Thursday, October 24, 2013

Pension Funds Love Wall Street?

David Crane wrote an op-ed for Bloomberg, Pension Funds Love Wall Street:
Public pension funds have been moving huge amounts of money into alternative investments managed by Wall Street.

According to a recent report by Cliffwater LLC, an adviser to institutional investors, from 2006 to 2012 state pension funds more than doubled their allocations to alternative investments, which include private equity, real estate, hedge funds and commodities. Totaling almost $600 billion, these nontraditional investments now constitute 24 percent of public pension fund assets. In contrast, the funds dropped their investments in stocks to 49 percent from 61 percent over the six-year period.

There’s a reason for that big move, as explained in a recent International Monetary Fund report. Over the last 10 years, the average U.S. public pension fund earned a return of 6.4 percent a year, very healthy but not enough to meet the 8 percent return guaranteed to government employees. In an effort to take pressure off the state budgets that must cover those deficiencies, the IMF reports that state pension funds have been shifting billions to alternative investments promising higher yields.

To the casual observer, public pensions and hedge funds might seem like strange bedfellows. Public pension funds like to portray themselves as battlers for the little guy; hedge funds levy sizable fees that often go into the pockets of rich people.
Cynical Ploy

Some commentators even depict pension fund participation in alternative funds as a cynical ploy by pension reformers to transfer wealth from retirees to billionaire fund managers. That was the myth promoted in an Oct. 12 op-ed article in the San Francisco Chronicle by self-proclaimed progressive writers Matt Taibbi of Rolling Stone and David Sirota.
But pension funds started shoveling money into alternative investment programs well before pension reform was even in the news. As one example, the California Public Employees’ Retirement System, the largest U.S. public pension fund and a vigorous opponent of pension reform, has more than doubled its targeted investment in private equity over the past 10 years. Its 2012 report lists almost $20 billion of investments in funds managed by Blackstone Group LP (BX), Apollo Global Management LLC (APO), the Carlyle Group LP (CG), KKR & Co. (KKR) and other well-known private equity companies. Calpers and other public-pension funds moved into alternatives for one reason: They are desperate to achieve higher yields to help close pension deficiencies. If they are successful, there will be greater security for retirees and less pressure to cut public services or to raise taxes.

Of course, the foray by Calpers into alternatives isn’t a panacea. Pension costs continue to rise in California. Calpers has announced an additional 50 percent increase in costs commencing in 2015, and the most recent performance of its alternatives has lagged that of its conventional assets. But the trajectory of California’s rising pension costs would have been even steeper had Calpers not increased its allocation to alternatives.

Sirota and Taibbi are right that the fees paid for alternative investment management are higher than those charged for managing conventional assets. But state pension funds are still welcoming alternative-fund managers with open arms because ultimately what counts most to them and their members are higher net yields after -- and regardless of -- fees. Would you prefer to earn (say) 10 percent after a 2 percent fee or (say) 7 percent after a 1 percent fee? In and of itself, fee size shouldn’t drive investment selection.
Higher Returns

Fortunately for those funds, the higher fees have paid off. According to Cliffwater, alternative investments played a role in the above-average performance of 19 of the 20 top-performing state pension funds over the last 10 years. Pension funds that allocated less to alternatives did worse.

Absurdly, Sirota and Taibbi also accuse alternative investment managers of favoring an end to defined-benefit pensions. The reality is exactly the opposite. Defined-benefit plans are a gravy train for private equity and hedge fund managers; 401(k) plans deploy much less capital into such nonconventional investments. Alternative investment managers would lose a fortune if pension money were shifted to 401(k) plans.

There’s no guarantee unconventional assets will outperform conventional assets, but for now state pension funds and defined-benefit pension defenders have good reason for their aggressive support of alternative investments. So-called progressives who prefer to portray Wall Street as sucking blood from working people and conspiring to end their pensions should acknowledge that truth.

(David Crane, a former financial-services executive, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011.)
This op-ed covers many points but ignores others. First, since 2006, state pension funds have significantly altered their asset allocation, getting out of stocks and bonds into alternative investments like private equity, real estate, infrastructure and hedge funds.

Crane rightly notes the main reason behind this shift is that U.S. state pension funds are not meeting their 8% bogey but he fails to mention the rate-of-return fantasy has forced these funds into taking on too much illiquidity risk at the wrong time.

Second, think highly of Cliffwater but take their report on state pension performance and trends with a grain of salt. There is no doubt some state funds have done better than others investing in alternatives. For example, Beth Healey of the Boston Globe reports the $53 billion Massachusetts state pension fund had the highest performance in private equity among large U.S. public pension funds over the last decade, delivering a 15.4% annualized return in private equity over the last ten years.

The figures are based on a recent report by the Private Equity Growth Capital Council, showing the Massachusetts state pension fund outperforming other large state funds over the last five and ten years. You can click on the image below to see the rankings of the top ten state pension funds by private equity returns.


You can see Texas Teachers actually performed just as well in private equity over the last ten years (15.5%) but hasn't fared as well over the last five years (6.3%). Interestingly, the average annualized return for private equity of these ten pension funds over the last five years is 7.8%, much lower than what it was over the last ten years (12.3% for nine funds where data is available) and only proves my point as more money comes into alternatives, returns will come down significantly.

I take all these reports by consultants recommending alternatives and industry trade groups representing alternative investment funds with a grain of salt. The bulk of U.S. state pension funds praying for an alternatives miracle, buying the hedge fund myth, are doling out huge fees and getting mediocre returns. Sure, Wall Street loves it but the approach and governance are all wrong. U.S. state pension funds can learn a lot from their Canadian counterparts, most of which are dodging Wall Street every chance they get.

Of course, it would be irresponsible of me to lump all alternative investment managers in one bucket, nor do I agree with Matt Taibbi that hedge funds are looting pension funds. Taibbi doesn't have a clue of what he's talking about when it comes to hedge funds or pension funds. He has a beef with Dan Loeb, one of the best hedge fund managers in the world, and doesn't understand that how good managers are bringing down the cost of state pension funds.

Taibbi appeals to the masses wrongly claiming there is a wealth transfer from pensions to "rich and evil" hedge fund managers. Great stuff for selling magazines but it's all sensational rubbish which ignores the hedge fund model with all its imperfections is a lot better than mutual funds charging fees for closet indexing. And despite the high fees, top alternative funds have helped state funds lower the cost of their pension plans.

This brings me to the last issue raised in Crane's op-ed, alternatives investment managers would lose a fortune if pension money were shifted to 401 (k) plans. In fact, Stephen Schwarzman, David Rubenstein, Henry Kravis, Ray Dalio, Dan Loeb, and many other financial elites benefiting from the shift into alternative assets should be pushing Washington hard to bolster defined-benefit plans and privatize Social Security (it's only a matter of time). They stand to lose the most from the demise of defined-benefit plans.

As always, welcome feedback from my readers on this subject and don't pretend to have a monopoly of wisdom when it comes to pensions or alternative investments. Feel free to email me if you have valuable insights you'd like to add to this comment (LKolivakis@gmail.com). I will edit it accordingly.

Chris Conradi, a retired actuary, shared this with me:
Although I did not work on the investment side, in my role as actuary for a number of public retirement systems, I occasionally was present at board meetings where proposed investments in hedge funds were discussed—either to invest initially or to increase the allocation. In these meetings, the rationale was almost always given as risk reduction, not increasing returns.
Hedge funds, it was argued, could dampen the impact of down markets, while giving up some of the return in a pure equity investment. Mathematically, they were treated as lower return and lower volatility than equities, and they were treated as poorly correlated with equities. If all this were true—and I am a skeptic—you can see why they might have a role, despite their high fees and poor liquidity.

The argument for private equity and venture capital, on the other hand, was to get exposure to these segments of the equity marketplace which were not as accessible as the S&P 500. There was a recognition (expectation) that these came with higher risk and higher returns. Getting into these spaces was treated as an extension of the movement from S&P 500 stocks to small cap.
I know all these arguments all too well unfortunately, there is a lot of hype in these investments and what they purport to offer in terms of downside protection and true diversification.

Below, Private Equity Growth Capital Council CEO Steve Judge discusses investing in private equity with Deirdre Bolton on Bloomberg Television's "Money Moves."

Again, take these performance reports touting alternatives with a grain of salt and remember the returns on all assets, including alternatives, are not going to be anywhere close to what they were in the last ten years. As pension and sovereign wealth money flows into these assets, returns will come down significantly. And if another crisis hits, alternative investments will get clobbered so choose your managers carefully and don't put all your eggs in the alternatives basket!