Tuesday, October 18, 2016

CalSTRS Cuts External Managers?

Aliya Ram of the Financial Times reports, Calstrs to pull $20bn from external fund managers:
The California State Teachers’ Retirement System plans to pull $20bn from its external fund managers. The third-largest US pension scheme is blaming the withdrawal on high fees and disappointing returns across the investment industry.

Sacramento-based Calstrs, which oversees $193bn of assets, currently allocates half of its assets to external fund companies.

Jack Ehnes, the chief executive of Calstrs, told FTfm the scheme will reduce the level of money run by external companies to 40 per cent because it “costs pennies” to run the money internally versus paying fees to external investment managers.

“The best way to get better returns is not finding better managers,” he said. “For every $10 we pay an outside manager, we would pay $1 inside. That is a pretty daunting ratio.”

According to its latest annual report, the pension scheme’s largest external mandates are with Generation Investment Management, the London-based company that was co-founded by Al Gore, the former US vice-president, New York-based Lazard Asset Management and CBRE Global Investors, the property investment specialist.

As pension deficits grow due to rising life expectancy and poor returns, other schemes have also pulled mandates from external fund companies that are already under pressure from market volatility and the popularity of cheaper, passive portfolios.

Alaska Permanent Fund, which manages $55bn, said last week it will retrieve up to half its assets from external managers, while ATP, Denmark’s largest pension provider, and AP2, the Swedish pension scheme, both dropped mandates from external managers earlier this year.

Calstrs has already shifted $13bn of its assets in-house over the past year, according to Mr Ehnes. The number of investment staff employed by the pension fund has risen 15 per cent, to 155, over the past two years to deal with the increase in capital managed internally.

Calstrs’ latest annual report showed it paid $155.7m in investment fees in the year to the end of June 2015, nearly a 10th less than it paid in fees the previous year.

The fee intake of investment managers Morgan Stanley, T Rowe Price and Aberdeen Asset Management fell significantly, by 61 per cent, 24 per cent and 15 per cent respectively.

Mr Ehnes said the proportion of assets managed in-house at Calstrs could increase beyond 60 per cent as its expertise develops.
Glad to read that CalSTRS finally woke up and discovered the secret sauce of the Ontario Teachers' Pension Plan (OTPP), the Healthcare of Ontario Pension Plan (HOOPP) and the rest of Canada's Top Ten pensions which manage most their assets internally.

Of course, CalSTRS still has to work on improving its governance structure to get politics out of its investment decisions and hopefully they're starting to pay their investment staff properly as they cut external mandates and bring assets internally (maybe not Canadian compensation standards but much better as responsibilities shift to internal management).

Why did CalSTRS decide to cut a big chunk of its external fund managers? There are a lot of reasons. First, the performance at CalSTRS during fiscal 2015-16 was far from great, likely prompting a lively internal discussion where they asked themselves the following question: "Why are we paying external fund managers excessive fees if they keep delivering mediocre returns?"

By the way, it's not just CalSTRS asking this question. CalPERS nuked its hedge fund program exactly two years ago and its senior officers have gotten grilled on private equity fund fees (so have the ones  at CalSTRS and rightfully so as private equity's misalignment of interests is the worst kept industry secret).

Even Ontario Teachers' which is by far one of the biggest and best investors in external hedge funds, cut allocations to some computer-run hedge funds that weren't delivering the goods.

And many other pensions and endowments are asking tough questions on their external managers and whether they are worth the fees. On Monday, Simone Foxman and John Gittelsohn of Bloomberg reported, Hedge Funds Cost N.Y. Pension Plan $3.8 Billion, Report Says:
The New York state comptroller’s decision to stick with hedge funds despite their poor returns has cost the Common Retirement Fund $3.8 billion in fees and underperformance, according to a critical report by the Department of Financial Services.

The state comptroller, who invests $181 billion for two systems covering local employees, police and fire personnel, "has over relied on so-called ‘active’ management by outside hedge fund managers," the department said Monday in the 20-page report. "For years the State Comptroller has been frozen in place, letting outside managers rake in millions of dollars in fees regardless of hedge fund performance."

Spokeswoman Jennifer Freeman defended the office of comptroller Thomas DiNapoli, accusing the department of harboring political motives.

"It’s disappointing and shocking that a regulator would issue such an uninformed and unprofessional report," Freeman said in a statement. "Unfortunately, the Department of Financial Services seems more interested in playing political games, so remains unaware of actions taken by what is one of the best managed and best funded public pension funds in the country."

Hedge funds, which charge some of the highest fees in the money-management business, have faced mounting criticism from clients over steep costs and performance that mostly hasn’t kept pace with stock markets since the financial crisis. The California Public Employees’ Retirement System, the largest U.S. pension plan, voted to divest of hedge funds in 2014 because they were too complicated and expensive. On Friday, the investment committee for the Kentucky Retirement Systems voted to exit its $1.5 billion in hedge fund holdings over three years.
Opening Round

The DFS report appears to be the opening round in an broader investigation into the management of New York’s retirement system, the third largest state fund at the end of 2015. Led by Superintendent Maria Vullo, the department said it was considering potential regulations on fees and profit-sharing "as well as pre-approval of contracts that provide for fees or profit sharing in excess of a certain rate."

The topic is of interest to Governor Andrew Cuomo, who oversaw a three-year investigation of the comptroller’s office when he was New York Attorney General. By the end of that probe, former Comptroller Alan Hevesi pleaded guilty to one felony count stemming from a pay-to-play kickback scheme.

Categorized under New York system’s “absolute return strategy,” hedge fund investments lost 4.8 percent in the fiscal year that ended March 31, according to the system’s annual report. The average hedge fund lost 3.8 percent in the same period, according to data compiled by Hedge Fund Research Inc. New York’s hedge fund investments have returned an average of 3.2 percent each year over the past 10 years, compared with 5.7 percent for the total fund.

The DFS’s report said the state had paid almost $1.1 billion in fees to its absolute return managers, a category that includes hedge funds, since 2009. Had the system allocated that money to global equities managers instead, their performance would have netted the fund $2.7 billion more in gains.
Doubling Down

In the face of three years of “massive hedge fund underperformance,” the report added, the comptroller continued the gamble by almost doubling -- increasing by 86 percent -- the assets poured into the managers between 2009 and 2011.

Freeman said DiNapoli and Chief Investment Officer Vicki Fuller have taken "aggressive steps" to reduce hedge fund investments and limit fees, and that the system hasn’t put money into a hedge fund in well over a year.

The report also criticized the lack of transparency related to the system’s private equity investments, saying the comptroller hadn’t taken sufficient action to make sure funds were disclosing all their fees and expenses.

The pension system "has only recently discovered what should have been clear long ago -- that making a commitment to alternative investments places a much greater monitoring burden on the investor," the report said. "Taking on asset allocations that are complex to monitor and oversee and only belatedly understanding the challenges reflects poor planning."
I don't know what all the fuss is about but I actually read the full DFS report and completely disagree with that spokeswoman who defended the office of comptroller Thomas DiNapoli, claiming the report is "uninformed and unprofessional" and politically motivated.

In fact, DFS Superintendent Maria T. Vullo put out a press release following the release of this report:
Yesterday the Department of Financial Services (DFS) issued a report finding that the New York State Common Retirement Fund (CRF), managed by the New York State Comptroller as sole trustee, for years has invested pension system funds in high-cost underperforming hedge funds, costing the system $3.8 billion over the last eight years. Contrary to the statement by the Comptroller’s communications director, and despite the fact that DFS, as regulator, had no obligation to inform them, the Comptroller’s office was well aware of this review. In a letter sent on September 9, 2016, DFS raised specific questions about the management and investment allocations of the CRF. None of the information provided to DFS in response to the September letter validates the claims being made now. And putting aside all of the bluster, the Comptroller has not contested, because he cannot contest, the fact that he took 8 years to address these significant issues while pension fund managers nationwide have significantly cut or entirely eliminated their hedge fund investments. Prior to the release of our report, I personally called the Comptroller but he has yet to return my call. DFS stands by its report and will continue to exercise its oversight of the pension systems and maintain its obligation to the public to report on these important issues.
Kudos to Superintendent Vullo and the Department of Financial Services for having the chutzpah and foresight to issue this report and spell out in clear terms the actual and opportunity cost of investing in hedge funds and private equity funds as well as other issues investing in these funds.

Moreover, I recommend all US, Canadian and European public pensions follow New York State's lead and commission similar reports from independent and qualified professionals who can perform a serious and in-depth operational, investment and risk management audit of their public plans.

New York's Common Retirement Fund should follow CalPERS, CalSTRS and others and nuke their hedge fund program and even cut a lot of their private equity funds which are delivering equally mediocre returns and charging it a bundle in fees ($1.1 billion in fees pays a lot of excellent salaries to bring assets internally provided they get the governance and compensation right).

Importantly, in a deflationary, ZIRP and NIRP world where ultra low or negative rates are here to stay, it's simply indefensible to pay external managers huge fees for mediocre or even solid returns.

Yes, let me repeat that so the Ray Dalios, Ken Griffins, David Teppers of this world can understand in plain English: no matter how much alpha you are reportedly delivering, it's simply ludicrous and indefensible to justify 2 & 20 (or even 1 & 10 in some cases) to your big pension and sovereign wealth fund clients.

I don't care if it's mathematical geniuses like Jim Simons and the folks at Renaissance Technologies or up and coming hedge fund gurus trying to one up Soros, the glory days of charging customers 2 & 20 or more on multibillions are over and they're never coming back.

What about Steve Cohen, the perfect hedge fund predator? Will he be able to charge clients 5 & 50 for his new fund like he used to in the good old days at SAC Capital? No, there's not a chance in hell he will be charging large institutional global clients anywhere close to that amount, provided of course that he first manages to lure them back to invest with him (a lot of big institutions are going to be reluctant or pass given his sketchy background but plenty of others won't care as long as his new fund keeps delivering outsize returns of SAC and his family office).

And it's not just hedge funds that need to cut fees. These are treacherous times for private equity funds and they need to cut fees too and reexamine their alignment of interests and whether they're truly in the best interests of their large institutional clients and their members.

The same goes for long-only active management where there's been a crisis going on for years. Why do institutional and retail investors keep forking over fees to sub-beta performers who obviously can't pick stocks properly? It's the very definition of insanity.

This is all part of the malaise of modern pensions and in a deflationary world where fees and costs add up fast, many other US public pensions will follow CalPERS, CalSTRS, and others who cut or are cutting allocations to external managers charging them hefty fees for mediocre returns or risk being the next Rhode Island meeting Warren Buffet.

Is this the beginning of something far more widespread, a mass exodus out of external managers? I don't know but clearly there are some big pensions and sovereign wealth funds that are tired of paying hefty fees to external managers for lousy absolute and risk-adjusted returns.

The diversification argument can only take them so far, at one point funds need to deliver the goods or they will face the wrath of angry investors who will move assets internally and never look back.

Below, I embedded CalSTRS's September 2016 Investment Committee. The committee began with public statements from California teachers and Chris Ailman, the CIO, starts discussing performance around minute 24. Take the time to watch the entire committee and listen to the discussion on fees (of course, most of the interesting discussions take place in closed camera sessions).

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