Thursday, October 15, 2015

Where Are The Pension Fund Heroes?

Dan McCrum of the Financial Times asks, Where are the pension fund heroes?:
Here is a request, or perhaps a challenge, for nominations: which pension schemes are any good at picking hedge funds?

The question arises in a week when Fortress became the latest brand name hedge fund sponsor to suffer the humiliation of inadequate performance. The US asset manager’s flagship macro fund will close, after losing large amounts of investors’ cash, and Michael Novogratz, the flamboyant money manager responsible, is considering his options.

He is far from the only star investor to have had a bad few months, with losses widespread since June and the industry on track for its worst performance since 2011 — the year of the European debt crisis. However, Mr Novogratz’s fall is a reminder of the way the cast of highflying hedge fund managers rotates. The top of the league tables always show someone making big profits, but the names change every year.

The reason is weight of numbers. With thousands of hedge funds competing, it is inevitable some will shine at any given moment. What is far harder, and rarely lauded, is selecting a group of hedge funds to manage money for several years.

Choosing hedge funds is difficult in part because of the rotation and randomness in investment returns. Statistical studies of past performance show it really is no guide, meaning every year the investor starts with a freshly shuffled pack of cards. Hence, perhaps, the lack of fund of hedge fund managers famous for their investment prowess. At the same time, the life of a hedge fund is fleeting: those that make it past the first year last only another four, on average. The manager of retirement savings for spans measured in decades must always be vigilant for signs of decline.

So when it comes to pension scheme investment in hedge funds, what sort of performance should be celebrated?

As a starting point consider the average hedge fund as judged by HFR, keeper of one of the more popular databases of fund performance. It is not possible to invest in the “average” hedge fund but, if it was, $100 placed in the industry’s care at the start of 2010 would now be worth $123, after fees. Some might think this a relatively low hurdle to beat, given $100 invested in Vanguard’s Total Bond index fund at the same time would now be worth $124, after rather fewer fees.

Instead, let us try to consider the best performance which might be hoped for from a collection of hedge funds. Keepers of commercial databases tend not to let journalists rummage unsupervised in their annals of mediocrity so, as a proxy, imagine choosing hedge fund strategies with perfect hindsight.

HFR breaks the industry into 31 separate strategies, reflecting the more popular types of fund. Say the best hedge fund investor could forecast the three strategies that will generate the greatest investment gains each year, and splits all her money between them every New Year's Day. In 2012 our imaginary genius went for activists, value-minded stock pickers and specialists in asset backed securities. A year later she would stick with the value guys, but swap in some funds focused on heathcare and technology stock pickers, as well as those that specialise in spotting pricing anomalies in energy and property-related securities.

Pick the three best hedge fund strategies every year and $100 at the start of 2010 would be worth almost twice as much — $193 — after fees.

Here’s the rub, however. Had our forecasting genius put $100 into the Vanguard fund that tracks the S&P 500 stock market index, it would also be worth $193.

The conclusion appears to be that the very best that might be hoped for from investing in smart, and expensive, hedge funds is simply to have kept pace with dumb old stocks.

One final, and perhaps more realistic benchmark, against which hedge funds and their investors might be measured, then. If a pension fund allocated 40 per cent of its money to Vanguard’s bond fund, 60 per cent to the US stock fund, and reset the balance back to those levels every year, its $100 would have grown to $164.

A hedge fund portfolio that has grown faster than that would be worth lauding indeed. Feel free to make nominations in the comments, or to the email address below.

For those pension funds left pondering the failures of their hedge fund programmes to keep up, perhaps a better question is worth asking: does it even make sense for them to try?
I answered Dan McCrum's question in my last comment covering another shakeout in hedge funds. Let me briefly go over some points below:
  • There is no question in my mind that Ontario Teachers' Pension Plan is one of the best hedge fund investors in the world. A big reason for this is the guy who was recruited to start this program back in 2001 and is now the leader of that organization, Ron Mock, had unbelievable experience co-founding and managing a huge hedge fund that blew up when one of his traders went rogue on him (Ron took full responsibility for that blow-up and learned first hand about operational risk). That and other harsh lessons taught Ron Mock all about the perils of investing in hedge funds and gave him and OTPP an edge over others who don't have any experience managing a hedge fund.
  • The reins of hedge fund program have been handed over to Wayne Kozun who is responsible for Teachers' Fixed Income and Global Hedge Fund portfolio (another great guy who knows his stuff). Wayne oversees a great team which includes a fellow called Daniel MacDonald, one of the best hedge fund portfolio managers in the pension fund industry (I know, I've seen him in action and he asks all the right questions). Together, the global hedge fund team pick and monitor a number of hedge funds and they make sure they're all delivering alpha, not leveraged beta (As Ron Mock always reminds me: "Beta is cheap; true alpha is worth paying for").
  • But even OTPP has gotten clobbered on hedge funds, especially in 2008 when it crashed and burned. So, if one of the most sophisticated and best funds of hedge funds can experience a serious setback, what makes you think that other much less sophisticated public pensions can navigate this space without being eaten alive by hedge fund fees?
  • The answer is quite simple. Most of these unsophisticated investors jumping on the hedge fund bandwagon are listening to their useless investment consultants which typically shove them in the hottest hedge funds they should be avoiding. This is why most investors consistently lose money on hedge funds, especially after you factor in the fees and illiquid nature of these investments.
  •  So why do so many U.S. public pension funds keep piling into hedge funds instead of following CalPERS and nuking their program? Because many of them are chronically underfunded, poorly staffed, and they keep chasing the pension rate-of-return fantasy which forces them to take increasingly more risks in hedge funds and more illiquid alternative investments like private equity and real estate. 
  • The central problem of course is governance. Unlike Canadian public pension funds, U.S. public pension funds are poorly governed, have too much government interference, are unable to pay their staff properly so they can manage public, private and hedge fund assets internally to significantly lower costs, and are pretty much at the mercy of their investment consultants which have hijacked the entire investment process. What this means is that U.S. public pension funds pay out insane fees to hedge funds, private equity funds, real estate funds and investment consultants. It's all about milking that public pension cow dry and making overpaid hedge fund and private equity managers and their Wall Street buddies much richer. 
  • But in a deflationary and low-return world, institutional investors from all over the world are starting to scrutinize fees and other hidden costs attached to investing in hedge funds and private equity funds. In California, both CalPERS and CalSTRS are being scrutinized by the state treasurer for the fees they pay out to private equity funds and I expect other states to follow suit with their own investigations (look at the mess in Illinois which is a disaster).
  • As far as hedge fund benchmarks, I don't think it's fair to compare them to the S&P 500 or even a balanced fund because hedge funds are suppose to deliver absolute returns in all markets or at least deliver much higher risk-adjusted returns than a balanced 60/40 fund. The problem is most hedge funds stink as do most hedge fund databases which are full of biases.  
  • This makes the job of picking the right hedge fund nearly impossible (akin to trying to pick the right mutual fund) but just like in private equity, there is some performance persistence among top hedge funds which is why they garner the bulk of the industry's assets. 
  • But in this environment, where even brand name funds are taking a beating, I would beware of large hedge funds and start focusing my attention on some of the smaller ones that are far from perfect but tend to have better alignment of interests. The problem with this strategy is how do you pick the smaller hedge funds and is it worth devoting resources to managers and strategies that are not highly scalable?
  • Small hedge funds deal with other problems including insane regulations which are destroying their chances of getting up and running unless they have at least $250 million or more of assets under management. I was talking to a manager who wants to start a macro fund, has great experience, and he told me the regulatory environment in Canada is just insane. He also told me that anyone who wants to manage more than a billion dollars off the start in this environment is asking for trouble. I agreed and pointed out that even Scott Bessent, Soros's protege, and Chris Rokos, the former star trader at Brevan Howard, are managing the growth of their new macro funds very carefully focusing on performance first and foremost.
So after reading all my comments, let's go back to Dan McCrum's question above, where are the pension fund heroes? I'd say most of them are in Canada where plans like OTPP and HOOPP keep delivering stellar returns as they match assets and liabilities with or without external hedge funds and pension funds like CPPIB bringing good things to life on a massive scale, which is why it's also posting great returns.

In fact, all of Canada's top ten are performing well and providing great benefits to the Canadian economy which is why I'm a stickler for enhancing the CPP here. If the U.S. got its governance right, I would also recommend it enhances Social Security for all Americans.

Finally, since we are on the topic of pension fund heroes, Northwater Capital Management Inc. ("Northwater") is pleased to announce the appointment of Neil J. Petroff to the role of Vice Chair, effective October 1, 2015:
Prior to joining Northwater, Mr. Petroff held the position of Executive Vice President of Investments and Chief Investment Officer at the Ontario Teachers' Pension Plan ("OTPP") since 2009, where he was responsible for all aspects of the firm's investment activities as well as the pension fund's asset-mix and risk allocations. Throughout his 22 year career with OTPP, Mr. Petroff held progressively more senior-level positions which have given him broad exposure and management experience in a wide range of asset classes and investment products. In 2014, Mr. Petroff was recognized as Chief Investment Officer of the Year and he received the prestigious Lifetime Achievement Award at the Industry's Innovation Awards ceremony.

Before joining OTPP, Mr. Petroff worked at the Bank of Nova Scotia , Guaranty Trust Company and Royal Trustco Limited. Neil has served on several corporate and charitable boards including Cadillac Fairview Corporation Limited, Maple Financial Group Inc. and the Integra Foundation.

"Neil Petroff is truly a world-class investment professional" said David Patterson , Chair and Chief Executive Officer of Northwater. "His substantial experience and expertise will be invaluable to Northwater and its clients as we continue to offer industry-leading alternative investment solutions to institutional investors around the world."

About Northwater Capital Management Inc.

Northwater Capital Management Inc. has, over the years, been known for being first into new and innovative investment strategies. It was the first Canadian firm in synthetic indexing, fund of funds in hedge funds, intellectual property funds, risk parity portfolios and bespoke liquid alternative strategies. Currently, it manages the Northwater Intellectual Property Funds and the Fluid Strategies portfolios. Founded in 1989, Northwater is a private investment company with offices in Toronto and Chicago.
I completely agree with Dave Patterson, "Neil Petroff is truly a world-class investment professional" and the folks at Northwater are truly lucky to have him on their team. [Note: You should read the latest from Northwater's Neil Simons, The Missing Piece to Alternative Investing - Part 1.]

You know who else is very lucky? All of you who read my daily insights and don't pay a dime for them! I'm no pension hero and will never receive a lifetime achievement award (couldn't care less), but I'm damn proud of  this blog and my unflinching and brutally honest comments on pensions and investments.

So, once again, please take the time to subscribe or donate on the top right-hand side and support my efforts in bringing you the very best insights on pensions and investments. I thank all my institutional subscribers and I'm tinkering with an idea of providing those who subscribe with premium content to give you an edge over your peers and just to thank you for supporting my blog.

Below, discussing challenges facing small hedge funds, with Daniel Stern, Reservoir Capital co-CEO, and Barry Sternlicht, Starwood Capital CEO. Interesting discussion which provides insights on why so many smaller funds are incapable to launch a hedge fund in this environment.

Also, Nicole Musicco, MD and new head of APAC at the Ontario Teachers' Pension Plan, discusses the fund's portfolio diversification. Smart lady, great discussion, listen to her comments.


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