Tuesday, October 4, 2016

Rhode Island Meets Warren Buffett?

Mary Childs of the Financial Times reports, Rhode Island cuts its hedge fund programme by two-thirds:
Rhode Island’s pension plan has decided to cut its investment in hedge funds by two-thirds, as retirement systems across the US re-evaluate their strategies for generating the returns they need to pay participants.

Over the next two years, the $7.7bn Employees Retirement System of Rhode Island will cut its allocation to hedge funds to 6.5 per cent from the 15 per cent it set in 2011 — joining a growing list of large investors who are dissatisfied by performance and pulling money from the sector.

“This wasn’t something we woke up one day and decided to do — it wasn’t something we did in response to headlines or political pressure,” said Seth Magaziner, general treasurer for the US state.

“We put a lot of work into this, a lot of modelling, a lot of testing and retesting of assumptions, and this was the result that the process led to,” he said: “We came to the conclusion that Rhode Island and many other states have been doing the process backward by starting with an assumed rate of return and trying to hit it.”

Instead, he said, Rhode Island set a risk tolerance “defined by real economic factors” such as the odds that certain costs may spike or that the fund would drop to less than 50 per cent funded. From there, it chose allocations designed to generate the most money possible at that risk level, and, working with the Pension Consulting Alliance, tested its conclusions against “thousands” of scenarios.

Many pension funds adopted alternative investment managers like hedge funds and private equity as high valuations across markets and low interest rates threatened returns from conventional long-only mutual funds. But hedge funds have struggled to generate returns in volatile markets, and their high fees have prompted some investors including the New Jersey and the New York City retirement systems to scrap or reduce their programmes.

Investors have already pulled more than $50bn from hedge funds this year, according to eVestment.

The total assets under management of the hedge fund industry exploded in size from $500bn at the turn of the millennium to almost $3tn by 2015. As assets have grown performance has suffered, with hedge funds as a whole failing to beat the S&P 500 over the past four years.

Rhode Island — which has less than 60 per cent of the assets it needs to pay its liabilities — is turning to passive trend-following strategies and private equity to help it claw back to a level where it can pay out its obligations. It is boosting its allocation to private equity from 7 to 12 per cent, over five years or more, to spread out exposure across different fund years and to avoid being forced to choose managers in a hurry, Mr Magaziner said.

Rhode Island will jettison its equity-focused hedge funds, but keep strategies categorised as “absolute return” with managers who have demonstrated that they are not correlated to the broader markets, and who will generate positive returns, he said.

“We’re going to stay passive when it comes to long public equity,” Mr Magaziner said. “We just didn’t have faith that active management could consistently achieve equity-like returns, so that’s that.”

Eight per cent of the plan has also been dedicated to a new strategy called “crisis offset” or “crisis protection” — long-duration Treasuries and passive momentum or trend-following strategies, assets that historically have made money in downturns.

“This is the part of our portfolio that we think is going to help us control against risk better than the bulk of our hedge funds have,” Mr Magaziner said. “If there really are strategies out there that will achieve positive performance at a time when everything else is dropping, that can be tremendously valuable.”
Things are not going well in Rhode Island. Edward Siedle recently wrote a comment for Forbes, Rhode Island Politicians' Billion-Dollar Pension Hedge Fund Gamble Loses $500 Million:
Yesterday Rhode Island General Treasurer Seth Magaziner announced that the state pension would cut its $1 billion hedge fund investments– made under former Treasurer, now-governor Gina Raimondo– after losing big over the past five years. Neither Raimondo nor Magaziner ever heeded warnings that these high-cost, high-risk investments were inappropriate for the pension. A version of this article was published in GoLocal Prov yesterday.


Do Rhode Island Governor Gina Raimondo and General Treasurer Seth Magaziner really believe they are smarter than Warren Buffett, considered to be one of the most successful investors in the world?

Of course not.

How could they?

The wreckage related to Raimondo’s failed stint as a small-time venture capitalist is finally out in the open for all Rhode Islanders to see.  The Point Judith II fund she pitched to the Employees Retirement System of Rhode Island (in which the pension risked $5 million) has returned a pathetic -1.1 percent over the past almost ten years—after paying her rich fees of 2.5 percent. If making money off your investors defines success, then Raimondo’s a superstar.

Magaziner, on the other hand, can boast a summer internship at Raimondo’s Point Judith Capital and two years as a portfolio associate, then research analyst at a small money management firm in Boston. Is this 31-year old qualified to manage $7.7 billion in state pension assets? Hardly.

Ignoring Warren Buffett and Other Questions

So why did Raimondo ignore Warren Buffett’s warning that public pensions should not gamble on hedge funds?

(As I advised Rhode Islanders approximately 4 years ago, Buffett made a million-dollar bet at the start of 2008 that a low-cost S&P 500 index fund would beat hedge funds over the next ten years. After eight years, as Buffett gloated at his company’s recent annual meeting in Omaha, the S&P 500 is crushing it. The fund Buffett picked, Vanguard 500 Index Fund Admiral Shares is up 65.67%; the high-cost, high-risk hedge funds are up, on average, a dismal 21.87%.

Also, when asked by a public pension trustee, Buffett advised that public pensions should avoid hedge funds and should prefer index funds.)

Worse still, why has Kid Magaziner stuck with Raimondo’s billion dollar-plus losing hedge fund bet and only yesterday announced plans to dump half the pension’s hedge fund investments for lower-cost, more traditional assets?

Why is it going to take Magaziner two years to exit hedge funds, even now?

The Answer to the Mystery

The answer to this longstanding mystery: Raimondo and Magaziner’s gambling state pension assets in hedge funds has never been about investing or prudent pension practices. It’s always been about politics.

These Rhode Island elected officials blatantly ignored credible warnings (by Buffett and, yes, me) and used $1 billion of public pension assets for their own political objectives. This week Magaziner even boasted that he gave my dire warnings about the dangers of high-cost, high-risk hedge funds “zero consideration.”

(Kid Magaziner should be sat down and told by a grown-up that when pension fiduciaries gamble and lose hundreds of millions of workers retirement savings, it’s probably not smart to admit having ignored the warnings of experts.)

Steering public monies to Wall Street has dramatically increased Rhode Island politicians’ campaign coffers to unprecedented levels. On the other hand, according to the General Treasurer’s office, the pension has lost 10 percent or approximately $100 million a year by investing in hedge funds. Over five years, that amounts to $500 million.

Any “savings” related to cutting workers’ 3 percent Cost of Living Adjustment (COLA) benefits over the past five years have been squandered. So much for Raimondo’s “pension reform” that was supposed to resolve the underfunding crisis. Further benefit cuts, or taxpayer infusions, will be required to restore funding.

The Bottomline

Workers’ benefits were slashed 3 percent to pay massive 4 percent fees to Wall Street hedge fund billionaires (who lost half a billion in workers’ retirement savings)—all in exchange for a measly few million dollars in political contributions. Talk about a deal with the devil. Was this foreseeable, and indeed foreseen, sleight of hand worth it?

Maybe to Raimondo and Magaziner the $500 million price paid by the pension to further their political ambitions is acceptable, but I doubt any state workers or taxpayers would agree.

That’s precisely the question the SEC, FBI (and, for that matter, Rhode Island’s sleepy Attorney General Peter Kilmartin) should be investigating.
Ted Siedle, the pension proctologist, is definitely not the type to tiptoe around issues. In this short comment, he rips into the former Treasurer of Rhode Island for using public money to invest in hedge funds in exchange for political contributions.

You'll recall Gina Raimondo, the now governor of Rhode Island, was one of the heroes in Jim Leech and Jacquie McNish's book, The Third Rail, for having the courage to implement tough pension reforms in that state.

Now we see Mrs. Raimondo may not be such a pension hero after all; she comes off as another cunning and opportunistic politician who went to bed with hedge fund sharks in order to advance her political career.

[Note: To be fair, if you read The Third Rail, you will see Raimondo implemented much needed and tough pension reforms but she's obviously no angel and used her hedge fund contacts to get elected as governor.]

And who is this 31-year old Seth Magaziner, the current General Treasurer? At 31, he definitely doesn't have the experience or qualifications to hold such a position. In fact, at 31, nobody should be in charge of $7.7 billion state pension fund, this is a complete travesty and farce.

Siedle is right, pensions and politics are not a good mixture, and he explains why. Hedge funds and private equity funds, many of which are underperforming and have a misalignment of interests with their limited partners, are effectively buying allocations and collecting fees no matter how well or poorly they perform.

But let me take a step back here because while I enjoy reading Ted Siedle's hard hitting comments, he he too comes off sounding like a self-righteous and arrogant jerk who thinks he has a monopoly of wisdom when it comes to pensions and investments.

Well, he doesn't, none of us do, and it's high time I expose some of his blatant and biased nonsense against hedge funds. Yes, Warren Buffett is going to win that famous and silly $1 million bet against hedge funds which he made back in 2008 with Ted Siedes, co-founder of Protégé Partners.

So what? Who cares? I am sick and tired of reading about this epic and dumb bet Warren Buffett made against hedge funds right before markets tanked and came roaring back to make record highs. Buffett can thank Ben Bernanke, Janet Yellen, Mario Draghi, and Haruhiko Kuroda for unleashing a liquidity tsunami (in their misguided and feeble attempt to stop the coming deflationary tsunami) which helped thrust all risk assets much higher as everyone chases yield.

Comparing hedge funds to low cost exchange traded funds (ETFs) is just stupid, period. And by the way, most long only funds charging fees are going through their own epic crisis. Moreover, let's not kid each other, this radical shift into exchange traded funds is one huge beta bubble which is making life miserable for all active managers.

In a recent comment of mine going over why  Ontario Teachers' Pension Plan is cutting computer-run hedge funds, I stated the following:
[...] we can argue whether we are on the verge of a hedge fund renaissance or whether active managers could be ready to shine again but the point I'm making is most large pensions and sovereign wealth funds are more focused on directly or indirectly investing huge sums in illiquid alternatives and I don't see this trend ending any time soon.

In fact, I see infrastructure gaining steam and fast becoming the most important asset class, taking over even real estate in the future (depending on how governments tackle their infrastructure needs and entice public pensions to invest).

I will end with a point Ron Mock made to me when I went over Teachers' 2015 results. He stressed the importance of diversification and said that while privates kicked in last year, three years ago it was bonds and who knows what will kick in the future.

The point he was making is that a large, well-diversified pension needs to explore all sources of returns, including liquid and illiquid alternatives, as well as good old boring bonds.

And unlike other pensions, Ontario Teachers has developed a sophisticated external hedge fund program which it takes seriously as evidenced by the highly trained team there which covers external hedge funds.
Why does Ontario Teachers' invest roughly $11 billion in external hedge funds through an overlay strategy? Are they dumb as nails? Haven't they learned anything from Warren Buffett and Charlie Munger about how stupid investing in hedge funds truly is and what a waste of money it is?

I can guarantee you one thing, even though I don't have the performance figures and fees paid to external hedge funds at Ontario Teachers', there is no doubt in my mind (none whatsoever) that Ron Mock, Jonathan Hausman and the team covering external hedge funds there know a lot more about alpha managers than the Oracle of Omaha, Munger, Siedle and many other so-called experts of hedge funds who make blanket and often erroneous statements.

Trust me, I am no fan of hedge funds, think the bulk (90%++) of them stink, charging outrageous "alpha" fees for leveraged beta, or worse, sub-beta performance. Moreover, I agree with Steve Cohen and Julian Robertson, there is too much talent in the game, watering down overall returns, but there are also plenty of bozos and charlatans in the industry which have no business calling themselves hedge fund managers.

But all these self-righteous investment experts jumping on the 'bash the hedge funds' bandwagon annoy me and if we get a prolonged deflationary cycle where markets head south of go sideways for a decade or longer, I'd love to see where they will be with their "keep buying low cost ETFs" advice (Buffett, Munger and Bogle will be long gone by then but Siedle and Seides will still be around).

I believe in the Ron Mock school of thought. When it comes to hedge funds and other assets, including boring old long bonds, always diversify as much as possible and pay for alpha that is truly worth paying for (ie. that you cannot replicate cheaply internally).

I will repeat what Ron told me a long time when we first met in 2002: "Beta is cheap. You can swap into any equity or bond index for a few basis points to get beta exposure. Real uncorrelated alpha is worth paying for but it's very hard to find."

Unlike other pensions, Ontario Teachers has developed a very sophisticated and elaborate program for investing in external hedge funds. Is it perfect? Are they hedge fund gods? Of course not, they experienced harsh lessons along the way but they were first movers in this area and always staffed this team with talented individuals who properly understand the risks of various hedge fund strategies.

In other words, they got the governance and compensation right and kept politics out of their investment decisions. That is why Ontario Teachers' Pension Plan is fully funded and why Ontario's teachers are in a great position when it comes to their retirement security.

I can't say the same for Rhode Island's public pension and many other US public pensions which are crumbling and facing disaster as the pension Titanic sinks. As long as they ignore the governance at their plans, they are doomed to fail and will keep succumbing to undue political interference which will only benefit a handful of hedge funds and private equity funds, not their members.

On Wednesday, I am off to cover the first ever emerging managers conference in Montreal which will feature emerging long only and hedge fund managers. I am looking forward to meeting managers I've already met in the past and new ones I have yet to meet. I will cover them on my blog.

I also wanted to cover parts of the AIMA Canada Investor Forum 2016 going on tomorrow and Thursday in Montreal but James Burron, AIMA Canada's chief operating officer, told me that at the request of speakers, no press (I guess bloggers fall into this category) are allowed to cover this conference and only AIMA members can attend (I think this is silly and self-defeating but these are the rules they set).

Let me end by plugging Brian Cyr, Managing Director of bfinance Canada. I typically don't plug investment consultants on my blog (quite the opposite, think most of them are useless), but over lunch yesterday, Brian explained the bfinance approach and how they get mandates from small to mid sized pensions for manager searches and I came away impressed with him and the approach.

Interestingly, unlike other consultants who put managers in a box, bfinance will take the time to understand its client's needs, then go cast a wide net asking managers who can fulfill their search for a request for proposal. If the client chooses one of the managers, it's the investment manager, not the client, that pays a fee to bfinance on assets obtained (a one time fee in the first year).

Amazingly, Brian told me that some clients think there is a conflict of interest in this model but they obviously don't have a clue of what they're talking about. The big conflicts of interest happen when consultants recommend funds they invest in or trade with or when they are used as "outsourced CIOs" to invest in funds they do business with.

No matter how big or small your organization is, I highly recommend you take the time to meet Brian Cyr and talk to him about their approach and what they can offer you in your search for traditional and alternative investment managers.

On that note, let me end by plugging yours truly. Please remember to support this blog via your PayPal contributions on the right hand side under my picture and show your appreciation for the work that goes into reading, researching and writing my comments.

Below, Seth Magaziner, Rhode Island General Treasurer, discusses the state's decision to cut its hedge fund holdings in its pension fund in half.

He talks the talk but was obviously coached (from one of their useless investment consultants) as to how to explain why he cut allocations to hedge funds after the state paid outrageous fees for mediocre returns for so long.

And the scary thing is Rhode Island isn't the only one investing in risky funds raking them on fees. There are plenty of other US public pensions that should have followed CalPERS and nuked their hedge fund program a couple of years ago.

Here, I agree with Ted Siedle, Charlie Munger and Warren Buffett. Most US public pensions (not all) have no business investing in hedge funds. It's a disaster and not in their members' best interests.

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