CEO of Ontario Teachers in 2007, a year before the financial crisis. Not even Ontario Teachers was able to escape the carnage, losing 18 percent in 2008, the fund’s worst year. But other public pension plans lost far more, including CalPERS, which shed 26 percent. Ontario Teachers’ direct investments helped mitigate the damage. TPC lost 13 percent, just half the loss of the average buyout firm. Bertram retired as CIO at the end of 2008, and Petroff succeeded him on January 1, 2009. That year Petroff and his team drafted a blueprint for the future, called Strategy 2020. The details of Strategy 2020 are under wraps. “Innovation is alive and well here,” says Leech. “It used to be that we could do something innovatively, and it would take six years before anybody else would catch on. Now it’s a lot shorter, so we don’t talk about it.”

Leech says going direct rather than through funds has meant that the private capital portfolio earns an extra billion dollars annually. “That’s enough to pay 25,000 pensions,” he adds. In 2010 the infrastructure portfolio earned 13 percent — generating C$600 million more than the industry benchmark, which was up 4 percent — because of Ontario Teachers’ direct-investment approach.

The plan has unique access to investments because of its reputation and capabilities. In November 2010 it partnered with Canada’s Omers Worldwide pension plan to buy the U.K.’s High Speed 1 railway, which runs from London to Paris and Brussels. The U.K. government in part chose the two Canadian pension plans because it wanted to close the deal quickly. They did so in 18 days. “And that was a £2 billion [$3.2 billion] deal. My home took three months to close, and we’re closing high-speed rail in under a month,” quips Petroff.

The infrastructure portfolio has matured, and Dowd is now working on building a team that is responsible for managing the assets in addition to accumulating them. He says that since 2008 the team has looked only at private infrastructure; public infrastructure companies didn’t fare well during the crisis. “Northumbrian Water [one of the plan’s holdings during the crisis] was a fantastic fundamental asset, but there was too much volatility for a pension fund,” Dowd explains.

Two years ago Ontario Teachers launched a long-term equity portfolio, which invests in private and public companies, and looks for companies that it can hold for a minimum of ten years. That might seem like the wrong dogma when investing legends like Pacific Investment Management Co.’s William Gross are publicly proclaiming the death of equities and others say the concept of buy-and-hold is dead. Ontario Teachers, though, has forged ahead for more than 20 years by being different. In 2010 it bought Camelot Group, a global lottery operator that holds the exclusive license to operate the U.K. National Lottery, for the long-term equity portfolio. In July 2011, Ontario Teachers also bought Imperial Parking Corp., the largest parking company in Canada, for its long-term equity portfolio. Because the pension plan will keep a property for as long as it generates good returns, Allan Copping, CEO of Impark, which had been bought and sold three times in the preceding ten years, has said he can finally strategize about the parking business.

Ontario Teachers wants to build its brand in Europe, especially in private equity. Jo Taylor, who joined the plan in January and is a 25-year veteran of private equity, including a stint running a business line for 3i Group, the U.K.’s biggest private equity shop, says: “In Europe there’s more familiarity with us as a fund investor than as an investor in companies. We’re going to be investing often enough that they see us as committed, and we’ll invest in brands and management teams that will get us recognition.”

Ontario Teachers’ recent foray with Jana to push McGraw-Hill to restructure is worth watching for a clue to the pension plan’s future. Though McGraw-Hill quickly said it would implement the majority of Ontario Teachers and Jana’s recommendations, the move raises the issue of how public a fight the plan would have been willing to wage. Leech has emphasized repeatedly that future equity returns will be meager and alternatives such as private equity and infrastructure won’t provide quite the feast they once did. Activist investing is another way to achieve outsize returns. It’s not always pretty, but it can be effective. Ontario Teachers’ model ensures that the pension plan can shift methods and strategies as markets change.

One of the plan’s biggest challenges is keeping ahead of all those people looking to copy its model, even if Leech is at the same time an evangelist about the benefits of direct investing. Ontario Teachers took an early interest in infrastructure, but now the copycats have bid up prices. “We want to go into places where other people aren’t,” says Leech.

As much as the plan’s CEO worries about copycats, they will have a hard time, at least in the U.S. , where pensions are governed by ERISA rules that prescribe what a plan can and can’t do to meet its fiduciary obligations. Canadian pension plans operate by “prudent man” rules, which set down best practices and provide more leeway and judgment.

But plans like NYCERS, which counts 300,000 municipal employees as members, may have no choice but to develop a new model for investing. New York City contributes $8 billion a year for pension costs, about 10 percent of its total budget, up from $1.5 billion, or 3 percent, ten years ago. Schloss, who is CIO of the entire New York City retirement system, says everybody with a stake in the pension fund will have to agree that getting the best returns at the lowest costs should be the plan’s mission. “Don’t blame public employees,” he says. “Go fix the governance and set up an asset management firm that makes independent, nonpolitical investment decisions and works.”

Leech intends to retire at the end of 2013. Although his successor has not been named, Ontario Teachers has built a structure and organization that will outlast his tenure: a professional, independent asset management firm that can attract the best and brightest investors in the world. Governments are bending under the weight of their liabilities to retirees; they need investors on their side who can find the next Microsoft Corp. or Google to save the pension system. The Maple Leafs are a lousy hockey team that actually made for a good investment. That’s not true of pension funds. Their investments need to be managed by a winning team.

“You can’t do it with B players,” says Leech.
Great article highlighting why Ontario Teachers' is one of the best pension plans in the world. And Jim Leech is lucky, he has a great team backing him up. He's also a very decent guy. Crossed paths with him last year when I was there with a commodity arbitrage manager from Montreal. I introduced myself, he asked us who we are waiting to see and he personally went to get them (you won't see that from many presidents of large pension funds).

Leech has been an ardent defender of the defined-benefit plan, responding to critics like Bill Tufts who think that costs  are unsustainable. In 2011, Ontario Teachers' returned 11.2%, stellar results beating out all its Canadian peers except HOOPP, which delivered 12.2% in 2011.

HOOPP and Teachers use different approaches. HOOPP does almost everything internally while Teachers' will often use external managers for investment activities they can't replicate internally. Both funds use repos extensively, leveraging up their stock and bond portfolios, saving millions in the process (instead of having some custodian do it off balance sheet, charging them insane fees).

The big difference, however, is Ontario Teachers' takes directional leverage whereas HOOPP doesn't (repos are matched by money market instruments, not invested in hedge funds, private equity and real estate). I have heard figures that Teachers' is leveraged up to 50%, which works well in good years, but goes against them in bad years like 2008, when they crashed and burned.

One thing that did surprise me from the article above is that Ontario Teachers'  uses a discount rate of 5.4% to determine the value of future liabilities. This is indeed among the lowest in the world for public plans. Most US public plans still use 7.5% to 8% and most Canadian public plans, including HOOPP which is private, use a discount rate closer to 6.3%.

Given the different demographic profile of Ontario Teachers' Pension Plan (older members), it would be appropriate for them to use a lower discount rate than most other Canadian and US plans, but some experts have told me the discount rate they use is extremely conservative, overstating their liabilities and understating their funded status.

Finally, let me clarify a myth about going direct in private equity. You can do some directs, but the reality is Teachers' cannot compete with the David Bondermans of this world. In private equity, it makes more sense to do what CPPIB does, ie. co-invest along with top managers. Of course, these days, even brand name PE funds are struggling to deliver results.

[Deborah Allen, Director, Communications and Media Relations at Teachers, shared this with me: "Just FYI, we do have a major co-investment program in our Teachers' Private Capital Division, which has about $12 billion in assets - In that group we do direct investments, co-investments and funds. TPC has had a 19% IRR over the past 10 years."]

Finally, in late February, nearly four hundred guests dined at the Pierre for FPA's annual Financial Services Dinner. The event honored financial and insurance leaders noted for their outstanding social responsibility initiatives. Below, Jim Leech's remarks from that dinner.