Wednesday, November 30, 2016

Liquidations Hurting Hedge Funds?

Amy White of Chief Investment Officer reports, How Liquidations Hurt Hedge Fund Returns (h/t, Ken Akoundi, Investor DNA):
It’s not just pension funds that have to worry about liability risks.

Hedge funds with high exposures to funding level risks “severely underperform” less exposed funds, according to research from the Copenhagen Business School.

“A good hedge fund follows alpha-generating strategies and simultaneously manages the funding risk that arises from the liability side of its balance sheet, that is, the risk of investor withdrawals and unexpected margin calls or increasing haircuts,” wrote PhD candidate Sven Klinger.

“If not managed properly,” he continued, “these funding risks can transform into severe losses because they can force a manager to unwind otherwise profitable positions at an unfavorable early point in time.”

At a time when many institutional investors are pulling out of hedge funds, proper management of liability risk is particularly essential—and failure to manage those risks can lead to a slippery slope, Klinger argued.

“If a fund generates higher losses than expected, investors get concerned about the possibility of unexpected future losses,” he wrote. “These concerns lead a fraction of the investors to withdraw their money from the fund, which, in turn, causes further losses for the bad fund.”

For the study, Klinger analyzed hedge fund returns between January 1994 and May 2015 using data from the TASS hedge fund database. He found that funds with low exposures to common funding shocks earned a monthly risk-adjusted return of 0.5%—while hedge funds taking higher liability risks earned zero risk-adjusted returns.

“Hedge funds that are exposed to more funding risk generate lower returns,” he wrote. “More precisely, hedge funds that generate lower returns when funding conditions deteriorate generate subsequent lower returns.”

These hedge funds also face larger withdrawals than hedge funds with lower exposure to liability risks, Klinger added—though they can temper risks by imposing strict redemption terms on investors.

“Higher risk should correspond to higher (expected) returns,” Klinger concluded. “Although this rule may hold for traded assets, it can be violated for hedge funds… a situation in which more risk-taking indicates less managerial skill.”

Read the full paper, “High Funding Risk, Low Return.”
There is nothing earth-shattering in these findings. Hedge funds have always been exposed to "redemption risk" which Klinger calls liability risk. The more concentrated a hedge fund is to any particular client, the higher the redemption risk, especially after a fund experiences significant losses.

A couple of months ago, I discussed why Ontario Teachers' cut allocations to computer-run hedge funds. A few hedge funds were forced to close shop after this move.

This is why most institutional investors cap their allocations to represent no more than 5% of the total assets under management and will typically never invest in any hedge fund where one client has more than  a 10% or 20% stake in the fund (I am giving you rough figures).

Obviously it varies and there are exceptions to this rule (like seeding a new fund) but why would anyone invest in a hedge fund knowing another big client can materially impact performance if they pull out? Also, from the hedge fund's standpoint, just like any business, it wants to properly diversify its client base so that it isn't exposed to liability risk if someone big pulls out.

But some hedge fund "superstars" have tight redemption clauses buying them time in case their performance gets hit. Case in point, Bill Ackman of Pershing Square.

Alexandra Stevenson and Matthew Goldstein of the New York Times recently reported, William Ackman’s 2016 Fortune: Down, but Far From Out:
William A. Ackman is a big-moneyed, swaggering hedge fund manager with a long list of accomplishments.

He played tennis against Andre Agassi and John McEnroe. He bought one of the most expensive apartments in Manhattan because he thought it would “be fun.” And three years ago, his hedge fund beat the competition to the pulp.

Now the silver-haired billionaire is on the verge of notching another accomplishment, but it is a dubious one. He is on pace to record a hefty double-digit loss for investors in his firm, Pershing Square Capital Management, for the second year in a row.

It is a rare accomplishment in hedge funds, as investors like public pension funds have grown impatient with disappointing returns and more than a handful of well-known firms have been forced to shut down as a result.

Yet Mr. Ackman is not like most of his peers. He has brushed off questions about whether his investors were worried and frustrated with his steep losses, countering that over time his firm had “a good batting average.” Together with his analysts, he told clients last week that the companies in which he has made big bold bets remain “unique,” “successful,” “fantastic” and “terrific.”

“We all know someone like him,” said Doug Kass of Seabreeze Partners Management, a small hedge fund firm. “Ackman is the smartest guy in the room who tells you he is the smartest guy in the room.”

It has helped that Mr. Ackman has structured Pershing Square so that investors have to wait as long as two years to take their money out. While some big investors have withdrawn their money recently, others believe that his firm will turn the corner.

The question is how much latitude investors will give to a man who fancies himself the next Warren E. Buffett. Over the last two years, investors have either withdrawn or announced plans to redeem more than $1 billion from his hedge fund, including New Jersey’s state pension fund, the Public Employees Retirement Association of New Mexico and the Fire and Police Pension Association of Colorado.

There is one mistake Mr. Ackman has admitted to making: Valeant Pharmaceuticals International. The drug company has come under political attack for its pricing policy and has faced regulatory scrutiny over its accounting practices. In April, Mr. Ackman was called to Washington to testify at a Senate hearing, where he was questioned over his aggressive support of the company. A flustered Mr. Ackman was forced to concede, “I regret that we didn’t do more due diligence on pricing.”

His investors have regretted it, too. Shares of the troubled pharmaceutical company have plunged to about $18 a share from the average $190 a share he said his firm paid in 2015 to acquire a big stake. As shareholders began to question the company and the stock plummeted, he bought a bigger stake in a show of confidence. Mr. Ackman has secured two board seats to try to position a turnaround.

“I have an enormous stomach for volatility,” he told an audience last week at the DealBook conference sponsored by The New York Times.

Privately, Mr. Ackman has told some investors that in six months or so, Valeant’s situation should start to look better as it sells off divisions to pay down debt obligations.

But now Pershing Square Holdings, a publicly traded version of his private hedge fund, is on course for a second year of double-digit annual loss and is currently down 20.7 percent, after dropping 20.5 percent last year. The losses are somewhat smaller at the private portfolios in his hedge fund in part because differences in leverage can magnify losses.

“He’s 50 years old. He has no boundaries to his ambitions,” said Ruud Smets of Theta Capital Management, an investment firm in the Netherlands. “So he is someone who will make his way back and is realistic about the mistakes he’s made and what they should do better,” he said, referring to Pershing.

Making its way back to positive territory will be challenging for Pershing, however. Its position in Valeant has helped wipe out a nearly 40 percent gain that the firm had in 2014.

Pershing started 2015 with more money than it had ever managed — $18.5 billion — including money raised from the public listing in Amsterdam of Pershing Square Holdings. Today the firm’s assets are down to $11.6 billion, and two years of losing performances threatens to chip away at Mr. Ackman’s reputation as one of the more successful investors in the $3 trillion hedge fund industry.

But Mr. Ackman has a knack for turning things around. He had to wind down his first hedge fund firm, Gotham Partners, after an investment in a golf course went sour. With Pershing, a remarkable run of lucrative payoffs from investments in General Growth Properties, the Howard Hughes Corporation and Canadian Pacific made him a celebrity and helped him raise huge sums of money from big state pension plans and other institutional investors.

And he can change. While he has long been known for favoring liberal causes and contributing mainly to Democrats, Mr. Ackman spoke glowingly of Donald J. Trump last week at the DealBook conference after his election.

“I woke up bullish on Trump,” Mr. Ackman said, surprising some in the audience. He clarified later in an interview that he was referring to Mr. Trump’s approach to the economy, adding, “I don’t agree with his views on immigration, on deportation and certain other social issues.”

His flexibility when it comes to national politics is at odds with the reputation he has earned at times of being a stubborn investor and a firm believer in his own views — qualities his Wall Street critics contend have informed his firm’s money-losing investment in Valeant.

Some on Wall Street have quietly compared him to another hedge fund hotshot, John Paulson, who made nearly $15 billion for his investors by betting on the collapse of the housing market during the financial crisis, but has struggled at times since then. Mr. Paulson’s firm now manages about $12 billion in assets, down from $36 billion five years ago.

Mr. Paulson, who is also bullish on Mr. Trump and was an economic adviser to him during the campaign, is the second-biggest shareholder in Valeant after Mr. Ackman.

But while predicting Mr. Ackman’s downfall has become something of a sport for some of his enemies on Wall Street, the prediction has yet to come true.

Over all, Mr. Ackman’s hedge fund firm has had more success than failure. Since 2004, the firm has registered nine winning years and four losing years, including the partial results for 2016. In four of those years, one of the firm’s main funds showed an annual gain more than 30 percent.

He also scored a moral victory this year with his bet against shares of the food supplement company Herbalife. The Federal Trade Commission took the company to task over its marketing and sale practices. The agency’s order endorsed many of Mr. Ackman’s claims that Herbalife had taken advantage of consumers, but regulators stopped short of declaring the company an illegal pyramid scheme, as Mr. Ackman had hoped.

Four years ago, Mr. Ackman announced at a conference that he had wagered $1 billion that Herbalife would either collapse on its own or be forced to close by regulators. But so far neither has happened, and Herbalife shares trade above the price they were at when he first disclosed his bearish trade.

“You can either view it as he has the courage of his convictions or he is being foolish,” said Damien Park, managing partner at Hedge Fund Solutions, who specializes in analyzing activist investors.

Still, some investors have put new money into Pershing Square recently. In August, Privium Fund Management, in a note to clients, said it had reinvested in Mr. Ackman’s publicly traded fund.

“He didn’t become stupid overnight,” said Mark Baak, a director at Privium, an Amsterdam-based investment firm that manages about $1.4 billion. “His prevailing track record wasn’t luck. Even if he was overrated prior to Valeant, he is still a very good investor.”

Maybe next year will be different for Mr. Ackman, who recently took a large stake in the burrito chain Chipotle Mexican Grill.

If nothing else, he will be on the move. His firm plans to relocate from its perch in Midtown Manhattan overlooking Central Park to a new office on the Far West Side near the Hudson River. Mr. Ackman’s new hedge fund home will be in Manhattan’s so-called auto dealership row.

One of the selling points of the new office is a rooftop tennis court that Mr. Ackman asked for.
I went over how Valeant (VRX) cost the hedge fund industry billions in my recent comment going over top funds' Q3 activity, noting there are some elite hedge funds that have followed Ackman buying big stakes in this pharmaceutical.

But thus far, it hasn't paid off for any of them as the stock is down 8% at this writing on Wednesday mid-day and is hovering near its 52-week low (click on image):

Like I stated, there is no rush to buy Valeant shares and I sure hope for the sake of Bill Ackman's investors that he turns out to be right on this company because from my vantage point, it still looks like a dog's breakfast.

I also noted the following in that comment going over top funds' activity in Q3:
In their Bloomberg article, Hedge-Fund Love Affair Is Ending for U.S. Pensions, Endowments, John Gittelsohn and Janet Lorin note the following:

While the redemptions represent only about 1 percent of hedge funds’ total assets, the threat of withdrawals has given investors leverage on fees.

Firms from Brevan Howard to Caxton Associates and Tudor Investment Corp. have trimmed fees amid lackluster performance.

William Ackman’s Pershing Square Capital Management last month offered a new fee option that includes a performance hurdle: It keeps 30 percent of returns but only if it gains at least 5 percent, according to a person familiar with the matter.

The offer came after Pershing Square’s worst annual performance, a net loss of 20.5 percent in 2015. Pershing Square spokesman Fran McGill declined to comment.

“They had a terrible year and they have to be extremely worried about a loss of assets under management,” said Tom Byrne, chairman of the New Jersey State Investment Council, which had about $200 million with Pershing Square as of July 31. “You’re losing clients because your prices are too high? Lower your price. That’s capitalism.”
Let me put it bluntly, Bill Ackman's fortunes are riding on Valeant, it's that simple. Luckily for him, he's not the only one betting big on this company. Legendary investor Bill Miller appeared on CNBC three days ago to say battered Valeant stock worth double the current price.
If Ackman is offering a new fee option that includes a performance hurdle, it's definitely because he's worried about big redemptions coming in before Valeant shares turn around (if they turn around).

When I was investing in hedge funds, I invested in directional hedge funds that were typically very liquid and didn't put up gates. Nothing pissed me off more than hearing some hedge fund manager recite lame excuses to explain his pathetic performance (and poor risk management).

Having said this, sometimes there are good reasons behind a hedge fund's bad performance and the illiquidity of the strategy might warrant investors to be patient and take a wait and see approach.

When Ken Griffin's Citadel closed the gates of hedge hell after suffering losses of 35% in its two core funds - Kensington and Wellington - during global financial crisis, I went on record stating investors who were redeeming were making a huge mistake because they didn't understand what was going on and why some of the strategies were getting clobbered after credit markets seized up.

Another example closer to home is Crystalline Management run by Marc Amirault, one of the oldest and most respected hedge funds in Canada. Its core convertible arbitrage strategy got whacked hard in 2008 and came roaring back the following year. There wasn't a market for these convertible bonds in the midst of the crisis and the fund's long-term investors understood this and stuck with it during this difficult time.

[Note: I recently visited the offices of Crystalline Management  and they told me there is some capacity left (roughly $50 million) in their core strategy which is up double-digits this year.]

Anyways, all this to say that there are no hard rules as to when to redeem, especially if you don't understand the drivers of the underperformance.

One last thought came to my mind. I remember Leo de Bever telling me that AIMCo offered its balance sheet to some external hedge funds to mitigate against the effects of massive redemptions during the crisis so that "funds wouldn't be forced to sell positions at the worst time."

I am not sure if this was actually done or if they were toying with the idea but it obviously makes sense even if it's a risky strategy during the thick of things.

Below, CNBC’s Gemma Acton discusses how CTA Strategies weighed on hedge returns in October. And Andrew McCaffery, global head of alternatives at Aberdeen Asset Management, talks about how hedge funds will prove their worth during a volatile 2017.

That all remains to be seen. One institutional hedge fund investor shared this with me today: "I think as everybody else, we're permanently exploring creative ways to ensure better commercial alignment of interest and improve capital efficiency." Well put.

Tuesday, November 29, 2016

Canada's Great Pension Debate?

In a response to Bernard Dussault, Canada's former Chief Actuary, Bob Baldwin, a consultant and former board of director at PSP Investments, sent me his thoughts on Bill C-27, DB, DC and target benefit plans (added emphasis is mine):
Bernard Dussault has circulated an article and slide presentation in which he has provided a endorsement of DB workplace pension plans coupled with an expression of concern about certain design features of DB plans that he sees as discriminatory. I share his preference for DB. But, I think his account of DB is incomplete and avoids certain issues and problems in DB that DB plan members, people with DB governance responsibilities and DB advocates should be aware of.

In his article “How Well Does the Canadian Landscape Fare?” Bernard says: “… DB plans offer better retirement security because they attempt to provide a predetermined amount of lifetime annual retirement income at an unknown periodic price.” The unknown nature of the price is unavoidable given the factors that determine the price that have magnitudes that cannot be foreseen such as: future wages and salaries, investment returns and longevity.
In context, two attributes of DB in its pure form are important to note. First, all of the uncertainty will show up in variable contribution rates and none in variable benefits. Second, the plan sponsor or sponsors have an unlimited willingness and ability to contribute more to the plan if need be.

The second of these attributes is, in principle, largely implausible. There simply are not sponsors who can and will contribute more without limit. Moreover, as I have noted in several publications, in practice when combined employer and employee contributions get up to the 15 to 20 per cent level, even jointly governed plans that were purely DB begin allocating some financial risk to benefits – usually by making indexation contingent on the funded status of the plan.

Moreover above some level, escalating pension contributions begin to depress pre-retirement living standards below post retirement levels. Even recognizing that the impact on living standards of a particular combination of benefit levels and contributions will vary from member to member in a DB plan (you can’t make it perfect for everyone), it is still desirable to try to avoid depressing pre-retirement living standard below the post-retirement level. The object of the workplace pension exercise is to facilitate the continuity of living standards and depressing pre-retirement living standards below the level of post-retirement living standards is not consistent with that objective. You can have too much pension!

The contributions that are relevant to the question whether contributions are depressing pre-retirement living standards to too low a level include both employer and employee contributions. This is because in most circumstances, the economic burden of employer contributions will fall on the employee plan members. This happens because rational employers will reduce their wage and salary offers to compensate for foreseeable pension contributions. There may be circumstances where an employer cannot shift the burden fully in the short term. But, in the normal case, the burden will be shifted. To the extent that required pension contributions are varying through time and being shifted back to the employee plan members, the net replacement rates generated by DB plans are clearly less predictable than the gross replacement rates.

Under the subheading “Strengths of DB plans”, Bernard’s slides include the following statement “investment and longevity risks are pooled, i.e. not borne exclusively by members, be it individually or collectively.” Having introduced the word “exclusively” the statement is probably correct. But, there are a variety of risks to plan members in DB plans. As was noted in the previous paragraph, there is a risk in ongoing DB plans that the pre-retirement living standards will be depressed below post-retirement levels. There is also a risk that a DB plans will get into serious financial difficulty and benefits will be reduced for future service and/or the plan will be converted to DC for future service. Both of these outcomes focus financial risks on young and future plan members as does escalating contributions. Finally, in the event of the bankruptcy of a plan sponsor, all members will face benefit reductions if the plan is not fully funded.

Bernard’s article and slides include reference to provisions in DB plans that he finds discriminatory. For me, the provisions on which he focuses raise a related issue.

The key factors that determine outcomes in all types of workplace pension plans are the same: rates of contributions, salary trajectories, returns on investment, longevity and so on. So what is it that allows a DB plan to provide a more predictable outcome? It is basically two distinct but related things: varying the contribution (saving) rate through time to meet a pre-determined income target; and, cross-subsidies within and between different cohorts of plan members.

In and of itself, the existence of cross-subsidies is not a bad thing. It is fundamental to all types of insurance and insurance is worth paying for. But, what DB plans could do much better than they do is to help plan members understand what the cross-subsidies are and how much they cost. This would allow plan members to decide what cross-subsidies are “worth it” and which ones are not worth it. My guess would be that within limits established by periods of guaranteed payments, members would accept cross-subsidies based on differential longevity in order to have a pension guaranteed for a lifetime. There may be less enthusiasm for a cross-subsidy from members whose salaries are flat as they approach retirement to those whose salaries escalate rapidly.

With respect to the plan features that Bernard has identified as discriminatory, my first and strongest inclination is to shine light on them so plan members have a chance to decide what is and is not acceptable.

The relatively predictable outcomes of DB plans in terms of the benefits they provide are clearly desirable. DC plans – especially those that involve individual investment decision-making and self-managed withdrawals – impose too much uncertainty on plan members with respect to the retirement incomes they will provide and demand excessive knowledge, skills and experience of plan members – not to mention time. As a renown professor of finance put it, a self-managed DC arrangement is like asking people to buy a “do it yourself” kit and perform surgery on themselves.

It is unfortunate however, that so much of the discourse about the design of pension plans is presented as a binary choice between DB and DC. There are several reasons why this is unfortunate.

First, the actual world of pension design is more like a spectrum than a binary choice. In Canada and across the globe, there are any number of pension plan designs that combine elements of DB and DC. Financial risks show up in both benefits and contributions.

Second, sometimes plans are managed in ways that are not entirely consistent with formal design features of plans. In the 1980s and 1990s when returns on financial assets were high and wage growth low, many DB plans ran up surpluses on a regular basis and these were often converted into benefit improvements. Many DB plans were managed as if they were collective DC plans (investment returns were determining benefits) with DB guarantees. The upside investment risk was not converted into variable contributions.

Third and finally, some plans that are labelled DB fall well short of addressing all of the financial contingencies that retirees will face. This is most strikingly true of DB plans that make no inflation adjustments. What is defined – in terms of living standards – only exists during the period immediately after retirement.

The difficulty in knowing exactly what we are referring to in using the DB and DC labels has not rendered the terms totally meaningless. As noted above, there are plans that are mainly DB but allocate some financial risk to the indexation of benefits. There are also a few grandfathered Canadian DC plans that include minimum benefit guarantees. The union created multi-employer plans have fixed rates of contribution like DC plans, pool many risks like a DB plan, but allow reductions in accrued benefits. The point is not to get stuck on the DB and DC labels but to understand how financial risks are being allocated.

The basic strength of DB plans in providing a relatively predictable retirement income is not diminished by the issues raised above. But, it is clear that for the well being of plan members and sponsors, the basic strength of DB has to be reconciled with acceptable levels and degrees of volatility of contributions. It also has to be reconciled with reasonable degrees of cross-subsidization within and between cohorts of plan members. With regard to cross-subsidies between cohorts, a regime in which accrued benefits cannot be reduced places all financial risk on young and future plan members. Target benefit plans try to avoid this problem by spreading the risk sharing across all cohorts as in the union created multi-employer plans.

Bernard’s article and slides touch on a number of regulatory issues. The only one of these that I will comment on is the prohibition of contribution holidays. This suggestion is put forward along with the use of realistic assumptions that err on the safe side.

In an environment where investment returns are consistently greater than the discount rate (e.g. the 1980s and 1990s), the practical effect of banning contribution holidays will be to build up surpluses that will significantly exceed what is required to protect against downside risks that plans may face. Rather than mandate the banning of contribution holidays, an approach that would create downside protection without building up excess surplus would be to mandate the adoption of funding policies that prohibit the use of surplus to reduce contributions or increase benefits until threshold levels of surplus have been achieved. The threshold levels should take account of the riskiness of the pension fund’s investments and the maturity of the plan. Funding policies of this general sort have begun to emerge in large Canadian plans and should be made to be common practice.
First, let me thank Bob Baldwin for sharing his thoughts on DB and DC plans. Bob is an expert who understands the complexities and issues surrounding pension policy.

In his email response, Bob added this: "(in a previous email he stated) my views were quite different from Bernard’s. I am not sure whether I should have said “quite different” “somewhat different” “slightly different”. In any event, they are attached. You would be correct in inferring that they cause me to be more open to Bill C-27 than Bernard is."

Go back to read my last comment on Bill C-27, Targeting Canada's DB Plans, where I criticized the Trudeau Liberals for their "sleazy and underhanded" legislation which would significantly weaken DB plans across the country. Not only do I think it's sleazy and underhanded, I also find such pension policy inconsistent (and hypocritical) following their push to enhance the CPP for all Canadians.

In that comment, I shared Bernard Dussault's wise insights but I also stated the following:
Unlike Bernard Dussault and public sector unions, however, I don't think DB plans can be bolstered just by prohibiting contribution holidays (something I agree with). I believe that some form of risk-sharing is essential if we are to safeguard DB plans and make sure they are sustainable over the long run. Target benefit plans are not the solution but neither is maintaining the farce that DB plans can exist with no shared-risk model.

[Note: To be fair, after reading my comment, Bernard sent me his proposed DB pension plan financing policy which "promotes true risk sharing at any level (ideally 50%/50%) between the plan sponsor and the plans members, in such a way that not only would both parties share the cost but also the 15-year amortization of surpluses and deficit."]

I take Denmark's dire pension warning very seriously and so should many policymakers and unions who think we can just continue with the status quo. We can't, we need to adapt and be realistic about what defined-benefit pensions can and cannot offer in a world of low or negative rates.

On that note, let me once more end by sharing this nice clip from Ontario Teachers' Pension Plan on how even minor adjustments to inflation protection can have a big impact on plan sustainability.

The future of pensions will require bolstering defined-benefit plans, better governance and a shared-risk model, which is why pensions like OTPP, HOOPP, OMERS, OPTrust, CAAT and other pensions will be able to deliver on their promise while others will struggle and will face hard choices.
This means while I firmly believe the brutal truth on defined-contribution plans is they aren't real pensions and will lead to widespread pension poverty because they shift retirement risk entirely on to employees and that the benefits of defined-benefit plans are grossly underestimated, I also firmly believe that some form of shared-risk must be implemented in order to keep DB plans solvent and sustainable over the long run.

I mention this because public sector unions think I am pro-union and for everything they argue for in regards to pension policy. I am not for or against unions, I am pro private sector, as conservative as you get when it comes to my economic policies and fiercely independent in terms of politics (have voted between Conservatives and Liberals in the past and will never be a card carrying member of any party).

However, my diagnosis with multiple sclerosis at the age of 26 also shaped my thoughts on how society needs to take care of its weakest members, not with rhetoric but actual programs which fundamentally help people cope with poverty, disability and other challenges they confront in life.

All this to say, when it comes to pension policy, I am pro large, well-governed DB plans which are preferably backed by the full faith and credit of the federal government and think the risk of these plans needs to be shared equally by plan sponsors and beneficiaries.

Now, Bernard Dussault shared this with me this morning:
I sense that the description of my proposed financing policy for DB pension plans deserves to be further clarified as follows:

My proposed improved DB plan is essentially the same as Bill C-27's TB plan except that under my promoted improved DB:
  1. Deficits affect only active members' contributions (via 15-year amortization, i.e. through a generally small increase in the contribution rate), and not necessarily the sponsor's contributions, as opposed to both contributions and benefits of both active and retired members under Bill C-27.
  2. Not only are contribution holidays prohibited, but any surplus is amortized over 15 years through a generally small decrease in the members' and not necessarily sponsor's contribution rate.
Therefore, my view is that if my proposed financing policy were to apply to DB plans, TB plans would no longer be useful. They would just stand as a useless and overly complex pension mechanism.
But Bob Baldwin makes a great point at the end of his comment:
Rather than mandate the banning of contribution holidays, an approach that would create downside protection without building up excess surplus would be to mandate the adoption of funding policies that prohibit the use of surplus to reduce contributions or increase benefits until threshold levels of surplus have been achieved. The threshold levels should take account of the riskiness of the pension fund’s investments and the maturity of the plan. Funding policies of this general sort have begun to emerge in large Canadian plans and should be made to be common practice.
Funding policies need to be mandated to prohibit the use of surpluses to reduce contributions or increase benefits until certain threshold elements of pensions are achieved.

Take the example of Ontario Teachers' Pension Plan and the Healthcare of Ontario Pension Plan, two of the best pension plans in the world.

They both delivered outstanding investment results over the last ten and twenty years, allowing them to minimize contribution risk to their respective plans, but investment gains alone were not sufficient to get their plans back to fully-funded status when they experienced shortfalls.

This is a critical point I need to expand on. You can have Warren Buffet, George Soros, Ken Griffin, Steve Cohen, Jim Simons, Seth Klarman, David Bonderman, Steve Schwarzman, Jonathan Gray and the who's who of the investment world all working together managing public pensions, delivering unbelievable risk-adjusted returns, and the truth is if interest rates keep tanking to record low or negative territory, liabilities will soar and they won't produce enough returns to cover the shortfall.

Why? Because the duration of pension liabilities is a lot bigger than the duration of pension assets so for any given drop (or rise) in interest rates, pension liabilities will soar (or drop) a lot faster than assets rise or decline.

In short, interest rate moves are the primary determinant of pension deficits which is why smart pension plans like Ontario Teachers' and HOOPP adjust inflation protection whenever their plans run into a deficit.

This effectively means they sit down like adults with their plan sponsors and make recommendations as to what to do when the plan is in a deficit and typically recommend to partially or fully remove inflation protection (indexation) until the plan is fully funded again.

Once the plan reaches full-funded status, they then sit down to discuss restoring inflation protection and if it reaches super funded status (ie. huge surpluses), they can even discuss cuts in the contribution rate or increases in benefits, but this only after the plan passes a certain level of surplus threshold.

In the world we live in, I always recommend saving more for a rainy day, so if I were advising any pension plan which has the enviable attribute of achieving a pension surplus, I'd say to keep a big portion of these funds in the fund and not use the entire surplus to lower the contribution rate or increase benefits (apart from fully restoring inflation protection).

I realize pension policy isn't a sexy topic and most of my friends love it when I cover market related topics like Warren Buffet's investments, Bob Prince's visit to Montreal, Trumping the bond market or whether Trump is bullish for emerging markets.

But pensions are all about managing assets AND liabilities (not just assets) and the global pension storm is gaining steam, which is why I take Denmark's dire pension warning very seriously and think we need to get pension policy right for the millions retiring and for the good of the global economy.

In Canada, we are blessed with smart people like Bernard Dussault and Bob Baldwin who understand the intricacies and complexities of public pension policy which is why I love sharing their insights with my readers as well as those of other experts.

It's not just Canada's pension debate, it's a global pension debate and policymakers around the world better start thinking long and hard of what is in the best interests of their retired and active workers and for their respective economies over the long run.

As I keep harping on this blog, regardless of your political affiliation, good pension policy is good economic policy, so policymakers need to look at what works and what doesn't when it comes to bolstering their retirement system over the long run.

Below, something that works for Ontario Teachers, HOOPP and other pension plans that have experienced pension shortfalls in the past is to adjust inflation protection when their plan is in a deficit.

It's not rocket science folks, in order to get stable, predictable pension payments for life, you need good governance and members need to accept some form of a shared risk model to keep these pension plans sustainable and viable over the long run.

Monday, November 28, 2016

GPIF Riding The Trump Effect?

Anna Kitanaka and Shigeki Nozawa of Bloomberg report, World’s Biggest Pension Fund Finds New Best Friend in Trump:
One of the world’s most conservative investors has found an unlikely new ally in one of its most flamboyant politicians: Donald Trump.

The unconventional president-elect’s victory is helping Japan’s giant pension fund in two important ways. First, it’s sending stock markets surging, both at home and overseas, which is good news for the largely passive equity investor. Second, it’s spurred a tumble in the yen, which increases the value of the Japanese manager’s overseas investments. After the $1.2 trillion Government Pension Investment Fund reported its first gain in four quarters, analysts are betting the Trump factor means there’s more good news to come.

“The Trump market will be a tailwind for Abenomics in the near term,” said Kazuhiko Ogata, the Tokyo-based chief Japan economist at Credit Agricole SA. “GPIF will be the biggest beneficiary among Japanese investors.”

While most analysts were concerned a Trump victory would hurt equities and strengthen the yen, the opposite has been the case. Japan’s benchmark Topix index cruised into a bull market last week and is on course for its 12th day of gains. The 4.6 percent slump on Nov. 9 now seems a distant memory. The yen, meanwhile, is heading for its biggest monthly drop against the dollar since 2009.

GPIF posted a 2.4 trillion yen ($21 billion) investment gain in the three months ended Sept. 30, after more than 15 trillion yen in losses in the previous three quarters. Those losses wiped out all investment returns since the fund overhauled its strategy in 2014 by boosting shares and cutting debt. It held more than 40 percent of assets in stocks, and almost 80 percent of those investments were passive at the end of March.

Tokyo stocks are reaping double rewards from Trump, as the weaker yen boosts the earnings outlook for the nation’s exporters. The Topix is the fourth-best performer since Nov. 9 in local-currency terms among 94 primary equity indexes tracked by Bloomberg.

Global Rally

But they’re not the only ones. More than $640 billion has been added to the value of global stocks since Nov. 10, when many markets around the world started to climb on bets Trump would unleash fiscal stimulus and spur inflation, which has boosted the dollar and weakened the yen. The S&P 500 Index closed Wednesday at a record high in New York.

Bonds have tumbled for the same reasons, with around $1.3 trillion wiped off the value of an index of global debt over the same period. Japan’s benchmark 10-year sovereign yield touched a nine-month high of 0.045 percent on Friday, surging from as low as minus 0.085 percent on Nov. 9.

GPIF’s return to profit is a welcome respite after critics at home lambasted it for taking on too much risk and putting the public’s retirement savings in jeopardy.

The fund’s purchases of stocks are a “gamble,” opposition lawmaker Yuichiro Tamaki said in an interview in September, after an almost 20 percent drop in Japan’s Topix index in the first half of the year was followed by a 7.3 percent one-day plunge after Britain’s shock vote to leave the European Union. Prime Minister Shinzo Abe said that month that short-term losses aren’t a problem for the country’s pension finances.

Feeling Vindicated

“I’d imagine GPIF is feeling pretty much vindicated,” said Andrew Clarke, Hong Kong-based director of trading at Mirabaud Asia Ltd. “It must be cautiously optimistic about Trump.”

Still, the market moves after Trump’s victory are preceding his policies, and some investors are questioning how long the benefits for Japan -- and GPIF -- can last. Trump already said he’ll withdraw the U.S. from the Trans-Pacific Partnership trade pact on his first day in office. The TPP is seen as a key policy for Abe’s government.

“It looks good for GPIF for now,” said Naoki Fujiwara, chief fund manager at Shinkin Asset Management Co. in Tokyo. But “whether the market can continue like this is debatable.”
In my opinion, it's as good as it gets for GPIF as global stocks surged, global bonds got hammered and the yen depreciated a lot versus the US dollar following Trump's victory.

I've already recommended selling the Trump rally. Who knows, it might go on till the Inauguration Day (January 20th) or even beyond, but the truth is there was a huge knee-jerk reaction mixed in with some irrational exuberance propelling global stocks and interest rates a lot higher following Trump's victory.

Last week, I explained why I don't see global deflation risks fading and told my readers to view the big backup in US bond yields as a big US bond buying opportunity. In short, nothing trumps the bond market, not even Trump himself.

All these people telling you global growth is back, inflation expectations will rise significantly, and the 30+ year bond bull market is dead are completely and utterly out to lunch in my opinion.

As far as Japan, no doubt it's enjoying the Trump effect but that will wear off fairly soon, especially if Trump's administration quits the TPP. And it remains to be seen whether Trump is bullish for emerging markets and China in particular, another big worry for Japan and Asia.

In short, while the Trump effect is great for Japan and Euroland in the short-run (currency depreciation alleviates deflationary pressures  in these regions), it's far from clear what policies President-elect Trump will implement once in power and how it will hurt the economies of these regions.

All this to say GPIF should hedge and take profits after recording huge gains following Trump's victory. Nothing lasts forever and when markets reverse, it could be very nasty for global stocks (but great for global bonds, especially US bonds).

One final note, I've been bullish on the US dollar since early August but think traders should start thinking about the Fed and Friday's job report. In particular, any weakness on the jobs front will send the greenback lower and even if the Fed does move ahead and hike rates once in December, you will see traders take profits on the US dollar.

If the US dollar continues to climb unabated, it will spell trouble for emerging markets and US corporate earnings and lower US inflation expectations (by lowering import prices).

Be very careful interpreting the rise in inflation expectations in countries like the UK where the British pound experienced a huge depreciation following the Brexit vote. These are cyclical, not structural factors, driving inflation expectations higher, so don't place too much weight on them.

And you should all keep in mind that Japan's aging demographics is a structural factor weighing down growth and capping inflation expectations. This is why Japan is at the center of the global pension storm and why it too will not escape Denmark's dire pension warning.

Below, Jonathan Pain, author of the Pain Report, says the dollar needed a technical correction before climbing further. And Marc Faber, The Gloom, Boom & Doom Reporter editor & publisher, weighs in on the Trump rally, and which areas he sees performing well under a Trump presidency.

Friday, November 25, 2016

Meeting The Oracle of Omaha?

Philippe Hynes, President of Tonus Capital here in Montreal, recently went on a trip with Concordia University students to meet the Oracle of Omaha. He shared his thoughts with me and his clients this morning via an email going over the meeting (added emphasis is mine):
I had the privilege to meet legendary investor Warren Buffett in Omaha last Friday. He occasionally meets with university students and Concordia University, where I have been teaching since 2006, was selected. For more than two hours, a group of 15 students accompanied by a few teachers could ask questions to The Oracle. I have always admired the human and professional qualities of Warren Buffett. Not only is he an outstanding investor but he is also an excellent communicator. You will find attached to this email a summary of his comments.

His thoughts coincide with our advantageous structure at Tonus Capital. As expected, Mr. Buffett mentioned that few opportunities are present on the market. He recommends to remain very patient and to have a concentrated portfolio (he would personally have only 4 or 5 stocks in his). These are exactly the advantages provided by our investment policy; namely the flexibility to hold cash and wait for great opportunities and the concentration in approximately fifteen to twenty stocks. Over the past nine years, we have been building the image and reputation of Tonus Capital and we will continue to put investors’ interest at the forefront in order to maintain your trust.

For those comfortable in French, I recommend reading the following articles published this week in journal La Presse and Les Affaires.


Meeting with Warren Buffett in Omaha, November 18th, 2016


At Berkshire, there are no contracts with senior managers. Being financially independent, they are passionate and driven. For them, working for Mr. Buffett and Berkshire is the opportunity of a lifetime.


“Interest rates are to stocks what gravity is to matter”. Mr. Buffett believes that long term interest rates are too low. He does not short sell at Berkshire but if he could he would short long-term bonds. He does not believe the stock market is currently overvalued and much prefers stocks over bonds right now. He mentions that if market participants believed that long-term rates would remain at current levels for some time, it would mean stocks are grossly undervalued. The reality is probably in between, and bonds are likely to lose some value in the future.

Active vs. passive investing

Because the market is an average, over time, both active and passive investing will yield similar (average) gross returns. To justify their higher fees, active managers must outperform over the long-term. Few will succeed, and the hard task for asset allocators (individuals, consultants, pension funds) is to identify these outperformers. Buffett considers the following factors enabling one to outperform the market:
  • Being a good investor has nothing to do with IQ. It is more about emotional discipline and the talent to pick good stocks with good management. It is critical that the portfolio manager has a good temperament in order not to panic when fear prevails. Fear is very contagious in the financial markets.
  • Smaller assets under management should increase the probability of outperforming. There are few great opportunities in the markets and when they arise, the manager must be quick and flexible.
  • Buffet strongly believes in portfolio concentration. He would only have 4 or 5 investments in his portfolio if he was managing a smaller amount.

Many think that computers will replace humans in finance (and in many other sectors). Computers’ advantage lies in their speed. Buffett thinks that the majority of these high frequency and algorithmic funds use the same strategy and make very similar trades which will likely lead to more volatility as they simultaneously try to unwind their trades. Fundamental investors with a good temperament should be able to take advantage of the opportunities created by such volatility. Buffett does not believe that computers can determine the durability of the long-term competitive advantages of a company nor can it assess the motivation and passion of management. Given fundamental analysis is not about speed, he does not believe computers will replace analysts.

National debt

As long as the Federal Reserve can print bank notes, Mr. Buffett does not believe that the national debt is a problem in the United States (but other problems could emerge from printing currency, namely, inflation). He thinks that health care costs, now representing 17% of GDP, are a bigger issue.
First, let me thank Philippe Hynes for sharing his comments from this trip with me. I met Philippe last month at the first ever Montreal emerging managers conference and covered it here.

Tonus Capital is a deep value contrarian fund which takes concentrated bets. Tonus Partners' Fund which was launched in January 2016 and follows the same investment approach as Tonus North American Composite since its inception in October 2007, is up 18% YTD (click on image):

You can learn more about Tonus Capital here and review its performance here.

Now, how lucky are those Concordia students to fly over to Omaha and meet with the Oracle himself? Not only did they meet him, they spent two hours asking him all sorts of investment questions. Talk about a trip of a lifetime!

A few years ago, I cold called Geico and got as far as Debbie Bosanek, Warren Buffett's personal assistant at Berkshire Hathaway. I told her that I'd like to meet with Mr. Buffett to discuss America's looming retirement crisis. She was polite but of course declined my offer (hey, it was worth a shot!).

Three years ago, I covered Warren Buffett's pension wisdom, stating the following:
Clearly Buffett foresaw the looming public pension catastrophe but does this mean he's against well-governed defined benefit plans?

I'm not sure. When I recently covered Warren Buffett's pension strategy, I stated the following:
What does the article say about Buffett's strategy for managing the defined-benefit plans Bershire inherited through acquisitions? First and most important, there is no talk of switching people out of defined-benefit to defined-contribution plans. Buffett plans to honor those commitments (Interestingly, I've tracked a lot of activity on my blog from Omaha, Nebraska over the last few years. Could it be the Oracle of Omaha?).

Second, fees matter a lot and Buffett isn't going to waste his time farming out the bulk of these pension assets to outside managers using useless investment consultants when he has the expertise to manage them in-house There is no mention of allocating money to hedge funds or private equity funds either. Again, fees matter a lot to Buffett and so does liquidity and performance. He is handily winning on a wager he made in 2008 with Protégé Partners, a fund of hedge funds manager, betting the S&P500 would beat a group of hedge fund managers selected by Protégé.

Third, Buffett and his team are not just great stock pickers, they also know how to engage in more sophisticated derivatives strategies. Buffett might have called derivatives "financial weapons of mass destruction," but the truth is Berkshire made a killing on the same long-term option strategy that allowed HOOPP to gain 17% in 2012.

Fourth, and hardly surprising, Buffett is not bullish on bonds given the current near record low interest rates. In this regard, he joins pensions that are massively betting on a rise in interest rates. This is understandable given that Buffett made his fortune picking great companies and he prefers stocks over bonds in the long-run. He thinks market timing is a loser's proposition and many long-term investors (like Doug Pearce at bcIMC) agree with him.

Keep in mind, however, that Buffett enjoyed the greatest bull market in stocks and never managed money during a prolonged debt deflation cycle (doubt he will ever see one in his lifetime). Also, the Fed's quantitative easing (QE) policy has been a boon for risk assets and I'm seeing a lot of activity in the stock market reminiscent of the 1999 liquidity melt-up in tech stocks. Momentum chasers trading high-beta stocks are loving it but be careful as the market's darkest days might be ahead.
I've also covered why Rhode Island recently met Warren Buffett (not literally, more like his warning) when it decided to shut down its hedge fund program. October was the worst month for hedge funds in terms of redemptions and we'll see if this trend continues in the new year.

In that comment on Rhode Island, however, I criticized Buffett, his long-time partner Charlie Munger and Ted Siedle, stating this:
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."
Earlier this month, I wrote about why ATP is bucking the hedge fund trend (to redeem assets) and explained why smart investors (like ATP and OTPP) are firmly committed to their hedge fund program which they take seriously by staffing it appropriately.

What else? Last year, I discussed how private equity discovered Warren Buffett, a strategy to mitigate the treacherous times that lie ahead in the industry. A lot  of people don't know that some of the biggest returns at Berkshire Hathaway don't come from public markets but from private equity deals typically done through great partners like 3G Capital.

But there is no denying Warren Buffett is one of the greatest stock investors ever which is why I track Bershire's holdings closely when I go over top funds' quarterly activity (click on image):

I'll bring to your attention the positions that caught my attention. First, Buffett took a big position in Goldman Sachs (GS) in the third quarter, which was a great move from a fundamental (betting rates would rise no matter who wins election) and technical basis (click on chart):

Do you see that beautiful double bottom off the 400-week moving average? That was the time to LOAD UP on Goldman's shares (I'm sure Buffett's team loaded up before that double bottom).

Second, Buffett made great money off Deere (DE), one of the top-performing large cap stocks in the United States which recently blew Street estimates away, sending the stock to a new 52-week high (click on image):

Now, I wouldn't touch Goldman or Deere shares here. In fact, I would be taking my profits and preparing to short them at these levels but it goes to show you, the Oracle of Omaha still has the Midas touch when it comes to picking winners (he also picks losers, like IBM and Wal Mart but shed a big stake in the giant retailer in Q3).

I will leave you with another chart that blew me away this year, one of Teck Resources (TCK) which hit a low of $2.56 (US) earlier this year and is now trading close to $26 dollars (US) after an incredible V-shaped recovery (click on image):

Buffett doesn't invest in resource stocks but I am sharing this with you because Daniel Brosseau and Peter Letko of Letko Brosseau & Associates -- the "Oracles of Montreal" -- had bought a huge stake in Teck late last year, added more early in the year making it their largest holding, and enjoyed huge gains on this position (they started dumping Teck in Q3 so don't bother chasing it here, I would be shorting this one in 2017).

All this to say, Buffett's adage of buying fear and selling greed makes perfect sense (more in hindsight however as buying fear in the thick of things takes big cojones and deep pockets, both of which Buffett has).

Lastly, go read my recent comment on Trumping the bond market to get more of my macro thinking on bonds and the global economy and what I see lying ahead. Unlike Mr. Buffett, I don't think bond yields are too low and I'm worried as the US dollar gains steam, it will wreak havoc on emerging markets and the US economy.

Below, an incredible Bloomberg clip where Carlyle's David Rubenstein interviews Warren Buffett on The David Rubenstein Show. Take the time to watch this interview and show it to your kids and grand kids, it's really worth watching it together with them over the holiday weekend (watch it here if it doesn't load below).

Hope you enjoyed this comment, as always, please remember to kindly donate or subscribe to this blog via PayPal on the top right-hand side under my picture to show your appreciation and support the work that goes into these blog comments (you need to view web version if reading it on your cell phone to see the right-hand side properly).

Have a great weekend and Happy US Thanksgiving!

Thursday, November 24, 2016

Targeting Canada's DB Pensions?

Grace Macaluso of the Windsor Star reports, Opposition MPs, labour groups decry federal 'anti-pension' bill:
A growing number of seniors could face poverty if the federal Liberals proceed with proposed legislation enabling Crown corporations and federally regulated private sector employers to back out of defined benefit pension plans, Essex MP Tracey Ramsey said Monday.

“With less and less retirement security, seniors in Windsor-Essex are living more precariously than they ever have because of the erosion of benefits,” said Ramsey.

In Windsor-Essex, one in 11 seniors was living in poverty, according to figures compiled by the Windsor-Essex County United Way. For a single family household, the low income cutoff totalled about $19,900 a year.

The NDP member and labour groups are sounding the alarm over Bill C-27, which would amend the Pension Benefits Standards Act, and allow federally regulated employers and Crown corporations to replace defined benefit plans with target benefit plans.

More than 820,000 people, or six per cent of all Canadian workers, are employed in such sectors as banking, rail, air and ferry transportation, radio and television broadcasting.

Introduced by Finance Minister Bill Morneau last month, the bill has yet to be debated in the House of Commons.

The legislation is “an attack on retirees and working people,” Ramsey said. “There couldn’t be a more wrong-headed approach. When we talk about defined benefits, that’s deferred wages. That’s something workers know they can count on. These new target plans are extremely unstable.”

Defined benefit pensions guarantee a specified payment upon an employee’s retirement. Any funding shortfall must be covered by the employer. Target pension plans borrow attributes from defined benefit plans and defined contribution pension plans, which absolve employers from covering any funding deficits. Target benefits plans can place limits on the volatility of employer contributions; in the event of a funding deficit, part or all of it can be compensated by reducing benefits. A traditional defined benefit plan would require the entire deficit to be made up by the employer.

The proposed federal legislation will broaden the scope of retirement savings opportunities, a Department of Finance spokesman said in an emailed statement.

Target benefit plans “represent a new, voluntary, sustainable and flexible pension option for employees in federally regulated private sector and Crown corporation pension plans,” the statement said. “For those who choose this option, (target benefit plans) will provide a lifetime pension that benefits from the pooling of market risk and protects against the risk of outliving one’s retirement savings. At the same time, transferring benefits from an existing plan to a (target benefit plan) is optional.”

Hussan Yussuff, president of the Canadian Labour Congress, viewed the move as yet another attempt by employers to shift workers out of defined benefit plans.

“Currently, defined benefit pensions provide stability and security to employees because employers are legally obliged to fund employees’ earned benefits,” said Yussuff. “Bill C-27 removes employers’ legal requirements to fund plan benefits, which means that benefits could be reduced going forward or even retroactively. Even people already retired could find their existing benefits affected.”

Yussuff said the former federal Conservative government attempted a similar move but, after holding public consultations, dropped the plan ahead of the October 2015 election.

The Liberals, on the other hand, introduced the proposed legislation, without consulting Canadians, unions or pensioners, he said. “This proposal directly contradicts Prime Minister Justin Trudeau’s campaign promise to help the middle class by improving retirement security.”

It also smacks of hypocrisy given the fact that MPs are enrolled in defined benefit pension plans, noted Yussuff. “They maintain a defined benefits plan for themselves, and I don’t have an issue with that. But why would they treat workers with such disregard?”

Pension numbers

4,402,000 Canadian employees were in defined benefit pension plans in 2013, down 0.5 per cent from 2012.

71.2 per cent of employees in a registered pension plan in 2013 had defined benefits, compared with more than 84 per cent a decade earlier.

1,037,000 employees were in defined contribution plans in 2013, up 0.6 per cent from 2012.

86 per cent of employees with defined contribution plans in 2013 worked in the private sector.

746,000 employees belonged to other pension plans, such as hybrid or composite, in 2013 — up two per cent from 2012.

Source: Statistics Canada
I asked Bernard Dussault, Canada's former Chief Actuary, to share his thoughts on Bill C-27 (added emphasis is mine):
For both concerned employers and employees, Bill C-27 is a poor, inappropriate and unduly complex solution to the possibly real, but generally highly overestimated debt of Defined Benefit (DB) plans sponsored by employers for their employees.

Such pension debt overestimates are caused by the DB plans-related legislation, i.e. the 1985 Pension Benefits Standards Act (PBSA), which compels these plans to be evaluated on a solvency as opposed to a realistic ongoing concern basis.

And as Bill C-27 allows any DB plan sponsor to shift to active and retired plan members the responsibility to assume any debt of the DB plan upon the effective date of its conversion into a Target Benefit (TB) plan, it plainly corresponds to an unfair and inappropriate legalized embezzlement of some pension benefits by the plan sponsor.

Actually, Bill C-27 is a replicate of the so-called Shared Risk Plan (actually and more precisely a TB plan that fully shifts the risks to, rather than shares risks with, plan members) introduced in New Brunswick on January 1, 2014, with the exception that DB plan members would have to consent to its conversion into a TB plan. It is to be reasonably feared that DB plan members would give such consent only pursuant to a misunderstanding of the complex TB plans provisions envisioned by Bill C-27.

By virtue of Bill C-27, a DB plan converted into a TB plan would no longer be subject to solvency valuations. Besides, the onus of any still emerging deficits would be assumed entirely by active and retired members.

Indeed, pension deficits would naturally continue to emerge from time to time as would surpluses. In this vein, Bill C-27 fails to address the existing unsuitable PBSA provision allowing plan sponsors to take possession of DB and TB pension plans surplus through contribution holidays (CH). These CHs are a sure recipe for financial disaster and are a very, if not the most important cause of financial difficulties encountered by DB plans.

In light of the above considerations, I have been steadily promoting since 2013 the following three amendments to the PBSA, which would be much more sensible, effective and appropriate than Bill C-27 and would also counteract its severe inadequacies:
  1. Evaluation of DB plans on a realistic (i.e. margin-free best estimate assumptions erring on the safe side, no asset value averaging, etc.) going concern basis rather than a solvency basis.
  2. Full prohibition of contribution holidays.
  3. Amortization of emerging surplus over 15 years, just as already are emerging deficits, i.e. through a generally small decrease or increase, respectively, in the contribution rate. This would well address one of the DB pan sponsors’ main aversion for DB plans, i.e. their highly fluctuating and unpredictable costs. In case where a given DB plan sponsor would still envision the higher stability of contribution rates under a TB pension plan, then there would be a case to maintain the DB plan (as opposed to convert it into a TB plan) and negotiate with plan members the transfer to them of the very light contribution rates volatility of my proposed DB plan financing policy.
I thank Bernard for sharing his wise insights with my readers. I've openly questioned the merits and logic of Bill C-27 in a recent post covering the Liberals attack on public pensions.

There is a wide gap in the pension policy the Liberals are implementing. On the one hand, they are enhancing the CPP for all Canadians which is a very smart move, and courting large funds to help them with their infrastructure program (another very smart move), but on the other hand they are introducing a bill which will potentially kill defined-benefit plans in Canada (a very dumb move).

This is a sleazy and underhanded move from a party which was attacking the Conservatives when they tried doing the same thing (at least they were upfront about it).

The global pension storm is gathering steam and one thing that worries me is bonehead policies like this which attack defined-benefit plans, the very plans we need to bolster and expand in a world where pension poverty and anxiety are on the rise. And make no mistake, if Bill C-27 passes, it will exacerbate pension poverty and negatively impact economic activity for decades to come.

Unlike Bernard Dussault and public sector unions, however, I don't think DB plans can be bolstered just by prohibiting contribution holidays (something I agree with). I believe that some form of risk-sharing is essential if we are to safeguard DB plans and make sure they are sustainable over the long run. Target benefit plans are not the solution but neither is maintaining the farce that DB plans can exist with no shared-risk model.

[Note: To be fair, after reading my comment, Bernard sent me his proposed DB pension plan financing policy which "promotes true risk sharing at any level (ideally 50%/50%) between the plan sponsor and the plans members, in such a way that not only would both parties share the cost but also the 15-year amortization of surpluses and deficit."]

I take Denmark's dire pension warning very seriously and so should many policymakers and unions who think we can just continue with the status quo. We can't, we need to adapt and be realistic about what defined-benefit pensions can and cannot offer in a world of low or negative rates.

On that note, let me once more end by sharing this nice clip from Ontario Teachers' Pension Plan on how even minor adjustments to inflation protection can have a big impact on plan sustainability.

The future of pensions will require bolstering defined-benefit plans, better governance and a shared-risk model, which is why pensions like OTPP, HOOPP, OMERS, OPTrust, CAAT and other pensions will be able to deliver on their promise while others will struggle and will face hard choices.

Tuesday, November 22, 2016

Trumping The Bond Market?

Ben Eisen of the Wall Street Journal reports, The $19.8 Trillion Hurdle Facing Higher U.S. Inflation:
The rise in Treasury yields slowed this week, highlighting skepticism in some quarters that Donald Trump’s presidency will usher in a period of rising inflation.

The yield on the 10-year Treasury note, which falls as prices increase, fell Wednesday, following a muted rise on Tuesday, while the 30-year bond yield fell both Tuesday and Wednesday.

Yields had surged since the U.S. presidential election on the view that Mr. Trump’s tenure will generate a period of rising inflation, as he pursues policies such as tax cuts, regulatory rollbacks and infrastructure spending to boost economic growth (click n image below). Market-based inflation indicators were rising before Mr. Trump’s victory last week, following sharp declines earlier in 2016.

But some investors say factors including the size of the U.S. debt load could limit the effectiveness of any fiscal-stimulus efforts. The more debt that is outstanding, the less bang for any given dollar of spending, some say.

These skeptics insist the bond selloff has gone too far.

“I was rolling my eyes so many times in the past few days that I thought I was going to go blind,” said David Rosenberg, chief economist and market strategist at Gluskin Sheff & Associates Inc. “The inflationistas have a lot to account for because history is not on their side.”

Other quarrels with the pro-inflation narrative focus on the numerous premature inflation calls of the past decade.

Some economists and businessmen wrote an open letter in 2010 warning then-Federal Reserve Chairman Ben Bernanke that monetary stimulus would have inflationary consequences, a view that now seems thoroughly discredited. Inflation has failed to hit the Federal Reserve’s 2% annual target for more than four years.

The U.S. producer-price index for final demand, a measure of business prices, held flat in October compared with the prior month, data showed Wednesday. Prices were up 0.8% from a year earlier.

Lacy Hunt, executive vice president at Hoisington Investment Management Co. in Austin, Texas, has long invested his fund in Treasurys with faraway maturities, reasoning that the economy is too weak to generate inflation that would erode the gains on those securities.

Since the election, he has been bombarded with calls from clients wondering whether the bond selloff is the death knell for the bond rally that began in 1981.

On Wednesday, the 30-year yield fell to 2.925%, while the 10-year yield fell to 2.222% (last week's data).

A bond-market gauge that compares nominal Treasury yields with inflation-protected counterparts forecasts that inflation will climb at 1.88% annually over the next 10 years, up from 1.4% in July, according to Tradeweb.

Mr. Hunt’s answer: No way. “There is always this rush to judgment when there’s a major policy change,” he said. He is investing new client money in long-term Treasurys, those maturing in 10 years or more.

One reason he thinks inflation is set to stay low is the nation’s $19.8 trillion debt load. The increase in debt stands to make each dollar go less far in spurring growth, he said. From 1952 to 1999, it took about $1.70 in nonfinancial debt for gross domestic product to expand by $1. In the year through June, it took $4.90 to do the same.

The national debt could increase $5.3 trillion over a decade should Mr. Trump cut taxes and boost spending as he has said during the campaign, according to the nonpartisan Committee for a Responsible Federal Budget.

Even after stimulus projects are completed, their impact on inflation isn’t necessarily positive. Improving roads and rails to make transportation more efficient can actually cut per-unit costs, Mr. Rosenberg said. He cited the New Deal package in the 1930s and the highway-construction spending of the 1950s as big stimulus measures that didn’t in their own right boost prices.

Still, many investors think inflation is headed higher as part of a broader economic reckoning. Prices had been rising in the months before the election, and a policy pivot could boost that, some say.

Market factors like higher interest rates and a stronger dollar also may have a damping effect on inflation because they can restrain the economy.

“There is a good chance that we are at one of those major reversals that last a decade,” Ray Dalio, chairman and chief investment officer at Bridgewater Associates, said in a LinkedIn post Tuesday. He suggested inflation was set to climb.

Even those who don’t see inflation in the cards suggest that some elements of Mr. Trump’s policy proposals may work toward that purpose, such as his vow to cut the corporate tax rate to 15% from 35%.

Yet the experience of tax cuts during President Ronald Reagan’s administration suggests this took a long time to filter through to the economy, Mr. Hunt said.
The most important macro theme I routinely cover on this blog is global deflation. You can view my past comments on deflation here. An equally important and closely related macro theme I love to cover is the so-called bond bubble. You can view my past comments on that topic here.

What do I keep warning all of you of? You need to get the macro right in order to get the micro right. If you don't understand the cyclical and structural forces driving the US and global economy, you will fall prey to the noise and get caught up in the price action and risk losing serious money.

In my last comment on Denmark's dire pension warning, I wrote:
Last week, I discussed the global pension storm, noting the following:
[...] last week was a great week for savers, 401(k)s and global pensions. The Dow chalked up its best week in five years and stocks in general rallied led by banks and my favorite sector, biotechs which had its best week ever.

More importantly, bond yields are rocketing higher and when it comes to pension deficits, it's the direction of interest rates that ultimately counts a lot more than any gains in asset values because as I keep reminding everyone, the duration of pension liabilities is a lot bigger than the duration of pension assets, so for any given move in rates, liabilities will rise or decline much faster than assets.

Will the rise in rates and gains in stocks continue indefinitely? A lot of underfunded (and some fully funded) global pensions sure hope so but I have my doubts and think we need to prepare for a long, tough slug ahead.

The 2,826-day-old bull market could be a headache for Trump but the real headache will be for global pensions when rates and risk assets start declining in tandem again. At that point, President Trump will have inherited a long bear market and a potential retirement crisis.

This is why I keep hammering that Trump's administration needs to include US, Canadian and global pensions into the infrastructure program to truly "make America great again."

Trump also needs to carefully consider bolstering Social Security for all Americans and modeling it after the (now enhanced) Canada Pension Plan where money is managed by the Canada Pension Plan Investment Board. One thing he should not do is follow lousy advice from Wall Street gurus and academics peddling a revolutionary retirement plan which only benefits Wall Street, not Main Street.
You should read my comment on the global pension storm to understand why I continue to worry about global deflation, the rising US dollar and why bond yields are likely to revisit new secular lows, placing even more pressure on global pensions in the years ahead.

This is why I respectfully disagree with Bob Prince and Ray Dalio at Bridgewater who called an end to the 30-year bond bull market after Trump's victory. I have serious concerns on Trump and emerging markets and I wouldn't be so quick to rush out of bonds (in fact, I see the big backup in bond yields as an opportunity to buy more long dated bonds (TLT) and will cover this in a separate comment).
Let me flat out state that I believe the recent backup in bond yields is another huge bond buying opportunity and smart global asset allocators and pensions are buying long dated US nominal government bonds at these levels (click on image):

The chart above shows price action of the iShares 20+ Year Treasury Bond ETF (TLT) and it's important to remember that bond yields and prices are inversely related (so when yields go up, bond prices fall). What this chart shows is that every time this ETF fell below its 50-week moving average and stayed above the 200-week moving average, it was time to load up on bonds.

I use weekly charts to determine long-term trends and to see if price action is breaking down and so far, despite all the noise of the "30-year bond bull market being dead," I'm not convinced and think smart investors are loading up on bonds here.

That is my technical argument. On a fundamental level, and I've written plenty of comments on this, I just don't see fading risks of global deflation and I'm worried if the greenback keeps surging higher, which I correctly predicted back in early August, then we will see deflationary headwinds in the US as earnings get hit, unemployment rises and we'll see lower inflation expectations because a rising US dollar lowers import prices.

Of course, deflation is most prevalent in Europe and Japan which is why the ECB and Bank of Japan are still buying government bonds, desperately trying to reflate inflation expectations which are moribund in these regions.

The divergence in US monetary and global monetary policy is driving the US dollar higher, as is the expectation of a massive US fiscal expansionary program. How long can this go on before it wreaks havoc on emerging markets and reinforces global deflation?

We will find out soon enough but my friend François Trahan of Cornerstone Macro did another great short video presentation this morning and he allowed me to share this chart with you which shows global PMIs relative to the 10-year US Treasury bond yield (click on image):

What the chart shows is global PMIs have peaked and that typically means lower global growth ahead, which is bullish for bonds, especially US bonds.

And if a crisis in emerging markets erupts under a President Trump or even before he takes office, global investors will be running into US bonds (flight to safety and liquidity).

[Note: François Trahan will be in Montreal on January 26 of the new year to present his outlook at a CFA Montreal luncheon. My former boss and colleague, Clément Gignac and Stéfane Marion will also be presenting their outlook as will professor Ari Van Assche of HEC Montréal. Details of this event can be found here.]

That is the global backdrop. As Lacy Hunt and Van Hoisington argue in their latest economic quarterly comment, 2015's surging debt levels will also weigh on domestic growth and constrain growth no matter what President Trump and Congress pass as a stimulus package (there are already grumblings from Republican lawmakers over deficits and Trump's agenda).

Remember my six structural factors as to why I am worried about global deflation ahead:
  • High structural unemployment in the developed world (too many people are chronically unemployed and we risk seeing a lost generation if trend continues)
  • Rising and unsustainable inequality (negatively impacts aggregate demand)
  • Aging demographics, especially in Europe and Japan (older people get, the less they spend, especially if they succumb to pension poverty)
  • The global pension crisis (shift from DB to DC pensions leads to more pension poverty and exacerbates rising inequality which is deflationary)
  • High and unsustainable debt (governments with high debt are constrained by how much they can borrow and spend)
  • Massive technological disruptions (Amazon, Priceline, and robots taking over everything!)
These six structural factors are why I'm convinced why global deflation is gaining steam and why we have yet to see the secular lows in global and US bond yields.

The reflationistas and bond bubble clowns will argue otherwise but I'm sticking with my macro call on global deflation which is why I'm recommending you load up on US long dated bonds after the latest backup in yields.

As far as stocks, in my recent post covering Bob Prince's trip to Montreal, I stated the following:
[...] at one point a rising US dollar impedes growth and is deflationary and if you ask me, the rise of protectionism will cost America jobs and rising unemployment is deflationary, so even if Trump spends like crazy on infrastructure, the net effect on growth and deflation is far from clear.

All this to say I respectfully disagree with Ray Dalio, Bob Prince and the folks at Bridgewater which is why I recommended investors sell the Trump rally, buy bonds on the recent backup in yields and proceed cautiously on emerging markets as the US dollar strengthens and could wreak a deflationary tsunami in Asia which will find its way back on this side of the Atlantic.

Unlike Ray Dalio and others, I just don't see the end of the bond bull market and I'm convinced we have not seen the secular low in long bond yields as global deflation risks are not fading, they are gathering steam and if Trump's administration isn't careful, deflation will hit America too.

This is why I continue to be long the greenback and would take profits or even short emerging market (EEM), Chinese (FXI),  Metal & Mining (XME) and Energy (XLE) shares on any strength. And despite huge volatility, I remain long biotech shares (IBB and equally weighted XBI) and keep finding gems in this sector by examining closely the holdings of top biotech funds.

And in a deflationary, ZIRP & NIRP world, I still maintain nominal bonds (TLT), not gold, will remain the ultimate diversifier and Financials (XLF) will struggle for a long time if a debt deflation cycle hits the world (ultra low or negative rates for years aren't good for financials).

As far as Ultilities (XLU), REITs (IYR), Consumer Staples (XLP), and other dividend plays (DVY), they have gotten hit lately partly because of a backup in yields but also because they ran up too much as everyone chased yield (might be a good buy now but be careful, high dividend doesn't mean less risk!). Interestingly, however, high yield credit (HYG) continues to perform well which bodes well for risk assets. 
I want people to first and foremost understand the big macro environment, then worry about which stocks the "gurus" are buying and selling.

Below, Oksana Aronov, JPMorgan Asset Management alternative fixed income strategist, and Barbara Reinhard, Voya Investment Management head of asset allocation, discuss current moves in the markets and what investors should be considering.

And while stock investors have calmed down, bond investors have gotten jittery. So who’s right about what’s ahead for the economy? Matt Maley of Miller Tabak and Gina Sanchez of Chantico Global discuss with Brian Sullivan (Note: This interview took place last week).

Lastly, Carmignac Managing Director, Didier Saint-Georges, gives his thoughts on the outlook for the bond market, following the US decision to elect Donald Trump. Listen very carefully to his discussion on what's driving inflation and deflationary headwinds have not disappeared.