Tuesday, January 31, 2017

California Crumbling?

Richard W. Raushenbush, a former Piedmont Unified School District Board of Education member and an attorney, wrote an op-ed for the East Bay Times: Increased pension payments threaten state’s schools:
In 2014, the Legislature finally addressed the $74 billion unfunded liability in the California State Teachers Retirement System (CalSTRS) Defined Benefit Program.

While long overdue, the Legislature’s action will significantly degrade California’s K-12 public education system. By placing the burden of paying down this debt primarily on school districts without providing any new funds to do it, the Legislature’s 30-year mandate will force stagnant wages and teacher layoffs.

The CalSTRS’ Defined Benefit Program provides pension benefits to our children’s teachers, who do not receive Social Security benefits. Teachers count on the CalSTRS benefits in pursuing a teaching profession.

The Legislature caused CalSTRS to become drastically underfunded. Under California law, the Legislature is the CalSTRS administrator — it sets the contributions into, and the benefits paid out of, CalSTRS. School districts have no control over contributions or benefits. In 2000, excited by temporary high investment returns, the Legislature passed a package of bills that increased CalSTRS retirement benefits without increasing the contributions necessary to pay for them, and in fact cutting the state’s contributions.

The mirage of endless high investment returns quickly vanished. A 2013 study found: “Had the Legislature not increased benefits, even if CalSTRS’s investments had still underperformed, the funding ratio would currently be 88.4 percent, thereby making CalSTRS one of the nation’s best-funded public pension plans.”

A 2013 report to the Legislature explained: “In 2001-02, when the DB Program first became underfunded, the state and employer contributed 90 percent of the amount needed to fully fund the program within 30 years. By 2011-12, that percentage had declined to 46 percent.” For over a decade, the Legislature ignored the CalSTRS Board’s warnings that the plan was underfunded, and it was getting worse.

In 2014, the Legislature adopted AB 1469, which seeks to pay down CalSTRS underfunding over about 30 years by relatively small increases in contributions from teachers and the State, and by increasing school districts’ contributions over seven years by 10.85 percent. In 2020, school districts’ CalSTRS contributions will be 19.1 percent of teacher payroll!

This is not sustainable. School districts are funded by the public to provide free public education; they do not make profits that can be devoted to paying off the Legislature’s CalSTRS debt. The Legislature did not provide any new funds to pay the significant CalSTRS’ increases. Worse, school districts are being hit twice.

Other school employees are covered by the California Public Employees’ Retirement System (CalPERS), and those contribution rates are projected to go up from 11.442 percent to 20.4 percent by 2020. Think of it this way. School districts spend about 60 percent of their budgets on teacher and staff compensation, so a 10 percent increase in retirement contributions means roughly 6 percent of the entire budget has to be reallocated from educating children to paying off underfunded pension plans.

School districts have few tools to manage their budgets. Absent sufficient funds, pretty quickly the ugly choice is to limit employee compensation or reduce the number of employees. Stagnant or declining compensation will reduce the pool of dedicated and qualified teachers. Teacher layoffs will impact children with larger class sizes and fewer courses. For school districts covering some of the CalSTRS and CalPERS increases with large LCFF “supplemental” and “concentration” grants, the impact may be deferred for a short time. For those districts without, the harm is now.

In Piedmont, where I have served on the Board of Education for the past eight years, the expected state LCFF funding increase in 2017-18 is less than the increase in CalSTRS and CalPERS contributions. For PUSD, the projected LCFF increase in 2017-18 is $196,000, while the CalSTRS and CalPERS increases are projected at $450,000. That’s a budget crisis even with no spending increases on employee compensation, health insurance contributions, Special Education, maintenance, instructional materials, technology, professional development, etc. Absent an increase in State funding, this will get worse as the contribution rates increase through 2020, and then persist until 2046.

The Oakland Unified School District faces significant deficits also. Some of this is caused by the CalSTRS and CalPERS increases. New funds from the state to cover this cost would help OUSD bring its budget back into balance.

Teachers cannot be expected to accept stagnant wages for decades. Good teachers will leave public schools and good candidates will avoid the teaching profession. Students will suffer from larger class sizes, reduced program, loss of counseling and poorer teaching. By placing the burden of paying off the CalSTRS debt on school districts, without any new funding, the Legislature is degrading, and may ruin, California’s public K-12 education system.

There are no easy solutions. The legislators in the 2000 Legislature put unfounded hope over fiscal prudence, and 15 years of adequate retirement contributions were lost. Now, the bill is due. The Legislature and Gov. Jerry Brown must act, and there are two choices, which can work in tandem. First, some budget surplus could be devoted to reducing the CalSTRS debt. Like any other loan, the quicker you pay it off, the less it costs. Second, the state must take responsibility for the portion that must be paid over time, either by increasing the state contribution rate and decreasing the school districts’ rate, or by providing new funding to school districts to pay the CalSTRS increases.

There are many demands on the state budget, but our children’s education must come first. Undoubtedly, this asks our current legislators, who mostly were not around in 2000, to make hard choices. But it must be done. Finally, once the Legislature has made these hard choices, it should then remove itself as CalSTRS pension manager and leave pension administration to professionals driven by their fiduciary duty to current and future retirees.
This is an excellent op-ed which explains the repercussions of California's pension gap and how stupid pension policy has long-term consequences on public finances, education and society at large.

What prompted this op-ed? Robin Respaut of Reuters reports, CalSTRS to consider lowering expected return rate:
The California State Teachers' Retirement System will consider lowering its expected return rate to 7.25 percent from 7.5 percent, based on economic factors and improvements to beneficiaries' life expectancies.

CalSTRS Board is scheduled to consider the move during its February meeting. The recommendation was published late on Wednesday on the public pension fund's website.

The changes are based on new lower assumptions for price inflation and general wage growth, which reduced the probability that CalSTRS would achieve its 7.5 percent return to 50 percent over the long-term, according to the report.

Across the country, public pension funds have been steadily decreasing their expectations for investment returns from an 8 percent median discount rate in 2010 to 7.5 percent today, according to the National Association of State Retirement Administrators.

CalSTRS's sister fund, the California Public Employees' Retirement System (CalPERS) in December lowered its expected rate of investment return from 7.5 percent to 7 percent by 2020, citing lower market growth forecasts over the next decade.

CalSTRS must also take into account improvements in beneficiaries' life expectancies, the report noted.

Under the proposed changes, CalSTRS's funding ratio would drop to 63.9 percent from 67.2 percent, and contribution rates would rise.

CalSTRS estimates that under a 7.25 percent expected return, the state contribution rate would increase by 0.5 percent of payroll for each of the next five years. Currently, the state contribution rate is 8.8 percent of payroll.
The key thing to remember is when CalSTRS or CalPERS lower their long-term expected return assumptions, contribution rates necessarily go up. Unions and governments don't like that because it means teachers and other public-sector workers and the state government need to pay more into the pension system to sustain it over the long run.

More money for pensions means less money for other services and that's where things get hairy. Unfortunately, there's not much of choice. In my opinion, both CalSTRS and CalPERS were running on delusional investment return assumptions for years, much like most US public pensions, and now that reality has caught up to them, they need to act or their pension beneficiaries will pay the ultimate price as benefits will necessarily be slashed if chronic pension deficits persist.

Unfortunately, and I have to be brutally honest here, CalSTRS, CalPERS and pretty much all other large US public pensions are still living in Lala Land when it comes to their long-term investment assumptions. In my opinion, they will be very lucky to obtain 6% nominal annualized ten-year rate of return over the next decade.

What am I basing this on? I look at the discount rate Ontario Teachers, HOOPP, and many other large Canadian public pension funds use and it ranges from just under 5% (OTPP) to 6% for others. How can these US public pensions, all of which are running much less sophisticated operations than their Canadian counterparts, justify a 7% or 7.25% long-term investment return target to discount their future liabilities?

It just doesn't add up. Worse still, the benefits they dole out to their beneficiaries are much more lavish than what Canadian teachers and public sector workers receive, not to mention double-dipping, pension spiking and other rampant abuses.

It's a joke and I keep telling people pensions are all about managing assets AND liabilities. If the math doesn't add up, pension deficits just keep getting worse until they threaten the pension system and other public services. By then, it's often too late to act.

Another problem with CalPERS, CalSTRS and most US public pensions is they keep avoiding implementing some form of a shared-risk model, which Ontario Teachers', HOOPP and other large Ontario pensions have adopted to make sure pension deficits are equally shared among all stakeholders.

Instead, they keep praying Mr. Market will keep going up, up, up, and that by some miracle, if markets go up and interest rates soar back to early 1980s level, voila, pension deficits will disappear and everyone will be happy.

Keep dreaming folks, if my long-term forecast of global deflation materializes -- and I am rarely wrong on my big macro calls like my recent one on the reflation chimera -- then every pension system in the world will be in big trouble, especially those that are already severely and chronically underfunded.

That is when some of you will remember my dire warnings of deflation decimating pensions, but most of California's retired teachers and public sector workers will meet a fate much like those poor retired Greek pensioners that saw massive cuts to their pension benefits.

What happened in Greece can never happen in the United States which prints the world's reserve currency and has a much bigger, more diverse and richer economy than that of Greece? Absolutely true but the thing is when it's time to pay the pension piper and taxpayers aren't able or willing to bail out public pensions, something will give and it isn't going to be pretty.

Let me end with something from The Daily Breeze which cites a study that says two-thirds of California's teachers are ‘pension losers’:
Labor unions and other supporters of traditional defined-benefit pensions tout the oftentimes generous and guaranteed nature of pensions, but many — and sometimes even most — do not come out ahead.

This is particularly true for California teachers, according to a recent University of Arkansas study. In fact, the authors estimate that fully two-thirds of all teachers in the California State Teachers’ Retirement System will be “pension losers” because either they will be among the 40 percent of new teachers who leave before they satisfy CalSTRS’ five-year vesting period, and thus receive no pension, or the value of their pension will be less than what they contributed to the system. A teacher who starts her career at age 25, for example, will have to work until age 53 before merely breaking even with her employer’s pension contributions, the study concludes.

“Under traditional defined-benefit plans, employees and employers make contributions of a given percentage of pay, but those contributions are an average of widely varying individual costs to fund the retirement system,” the authors note. Those costs vary greatly based on how old teachers are when they start working and how many years they end up working.

“With benefits de-linked from contributions, some individuals will receive benefits that cost more than the contributions made on their behalf and some will receive less, effectively a system characterized by cross-subsidies,” they explain.

In other words, those who remain in the system for a very long time are significantly subsidized by newer — and even many not-so-new — teachers.

This is in stark contrast to 401(k)-style defined-contribution plans or cash balance plans, a hybrid that has elements of both defined-benefit and defined-contribution plans. “Under such plans, there would be no cross-subsidies,” the authors observe.

There is also the matter of how financially sound CalSTRS actually is. Under current assumptions, the system is only about 69 percent funded. The CalSTRS board will meet this week to consider reducing the pension fund’s annual investment rate of return assumption from 7.5 percent to 7 percent.

The proposal was prompted by a report from the pension system’s actuary, Milliman Inc., which counseled that keeping the 7.5 percent rate “is not recommended since the probability of achieving this return is less than 50 percent.” It would follow CalPERS’ decision last month to reduce its return rate assumption from 7.5 percent to 7 percent over three years, and would be the third reduction for CalSTRS since 2010, when the rate was as high as 8 percent.

Critics have long argued that such assumptions were unreasonable, and led to smaller government pension contributions that shortchanged the system because they were inadequate to cover future liabilities. The move would require the state to sock away an additional $153 million next fiscal year, and the approximately 80,000 teachers hired since the Public Employees’ Pension Reform Act went into effect in 2013 would have to contribute approximately $200 more per year.

In light of the pension subsidies paid by all but the most seasoned teachers and the financial difficulties experienced by CalSTRS’ defined-benefit system, it would be better for teachers and taxpayers alike to switch to a reasonable defined-contribution or cash balance plan instead.
My thoughts? Any study on pensions from the  University of Arkansas which is heavily influenced by the Koch brothers should be immediately disqualified. Why? Because any study which fails to outline the brutal truth on defined-contribution plans and recommends switching from a DB to a DC, 401(k) type plan is absolute and utter rubbish. Period.

Don't waste your time reading this nonsense. You are much better off reading a study from University of California, Berkeley which shows that for the vast majority of teachers, the California State Teachers’ Retirement System Defined Benefit pension provides a higher, more secure retirement income compared to a 401(k)-style plan.

If the Koch brothers want me to explain in "right-wing, conservative terms" why defined-benefit plans make great sense and are the way to move forward to address America's looming retirement crisis and long-term fiscal crisis, I'd be more than happy to do so. All they need to do is donate or subscribe $5,000 to my blog and fly me over to Wichita and I will explain to them in clear detail why DB plans are far superior to DC plans as long as the assumptions, risk-sharing and governance are right.

Below, CalPERS CIO Ted Eliopoulos discusses reducing the fund’s annual investment return it anticipates to 7 percent from 7.5 percent. It is my understanding that Eliopoulos wanted to reduce the rate even more but they opted to lower it gradually and only to 7 percent.

Eliopoulos also talked about plans to shift as much as $30 billion to internal managers. Smart move, confirms my last comment on the big push to insource pension assets.

Monday, January 30, 2017

The Big Push To Insource Pension Assets?

Back in early December, Aliya Ram of the FT reported, Danish pension fund halves outsourced money:
Denmark’s biggest pension fund has halved the amount of money it outsources to external asset managers over the past two years, arguing that increased scrutiny of costs and transparency has made hiring them untenable.

ATP, which manages DKr806bn (£91bn) for 5m Danish pensioners, used to allocate more than a third of its DKr101bn (£11.4bn) investment assets to external fund managers.

However, Kasper Lorenzen, the chief investment officer, told FTfm that this has halved to 19 per cent since December 2014, a loss of DKr19.3bn (£2.2bn) for the industry.

“Some of these more traditional, old-school mandates, where you hire some asset manager, and then they track a benchmark and try to outperform by 14 basis points . . . we kind of tried to get rid of that,” Mr Lorenzen said.

He added that after the financial crisis investors wanted cheaper options. “I think the main thing is that there is more focus on costs. I think there is more transparency. There are really low-cost implementation vehicles [out] there.”

ATP joins a growing group of asset owners that have pulled money from active managers in favour of cheaper, passively managed funds, or more complicated investments in infrastructure, financial derivatives and property.

The California State Teachers’ Retirement System, the third-largest pension plan in the US, told FTfm in October that it plans to pull around $20bn from its external fund managers. It has already shifted $13bn of its assets in-house over the past year.

Alaska Permanent Fund, which manages $55bn, said this summer that it will retrieve up to half its assets from external managers, while AP2, the Swedish pension scheme, dropped mandates from external managers earlier this year. AP2 has moved more than $6bn from asset managers to internal investment staff over the past three years.

Railpen, the £25bn UK pension scheme, also said last year it had achieved £50m of annual cost savings by cutting the number of external equity managers it worked with from 17 to two, and managing more money internally.

The active industry has come under pressure for failing investors with poor returns and high fees in an era of low interest rates where returns are more difficult to come by.

Last month the UK regulator sharply criticised the industry for charging high fees and generating significant profits despite failing to beat benchmarks.
There is nothing new or surprising about ATP's decision to significantly cut its traditional external managers. There is a crisis in active management that has roiled the industry and many large institutional investors are bringing assets in-house, especially in the more traditional mandates where they can significantly cut costs and gain the same or better performance.

And it's not just large pensions that are cutting external managers. Attracta Mooney of the FT reports, CIO of £12bn pension pot threatens to cull external managers:
Chris Rule, the man charged with investing £12bn on behalf of more than 232,000 current and former local authority workers in England, begins his meeting with the Financial Times earlier this month by apologising.

Standing in his office in Southwark in the south of London, he explains the air-conditioning is on the blink. It is a crisp, cold January evening, but Mr Rule’s small office, located in a building that also houses London Fire Brigade’s headquarters, is sweltering. It has been all day.

The building managers are on the case, he says, but for now the only way to cool down is to resort to shirt sleeves and big glasses of cold water.

Mr Rule seems unperturbed, if a little hot. It is hard to imagine that many chief investment officers across London would so easily shrug off such an uncomfortable office environment. But the father of three has other things on his mind, namely the radical overhaul happening across the UK’s local authority pension funds.

In 2015 George Osborne, the chancellor at the time, called on the 89 local authority retirement funds across England and Wales to create six supersized pension pots or “British wealth funds”.

The plan was that these funds would work together to reduce running costs and invest more in infrastructure. Since then, proposals for the formation of eight local authority partnerships have been put forward to the government for approval.

Mr Rule is the chief investment officer of one of these pools: the Local Pensions Partnership, or LPP, which was set up to oversee the combined assets of the London Pensions Fund Authority and the Lancashire County Pension Fund. The two pension schemes’ plans for a partnership predates Mr Osborne’s proposals, but his demands cemented their efforts.

Mr Rule says: “People [across local authorities] have done a lot of heavy lifting over the past 12 months and got the sector massively further forward than many stakeholders or commentators would have believed was possible in that space of time.”

Last month, LPP received the seal of approval from the government, when Marcus Jones, the UK minister for local government, signed off its plans. But the minister flagged some concerns, not least the size of the fund. LPP is short by almost half the £25bn figure Mr Osborne indicated he wanted the pooled funds to manage.

“It is no secret that the minister would like us to be that magic £25bn [in assets]. But it is important to realise that we are up and running; we are live today,” Mr Rule says.

LPP, which began operating in April 2016, is one of the few local authority partnerships that is already functioning. It has also received regulatory approval from the UK’s financial watchdog, unlike the majority of the other local authority pots.

Mr Rule’s job at LPP is highly pressured, especially at a time when record-low interest rates are hurting returns and driving up liabilities for retirement schemes. LPP has been tasked with undertaking the majority of the work that the two local authority funds once did, from asset allocation to pension administration.

The 38-year-old is at pains to stress that LPP has already used its increased scale to reduce costs for its two founding funds, despite falling far short of the desired level of assets.

The partnership has a far bigger allocation to infrastructure than other local authority pools. “At the size we are, we are already getting significant discounts when we are negotiating with third-party managers,” he says.

The former Old Mutual fund manager is now focused on axing asset managers in favour of running more money internally in order to cut costs.

“Our intention is to expand our internal capability, develop new internal strategies and therefore be able to insource more of the assets. That is clearly where we get the greatest fee savings, because we can operate at a much lower cost.”

Last November, LPP launched a £5bn global equity fund, consisting of the pooled cash of the LPFA and LCPF. About 40 per cent of the assets are managed internally by LPP, while a trio of fund houses — MFS, Robeco and Magellan — run the remaining 60 per cent.

Morgan Stanley, Harris Associates and Baillie Gifford, which previously ran equities for the pension funds, were axed as a result. This move is expected to save £7.5m a year in investment management costs. The trend of cutting managers is set to continue as part of Mr Rule’s aim of running around half of LPP’s assets internally, up from a third currently.

The managers most at risk are those running equities: Mr Rule would like to manage about 80 per cent of LPP’s investments in stock markets internally.

But he adds: “I would never expect to be 100 per cent internal. There will always be areas that we want to go and get [external] expertise for.

“We are only going to allocate money internally where we believe that is better than anything we can get externally. There is no point saving £5m in costs if it costs us £30m in returns.”

If LPP manages more money itself, it needs to grow its investment team. There are 25 investment staff positions at LPP, almost double the combined size of the now-defunct investment teams at the two founding pension funds. Some of the LPP positions, however, are yet to be filled.

Mr Rule admits that convincing employees to switch from private sector asset management, where higher salaries are the norm and offices have working air con, is a difficult task.

“If they don’t care about anything apart from money, we are going to have a challenge attracting and retaining them because there is always going to be someone that will pay more than us,” he says. “We can offer people a degree of autonomy that perhaps they would not have in a traditional asset manager.”

As Mr Rule continues to extol the virtues of a career in a local authority pension fund, it starts to become clearer why he left the private sector.

“There is always a bit of a conflict with an asset management firm, and I say that having worked all my career in asset management firms. As an individual, sometimes it can cause you to question the merit of what you are doing,” he says. “We are the asset owner. It is not about how we can generate fee income and profitability for the [company]. We have a different lens we look through.”
For a young 38-year old buck, Mr. Rule has huge responsibilities but at least he gets the name of the game. When you work for an asset management firm, it's all about gathering assets. This goes for firms working on traditional mandates (beating a stock and bond benchmark) and it also goes for elite hedge funds shafting clients on fees.

When you work for a pension, your objective is to maximize the overall return without taking undue risk and in order to achieve this objective, pensions need to cut costs wherever they can, especially in a low return/ low interest rate world.

Rule is right, pensions can't go 100% internal but many are cutting costs significantly wherever they can. And I agree with him when he states the following: “We are only going to allocate money internally where we believe that is better than anything we can get externally. There is no point saving £5m in costs if it costs us £30m in returns.

Go back to read an older comment of mine when Ron Mock was named Ontario Teachers' new leader where I went over the first time we met back in 2002 when he was running Teachers' massive external hedge fund program:
Ron started the meeting by stating: "Beta is cheap but true alpha is worth paying for." What he meant was you can swap into any index for a few basis points and use the money for overlay alpha strategies (portable alpha strategies). His job back then was to find the very best hedge fund managers who can consistently deliver T-bills + 500 basis points in any market environment. "If we can consistently add 50 basis points of added value to overall results every year, we're doing our job."

He explained to me how he constructed the portfolio to generate the highest possible portfolio Sharpe ratio. Back then, his focus was mainly on market neutral funds and multi-strategy funds but they also invested in all sorts of other strategies that most pension funds were too scared to invest in (strategies that fall between private equity and public markets; that changed after the 2008 crisis). He wanted to find managers that consistently add alpha - not leveraged beta - using strategies that are unique and hard to replicate in-house.
The key message? Beta is cheap!! Why pay some asset management firm big fees especially in traditional stock and bond mandates when most of them are incapable of beating an index over a long period? The same goes for hedge funds charging alpha fees for leveraged beta? Why pay them a ton of fees when they too consistently underperform a simple stock or bond benchmark over a long period? That too is insane!

Now, I know the arguments for active management. We went from a big alpha bubble which deflated to a mega beta bubble where the BlackRocks, Vanguards and a whack of Robo-advisors are inflating a giant beta bubble, indiscriminately shoving billions into ETFs, and it's all going to end badly.

Moreover, just like François Trahan of Cornerstone Macro who was in Montreal last week, I am openly bearish and you'd think in a bear market active managers will outperform all these beta chasers, but it's not that simple. Most active managers will perform even worse in a bear market, incapable of dealing with the ravages of a brutal decline in stocks.

Having said this, there will always be a market for good active managers, whether they are traditional asset management firms or elite hedge funds or private equity funds, so whenever pension fund managers think they are better off outsourcing assets to obtain their actuarial rate-of-return target, they should do so and gladly pay the fees (as long as they are not getting the big shaft on fees).

Pension fund managers don't mind paying fees when they get top performance and great alignment of interests, but when they don't, they just bring assets internally and cut costs, even if that means lower returns on any given year (over the long run they are better off with this strategy).

An example of where it makes sense to outsource assets, especially in illiquid markets, is in a recent deal involving the UK's Universities Superannuation Scheme. Dan Mccrum of the FT reports, UK universities pension plan in novel deal with Credit Suisse:
The pension plan for UK universities has snapped up most of a $3.1bn portfolio of loans to asset managers, in a collaboration with Credit Suisse which highlights the shifting roles of banks and investors in the continent’s capital markets.

The £55bn Universities Superannuation Scheme has agreed to provide debt financing to private equity and asset management groups that have raised so-called direct lending funds. These funds make loans to medium-sized businesses, displacing traditional bank lending.

It comes as Credit Suisse undertakes a reordering of its business designed to reduce activity which requires large commitments of capital, in favour of advising clients in return for regular fees.

In the first deal of its kind for a UK pension fund, the collaboration begins with the Swiss investment bank offloading most of a portfolio of loans and loan commitments made in 2014 and 2015, typically lasting five to seven years. The bank, which retains a small portion of the original lending, will manage the pool of loans and arrange new financing for USS on the same basis.

Ben Levenstein, head of private credit and special situations for USS, said the pension fund allocates a quarter of its capital to investments where it can earn a higher income than equivalent securities in public markets, which can be easily bought and sold. “We do have a tolerance for illiquid assets,” he said.

The $3.1bn of existing lending commitments to groups such as GSO Capital Partners, part of the alternative investment group Blackstone, will eventually be backed by around $6bn of lending to medium-sized businesses, in competition with commercial banks.

“Non-bank lending is a structural shift in capital markets, and the asset managers want a funding source not reliant on bank financing,’’ said Jonathan Moore, co-head of credit products in Europe, the Middle East and Africa for Credit Suisse.

Several years of very low interest rates have forced pension funds to search for unusual sources of income, at the same time as regulatory changes have caused many banks to conserve capital. Since 2013, $119bn has been raised for direct lending, by more than 200 investment funds, according to Preqin, a data provider.

The funds typically lend to businesses with earnings before interest, taxes, depreciation and amortisation of less than €50m, too small to access public debt markets. A borrower might expect to pay 600-800 basis points above interbank borrowing costs, for a five-year loan.

Asset managers boost investment returns by raising debt against the funds. The lending commitments arranged by Credit Suisse are so-called senior loans, financing half the value of the underlying portfolio at low risk. The typical cost of such funding is around 250-300 basis points over interbank borrowing costs, according to participants in the market.

While the deal may be a model for institutional investors to follow, USS is unusual among large UK pension schemes which offer defined benefits to members in retirement. USS remains open to new members and continues to make new investments as contributions flow in.
Private debt is a huge market, one which many Canadian pension funds have been pursuing aggressively through private equity partners, in-house managers or by seeding new credit funds run by people that used to work at large Canadian pensions. In this regard, I'm not sure how "novel" this deal between Credit Suisse and the UK's Universities Superannuation Scheme really is (maybe by UK standards, certainly not by Canadian ones).

Lastly, it is worth noting that while many pensions are rightfully focusing on cutting costs and insourcing assets wherever they can, large endowments funds like the one at Harvard, are moving in the opposite direction, adopting Yale's model which is based on outsourcing most assets to top external asset managers.

The key difference is that top US endowments have a much shorter investment horizon than big pensions and they allocate much more aggressively to illquid private equity, real estate and hedge funds. They have also perfected the outsourcing model which has served many of them well and have developed long-term, lasting relationships with top traditional and alternative asset managers.

Below, stocks are sinking on Monday after President Trump signed an executive order late Friday that would temporarily bar entry into the US to Iraqi, Syrian, Iranian, Sudanese, Libyan, Somali and Yemeni refugees.

For every three steps forward, President Trump then goes ahead and signs this nonsense which takes the country back to the isolationist Dark Ages. No wonder tech giants and many other companies are strongly denouncing this latest controversial executive order. It makes absolutely no sense whatsoever, especially since the vetting of Syrian and other refugees coming to the US is already extremely stringent.

Interestingly, it took 3 years for George W. Bush to hit 50% disapproval. Trump is there after 8 days. I think President Trump needs to think long and hard before foolishly signing executive orders that are unconstitutional and simply don't make sense.

Lastly,  CBC reports two men were arrested following the deadly shooting at a Quebec City mosque Sunday night. These senseless slaughters make my blood boil and unfortunately remind us all that racism, hatred and savagery are alive and well in the US, Europe and even here in "peaceful" Canada.

Friday, January 27, 2017

Sparks Fly at CFA Montreal Luncheon?

On Thursday François Trahan of Cornerstone Macro was in town for a CFA Montreal luncheon featuring a few panelists presenting their outlook 2017 (click on image):

Along with François were Stéfane Marion, Chief Economist and Strategist at the National Bank of Canada and Ari Van Assche, professor of business from HEC Montréal. Clément Gignac, Senior Vice-President and Chief Economist at Industrial Alliance Financial Group was the moderator and he did an excellent job.

Please note some of the presentations are available on the CFA Montreal website here. In particular, you can download Stéfane Marion's presentation here and Ari Van Assche's presentation here.

Unfortunately, François Trahan's presentation is not on the CFA Montreal website. I contacted François this morning by email to get it but he told me his compliance department said it's a no-go (why are compliance people so fussy on such trivial matters?!?).

Anyways, I'm a good internet researcher and can find pretty much anything online so we'll work around this annoying compliance issue. You should all go back a year to see François Trahan's 2016 outlook which can be found here.

A year ago, François was bullish, stating structural headwinds were going to collide with cyclical stimulus. But his views have changed "bigly" (to borrow one of Trump's favorite adjectives) and he's now on record being bearish for 2017.

Before I get into the luncheon, let me thank Andrea Wong of National, a public relations firm in based in Montreal. She and her team once again did a wonderful job, just like the last event when the prince of Bridgewater was in town.

When I got to the conference center, it was jam-packed and I didn't know where to sit. I saw Andrea at the door and she directed me toward the back of the room where there was a chair in between two tables and I sat listening to all those dreadfully boring presentations.

Just kidding! I love François, Stéfane and Clément, know them well. François is a BCA Research alumnus like me and worked there before moving on to bigger and better gigs at Ned Davis, Brown Brother, ISI Group and now Cornerstone Macro. He's now a top Wall Street strategist and enjoys living in New York with his wife and kids but they still come to their farm outside Montreal from time to time.

Clément Gignac was my boss at the National Bank of Canada when he was the chief economist and strategist back in the bear market of 2000-2. Great guy, he is very nice and always knew how to butter me up when he wanted something, like writing a market comment for him: "Léo, t'as une bonne plume!" ("Leo, you write so well").  [Note: You can read Clément's current economic views at Industrial Alliance here.]

Stéfane Marion was my colleague back then. Great economist, really knows his stuff on the US, Canadian and global economy and is genuinely one of the nicest people I've met in the industry. I learned a lot working with him, Clément and Vincent Lépine who is now Vice-President, Global Economic Strategy, Global Asset Allocation and Currency Management at CIBC Asset Management.

Who else did I learn from back then? Martin Roberge who was then the chief quantitative strategist at the National Bank and is now Portfolio Strategist and Quantitative Analyst at Canaccord Genuity. I used to go into Martin's office and we would talk stocks, bonds and markets and just look at a bunch of charts.

Good times back then even if it was a long and painful bear market. The stock prop traders on the fifth floor who were partying it up like no tomorrow in 1999, living the high life on St-Laurent street, ended up hurting when the bear market hit and eventually they all lost their jobs.

Very few people remember the bear market of 2000-2002. It wasn't as bad as the one in 1973-1975 (so I was told by the seniors) but it was brutal, just brutal, especially for stock traders and investors.

I remember Clément rounded us up back then in his office and told us we needed to kick it into fifth gear because "in a bear market, clients love economists." And along with Martin Roberge, we were pulling in most of the soft dollars from clients and we all worked very hard producing great economic and market research and presented our ideas to clients on many road shows.

Why am I sharing all this with you? Because I believe we're headed back into another major bear market unlike anything we've experienced before but before it strikes in a "bigly" way, we might have some more irrational exuberance and Trumptimism to contend with.

Now, let's finally get into the CFA luncheon which ended up being a clash between Stéfane Marion, the cautious bull, and François Trahan, the somewhat uncomfortable bear.

Again, I like both these guys, know their strengths and weaknesses very well, so I refuse to take sides even if in my own Outlook 2017 on the reflation chimera, I referred to François's bearish call and pretty much outlined why I think we're headed into big trouble in the second half of the year. 

Please take the time to go over Stéfane Marion's presentation here. Stéfane was kind enough to share his main points with me earlier today via email (click on image):

The key point is the global economy is showing its best economic surprises in seven years and inflation is picking up everywhere including the US, which is why he believes the yield on the 10-year Treasury note could hit 3%. He also states even though Trump is unlikely to deliver massive fiscal stimulus, his moves to deregulate the economy could extend the expansion going on now.

However, he admitted that P/E expansion is very hard at this mature phase of the expansion but thinks P/E contraction will eventually come, but only after the curve flattens.

He prefers equities over bonds and thinks the biggest risk now s geopolitical. He states: "This cycle is most unusual for the U.S. as fiscal stimulus is being deployed with the unemployment rate below 5%. The last time this was attempted was in the 1960 (Kennedy-Johnson). The mature phase of the expansion was extended to 84 months back then (slide 28). Fiscal policy (including deregulation) will play a crucial role in this cycle."

François Trahan was the opposite of what he was last year, shifting from raging bull to a raging bear.  He admitted that economic surprises, especially in lagging or coincident indicators like inflation and employment can continue to surprise on the upside in the near term, but he said this sets up the bearish scenario of the Fed tightening as the global economy begins decelerating.

Here, I agree with François and have been voicing my concerns of a 2017 US dollar crisis where the greenback continues to surge higher bringing about the next financial crisis. More on this below.

François wasn't particularly impressed with Trump's massive fiscal stimulus and referred to a New York Times chart showing that if you look at historical episodes of massive fiscal stimulus, the effects on the economy were muted.

He made me laugh when he referred to his wife as a "North Eastern liberal" who credits President Obama with saving the US economy and basically stated it doesn't matter who is in the White House, the economy moves to its own rhythm (Amen! I get into email spats with my buddies out in California who are geniuses and yet they're "petrified" of Trump and think Obama was the best president ever...whatever!!).

Given his bearish stance, François favors bonds over stocks and he said he wouldn't be surprised if stocks slip 15-20% from these levels by year-end and if the yield on the 10-year Treasury note declines below 1.3%.  That's about as bearish as I've ever heard Mr. Trahan.

He had an interesting discussion on the behavior of P/Es saying they are acting more cyclically lately. "If the P/E was more correlated to inflation, we might change our scenario, but that just isn't the case."

In his presentation, Ari Van Assche discussed demographic changes in China and discussed structural changes going on there and what might happen in the future as growth slows and policies change. I must admit I didn't pay enough attention to Ari's presentation as I was chit chatting with my buddy at this point (my bad).

During the Q&A, François stated that sell-side economists and strategists are perennially optimistic, part of their occupational hazard. Stéfane responded by saying he is the chief economist but also sits on the bank's pension committee so he wears a sell-side and buy-side hat.

Anyways, enough of that, sparks didn't fly at the CFA luncheon but there was a civil disagreement. As you all know, I'm a deflationista, have NOT changed my mind as to where the global economy is headed and think too many smart people are making way too big a deal of a pickup in inflation in Germany, the US and elsewhere and they're reading way too much into it, erroneously believing it's  the beginning of the end for US bonds.

Where did I go wrong last year? I correctly ignored Soros's warning of another 2008 crisis and correctly predicted the bloodbath in stocks was ending in mid January, but I completely missed the reflation trade going in cyclicals like industrials and energy. I remember at one point I was trading and noticed the Metals and Mining (XME) ETF hit an intraday low of where it was back in the crisis of 2008 and I said to myself "hold your nose and just pounce!". I didn't and partially regretted it but my deflationary views remained in place and are still strong, so I don't care if I missed that rally. 

What surprised me yesterday is there wasn't a more serious discussion on the likelihood of a 2017 US dollar crisis where the greenback continues to surge higher and emerging markets get clobbered. This is my worst case scenario and I'm sticking with it and think there will be real fireworks in the fourth quarter of the year.

Stéfane did mention that commodity prices keep creeping up despite the stronger dollar, which has eased pressure on commodity exporting emerging markets but this won't likely last and when correlations get back to normal, a surging greenback will clobber Chinese (FXI), emerging markets (EEM), energy (XLE), Metals and Mining (XME), Oil & Gas Exploration (XOP) and all commodities (GSG) in general. 

I'm bearish like François but where I disagree with him is on the timing of his call. Remember what Keynes once said: "markets can stay irrational longer than you can stay solvent." There is a lot of money out there chasing risk assets higher, hedge funds leveraging up like crazy, animal spirits fueling excessive optimism, so this silliness can last a little longer.

Lastly, as Stéfane was leaving, I told him that Trump has signed more executive orders this week than Obama, Clinton and George "W" Bush did in their first month of office combined. I may be off a bit but President Trump isn't fooling around, working like a dog, perhaps fearful of the downturn that lies ahead.

As always, please remember to kindly donate or subscribe to this blog on the top right hand side under my picture using PayPal options. Every time I write a long comment like this one, I remind myself that I don't get paid for this and it's a lot of work which is grossly under-appreciated. Please show your financial support and kindly donate or subscribe to the blog.

Below, François Trahan defends his case for turning bearish. Listen carefully to his arguments and trust me, even though his timing is a bit early, I would definitely heed his warning.

I'll leave you with another thought. Soros lost a billion dollars last year following Trump's victory. Soros won't lose a billion dollars two years in a row.

And Steve Cohen just had his worst year since the financial crisis, up a mere 1% in 2016. That too is an anomaly. My money is that Soros and Cohen will kill their competition this year, including the quant hedge fund beast that helped elect Trump and killed it in terms of performance last year (more on top 2016 hedge fund performers in a subsequent comment). 

Thursday, January 26, 2017

Harvard's Endowment Adopts Yale's Model?

Alvin Powell of the Harvard Gazette reports, Course change for Harvard Management Company:
Explaining that challenging investment times demand “we adapt to succeed,” the new head of the Harvard Management Company (HMC) announced sweeping internal changes today, including a major shift in investment strategy, workforce reductions, and a compensation system tied to the overall performance of the University’s endowment.

N.P. Narvekar, who took over as HMC’s president and chief executive officer on Dec. 5, immediately began executing his reorganization, announcing four new senior hires: Rick Slocum as chief investment officer, and Vir Dholabhai, Adam Goldstein, and Charlie Savaria as managing directors.

“Major change is never easy and will require an extended period of time to bear fruit,” Narvekar said in a letter announcing the moves. “Transitioning away from practices that have been ingrained in HMC’s culture for decades will no doubt be challenging at times. But we must evolve to be successful, and we must withstand the associated growing pains to achieve our goals.”

Founded in 1974, HMC has overseen the dramatic growth in the University’s endowment that has made it, at $35.7 billion, the largest in higher education. Made up of more than 13,000 funds, many of them restricted to particular purposes, the endowment is intended to provide financial stability year to year for the University. In the last fiscal year, which ended on June 30, endowment funds provided $1.7 billion, more than a third of the University’s $4.8 billion budget. Such endowment income supports Harvard’s academic programs, science and medical research, and student financial aid programs, which allow the University to admit qualified students regardless of their ability to pay.

During the 1990s and early 2000s, returns on Harvard’s endowment regularly outstripped those of other institutions, making HMC a model for endowment management. Since the market crash of 2008, however, endowment performance has been up and down. Last year, endowment returns fell 2 percent, dropping the value below the $36.9 billion high-water mark reached in the 2008 fiscal year.

Narvekar has decided to shift from the policy of using both in-house and external fund managers that had made HMC’s approach to investing unique. In recent years, he said in his letter, competition has intensified for both talent and ideas, making it tougher to both find and retain top managers and exploit “rapidly changing opportunities.”

In what he called “important but very difficult decisions,” Narvekar announced that the in-house hedge fund teams would be leaving HMC by July, and the internal direct real estate investment team would leave by the end of the calendar year. The natural resources portfolio, meanwhile, will remain internally managed. Altogether, he said, the changes will trim HMC’s 230-person staff roughly in half.

“It is exceptionally difficult to see such a large number of our colleagues leave the firm, and we will be very supportive of these individuals in their transition,” Narvekar said. “We are grateful for their committed service to Harvard and wish them the very best in their future endeavors.”

The changes are in step with an overall strategy shift that will move away from what Narvekar called a silo investing approach, wherein managers focus on specific types of investments — whether stocks, bonds, real estate, or natural resources — to one in which everyone’s primary goal is overall health and growth for the endowment.

The problem with the silo approach, Narvekar said, is that it can create both gaps and duplication in the overall portfolio.

“This model has also created an overemphasis on individual asset class benchmarks that I believe does not lead to the best investment thinking for a major endowment,” Narvekar added.

Narvekar sees his incoming “generalist model,” which is employed at some other universities, as fostering a “partnership culture” in which the entire team debates investing opportunities within and across asset classes.

Narvekar, who previously oversaw the endowment at Columbia University, said he would encourage managers to be open-minded and creative as they move forward, adding that the generalist model is flexible enough that, under the proper circumstances, it could again allow for hiring in-house managers down the road.

“While I don’t expect a large portion of the portfolio to be managed internally as a practical matter … nothing is out of bounds in the future,” he said.

Narvekar expects a five-year transition period for the changes to be fully implemented, and although he warned that investment performance will likely be “challenged” this year, by the end of the calendar year organizational changes should have taken hold and HMC will look and act differently.

In effect, HMC’s compensation structure will move away from a system where managers are compensated based on how their siloed investments perform relative to benchmarks. The new system, to be implemented by July, will be based on the endowment’s overall performance.

In a press release, Narvekar said he has known the four executives brought aboard to implement the changes for much of his career. Three of them — Dholabhai, Goldstein, and Savaria — have earlier experience at the Columbia Investment Management Co. where Narvekar was CEO. The fourth, Slocum, who starts as chief investment officer in March, comes to Harvard from the Johnson Company, a New York City-based investment firm. He has worked at the Robert Wood Johnson Foundation and the University of Pennsylvania.

In addition to his experience at Columbia, Dholabhai, who starts on Monday, was most recently the senior risk manager for APG Asset Management US. Goldstein, who starts on Feb. 6, comes directly from Columbia, where he was managing director of investments. Savaria, who also starts on Monday, co-managed P1 Capital.

“I am pleased to welcome four senior investors to HMC who bring substantial investment expertise and deep insight into building and working in a generalist investment model and partnership culture,” Narvekar said. “I have known these individuals both personally and professionally for the majority of my career, and I value their insights and perspectives.”
The last time I discussed Harvard's 'lazy, fat, stupid' endowment was back in October where I drilled down to examine criticism of another dismal year of performance and 'mind blowing' compensation.

HMC's new president, N.P. Narvekar, wasted no time in setting a new course for Harvard's endowment fund. In essence, he's basically admitting that Yale's endowment model which relies primarily on external managers is a better model and he's also putting an end to insane compensation tied to individual asset class performance.

Narvekar is absolutely right: “The problem with the silo approach is that it can create both gaps and duplication in the overall portfolio. This model has also created an overemphasis on individual asset class benchmarks that I believe does not lead to the best investment thinking for a major endowment.”

I don't believe in the silo approach either. I've seen first-hand its destructive effects at large Canadian pension funds and I do believe the bulk of compensation at any large investment fund should be tied to overall investment results (provided all the asset class benchmarks accurately reflect all the risks of the underlying portfolio).

At the end of the day, whether you work at Harvard Management Company, Yale, Princeton, or Ontario Teachers' Pension Plan, the Caisse, CPPIB, it's overall fund performance that counts and senior managers have to allocate risk across public and private markets to attain their objective.

Now, US endowment funds are different from large Canadian pensions, they have a shorter investment horizon and their objective is to maximize risk-adjusted returns to more than cover inflation-adjusted expenses at their universities, not to match assets with long-dated liabilities.

Still, Narvekar and his senior executives now have to allocate risk across public an private market external managers. And while this might sound easy, in an low interest rate era where elite hedge funds are struggling to deliver returns and shafting clients with pass-through and other fees, it's becoming increasingly harder to allocate risk to external managers who have proper alignment of interests.

What about private equity? Harvard and Yale have the advantage of being premiere endowment funds which have developed long-term relationships with some of the very best VC and PE funds in the world but even there, returns are coming down, times are treacherous and there are increasing concerns of misalignment of interests.

And as Ron Mock recently stated at Davos, you've got to "dig five times harder" to find deals that make sense over the long run to bring in a decent spread over the S&P 500.

All this to say that I don't envy Narvekar and his senior managers who will join him at HMC. I'm sure they are getting compensated extremely well but they have a very tough job shifting the Harvard Endowment titanic from one direction to a completely different one and it will take at least three to five years before we can gauge whether they're heading in the right direction.

What else worries me? A lot of cheerleaders on Wall Street cheering the Dow surpassing the 20,000 mark, buying this nonsense that global deflation is dead, inflation is coming back with a vengeance and bonds are dead. Absolute and total rubbish!

When I read hedge funds are positioned for a rebound in the oil market and they're increasing their bearish bets on US Treasuries, risking a wipeout, I'm flabbergasted at just how stupid smart money has become. Go read my outlook 2017 on the reflation chimera and see why one senior Canadian pension fund manager agrees with me that it's not the beginning of the end for US long bonds.

In fact, my advice for Mr. Narvekar and his senior team is to be snapping up US Treasuries on any rise in long bond yields as they shift out of their internal hedge funds and to be very careful picking their external hedge funds and private equity funds (I'd love to be a fly on the wall in those meetings!).

Below, Bloomberg reports on why Harvard's new fund manager is copying Yale, farming out money, ending on this sobering note: 
Mark Williams, a Boston University executive-in residence who specializes in risk management, said the moves mark the end of a long, painful realization that its strategy was failing, a capitulation he considered “long overdue."

Williams said the move will mark an opportunity for outside managers eager to oversee funds for such a prestigious client: "It’s going to be a bonanza for those money shops.”
That's what worries me, a bunch of hedge funds and other asset managers lining up at Harvard's door begging for an allocation, looking for more fees. But I trust Narvekar and his senior team will weed out a lot of them. For the rest of you, pay attention to what is going on at Harvard, it might be part of your future plans.

Wednesday, January 25, 2017

Canada Has No Private Equity Game?

Tawfik Hammoud and Vinay Shandal of BCG recently wrote an op-ed for the Globe and Mail, Canada needs to work on its private-equity game:
When you look at who attended last week’s World Economic Forum in Davos, it’s striking how many are global investors or work for large funds – and in particular, private-equity firms.

The question Canadians should be asking themselves is, how do we ensure that Canada receives its fair share of the trillions of dollars deployed by global investment funds, including real estate, infrastructure, venture capital and private equity? How can our entrepreneurs and company owners benefit from this growth capital and the opportunities that come with it?

How can we create an investment ecosystem that gives rise to more Canadian investment firms led by top professionals?

The global investors who gathered in Davos, Switzerland, have much to be thankful for. Business is thriving and the various private asset classes’ performance keeps pumping up demand, especially relative to fixed income and public equities. Take private equity, for example: 94 per cent of investors in a recent survey count themselves satisfied with the returns, and more than 85 per cent say they intend to commit more or the same amount of capital to private equity next year. As a result, the capital flowing into private equity is unprecedented, established firms are raising record amounts of money and fund oversubscription is common.

More than 600 new private-equity funds were created last year alone and the industry is holding $1.3-trillion (U.S.) of “dry powder,” or uninvested capital, that is sitting on the sidelines waiting to be invested. While the merits and operating model of private equity can and should be debated (as they were when former private-equity man Mitt Romney ran for president in the 2012 U.S. election), there is no denying its growing importance in many economies. Carlyle Group and Kohlberg Kravis Roberts & Co. (and their portfolio companies) employ more people than any other U.S. public company outside of Wal-Mart Stores Inc.

The sector’s roaring success might also be the biggest risk to its future. There might be such a thing as too much money, after all.

A swath of new entrants is pouring into private assets, searching for yield in a world of low interest rates. Chinese, Middle Eastern and other emerging markets investors are on the rise and have quadrupled their outbound investment over the past few years. Sovereign wealth funds, pension plans, insurance companies and even some mutual funds are allocating money to the private markets and borrowing from their playbooks. So much money chasing a limited number of opportunities has pushed prices up: historically high multiples combined with lower levels of leverage are putting pressure on returns. Private-equity deal multiples, for example, have exceeded the peaks last seen in 2006-07 for larger transactions (deals above $500-million) and deals above $250-million are also flirting with these highs. But most indicators still point to a favourable outlook as long as the credit markets remain fluid and fund managers continue to create value during their ownership period.

Canadian pension funds, many of which were present at Davos, are increasingly active in this crowded field. They have invested time and money to develop direct capabilities and increasingly stronger investment teams. In many regards, they are years ahead of their peers around the world. However, outside of our pension funds and a few select local firms, Canada tends to punch under its weight. We lack the kind of developed investment ecosystems that are thriving in other countries. As an example, the United States has 24 times more private-equity funds than Canada and has raised nearly 40 times more capital over the past 10 years.

The point is broader: Canada should be attracting more foreign direct investment, including money from global investment firms. FDI in Canada has grown by just 2 per cent a year since 2005, compared with an average of 7 per cent for all OECD countries and 8 per cent for Australia. As a percentage of GDP, Canada still sits in the middle of pack of OECD countries, but 30 per cent of that investment is driven by mining and oil and gas and is heavily skewed to M&A as opposed to greenfield investment (relative to other countries).

Something doesn’t add up. Canada is a great place to put money to work. We are a country with low political risk, competitive corporate taxes, an educated and diverse labour force, liquid public markets and a real need for infrastructure investments. Yet, we are net exporters of capital: foreign investors are often not finding Canadian opportunities as attractive as they should.

For all the criticism the investment industry sometimes faces, it would be a real miss if we failed to show long-term, growth-minded investors that Canada is an attractive place to put their money to work. We want global investors writing cheques for stakes in Canadian companies, so they can help improve their productivity, invest in technology, create new jobs, and grow global champions in many industries. If investors don’t hear our compelling story, Canada and many of its companies could be left on the sidelines as they watch all this dry powder get deployed in other markets.
This is an excellent op-ed, one that I want all of you to read carefully and share with your industry contacts. The last time I saw Tawfik Hammoud of BCG is when we worked together on a consulting mandate for the Caisse on sovereign debt risks (back in 2011). He is now the global head of BCG’s Principal Investors & Private Equity practice and is based in Toronto (all of BCG's team are very nice and bright people, enjoyed working with them).

So, what's this article all about and why is it important enough to cover on my blog?  Well, I've been short Canada and the loonie since December 2013, moved all my money to the US and never looked back. I know, Canadian banks did well last year but investing in the Canadian stock market is a joke, it's basically composed of three sectors: financials, telecoms and energy.

Ok, now we're in January 2017, the Bank of Canada recently "surprised" markets (no surprise to me or my buddy running a currency hedge fund in Toronto) by stating they are on guard and ready to lower rates if the economic outlook deteriorates, sending the loonie tumbling to about 75 cents US (it now stands at 76 cents US).

You would think global investors, especially large US investors, would be taking advantage of our relatively cheap currency to pounce on Canadian public and private assets.

Unfortunately, it doesn't work that way. Canada isn't exactly a hotbed of private equity activity. Yes, our large Canadian public pensions invest in private equity, mostly through funds and co-investments and a bit of purely direct investments, but the geographic focus remains primarily in the United States, the UK, Europe and increasingly in Asia and Latin America.

Sure, we have great private equity companies in Canada like Brookfield Asset Management (BAM), our answer to Blackstone (BX), the US private equity powerhouse, but even Brookfield focuses mostly outside Canada for its largest private equity transactions.

So why? Why is Canada's private equity industry under-developed and why are global and domestic private equity powerhouses basically shunning our economy, especially now that the loonie is much cheaper than it was a few years ago?

The article above cites Canada's stable political climate, competitive corporate tax rate and diverse and highly educated workforce but I think when it comes to real entrepreneurial opportunities, Canada lags far behind the United States and other countries.

Now, we can argue that maybe Canada's large pensions should do more to invest in and even incubate more domestic private equity funds (they already do some) but the job of Canada's pension fund managers isn't to incubate domestic private equity funds or hedge funds, it's to maximize returns taking the least risk possible by investing across global public and private markets.

Only the Caisse has a dual mandate of investing part of its assets in Quebec's public and private markets and we can argue whether this is in the best interests of its beneficiaries over the long run (the Caisse will talk up its successes but I'm highly skeptical and think Quebec pensioners would have been better off if that money was invested across global markets, not Quebec).

In my opinion, the biggest problem in Canada is the culture of defeatism and government over-taxation (on individuals) and over-regulation of industries. At the risk of sounding crazy to some of you tree hugging left-wing liberals, Canada needs a Donald Trump which will cut out huge government waste and insane regulations across the financial and other industries, many of which are nothing more than a government backed oligopoly charging Canadians insane fees (look at banks, mutual funds and telcom fees and tell me we don't need a lot more competition here).

My close buddies reading this will laugh as they recently blasted me for voting Liberal in the last election. Yes, I too voted for "boy wonder" mostly because I was sick and tired of Harper's arrogance but Trudeau junior's ineptitude, inexperience and recent comments on Alberta's tar sands and ridiculous and needless cross country tour just pissed me off enough so I will be returning to my conservative economic roots during the next election even if O'Leary wins that party's leadership race (love him on Shark Tank, not so sure how he would be as our PM).

Politics aside, we need to ask ourselves very tough questions in Canada and across all provinces because it's been my contention all along that far too many Canadians are living in a Northern bubble, erroneously believing that we can afford generous social programs forever. Canadians are in for one rude awakening in the not too distant future.

What else pisses me off about Canada? Unlike the United States where the best of the best rise to the top regardless of the color their skin, gender, sexual orientation, religious beliefs and disabilities, there is a pervasive institutionalized racism that is seriously setting this country back years, if not decades (you can disagree with me but I'm not going to be politically correct to assuage your hurt feelings, Canada lacks real diversity at all levels of major public and private organizations).

So, before Canada can rightfully argue that it deserves a bigger chunk of the global private equity pie, we need to reexamine a lot of things in this country on the social, cultural and economic front, because the way I see it, we're not headed in the right direction and have not created the right conditions to attract foreign investment from top global private equity funds.

As always, these are my opinions, you have every right to disagree with me but I'm not budging one iota and I can back up everything I've written above with concrete facts, not fake news.

Below, take the time to listen once again to Ron Mock and Michael Sabia at Davos. These are two very smart and hard working pension fund leaders who expressed great points at these interviews.

Tuesday, January 24, 2017

Elite Hedge Funds Shafting Clients on Fees?

Lawrence Delevingne of Reuters reports, Struggling hedge funds still expense bonuses, bar tabs:
Investors are starting to sour on the idea of reimbursing hedge funds for multi-million dollar trader bonuses, lavish marketing dinners and trophy office space.

Powerful firms such as Citadel LLC and Millennium Management LLC charge clients for such costs through so-called "pass-through" fees, which can include everything from a new hire's deferred compensation to travel to high-end technology.

It all adds up: investors often end up paying more than double the industry's standard fees of 2 percent of assets and 20 percent of investment gains, which many already consider too high.

Investors have for years tolerated pass-through charges because of high net returns, but weak performance lately is testing their patience.

Clients of losing funds last year, including those managed by Blackstone Group LP's (BX.N) Senfina Advisors LLC, Folger Hill Asset Management LP and Balyasny Asset Management LP, likely still paid fees far higher than 2 percent of assets.

Clients of shops that made money, including Paloma Partners and Hutchin Hill Capital LP, were left with returns of less than 5 percent partly because of a draining combination of pass-through and performance fees.

For a graphic on the hedge funds that passed through low returns, click on image below:

Millennium, the $34 billion New York firm led by billionaire Israel Englander, charged clients its usual fees of 5 or 6 percent of assets and 20 percent of gains in 2016, according to a person familiar with the situation. The charges left investors in Millennium's flagship fund with a net return of just 3.3 percent.

Citadel, the $26 billion Chicago firm led by billionaire Kenneth Griffin, charged pass-through fees that added up to about 5.3 percent in 2015 and 6.3 percent in 2014, according to another person familiar with the situation. Charges for 2016 were not finalized, but the costs typically add up to between 5 and 10 percent of assets, separate from the 20 percent performance fee Citadel typically charges.

Citadel's flagship fund returned 5 percent in 2016, far below its 19.5 percent annual average since 1990, according to the source who, like others, spoke on the condition of anonymity because the information is private.

All firms mentioned declined to comment or did not respond to requests for comment.

In 2014, consulting firm Cambridge Associates studied fees charged by multi-manager funds, which deploy various investment strategies using small teams and often include pass-throughs. Their clients lose 33 percent of profits to fees, on average, Cambridge found.

The report by research consultant Tomas Kmetko noted such funds would need to generate gross returns of roughly 19 percent to deliver a 10 percent net profit to clients.


Defenders of pass-throughs said the fees were necessary to keep elite talent and provide traders with top technology. They said that firm executives were often among the largest investors in their funds and pay the same fees as clients.

But frustration is starting to show.

A 2016 survey by consulting firm EY found that 95 percent of investors prefer no pass-through expense. The report also said fewer investors support various types of pass-through fees than in the past.

"It's stunning to me to think you would pay more than 2 percent," said Marc Levine, chairman of the Illinois State Board of Investment, which has reduced its use of hedge funds. "That creates a huge hurdle to have the right alignment of interests."

Investors pulled $11.5 billion from multi-strategy funds in 2016 after three consecutive years of net additions, according to data tracker eVestment. Redemptions for firms that use pass-through fees were not available.

Even with pass-through fees, firms like Citadel, Millennium and Paloma have produced double-digit net returns over the long-term. The Cambridge study also found that multi-manager funds generally performed better and with lower volatility than a global stock index.

"High fees and expenses are hard to stomach, particularly in a low-return environment, but it's all about the net," said Michael Hennessy, co-founder of hedge fund investment firm Morgan Creek Capital Management.


Citadel has used pass-through fees for an unusual purpose: developing intellectual property.

The firm relied partly on client fees to build an internal administration business starting in 2007. But only Citadel's owners, including Griffin, benefited from the 2011 sale of the unit, Omnium LLC, to Northern Trust Corp for $100 million, plus $60 million or so in subsequent profit-sharing, two people familiar with the situation said.

Citadel noted in a 2016 U.S. Securities and Exchange Commission filing that some pass-through expenses are still used to develop intellectual property, the extent of which was unclear. Besides hedge funds, Citadel's other business lines include Citadel Securities LLC, the powerful market-maker, and Citadel Technology LLC, a small portfolio management software provider.

Some Citadel hedge fund investors and advisers to them told Reuters they were unhappy about the firm charging clients to build technology whose profits Citadel alone will enjoy. "It's really against the spirit of a partnership," said one.

A spokesman for Citadel declined to comment.

A person familiar with the situation noted that Citadel put tens of millions of dollars into the businesses and disclosed to clients that only Citadel would benefit from related revenues. The person also noted Citadel's high marks from an investor survey by industry publication Alpha for alignment of interests and independent oversight.

Gordon Barnes, global head of due diligence at Cambridge, said few hedge fund managers charge their investors for services provided by affiliates because of various problems it can cause.

"Even with the right legal disclosures, it rarely passes a basic fairness test," Barnes said, declining to comment on any individual firm. "These arrangements tend to favor the manager's interests."
Interestingly, Zero Hedge recently reported that Citadel just paid a $22 million settlement for front-running its clients (great alignment of interests!). Chump change for Ken Griffin, one of the richest hedge fund managers alive and part of a handful of elite hedge fund managers in the world who are highly regarded among institutional investors.

But the good fat hedge fund years are coming to an abrupt end. Fed up with mediocre returns and outrageous fees, institutional investors are finally starting to drill down on performance and fees and asking themselves whether hedge funds -- even "elite hedge funds" -- are worth the trouble.

I know, everybody invests in a handful of hedge funds and Citadel, Millennium, Paloma and other 'elite' multi-strategy hedge funds figure prominently in the hedge fund portfolios of big pensions and sovereign wealth funds. All the more reason to cut this nonsense on fees and finally put and end to outrageous gouging, especially in a low return, low interest rate world.

"Yeah but Leo, it's Ken Griffin and Izzy Englander, two of the best hedge fund managers alive!" So what? I don't care if it's Ken Griffin, Izzy Englander, Ray Dalio, Steve Cohen, Jim Simons, or even if George Soros started taking money from institutional investors, nonsense is nonsense and I will call it out each and every time!

Because trust me, smart pensions and sovereign wealth funds aren't stupid. They see this nonsense and are hotly debating their allocations to hedge funds and whether they want to be part of the herd getting gouged on pass-through and other creative fees.

Listen to Michael Sabia's interview in Davos at the end of my last comment. Notice how he deliberately avoided a discussion on hedge funds when asked about investing in them? All he said was "not hedge funds". The Caisse has significantly curtailed its investments in external hedge funds. Why? Because, as Sabia states, they prefer focusing their attention on long-term illiquid alternatives, primarily infrastructure and real estate, which can provide them with stable yields over the long run without all the headline risk of hedge funds that quite frankly aren't delivering what they are suppose to deliver -- uncorrelated alpha under all market conditions!!

Now, is investing in infrastructure and real estate the solution for everyone? Of course not. Prices have been bid up, deals are very expensive and as Ron Mock stated in Davos, "you have to dig five times harder" to find good deals that really make sense in illiquid private alternatives.

And if my long-term forecast of global deflation materializes, all asset classes, including illiquid alternatives, are going to get roiled. Only good old US Treasuries are going to save your portfolio from getting clobbered, the one asset class that most institutional investors are avoiding as 'Trumponomics' arrives (dumb move, it's not the beginning of the end for bonds!).

By the way, I know Ontario Teachers' Pension Plan still invests heavily in hedge funds but I would be surprised if their due diligence/ finance operations people would let any hedge fund pass through dubious fees on to their teachers. In fact, OTPP has set up a managed account platform at Inncocap to closely monitor all trading activity and operational risks of their external hedge funds.

Other large institutional investors in hedge funds, like Texas Teachers' Retirement System (TRS), are tinkering with a new fee structure to get better alignment of interests with their external hedge funds. Imogen Rose-Smith of Institutional Investor reports, New Fee Structure Offers Hope to Besieged Hedge Funds (click on image):

You can read the rest of this article here. According to the article, TRS invests in 30 hedge funds and the plan has not disclosed how it will apply this new fee structure.

I think the new fee structure is a step in the right direction but if you ask me, I would get rid of the management fee for all hedge funds managing in excess of a billion dollars and leave the 20 percent performance fee (keep the management fee only for small emerging hedge fund managers that need it).

"But Leo, I'm an elite hedge fund manager and my portfolio managers are expensive, rent costs me a lot of money, not to mention my lifestyle and my wife who loves shopping at expensive boutiques in Paris, London, and New York and needs expensive cosmetic surgery to stay youthful and look good as we keep up with the billionaire socialites."

Boo-Hoo! Cry me a river! Life is tough for all you struggling hedge fund managers charging pass-through fees to enjoy your billion dollar lifestyles? Let me take out the world's smallest violin because if I had a dollar for all the lame, pathetic excuses hedge fund managers have thrown my way to justify their outrageous fees and mediocre returns, I'd be managing a multi-billion dollar global macro fund myself!

If you're an elite hedge fund manager and are really as good as you claim, stop charging clients 2% to cover your fixed costs, focus on performance and delivering real alpha in all market environments, not on marketing and asset gathering (so you can collect more on that 2% management fee and become a big fat, lazy asset gatherer charging clients alpha fees for leveraged beta!).

I'm tired of hedge funds and private equity funds charging clients a bundle on fees, including management fees on billions, pass-through fees and a bunch of other hidden fees. And trust me, I'm not alone, a lot of smart institutional investors are finally putting the screws on hedge funds and private equity funds, telling them to shape up or ship out (it's about time they smarten up).

Unfortunately, for every one large, smart institutional investor there are one hundred smaller, dumber public pension plans who literally have no clue what's going on with their hedge funds and private equity funds. Case in point, the debacle at Dallas Police and Fire Pension System which I covered last week.

I'm convinced they still don't know all the shenanigans that went on there and I bet you a lot of large and small US public pensions are in the same boat and petrified as to what will happen when fraud, corruption and outright gross incompetence are uncovered at their plans.

For all of you worried about your hedge funds and private equity funds, get in touch with my friends over at Phocion Investment Services in Montreal and let them drill down and do a comprehensive risk, investment, performance and operational due diligence on all your investments, not just in alternatives.

What's that? You already use a "well-known consultant" providing you cookie cutter templates covering operational and investment risks at your hedge funds and private equity funds? Good luck with that approach, you deserve what's coming to you.

On that note, I don't get paid enough to provide you with my unadulterated, brutally honest, hard-hitting comments on pensions and investments. Unlike hedge funds and private equity funds charging you outrageous fees, I need to eat what I kill by trading and while I love writing these comments, it takes time away from what I truly love, analyzing markets and looking for great swing trading opportunities in bonds, biotech, tech and other sectors.

Please take the time to show your financial appreciation for all the work that goes into writing these comments by donating or subscribing to this blog on the top right-hand side under my beautiful mug shot. You simply won't read better comments on pensions and investments anywhere else (you will read a bunch of washed down, 'sanitized' nonsense, however).

Below, Peter Laurelli, eVestment, talks about last year's record outflow of money from hedge funds and the likelihood it will return. Not likely but never underestimate the stupidity of the pension herd.