Friday, August 30, 2013

Dispelling Public Pension Plan Myths

Helen Fetterly, chair of Healthcare of Ontario Pension Plan (HOOPP), wrote an article for Benefits Canada, Dispelling public pension plan myths:
I’ve been involved with the Healthcare of Ontario Pension Plan (HOOPP) for 17 years now, and in 2013, am serving my second term as board chair. Recently, HOOPP created a two-part white paper with The Gandalf Group called The Emerging Retirement Crisis. In my first column based on this data, I looked at why the DB model, of which HOOPP is one, works.

Some of the key findings in the second part of the white paper relate to the fact that 64% of Canadians don’t believe Canada has a good workplace pension system. Seventy-three percent of those say that employers aren’t offering sufficient pension plans.

Yet, continually, on the HOOPP board we hear that DB pension plans—common in the public sector and unionized private sector workplaces—are gold-plated and not sustainable. Nothing could be further from the truth.

The average HOOPP member receives a pension of under $17,000 a year after a long, hard career. That’s an adequate pension, but not gold-plated.

Critics of public sector DB pension plans say that they should be replaced by “cheaper” DC plans. But with DC plans, there are no guarantees. A lower percentage of earnings, typically 3% to 5%, is set aside on payday, but it’s up to the individual member to decide how to invest it. The member usually gets to choose from a family of mutual funds. Those funds charge very high fees, up to 2% a year, whether the investments are up or down. So a DC pension is far less than even the modest pensions HOOPP and other DB pension plans provide. And worse, it’s again up to the member to decide how to turn that savings into income.

That’s why, rather than cutting DB pension plans, we should look at ways to ensure they can continue to contribute to the well-being of retirees. And we should look at improving the retirement system for those who lack DB coverage.

CUPE and other groups such as the Canadian Labour Congress, many provincial premiers and other retirement industry observers see the answer for those without adequate coverage in the expansion of the Canada Pension Plan (CPP), through small, gradual contribution increases over time. That would double its modest benefit of $12,000 a year maximum to more like $24,000.

Ontarians are telling us that they are willing to pay more into their employer-sponsored pension plans. They aren’t critical of public sector pension plans—in fact, in reading their responses in the white paper, you can see that they would like to see the bar raised for everyone. Seventy-seven percent of Ontarians said they would like to be part of a DB plan, and an equal number (77%) want to see the CPP expanded.

Rather than discarding the pillars of the system that work, we should look at those that are not working with an eye to improving them.
I've long argued that we need to expand the CPP and bolster our defined-benefit plans. HOOPP's former CEO, John Crocker, made the case for boosting DB plans right here a couple of years ago. I recently commented on the benefits of Canada's top ten and think it's worth remembering that Canadians are blessed with some of the best pension plans in the world.

Ms. Fetterly is right, there are too many myths regarding public pensions. The media loves focusing on abuses but the reality is many members pay a lot for the privilege of a DB plan and the alternative, a DC plan, falls short, leaving people exposed to the vagaries of the market.

Importantly, a DC plan is not a real pension; there is no pension promise attached to it like a DB plan. It places the responsibility on members to choose the right funds. Also, the fees attached to mutual funds are astronomical, further reducing the pension pot of those in a DC plan. Moreover, unlike Canada's top ten, mutual funds cannot invest in the best public and private market managers across the world or make direct investments in private equity, real estate and infrastructure. Simply put, the alignment of interests are much better at DB plans than DC plans.

But I'm tired of beating the drum on this issue. Think tanks like the C.D. Howe Institute are at it again, pushing for pooled registered pension plans, as if they will make a difference. If you want to know why DB plans are much better, read this Financial Post article below from a 40-something Canadian soldier, ‘Spend, spend, spend’: Living (happily) with a defined benefit pension:
It all started when I turned 18 years of age. This was in 1984; I had done a fair amount of research in conventional investment options during my last year in high school. As I pondered post secondary education, I realized that my childhood dream of becoming a pilot was not possible under my current financial reality.

I was 18 with a grade twelve education, unemployed, and my parents were doing all they could to stay afloat. So what the heck, I joined the Canadian Forces and worked towards my goal and became a military pilot. For ‘young investors’ the most critical start to any investment strategy is to ensure you choose a profession that you will love for a very long time, this will assure stability and consistency in investment discipline.

Today, I happen to be very well situated financially and yet I have absolutely no personal investments; all of my income is dedicated to living for today, anything that is left at the end of the month goes towards the next month of fun.

In researching investment strategies during my last year of high school, I also delved into the realm of pension plans and the variety of options available at the time; remember I was 18 and had my whole life ahead of me. So I came across the topic on public service pension plans and let me tell you, my eyes lit up.

Not only that but at the time, the Canadian Forces had a defined benefit pension plan that would allow me, upon completion of 20 years service, a non-penalized pension equal to 40% of my salary. Simply stated; join the military, fly awesome aircraft all over the world and retire at the ripe old age of 38 years old with a $35,000 pension.

Additionally, as soon as I turn 60 (not for another few years, I’m currently in my late 40’s), my pension will be adjusted for cost of living, after which I will realize an annual cost of living increase for as long as I’m around. This means that my pension will increase by approximately 40% on the day I turn 60 years old and increase onwards and upwards annually going forward. It will just keep on giving; you can’t stop it!

Yes it is true that in this day and age, one cannot live on $35K per year especially with my kind of zest for life; remember, the only investment I believe in is to buy a home; everything else spend, spend, spend and enjoy life.

So the day that I retired from the military, I competed for an inspectorate position with the federal government. It’s completely above board and here comes pension number two!

Assuming I work until 55; I will be able to accumulate an additional 30% of pensionable service in addition to the original pension that I started receiving when I retired from the Canadian Forces.

In a nutshell; here’s the investment strategy that has worked and will work for me:

20 years in the Air Force as a military pilot: $35,000 pension for life, starting at 38 years of age;
  • At 60 years of age, the $35,000 military pension automatically increases by an additional 40% (approx);
  • At 38 years of age; change careers, but remain within the public service, this allows you to build on a second defined benefit pension plan;
  • Since I still love my career, I will work until 60; hence will realize a combined pension portfolio earning $70,000 per year indexed for life
How much would one need to save to assure a lifetime annuity of $70,000 per annum, not to mention the annual increase to cost of living?

Answer: approximately $2 million!

So, just to recap; join the military and fly awesome planes until your first eligible retirement year; get back into the public service and complete a second pension. In the meantime spend all you make, every month and live life as though it will be your last day.
That sounds like one happy camper and his military and federal government pensions are both managed by PSP Investments, which recently reported exceptional four-year gains in their latest annual report. He will earn a very decent pension -- one that most people in the private sector can only dream of -- without worrying about the stock market or low interest rates.

But as discussed above, public sector pensions are much more modest than this example and public sector workers pay a lot for the privilege of a DB plan. They work hard, are forced to save and their pensions are managed by well-governed pension plans, allowing them to retire with a modest income which they can count on in their golden years. This isn't rocket science; it's good pension policy and we need to expand this coverage to more Canadians.

Below, Jim Leech, President and CEO of the Ontario Teachers' Pension Plan, describes several advantages of the defined benefit pension model. And clips from last year's Walrus/ HOOPP Great Pension debate. Listen to Jim Keohane, President and CEO of Healthcare of Ontario Pension Plan, explaining why the current system is failing far too many Canadians. Luckily this isn't the case for HOOPP or OTPP's members because their DB plans are the best pension plans in the world.

Thursday, August 29, 2013

From Bond Apathy To Bond Panic?

Yves Lamoureux of Lamoureux & Co. wrote a comment on ETF Daily News, From Bond Apathy to Bond Panic:
We have been glad this year to be on the side of the bull camp. Our job has been an easy one as we pursued the long side of stocks. We remain bullish despite raising big amounts of cash many weeks ago. We think we can redeploy money shortly once we feel the corrective phase is over.

It has been a much different story on the income side. One that shows only the start of something much bigger. We did forecast long bonds to drop to a yield of 2.5%.

For us that was the marker both in time and price that satisfied our interpretation of the end of the bond bull market.

It is our opinion that we are just in the first leg up in rates. Once completed we favor a correction that can last for a little less than a year. The second wave, we feel, will be as large as this recent move. This is why late last year we urged to look at a new asset allocation system based on credits only. We felt that rates would be at 3.5% mid year 2013 and a target of 4% year end 2013.

We have had this scenario in mind for many years as past episodes rhyme in time. Our work is both based on comparative money velocities and behavioral economics. We tend to think that fear and greed are always the same. They tend to repeat more frequently than market theory allows us to believe.

Bond Apathy

In recent presentations, we are amazed to observe the level of apathy toward the recent action of the bond market. It does match up behaviorally speaking with shock and the lack of preparation.

Investors have convinced themselves that rates are staying low for a prolonged amount of time. Of course this conviction will not be proved wrong rapidly. Over time, as we have suggested, money will leave the bond market to head to the safety of a term deposit at a bank.

Having been proved wrong twice about stocks makes the return back for most impossible.

The great difficulty in this environment will be the lack of perceived safe alternative. It is also why midterm we are very bullish on gold even if we have avoided it all year long.

We think there are many pitfalls ahead that people will not avoid. We prefer to stick to being long indices as opposed to stock picking.

Rising rates will reveal the extent of debt levels. It first will be marked by companies cutting dividends. Bankruptcies will follow. It will be harder and harder to perform with the benchmarks.

Being long an index also has a positive survival bias. Bad stocks are replaced with good ones. The odds are in your favor with patience.

It is not the same say in the case of a bond fund. As rising rates will pressure your investments lower and lower. Doing nothing is sure to undermine your strategy and goals.

Dividend stocks are as much in a bubble as bonds are. We think its best to avoid income all together.

This will be a time of reflection. Some investors are not meant to be in the market. We expect a mass exodus of money that will be moving back to bank accounts.

Of course it is not what most in the financial business would like to hear. Markets are markets and they tend to behave in a certain predictable way.

The key to some of our future forecasts come from the inversion of the behavior in the treasury market.

We have been great believers in using treasuries as stock hedges in a portfolio.

We think this era is over as we have predicted well over a year ago. We are of the opinion that treasuries will revert to a positive correlation with stocks.

They will go up and down in price with stocks.

This is far from expected behavior of the last decade when treasuries rose in price when stocks fell.

Emerging market implosion

We read with astonishment that deflation is over. The sudden drop in both emerging market currencies and stocks is testament to further aerial bombs we suggested would happen recently.

We are in complete disagreement over this topic as deflation shocks being short and fast creates lasting disinflation

The wipe outs are dramatic in many cases. Caught by surprise many have been.

Where people now see a bust credit cycle we see opportunity. The flow of hot money had created huge imbalances and a perception of superior fundamentals. The king is now naked.

We are taking a hard look at re-balancing our cash into some of those interesting emerging markets.

It reminds us of European markets that nobody got interested in because of fear. Recent positives on Europe had us unload these plays at much higher prices than a few months ago.

Interesting times indeed!
These are interesting times and it's critical to understand whether we are in the midst of a prolonged bear market in bonds where rates continue to climb higher. Rising bond yields will continue to hurt interest-sensitive sectors of the economy and give cyclical stocks the advantage this year, say equity strategists on both sides of the border:
"Most interest-sensitive assets/sectors have been hit hard in the past few months, and although a rebound from oversold levels is possible in the short term, we continue to believe the uptrend in bond yields will hurt their absolute and relative performance," said Hugo Ste-Marie, small-and mid-cap analyst at Scotia Capital. "We continue to prefer cyclical plays." ...

"After a few years of strong outperformance, dividend payers' valuation was getting rich relative to non-payers, and with bond yields rising, the premium relative to non-payers is likely to compress further," Mr. Ste-Marie said.

He added he sees no reason for this trend to change any time soon, and he continues to view cyclicals as outperformers over the next year.

"Further normalization in bond yields could accelerate the Great Asset rotation and equity portfolio realignment toward more economically sensitive sectors," he said.

Tobias Levkovich, U.S. equity strategist at Citigroup Global Markets Inc., said there is very little historical evidence as to what impact the Fed's tapering may have on stock prices. But past periods of rising bond yields may shed light on how investors should be positioned.

He said the past impact on stock prices after the first 100 basis points of higher 10-year treasury yields shows that cyclicals have generally outperformed defensive names.

"Energy looks most rewarding, while the various consumer staples sector groups typically underperform, as do health care and transportation stocks," he said.

"Given soaring biotech names, we suspect that backing off these high flyers makes sense at this juncture. Similarly, utilities and telecoms do not look like profitable trades either, which means there are many mixed messages from a macro perspective and single-stock picking may be needed to get things right."
And rising bond yields have hit emerging markets hard, prompting Robert Samuelson to comment, Pop goes the 'emerging-market bubble':
To the extent there was an emerging-market "bubble," it has popped. Yesterday's conventional wisdom is not today's. Economic policies turned out to be not so sensible -- or sustainable. India's inflation is running about 10 percent, and its budget deficit is about 8 percent of the economy (gross domestic product). Contrary to widespread expectations, commodity prices have not inexorably climbed. Economic growth has disappointed. In 2012, Brazil's GDP grew only 0.9 percent, down from 2.7 percent in 2011 and 7.5 percent in 2010. The China story is similar: Growth has slowed, policies seem less sound.

Global investors' reappraisal was apparently triggered by the possibility that the Federal Reserve would reduce its $85 billion of monthly bond purchases. This would mean less money to prop up stock prices around the world, including in emerging markets. Brazilian officials and some others complain that Fed policy whipsaws them: first, an inrush of money fosters easy credit and higher stock prices; then, an exit of funds does the opposite. Fed actions inevitably cause investors to re-evaluate their portfolios, says Ubide. He also rates Turkey and South Africa as vulnerable to shifting investor sentiment.

Still, Ubide and many economists doubt a doomsday outcome. "There is no serious risk of a major global crisis," says Subramanian. That could happen if uncontrolled sell-offs around that world exhausted countries' foreign-exchange reserves (mostly dollars) that ultimately enable them to import. Global trade and production would plummet. By contrast, says Subramanian, today's market turmoil reflects an unavoidable adjustment to more normal Fed policy. In a report to clients, Capital Economics, a consulting firm, says emerging-market countries have defenses against a broader crisis: high foreign-exchange reserves; low foreign-currency debts; more flexible currencies.

All this sounds reassuring -- and probably is. But nagging doubts remain. Every major financial crisis of the past 20 years has begun with some relatively minor event whose significance seemed isolated: weakness of the Thai baht in the summer of 1997; trouble in the market for "subprime" U.S. mortgages in 2007; Greece's misreporting of its budget deficit in 2009. Could this be "deja vu all over again"?
It could be deja vu all over again and an emerging market crisis or slowdown is disinflationary and will ultimately mean lower bond yields. But for now traders are focused on shorting bonds to profit from Fed tapering.

The backup in yields has caught many investors off guard but it's worth taking a step back. In his article written earlier this month, Treasuries: Are We Watching A Bubble Burst?, Martin Tiller notes:
As 10 Year Note rates have risen and prices fallen ( the i-Shares 20+ Year Treasury ETF, TLT, has lost 16.2% since the highs in late April) bond investors have taken a serious hit, something for which the aforementioned 30 year bull market has left them unprepared. If we accept, however, that the recent move is simply a normalization of the Treasury market and represents expectations of moderately higher inflation to come, then the worst is over, and from here the positives of the move outweigh the negatives.

If this is the reason for the recent spike in yields it is unlikely to continue much longer, as I don’t think many expect real raging inflation, and the exit from what was a very crowded space in the years following the recession can continue in an orderly manner. This cash that is released from bonds will seek a home, and in even a mildly inflationary environment, stocks will look like a good bet. This move, then, is natural and needed. It will enable real interest rates (after inflation) to return to the positive, and contribute some upward pressure to the stock market. All is for the best in the best of all possible worlds!
And Roger Webb, investment director at SWIP and co-manager of the group's Strategic Bond fund, explains why the bond bubble won't be allowed to burst:
It is worth highlighting that tapering of QE is not tightening, but loosening less, and this first step in changing policy is because the world – or the US at least – is getting better. Similarly, we are sure that if the US economy slows once more, the medicine will be administered again.

Where does that leave markets? The central banks' sponsored asset bubbles created over the past few years have generated some good returns for bondholders and shareholders alike, but now are suddenly worrying about what’s next.

Consensus views have quickly become that bonds are a bad place to be as yields have to rise. We feel sure they will do so over time, but are less sure they are going to in the near-term.

Inflation remains subdued; the global growth outlook is uncertain, especially in developing markets; and the on-going risks from the periphery still mean that "safe haven" assets like Bunds and gilts have a place for some investors.

On top of that, pension funds also in the UK and Europe have an ongoing structural demand for investment grade bonds – both sovereign and corporate.

As we have said before, even in the US where growth is more robust, policymakers will be keen to control yield levels to some degree given the negative impacts of a sharp rise on both the consumer and banking sectors.

The bond bubble may be nearing its end and will be slowly deflated, but it cannot be allowed to burst. Too many parties with too much to lose are exposed to longer-dated bonds so the path to higher yields will most likely be a longer one than the early summer volatility spike suggested.
Indeed, the path to higher yields will likely be longer than what most investors expect. Brian Romanchuk, a former senior quantitative analyst at Caisse's fixed income group, wrote an excellent blog examining whether Treasury bond yields will stabilise here. I will let you read his analysis but he concludes:
...although one could argue that the forward rate might seem relatively low compared to a longer history, in that past history forward rates were comically high when compared to subsequently realised rates. The amazing bond returns of the past decades were not the result of a "bubble" – they were the result of bond yields being badly priced, with an unsustainably large risk premium.

Consideration of implied forward rates thus seems to indicate that there may be enough of a risk premium in bond yields currently to absorb good economic and tapering news, at least until actual rate hikes are on the table. With the consensus for rate hikes still being some time in 2015, it seems that it may be somewhat early for the market to take the rate hike threat too seriously.
Brian is one of the smartest and nicest guys in the industry. Worked with him at BCA Research and at the Caisse. He really knows his stuff and unlike most quants, he is well read on economic history (can tell you all about Minky's moment and debt deflation). He's now a consultant - blogger and I want to plug his blog, Bond Economics. You can reach him via the blog where he has a contact form.

Why did I write a comment on rising rates? Because some pretty smart people, like Leo de Bever, have been warning investors of the storm clouds ahead, calling the top of the bond market way before other investors. Commenting on AIMCo's record results in 2012, he said: “The biggest issue we foresaw last year was the end of the bull market in bonds, and that’s coming on in spades this year.”

But this comment was also written to give my readers food for thought. How will rising bond yields impact interest-sensitive stocks? Is the dividend bubble over and should investors shift into cyclical stocks? Are we on the cusp of an emerging market crisis and how will will this impact bond yields? Will the bond bubble be allowed to burst or will it slowly deflate? Have rates stabilized here?

These are all critical questions with profound implications for retail and institutional investors. And while my focus has been on public markets, these issues will impact private markets too. Pension funds that are broadly invested in private equity, real estate, and infrastructure are examining their portfolios to determine the risks and opportunities of a backup in bond yields.

Having said this, think markets have gotten way ahead of themselves when it comes to rising rates. The upcoming jobs report will be critical but I agree with Brian, the implied forward rates seem to indicate that there may be enough of a risk premium in bond yields currently to absorb good economic and tapering news.

Below, as PIMCO's Bill Gross declares a war to defend bonds, others have different views. Steve Auth, Federated Investors Global Equities, and Ron Kruszewski, Stifel Nicolaus, discuss their views on the bond market. "We think we're in a bond bear market," says Auth.

Wednesday, August 28, 2013

Corporate Pensions Embrace Riskier Assets?

Maxwell Murphy of the Wall Street Journal reports, Some Pensions Embrace Riskier Assets:
Thinly traded and hard-to-value investments such as real estate and private equity stakes are taking up a larger piece of the corporate pension pie. The shift lets companies chase higher returns for their plans, but merits a closer look because such assets can be risky, says Fitch Ratings.

Among 224 large corporate pensions studied by Fitch, plans were on average 8.5% invested in illiquid “Level 3” assets, a significant boost from 7.8% at the end of the year-earlier period. Some 66 of those plans held illiquid assets worth more than 10% of their plans, which Fitch says is concerning.

“Plans with more than 10% of assets in Level 3 assets may call for further investigation, because these include relatively illiquid holdings,” Fitch said in a research note. Pension plans at companies with lower credit ratings and higher near-term benefits obligations are the most at-risk, Fitch said.

Concentrations of illiquid assets could complicate business decisions. For example, if a company needed to sell or close a business line, triggering large one-time cash payments to pension plan beneficiaries that work in that unit, illiquid assets could make it hard to come up with the cash.

But retirees shouldn’t necessarily worry that a buildup of hard-to-value assets mean their plans won’t be able to meet obligations. Companies with pension funding difficulties could find themselves further underfunded if those assets become impaired, according to Don Fuerst, senior pension fellow at the American Academy of Actuaries. Mr. Fuerst couldn’t recall a case where this happened, however.

The Financial Accounting Standards Board requires companies to break down assets into three levels, according to how easy they are to price and sell. Such rules went into effect after the financial crisis froze markets for many inscrutable investments, such as mortgage-backed securities.

Fitch said the top five corporate pensions, in terms of the proportion of Level 3 assets to the total, are: Exelis Inc., at 45%; Hanesbrands Inc., 44%; Verizon Communications, 43%; Lorillard Inc., 38%; and Kroger Co., 37%.

“From a management standpoint, it doesn’t scare us,” Hanesbrands treasurer Donald Cook told CFO Journal. Most of its Level 3 assets are in “hedge fund of funds,” or investments products that allow companies to invest in a basket of hedge funds simultaneously, he said, and just 5% or so of the pension’s assets are in real estate.

Mr. Cook said half of the Hanesbrands’ plans’ roughly $644 million in assets can be liquidated immediately, with the cash received a few days later when the trade settles, Mr. Cook said. He added that another 25% of the assets can be turned into cash in one quarter or sooner.

Pension managers typically do a good job of keeping the funds liquid enough to meet their liabilities as they come due, industry watchers say.

Although hedge funds are considered Level 3, valuing them correctly isn’t terribly difficult as they typically bet on and against stocks, said Scott Henderson, vice president of pension and investment strategy for grocer Kroger.

Mr. Henderson said investment-grade rated Kroger isn’t concerned about its plan, which had about $2.7 billion in assets at the end of its fiscal year in February. But he said Fitch is correct that companies with sizable Level 3 assets and a combination of low credit ratings and weak cash flow, or whose pensions are underfunded, have reason to worry. If Kroger found itself in such a situation, he said, “We would move away [from such investments].”

Spokesmen for Exelis, Verizon and Lorillard declined to comment. Companies are required to update their pension funding levels and broadly categorize their asset classes annually.

Hanesbrands’ Mr. Cook said the undergarment and casual-apparel maker, which was spun off with a large debt burden from what was then Sara Lee Corp. in 2006, decided to try “to get a nice risk-weighted return” for its pensions. By choosing hedge funds that can both buy long-term positions and sell short stocks, the company’s returns have outperformed long-only funds, he said.
I wouldn't worry too much about corporate pension plans and their "Level 3 assets." Sounds a lot scarier than it actually is. While the top five plans in terms of proportion of Level 3 assets to total have sizable investments, they're mostly hedge funds which are a lot more liquid than real estate, private equity or infrastructure. And their corporate balance sheets are in great shape, which means these assets pose little credit risk.

Also, these plans are run by very smart people who know how to manage liquidity risk. I guarantee you they have thoroughly vetted their redemption clauses with their funds of funds and hedge funds and know exactly how long it takes to raise cash if a situation arises where they need liquidity to meet obligations. Moreover, a small allocation to real estate and private equity is well worth the illiquidity risk if the performance is there.

I'm much more concerned about grossly underfunded public pension funds that are indiscriminately plowing into very illiquid alternative investments, hoping this strategy will save them. If another crisis hits them, they will suffer serious liquidity issues, further imperiling their weak funded status.

Below, James Tisch, who invests in hedge funds to boost returns at Loews Corp. (L), said he avoids managers with the largest pools of money and sleeps better at night knowing he doesn’t face the same prospect of client withdrawals. Smart man, guarantee you his managers are not coming up short.

Tuesday, August 27, 2013

Pensions Inflating an Infrastructure Bubble?

Sally Patten of the Australian Financial Review reports, Future Fund says infrastructure assets not in bubble territory:
The $85 billion Future Fund has defended the price it paid for a stake in Perth Airport and dismissed concerns that infrastructure assets are in bubble territory.

The fund, which was established in 2006 to oversee the retirement savings of commonwealth government public servants, said fears that recent entrants to the market, such as global pension and endowment funds, had pushed up prices to unsustainable levels were overdone.

Future Fund chief investment officer David Neal said infrastructure assets were “certainly well bid”, but denied they were over-priced. “We are not in bubble territory. The market doesn’t feel frothy or bubbly,” he said.

The Future Fund said infrastructure investments continued to generate attractive returns for the prices paid.

“If you are a long-term investor, infrastructure provides long-term, stable, inflation-related income flows that are valuable. A lot of assets are providing just that,” said Mr Neal.

“We think in general the prices being paid reflect the cash flows we expect to receive,” he said.

Earlier this year the fund stunned investors when it paid $875 million for a 30 per cent stake in Perth Airport, which was a 43 per cent premium to an independent valuation provided in June 2012. The stake was bought as part of a $2 billion deal with listed ­investment company Australian ­Infrastructure Fund (AIF).
Fund happy

The Future Fund’s head of infrastructure and timberland, Raphael Arndt, said the fund was happy with the prices it paid for the assets it acquired through the AIF deal, including ­holdings in Melbourne Airport, ­Sydney Airport and a clutch of European airports.

Separately the fund owns 17 per cent of London Gatwick in the United Kingdom and has stakes in airports in Europe and South America.

Mr Arndt said Western Australia’s biggest airport was particularly attractive because it had experienced massive growth in recent years and the car parks and terminals were now congested. As a result, there was an opportunity to upgrade the facilities.

Although Mr Neal said infrastructure assets were not overpriced, he said the current investment environment was difficult. Prices of growth assets, such as shares, had risen substantially in recent months, partly due to aggressive monetary easing by central banks, while government bond yields remained low.

“It is an interesting and really challenging time,” Mr Neal said.

“It is almost the first time in our ­history when we don’t see any sectors that stand out as being really attractive. It is starting to get a lot harder. No areas are screamingly expensive but across the board everything looks full,” Mr Neal said.
Pensions replace banks

Mr Neal said pension funds had replaced investment banks as big owners of assets such as roads, tunnels, pipes and bridges. Investment banks were largely forced out of the market after the global financial crisis due to tougher regulations and business models that collapsed under too much debt.

“[The investment banks] aren’t there any more,” said Mr Neal.

“[In some cases] we are seeing the new kids on the block,” he said.

In Australia infrastructure vehicles operated by Macquarie Group and the defunct Babcock & Brown have disappeared in the past few years.

The Future Fund said in March it had $5.5 billion of infrastructure and timberland assets, representing 6.5 per cent of total investments. It is believed that figure has since increased to $7 billion.

The Future Fund has been set a return target of between 4.5 per cent and 5.5 per cent over the rate of inflation over the long term.

It is due to report its performance for the 12 months to June 30 in the coming weeks. The average balanced superannuation fund posted an increase of 15.6 per cent last year.
Mr. Neal is right, pension funds are the new banks. As big banks like Citi exit alternative investments to comply with new regulations, pension funds are stepping in to fill the void.

But the question of valuations and paying too much for infrastructure assets is worth looking into. Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), warned my readers about pension funds taking on too much illiquidity risk in this environment. Leo de Bever, President and CEO of AIMCo, recently told Bloomberg that real estate "keeps me up at night" and he warned investors three years ago not to rush into infrastructure.

Like all private assets, it's all about projected cash flows, what price you get in at and the long-term prospects of an investment. I recently wrote a comment on the risks of toll roads where I highlighted weakness in this sector and how exuberant projected cash flows turned out to be dead wrong, costing millions to private investors.

As far as airports, I commented on PSP Investment's big bet on airports, stating that they got in at an attractive price and this will prove to be an excellent long-term investment. In a recent article covering the $283 million new equity financing of Sydney Airport, Bruno Guilmette, senior vice president of PSP said: “Airports are resilient businesses with attractive cash flow profiles, and they fit well with our long-term investment horizon.”

I can't comment on the terms of the Perth Airport deal except that there is a legal dispute with another retirement fund, the $46bn Australian Super, which is seeking information on the sale claiming the bidding process was gamed to deter other shareholders including Australian Super from exercising preemptive rights. Future Fund denies any wrongdoing.

It's worth noting, however, most pension funds are pulling back on infrastructure which explains why infrastructure managers are having a tough time raising their latest funds. In fact, Arleen Jacobius of Pensions & Investments reports the heydays of infrastructure are over and funds are feeling the heat, signaling an expected industry shakeout:
The managers are almost out of money from the 2006-2008 heydays when about 50 funds collectively raised close to $50 billion a year, mostly in private equity-style funds.

Last year, a little more than half that was raised, with most of the money going to just a few managers.

Industry Funds Management, for example, raised a total of $8.3 billion for an infrastructure fund last year. By contrast, CVC Capital Partners Ltd. called it quits on efforts to raise a e2 billion ($2.6 billion) infrastructure fund, even though it's about to close on a e10.5 billion leveraged buyout fund.

Infrastructure fund managers closed on $26.9 billion last year, down 67% from the $44.8 billion raised in 2008.

Concentration of assets in the hands of a smaller group of managers will cause a drop-off in the number of infrastructure managers, with managers focused on stable, income-producing investments especially vulnerable, said Duncan Hale, senior investment consultant and head of global infrastructure at Towers Watson & Co. in London.

There's pressure on infrastructure managers' business models that will result in some managers merging and others fading away over time, Mr. Hale said.

Traditional infrastructure vehicles have a five-year investment period, which means many of the funds raised in 2007 and 2008 are coming to the end of the their investment periods — the time in which managers have to spend the capital raised. Now, these same managers are out raising their next funds, and are finding less money being invested in infrastructure, Mr. Hale said.

According to London-based alternative investment research firm Preqin, 144 infrastructure funds are attempting to secure a total of $93 billion from increasingly choosy investors. While there has been an increase in institutions creating broad “real asset” portfolios, infrastructure assets dropped 10.4% as of Dec. 31, according to the most recent of Pensions & Investments' annual surveys of managers of U.S. institutional, tax-exempt assets.

“There's a smaller pie for people to take a piece of,” Mr. Hale said, and most of the pie is being taken by a handful of managers.
Winners and losers

“Winners are raising lots of money and losers are not necessarily raising any,” Mr. Hale said.

Indeed, the 10 largest infrastructure money managers accounted for 45% of the capital raised in closed-end funds in the 10 years through June 30, according to Preqin. The top 10 managers raised $103 billion of the $231 billion raised over the past 10 years.

To survive, some managers are testing different models, Mr. Hale said. They are considering changing to funds with investment periods that last 10 to 15 years or to an evergreen approach, with funds lasting even longer, he said. Other managers are starting to invest in infrastructure debt and advising the very largest investors looking to make direct investments in infrastructure.

However, Mr. Hale noted, “for most investors, investing in well-aligned pooled funds is a better governance solution for them than owning these assets directly.”

Open-end funds are starting to look more attractive than closed-end funds, he said. Both IFM and J.P. Morgan Asset Management (JPM) offer open-end funds.

Still, offering an open-end structure is not a foolproof recipe for survival. J.P. Morgan Asset Management's infrastructure business has gone through some growing pains. There has been some rejiggering in the executive ranks that culminated in March with Paul Ryan being named CEO of OECD infrastructure equity and debt from his post as a managing director and co-head of the bank's public finance banking unit.

“Unlike private equity, in infrastructure — really the whole real-asset area — there has not been a preferred fund structure,” said Stephen Nesbitt, CEO of alternative investment consulting firm Cliffwater LLC, Marina del Rey, Calif. “There are some open-end structures, partially open-end structures and closed-end structures and the deal terms can vary significantly.”

Markus Hottenrott, chief investment officer of Morgan Stanley (MS) Investment Management's infrastructure unit in London, contends the open-ended model only works for core infrastructure assets. Even then, he said, the “ideal holding structure” for core infrastructure — which he defines as assets that realistically justify 8% to 10% target internal rate of returns — is direct ownership by institutional investors such as pension plans, sovereign wealth funds and insurance companies.

However, direct investing requires a certain critical mass to build and maintain an internal team, he said.

Some investors are seeking alternatives to the private equity, closed-end model, but open-end funds are not necessarily the answer, Mr. Hottenrott said.

“Some people argue that because infrastructure investing is in long-dated assets, there should be long-term capital structures, i.e. long-term debt,” he said. “They may ask themselves, "Shouldn't we have open-ended, perpetual exposure to these assets?' The reality is there have not been that many (open end) funds.”

What's more, the open-end fund structure gives limited partners only “a limited degree of direct influence,” he argued. Investors have limited governance rights, and not all open-end models give investors redemption rights.

Much of what is happening in the industry is the result of growing pains of a relatively new asset class, said Mathias Burghardt, senior managing director and head of the infrastructure group at AXA Private Equity, Paris.

A number of firms were raising massive infrastructure funds and spending heavily before the 2008 financial crisis, Mr. Burghardt said. “They were paying sometimes aggressive prices and the debt was quite cheap,” he explained. “When the crisis hit, the largest players were hit more than others and so a lot of U.S. managers, particularly U.S. bank-managed funds, were hit hard.”
Many struggling now

Many firms are struggling now because they paid too much for assets and used too much debt then. “They were too eager to deploy money,” he said.

Again, there are limits.

AXA Private Equity finished raising a e1.8 billion infrastructure fund in March, including a e300 million co-investment vehicle. He attributed the success to the addition of new, mostly European and Asian investors to the mix of investors.

“U.S. investors show interest, but are worried about the European economic situation. But my impression is that they are getting over that,” he said.

In the end, it's all about returns, said Marietta Moshiashvili, New York-based managing director and portfolio manager of TIAA-CREF's private infrastructure portfolio.

Many of the managers that raised funds before the crisis were raising infrastructure funds for the first time. Now that investors have track records on which to base their investment decisions, some managers have not been able to raise a second fund and have stopped fundraising.

“We are seeing fund managers that are not as successful, and some are offering mixed messages to the market,” Ms. Moshiashvili said.

But it is part of the maturation of the asset class.

“There's more clarity in defining winners and losers in the industry,” she said.
Indeed, it's part of the maturation of the asset class. The industry is going through a needed shakeout. There will be winners and losers and just like in private equity, real estate and hedge funds, money will be concentrated in the hands of a few top funds.

But it's important to remember that infrastructure is a long-term asset class, much longer than real estate and private equity. And some pension funds, like OMERS, are world leaders when it comes to direct investments in infrastructure. OMERS Borealis recently announced it is planning to open an Australian office and they've been busy on many infrastructure deals, including a recent transaction with Allianz to complete their purchase of Net4Gas.

Also, aiCIO reports that some of the largest investment pools have stepped up their infrastructure buys in the past 18 months:
In July, the once very conservative Japanese Pension Association, a federation of employees' pension funds, joined the Ontario Municipal Employees' Retirement System (OMERS) in a purchase of the gas-fired power station in Michigan.

Today, PensionDanmark, the DKK139bn (€18.6bn) Danish pension provider, announced it was helping establish a mine in Armenia with financial backing worth $62.7 million. The money is being made available to the company building the mine, Teghout CJSC, so it may purchase equipment from Danish engineering firm FLSmidth.

Torben Möger Pedersen, CEO of PensionDanmark, said the deal was killing two birds with one stone: “On the one hand, the partnership will ensure a return for our members well above the bond rate, and on the other hand it will help make more Danish export orders possible at a time when more traditional financing is difficult.”

Earlier this month, PensionDanmark announced a joint venture with Burmeister & Wain Scandinavian Contractor A/S to build, own, and operate biomass power plants internationally.
In sum, infrastructure is an important asset class for pension funds looking for long duration assets. There is a shakeout going on in the industry but talk of an "infrastructure bubble" is way overblown, leading investors to conclude there are no opportunities worth investing in this space. There are opportunities and pension funds with expertise in this space will find them and do well over the long-run.

Nonetheless, infrastructure investments can sour and investors should tread carefully, especially if they have no experience in this asset class and don't know how to approach it. A friend of mine who is an expert in infrastructure tells me there will be a "big cleanup" in the future as many infrastructure investments are badly managed and investors will need "operational advice" to get out of very messy situations. "The investment banking types are great at striking deals, terrible at managing infrastructure assets."

After reading my comment above, my friend shared this with me:
"Not sure I agree with all your conclusions but you covered the topic well. The fundamental issue comes down to pricing. Are funding providers generating enough spread across a portfolio of transactions to cover losses if a few transactions do not go as planned? I am not yet convinced because this asset class has not gone through enough business cycles to understand the risk/reward relationship completely. Also, the definition of infrastructure seems to mean different things to different people and projects with very different risk profiles are being lumped into the same asset class."
Below, more evidence on the risks of toll roads. Road traffic has fallen more in Portugal than in any other European country in the past 15 months. Peter Wise, FT's Lisbon correspondent, reports on why empty roads provide a revealing insight into the depth of the country's recession.

Monday, August 26, 2013

Investors Lukewarm on Private Equity?

Sean Farrell of the Guardian reports, Private equity: have investors learned from their mistakes?:
It seems a long time ago when private equity was the unacceptable face of capitalism in Britain. But on the eve of the banking crisis, in June 2007, prominent British representatives of the industry were hauled before parliament's Treasury select committee to explain themselves as political and public disquiet over the sector reached a peak.

"You are effectively filling your boots with debt," said Brooks Newmark, a committee member. The then chair of the committee, John McFall, excoriated witnesses – including executives at Permira, 3i and Carlyle Group – for failing to clean up their public image. "Here is an industry which you tell us is so successful, but there is opprobrium out there. I think you have to do something about it."

A phenomenon of bigger and bigger deals, paid for with escalating debts that produced lightly taxed profits, had given rise to the perception of an unaccountable industry picking off UK companies, stripping them to the core and selling them on with scant regard for the social consequences. The lightning rod was a regime that allowed firms to pay as little as 10% tax on the "carried interest", or profits, that they made on their investments, when the lowest income tax bracket at the time was nearly double that at 22%.

The deal frenzy reached its peak in 2007 when US firm KKR and Axa Private Equity backed the £11.1bn buyout of Alliance Boots. It was the biggest private equity bid for a British business and the first for a FTSE 100 company.

Now there are signs of a tentative re-emergence. Cinven this week agreed to buy Lloyds Banking Group's German life insurance business in a £250m deal and has spent €4bn (£3.4bn) over the past 12 months.

But this is no return to the boom years. The number of private equity deals hit a record 367 in 2007 with a total value of £38bn, according to industry analyst Preqin. That figure would have been £10bn higher if a joint attempt by CVC Capital Partners, TPG and Blackstone to buy Sainsbury's had succeeded.

Then everything changed. As the credit crunch hit, the bank loans that fuelled the buyout boom dried up and many firms' prized acquisitions were burdened by debts they could not pay.

Britain's second biggest buyout – the £4.2bn acquisition of EMI by Guy Hands – met this fate when his Terra Firma defaulted on loans from Citigroup. The bank took control in 2010 and the group that gave the world the Beatles, Coldplay and much else in music was broken up. The number of private equity acquisition s slumped by 2009 to a total value of £5.4bn and firms were left with £78bn in "dry powder", or uninvested cash raised from investors. Some firms went to the wall while others limped on.

The Bank of England warned this year that a legacy from the pre-crunch years could still destabilise the UK economy, as it cautioned that debt-laden private equity deals could unravel with disastrous consequences.

Tim Hames, chief executive of the British Private Equity & Venture Capital Association (BVCA), said the buyout boom should be seen as a blip instead of something the industry wants to repeat. "There was an overwhelming sense that scores of FTSE 100 firms were going to go private but it turned out Boots was the only one. It was a period of crack-house capitalism compared with which almost anything is going to look more modest. But if you take 2006-07 off the graph what we have got is a much more natural continuum."

Private equity firms raise money from pension funds and other investors to buy companies, typically with heavily debt-funded bids, and sell them on after a few years at a profit. The industry says it provides expertise, international contacts and management discipline that can transform a company. A typical investment period of three to five years gives management the time to revolutionise a stuffy private business or a public company away from the sometimes debilitating glare of quarterly reporting.

Critics have accused the industry of loading up healthy companies with dangerous debt, charging investors excessive fees and exploiting tax benefits intended for genuine entrepreneurs.

Nicholas Ferguson, chairman of SVG Capital, said in 2007 that private equity bosses were paying "less tax than a cleaning lady" because they could be taxed at 10% of earnings.

As financial markets returned to health, activity picked up, with acquisition values hitting £17bn in 2010. However, about half these deals were so-called pass-the-parcel transactions as private equity firms sold their debt-laden acquisitions to stronger buyout firms.

There are still 475 UK-based firms looking for funds and deals. But buyers are harder to come by. TPG, one of the world's biggest private equity firms that operates in the UK, recently asked its investors for more time to use $3bn of capital it had not been able to spend. In return it has offered to waive tens of millions of dollars in management fees.

It is also harder to exit investments. Despite booming equity markets, investors are wary of share offerings from private-equity-owned companies returning to the market. And weakened banks are no longer providing loans at the knock-down rates that used to fuel acquisitions such as the Alliance Boots deal.

Tim Syder, deputy managing partner at Electra Partners, said: "Banks providing acquisition debt have drawn in their horns and what debt there is out there is more expensive – banks' margins have more than doubled. In this market, private equity firms have got to be cleverer. The days of simplistic financial engineering – buying a company, loading it up with debt and believing that it will grow in value – have long gone."

Now, he says, deals are about encouraging management teams to get out and find new markets as London-based Electra did with Allflex, a UK animal-tag producer that is now the biggest of its kind, including a significant business in China. After 15 years of ownership, Electra sold Allflex in July for $1.35bn (£830m) but kept a 15% stake.

Investors are also taking a hard line on buyout firms' fundraisings after accepting their claims too readily before the crisis.

Sandra Robertson, who runs Oxford University's £1.5bn investment fund, stunned private equity luminaries at a conference late last year with her attack on sharp practices, impenetrable paperwork and unjustified fees. She said: "Why on earth as a rational investor would I allocate blindly to private equity…? There is no longer an alignment of interests. Entrepreneurs have been replaced by brands and partnerships by organisations."

Bain & Co, the management consultants, has identified three surges in private equity activity: the break-up of unwieldy conglomerates and the rise of junk bonds in the 1980s, economic growth and surging stock markets in the 1990s, and the credit bubble of the 2000s. Economic conditions are improving but there is no sign of a trigger to start a new frenzy. It is steady as she goes.

Syder said: "Compared with past excesses, private equity is going to remain at these reduced levels – and many would argue that is a good thing."
Syder is right, the excesses of the past are long gone and this is a good thing. The credit crisis led to a major shakeout in the industry. Many PE firms have closed shop and the ones that are surviving can no longer rely on financial engineering to produce outsized returns.

Still, there are concerns going forward. While soaring stock markets have been a boon to funds, the pressure is on private equity to find deals in an increasingly unfavorable investment environment where the world is awash with liquidity and asset prices are being bid up.

And investors are taking notice. Some of the largest pension and sovereign wealth funds in the world are dodging Wall Street, taking control of their assets. Others are lowering their return expectations. Becky Pritchard of Dow Jones Financial News reports that investors into private equity and hedge funds may be gradually lowering their return expectations, but there is still a significant rump who aren’t happy with performance:
A quarter of investors into hedge funds said their investments have fallen short of their expectations over the past year, according to a survey by data provider Preqin.

The survey, which is based on interviews with 450 investors in alternative funds, also found that only 14% of private equity investors were not happy with their investments.

However, investors are happier than last year. In the period from June 2011 to June 2012, 41% of hedge fund investors and 21% of private equity investors were dissatisfied with the performance of their investments.

But the survey also revealed that private equity investors have lowered their expectations about the level of returns they will get from their portfolios. Just 49% of respondents said that they expected their private equity portfolios to make returns of 4% above the public markets, this compares to 64% of respondents that expected to make those returns in the previous 12-month period and 70% in the year before that.

This year, a third of investors expected private equity portfolios to deliver returns of 2% to 4% above the public market, while 17% expected private equity to deliver less than 2% above the public market.

For hedge fund investors, CTA and macro funds were the most disappointing over the last year, with 31% and 27% of investors, respectively, saying that these strategies had underperformed. Event driven funds were the best performers over the past 12 months, with 23% of investors stating that they felt these funds had exceeded expectations.
I highly recommend you read Preqin's entire survey on alternatives for H2 2013 (PDF file available here). It contains a wealth of information on investors' attitudes and approaches in all alternative asset classes.

As far as private equity, the survey is mostly positive. While most investors are lowering their return expectations, it is clear that private equity investment is still attractive to LPs, with 92% of investors interviewed intending to maintain or increase their allocation. Furthermore, investors are actively looking to access the asset class through a diverse range of methods. In particular, Preqin’s interviews with investors reveal a growing interest in private debt. "The emergence of this space adds to an exciting layer to a dynamic private equity landscape, along with all others, for investors to contemplate."

Again, read the entire Preqin survey on alternatives for H2 2013. It's clear that investors are increasing their allocations to alternatives but they're also beefing up their due diligence, changing their approach and focusing on alignment of interests. For example, among the key issues in LP and GP relations, the survey states:
Management fees have consistently been at the forefront of investors’ minds as an area within fund terms and conditions which needs improvement; a significant 59% of investors interviewed highlighted management fees as an area of contention at present. Over a third (35%) of LPs cited the amount of capital committed by a GP as an area within fund terms and conditions that needs improvement, while carry structure and rebate of deal-related fees were named by 27% and 16% of investors respectively.
The institutionalization of alternative asset classes means there will be increasing pressure on GPs to better align their interests with those of LPs. You already see this with hedge funds, most of which are coming up short, but you will see it in other alternative asset classes too.

In sum, while the landscape in private equity has changed and the excesses of the past are long gone, there is still plenty of interest in the asset class but investors are tempering their return expectations, changing their approach and focusing on alignment of interests.

Below, Blackstone, the world’s biggest private equity firm, is in talks to buy a stake in Goldman Sachs’ European insurance business.  And KKR & Co., the private equity firm led by Henry Kravis and George Roberts, created a unit to lend to the maritime industry, including assets such as drilling rigs and shipping vessels. Devin Banerjee reports on Bloomberg Television's "Money Moves."

Friday, August 23, 2013

Hedge Funds Coming Up Short?

Steven Russolillo of the Wall Street Journal reports, Hedge Funds Severely Underperforming This Year:
It’s been a great year for the stock market. It’s been a tough year for a hedge-fund manager.

A typical hedge fund has risen 4%, on average, this year through Aug. 9, according to an analysis conducted by Goldman Sachs. That performance compares to a 20% total return (including dividends) for the S&P 500 over the same time frame, meaning the market has outperformed an average hedge fund by five times this year (click on image below).

Hedge funds, on average, underperformed the markets last year as well, with an 8% gain, compared to a 16% total return for the S&P 500.

Hedge funds typically shine when markets struggle and underperform during long rallies, largely because they hedge their bets to try to generate steady performance. But the gap this year has been wider than usual. Fewer than 5% of the hedge funds that Goldman monitored have outperformed the S&P 500 this year, while about 25% of these funds have posted absolute losses.

Goldman’s analysis tracked the investments of 708 hedge funds that had $1.5 trillion of gross equity positions ($1 trillion long and about $500 billion short) as of the beginning of the third quarter. Google Inc.’s shares were the most widely held by hedge funds, followed by Apple and AIG. Citigroup and General Motors rounded out the top five, according to Goldman.  Here’s a look at the 50 stocks most loved by hedge-fund managers.

Part of the blame for the weak performance in 2013 was due to how detrimental short positions have been for hedge funds.

“While key hedge funds long positions have outpaced the S&P 500 year-to-date, short selections have hampered returns,” Goldman analysts said in a note to client. The firm pointed out the 50 stocks with the highest short interest as a percentage of market cap have soared 30%, on average, this year. Here’s a deeper dive into the 50 stocks that are most heavily shorted by hedge funds.

Goldman’s analysis meshes with WSJ’s Page One story Wednesday that detailed how short sellers are facing their worst losses in at least a decade. In the Russell 3000 index, the 100 most heavily shorted stocks are up by an average of 33.8% through Aug. 16, versus 18.3% for all stocks in the index, according to a Journal analysis of data provided by S&P Capital IQ.

The gap between the performance of the most-shorted shares and the market as a whole is wider than it has been in at least a decade.

Goldman found that these hedge funds operate 51% net long, representing a slight decline from record high levels of 53% last quarter. “Risk appetite remained roughly flat despite the S&P 500 rising to new all-time highs,” the firm said.

Turnover in these funds remained low, at about 30%. Popular positions included holding large net-short positions in emerging-market stocks, volatility, gold and high-yield bond ETFs.

“Hedge funds generally use ETFs more as a hedging tool than directional investment vehicles, but these positions reflect large changes versus the prior quarter,” Goldman says.

The upshot, however, is hedge funds continue to struggle as stocks hover around record highs.
Similarly, Tommy Wilkes of Reuters reports, Equity hedge funds come up short in 2013:
Less than 5 percent of hedge funds betting on share prices have outperformed the S&P 500 this year after rallying stock markets hit managers holding short positions, a report by Goldman Sachs shows.

Hedge funds generated an average return of 4 per cent from the start of the year to Aug. 9, against a 20 percent rise in the U.S. benchmark index, with one in four having lost money over the period.

The Goldman Sachs report, which analyzed the positions of 708 hedge funds with $1.5 trillion of gross assets, said that short positions - a bet on the price of shares falling - had weighed on managers.

The 50 stocks that attracted the highest amount of short-selling have risen by an average of 30 percent this year, leaving managers with losses, the report found.

A rebound in developed market economies and the more stable macroeconomic environment have encouraged investors to buy equities this year. The S&P 500 has hit record highs several times in recent months, aided by strong company earnings.

Hedge funds have fared better on the long side. Stocks among hedge funds' top 10 holdings - in the expectation of rising share prices - outperformed the S&P by nearly 12 percent this year.

Shares that most frequently appear among the largest hedge fund holdings include AIG, Google, Apple , General Motors and Citigroup.
The message is clear, equity hedge funds are struggling and they're better at picking stocks in their long book than shorting stocks (no wonder hedge fund clone ETFs are whooping the index and hedge funds). One hedge fund manager told me that shorting stocks is increasingly more difficult and harder to do in the size required by large hedge funds. He fears the next crisis will be worse than 2008 and equity hedge funds will get "smoked."

I'm not sure if shorting stocks is harder but there are plenty of opportunities in this market to make money on the short and long end. For example, the recent backup in yields hit dividend stocks hard and obliterated mortgage REITs.

The backup in yields is also hitting credit hedge funds but some are still managing to outperform:
As bond yields spike all across the developed markets and stock markets plummet in most countries, credit focused hedge funds are up for a tough time ahead. This comes after a very rosy year for funds who invest in debt of corporates and sovereigns, when several of them managed to beat the market in 2012. Benchmark credit indices have done poorly, iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG) was down 3.6% till the end of July, Credit Suisse Leveraged Bond Index was up 2.8% and Barclays US Corp. HY Index has gained only 1.4% through the first half of the year. This year has so far proved to be far less profitable for these funds, however there are a few who have gained a decent sum through the year.

Tough year after a profitable 2012

One of the best performing hedge funds of the year has been David Tepper’s Palomino Fund which applies a long/short credit strategy, the fund has gained 23% in the seven months ending on July 31, after a brilliant +5% gain in last month. Palomino was down in June when credit markets shook, so if more difficult months are ahead, the returns may not remain as healthy anymore.

Josh Brinbaum’s Tilden Park Offshore Fund, which principally invests in MBS instruments, has netted a 14% gain in the same period, after a +0.78% return in July. However the moderate return does not compare at all with the whopping +41% that the fund returned in last year.

Mitchel Julis and Joshu Firedman $2.3 billion Canyon Balanced Fund has gained 12.3% thorugh July after a +20.5% return in last year. Canyon Value Realization Fund which manages $5.7 billion is up 9.6% in this year.

Edward Mule’s Silver Point Capital Offshore is up 11.6% in the $5.1 billion fund. John Paulson is up 12.5% through July in Paulson Credit Opportunities Fund.

Smaller funds like, Brazil based BTG Pactual’s Distressed Mortagage Fund is up 11% for the year, in stark contrast to the +46% gain it posted in 2012. Chenavari Toro Capital IA has netted a 15.4% gain through the first half of the year, and at this rate seems on track to come head to head with the 32% return the fund posted in 2012.
Clearly there have been some stellar outperformers in credit hedge funds but the road ahead will be much tougher. Nevertheless, credit hedge funds resumed their upward path in July while macro & futures dragged down overall performance of hedge funds:
Hedge funds rose an average of 1.2% in July and have returned an average of 4.5% through the first seven months of 2013. On an annualized basis the industry is on pace to return 7.8% in 2013, or 12.1% with Macro and Managed Futures strategies removed.

Funds most willing to embrace the current equity market euphoria have been among the industry’s best performers. On a sector by sector basis, technology, healthcare and micro cap funds were best situated in July for another month of new records from equity indices.

Hedge fund returns in July, and for much of 2013, were again weighed down by poor aggregate performance from Macro and Managed Futures strategies. Whether losses are mainly due to the recent three month surge in treasury yields, falling AUD or the surge in oil, the group is simply not getting the trend or momentum right.

The last three month cumulative return for Macro strategies has been their worst stretch since the three months ending October 2008. For Managed Futures funds you have to look back to June 2004 to find a worse three month period, however they have come close to matching the magnitude of the current drawdown several times in just the last year.

Credit strategies resumed their path upward in July with securitized credit funds again leading the way. Those focused on mortgage markets have faired relatively well during the recent treasury induced MBS market declines, returning an average of 0.4% while the Barclays US MBS Index has fallen 2.6%.

Investor flows for credit strategies have remained strong despite the recent bond market turbulence, with a preference away from purely directional exposures. It is the aforementioned relative performance which has likely been a key reason for this strength as institutional investors seek alternative exposures to their substantial traditional long-only bond fund allocations.

Emerging market hedge fund returns rebounded in July, with the exception of Brazil. Brazil focused funds have shown mixed results in an otherwise positive market environment in July and trail only India as the worst exposure for hedge funds in 2013. Funds investing in the Middle East & Africa have been one of the best performing universes by region and relative to the overall industry in both 2013 and 2012.

Commodities trail only exposures to India and Brazil in terms of loss generation in 2013 after yet another negative month in July, the universe’s sixth consecutive negative month during which they have posted an aggregate decline of 5.5%.
As rates rise, there could be a significant shift in the performance of all these hedge fund strategies. But there is no doubt that macro & futures funds are struggling. When you see traders departing Brevan Howard because of poor performance and Bridgewater patching up its All Weather Fund's risk, you know it's a tough environment for macro funds.

Still, as Sam Jones of the FT reported in early August, macro and other hedge funds that bet heavily on a US recovery are reaping huge rewards:
John Paulson, the widely followed US hedge fund manager, may have been spectacularly wrong on the gold market this year, but he has been right with his other big wager.

Betting on a US recovery – as Mr Paulson’s aptly named Recovery Fund does – has been one of the most profitable trades around. And not just for Mr Paulson.

For many hedge funds, US equities are back in vogue as one of the most opportunity-rich markets worldwide, with the promise of big returns as corporate profitability rises and companies geared to the underlying state of the American economy re-rate.

As if to underscore the point, the S&P 500 passed the 1,700 mark on Thursday to reach an all-time high.

Indeed, among main markets, US equities are second only to Japanese equities, whose valuation has soared on the back of prime minister Shinzo Abe’s radical expansionist monetary agenda, when it comes to performance for 2013.

The case for US equities is “very compelling”, says Troy Gayeski, senior portfolio manager at the hedge fund investor SkyBridge Capital. “The US market is performing much better than Europe and most emerging market countries. The bottom line is that among developed market economies, the fundamentals in the US are the best.

“The yield on US Treasuries will probably never go back to 1.3 [per cent] whatever happens, but equities have every chance of going higher.”

Mr Paulson’s Recovery Fund, which according to an investor is up 35 per cent this year, has had some spectacularly good bets. Among its two largest holdings are mortgage insurers MGIC and Radian.

As Mr Paulson explained to investors in the first quarter, both offered an attractive opportunity to play the resurgence of the US housing market in a purer form than through bank stocks. Radian’s shares have soared 137 per cent this year and MGIC’s are up nearly 200 per cent.

If the US recovery started with the rebound of the housing market, it is also filtering through into the broader economy.

Lansdowne Partners, one of the world’s biggest equity hedge funds, has seen significant gains from its holdings in US blue-chips, which it has intensified in recent months. Investments in US-consumer focused businesses such as Amazon, Google, Bank of America, Comcast and Delta Air Lines have made between 22 and 85 per cent this year.

Other equity hedge fund winners include Larry Robbins Glenview Capital, up nearly 30 per cent at the end of May after bets on US healthcare stocks, and Ricky Sandler’s Eminence Capital, up 24 per cent as of the end of June.

The latest numbers on the US economy have only served to underscore the bull equity investing thesis.

On Thursday, figures from the Institute for Supply Management showed the fastest rise in US factory activity in two years. The ISM’s widely followed index rose from 50.9 in June to 55.4 in July, with any number above 50 indicating growth.

Meanwhile, the US unemployment rate on Friday dropped from 7.6 per cent to 7.4 per cent.

If the fundamentals are strong, then so too are the headwinds from global asset flows – a factor some investors consider to be even more important to the future of US equity markets.

For Caxton Associates, one of the world’s most prominent global macro hedge funds – which use a range of instruments to speculate on broad shifts in the world economy – US equities have been the most profitable bet this year.

Many global macro funds see potentially large sums moving into developed market equities as bonds come to be seen as increasingly less attractive and emerging market growth slows markedly.

Ever since Federal Reserve chairman Ben Bernanke’s comments to the US Congress on May 22 that the central bank may taper its quantitative easing programme, investors worldwide have been on notice that the era of ultra-low bond yields may be coming to an end, macro traders note.

There is “a wall of money” heading for traditional risk assets and US equities, in particular, says one top macro trader. On Friday, Singapore’s $100bn sovereign wealth fund GIC told the FT that it was turning its focus to US stocks.

All of which, however, is not to say that any US stock is a good stock.

“Yes, 90 per cent of the S&P is up, year to date,” says Anthony Lawler, portfolio manager at GAM, “but there is also real dispersion [a measure of divergence in performance among stocks] going on.”

“Cross asset correlations have dropped dramatically,” says Mr Lawler, and sectors have performed markedly differently. The CBOE implied correlation index on the S&P 500, for example, has declined from 60 in January to 47 – close to its lowest level in five years.

“Healthcare, consumer and financials have all done well, but commodity and tech stocks have all underperformed.”

For hedge fund managers, the real test of their abilities will come not from performing in line with a soaraway US equity market, but doing better than it – and indeed, being mindful of a correction.
True, the real test for hedge funds will come when the next big downturn hits financial markets. And while the hedge fund myth has been exposed, prompting some big funds to dodge Wall Street and family offices to increase their scrutiny, I would caution investors not to throw the hedge fund baby out with the bathwater.

Importantly, there will always be excellent hedge funds delivering performance worth paying for. As you read above, yesterday's losers can recover nicely just like past winners can falter. In this environment, you need to beef up your due diligence, monitor your hedge funds very closely and understand how a significant change in the macro environment will impact each strategy and who is best positioned for such a shift.

Below, Bloomberg’s Nathaniel Baker discusses the changing face of hedge funds with Deirdre Bolton on Bloomberg Television’s “Money Moves.” And Mark Dowding, co-head of investment grade at Bluebay Asset Management, discusses the bond markets with his outlook for Treasury yields and what it means to tapering form the Federal Reserve. He speaks on Bloomberg Television's "Countdown."

Thursday, August 22, 2013

Rising Returns Bolster U.S. Public Pensions?

Tim Reid of Reuters reports, Rising returns give U.S. public pension funds chance to reform:
Many U.S. public pension funds are benefiting from double-digit annual returns in fiscal 2013 that are giving them breathing space to try to implement reforms and fix gaping deficits.

A raft of pension reforms since the financial crisis by many U.S. state and local governments have not repaired their pension debt, a factor in the bankruptcies of Detroit, Michigan, and the California cities of Stockton and San Bernardino.

A 20 percent gain on the U.S. stock market in the twelve months to June is, however, alleviating acute funding gaps in many areas.

"It is a marathon, not a sprint," said Keith Brainard, at the National Association of State Retirement Administrators. "I do not think any one-year returns are likely to affect the thinking about pension reforms but we have seen very strong returns since the low point of the equity market in 2009 and it is encouraging," he said.

Recent reforms by many U.S. cities and states have seen retirement benefits for new hires cut, and their contributions into pension plans raised. It will be several years before these reforms start to have an effect on gaps in pension funding.

As well as stock market gains, pension funds are being helped by relatively low exposure to the struggling bond market.

In the last decade bonds held by public pension funds fell from around one third to around one fourth of assets as yields declined.

According to Wilshire Associate U.S. public pension funds have about 25 percent of assets invested in bonds, compared to an average of 37 percent for corporate funds.

In the longer run, higher yields could even provide a boon for pension funds because of higher returns.


Funds will need higher returns as they adapt to new accounting rules set to begin taking effect next year.

Alicia Munnell, at the Center for Retirement Research at Boston College, co-authored a report last month showing U.S. state and local public pensions would have been a paltry 60 percent funded in 2012 if measured by the new rules. That compares with an estimated 72 percent for fiscal 2012 under old rules.

The new rules have been issued by the Governmental Accounting Standards Board (GASB). One key provision is to slash projected rates of return for pension funds' unfunded portions from roughly 7.5 percent to a much lower market level. The move will greatly increase the amounts at which unfunded liabilities are calculated and the money states and cities will have to pay into their funds.

Munnell's study showed that if current projected return rates for public funds are reduced nationwide to five percent, the unfunded figure for America's public pensions jumps from $1 trillion currently to $2.8 trillion.

Still, Munnell is warning against alarmism.

"Public plan sponsors have made numerous changes to reduce their pension costs in the wake of the financial crisis and ensuing recession. The market has performed well in the last few years. Let's give the plans the time and space to work their way back to more comfortable funding limits," Munnell said. The funded ratios of state and local pension funds was at 103 percent in 2000, after a decade-long bull market.


So far this year, plans such as the California Public Employees' Retirement System, Florida's state fund, Ohio state teachers and Connecticut have reported returns well above 11 percent. Most others are expected to follow suit.

A recent report by Wilshire Associates found that in the 12 months preceding June all public funds had a median return of 12.4 percent, although that declined in the last quarter to just 0.24 percent.

Similar results are reported by Callan Associates, the San Francisco-based investment consulting firm.

A report by the credit rating agency Standard & Poor's said there are signs of stabilization in public pension underfunding.

John A. Sugden, primary analyst on the report, said signs were encouraging but warned against over-optimism.

"Good returns are a positive development," Sugden said. But he said recent reforms, where many states and cities have curbed benefits and increased contributions for new hires, will take a long time to produce results.

Rachel Barkely, a municipal credit analyst at Morningstar, said the new GASB accounting system and the stock market "are the two key factors that will drive the pension conversation for governments over the next few years."

Barkley said stock market returns could change if the Federal Reserve eases off its expansionary policy known as quantitative easing.

"There is a lot of uncertainty on whether and how financial markets will keep delivering good results," Barkley said.
I've already covered the slowing deterioration at U.S. public pensions. It's not just about rising returns. Rising interest rates are the primary factor driving pension deficits lower. The new GASB rules, which will slash projected rates of return for public pension funds' unfunded portions from roughly 7.5 percent to a much lower market level, will bite but as long as rates keep rising, funding gaps will shrink.

Of course, nobody expects double-digit annual returns to continue indefinitely and there is always a risk that  rates plunge back to historic lows if  the global recovery falters. Sluggish retail sales in the U.S. and Europe suggest that consumers are weak. The world economy is showing signs of a rebound but the recent pullback in global equities shows just how jittery financial markets are in this environment.

Having said this, I agree with Alicia Munnell:  "Public plan sponsors have made numerous changes to reduce their pension costs in the wake of the financial crisis and ensuing recession. The market has performed well in the last few years. Let's give the plans the time and space to work their way back to more comfortable funding limits."

Pension funding deficits take a long time to correct and looking at them on a short-term basis can scare plan sponsors into taking irrational actions. Sounding the alarm makes for great media coverage but it only diverts attention from the real retirement crisis -- America's new pension poverty.

Below, McKenna, Long & Aldridge Municipal reform Co-Chair Mark Kaufman discusses whether Michigan had the authority to approve Detroit’s Chapter 9 bankruptcy filing, as well as the bankruptcy’s potential effect on pensions. He speaks with Mark Crumpton on Bloomberg Television’s "Bottom Line."