Tuesday, February 28, 2017

Buffett Baffled by 30-Year Bonds?

Matthew J. Belvedere of CNBC reports, Why anyone would buy a 30-year bond 'absolutely baffles me,' Warren Buffett says:
Billionaire investor Warren Buffett told CNBC he can't see any reason for investors to buy 30-year bonds right now.

"It absolutely baffles me who buys a 30-year bond, the chairman and CEO of Berkshire Hathaway said on "Squawk Box" on Monday. "I just don't understand it."

"The idea of committing your money at roughly 3 percent for 30 years ... doesn't make any sense to me," he added.

Buffett said he wants his money in companies, not Treasurys — making the case throughout CNBC's three-hour interview that he sees stocks outperforming fixed income.
Buffett has a lot to say this time of year. In his widely read annual letter to shareholders of his Berkshire Hathaway holding company, the Oracle of Omaha blasted hedge funds and their high fees and urged average investors to buy regular index funds instead of trying to chase the next hot sector or plow their life savings into high-fee hedge funds:
"When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients," said Buffett's letter.

"The problem simply is that the great majority of managers who attempt to overperform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well," Buffett wrote.

"Both large and small investors should stick with low-cost index funds," he added.
Buffett is right, the bulk of hedge funds charge high fees and deliver mediocre returns over the long run. And there are plenty of glorified hedge fund asset gathers out there charging alpha fees for low-cost beta returns.

Moreover, in my latest top funds' quarterly activity report, I discussed how Buffett took some of these young hedge fund titans to school and bought Apple shares in the last quarter of 2016 and even more this year, making a lot of money and effectively making him a huge owner of the company.

But what he neglects to say is there are elite hedge funds, some of which are shafting clients on fees, with a long, outstanding track record of consistently delivering great risk-adjusted returns. Some of these elite hedge funds are super quants taking over the world while others are top stock pickers or global macro funds speculating billions on economic trends.

Buffett may not agree with their approach or fee structure -- and some of these elite hedge funds are cutting their fees while others are changing their fee structure to get better alignment of interests -- but they have been around for a long time and institutions looking for the best risk-adjusted returns will keep plowing billions into them.

Interestingly, in his annual letter, Buffett praised Jack Bogle, the founder of the Vanguard Group, for transforming investing forever with the index fund:
"If a statue is ever erected to honor the person who has done the most for American investors, the hands- down choice should be Jack Bogle," Buffett writes, adding:

"For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value.

"In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me."
No doubt, Jack Bogle is an investment pioneer. He is not as filthy stinking rich as most mutual fund or hedge fund giants and he doesn't command the respect of a Buffett or Soros, but Jack Bogle is arguably the most important man in investing and I highly recommend you read his books and follow his 4 rules of investing.

[Note: Other investing books I highly recommend are William Bernstein's The Four Pillars of Investing and The Intelligent Asset Allocator, Marc Litchenfeld's Get Rich With Dividends and my favorite, Peter Lynch's One Up on Wall Street.]

But what worries me is that too much of a good thing may turn out terribly wrong.

In particular, I openly worry that we have moved from a George Soros hedge fund "alpha" bubble to a Warren Buffett - Jack Bogle "beta" bubble and now we have a bunch of investors, including large hedge funds and robo-advisors, plowing trillions into low-cost index funds erroneously thinking there are diversifying risk when in reality they are taking part and adding to systemic risk.

"Huh? You're losing me. I understand Buffett, Bogle and hedge funds charging high fees for lousy returns but I don't understand all this talk of a beta bubble and systemic risk."

Ok, let me explain. A long time ago, there was a great economist, Paul Samuelson, who fretted the day everyone starts following Burton Malkiel's advice in A Random Walk on Wall Street (another Bogel disciple).

In particular, when everyone starts doing the same thing, they might not realize it, but they're contributing to a trend which taken to its limits, can cause serious systemic failures. The subprime mortgage crisis which led to the 2008 meltdown is an obvious example of this, but some trends are more stealth in nature, take a much longer time to develop, and by the time you realize it, it's too late.

I mention this because there are important cyclical and structural trends going on in the global economy, trends that will forever reshape the global labor market. 

Last Monday when I discussed how CPPIB is helping to fix China's pension future, I brought some of these worrying trends up:
[..] bolstering pensions is critically important all over the world, not just China. A friend of mine is in town from San Francisco this long US weekend and we had an interesting discussion on technological disruption going on in Silicon Valley and all over the United States.

My friend, a senior VP at a top software company, knows all about this topic. He told me flat out that in 20 years "there will be over 100 million people unemployed in the US" as computers take over jobs -- including lawyers and doctors -- and make other jobs obsolete at a frightening and alarming rate (Mark Cuban also thinks robots will cause mass unemployment and Bill Gates recently recommended that robots who took over human jobs should pay taxes).

"It's already happening now and for years I've been warning many software engineers to evolve or risk losing their job. Most didn't listen to me and they lost their job" (however, he doesn't buy the "nonsense" of hedge fund quants taking over the world. Told me flat out: "If people only knew the truth about these algorithms and their limitations, they wouldn't be as enamored by them").

He agreed with me that rising inequality is hampering aggregate demand and will ensure deflation for a long time, but he has a more cynical view of things. "Peter Thiel, Trump's tech pal, is pure evil. He wants to cut Social Security and Medicare and have all these people die and just allow highly trained engineers from all over the world come to the US to replace them."
Well, there is no way President Trump will touch Social Security and Medicare but that comment of mine elicited this response from an informed reader:
The US and EU are facing the same [pension] problem, and that has much to do with why the global elites are so big on immigration. The Davos crowd know that unless there's a large influx of immigrants to pick up the slack in payroll taxes, the govt. is going to come after the elites because global wealth is overly concentrated among the elites, the vulgar masses haven't got anything to tax.

In the US, the top 20% of the population controls 93% of the wealth. Small wonder the global elites have $30 trillion+ socked away in tax havens. Greed will always be a part of the human condition. If I had their money, I'd probably be doing the same thing, nobody enjoys paying taxes.

Their plan won't work because AI, technology and continued offshoring of jobs are going to put many more millions of people out of work in the coming future.

Buffett and Gates were interviewed in late January by Charlie Rose, and Buffett stated that these people that are displaced by technology, and are 55+ years old (read: too old to be re-educated), they need to be "taken care of". By who? I assume Buffett means the US government because Buffett shuttered the Dexter Shoe Co. plant in Dexter, ME in 2003 putting 1500 employees out of work. The workers were told on a Thursday morning that Friday (the next day) was to be their last day of work. I've heard on good authority (The CEO of another shoe Co. in Dexter, ME, Maine Sole) that only the top 35 employees received any compensation upon being terminated.

Buffett, Gates and their ilk have so much of their wealth socked away in tax free foundations, where is the money going to come from to take care of these displaced workers?
He added:
I see in the not too distant future the elites in the US putting excess pressure on Congress to reform entitlements (Medicare and Social Security), because these are unfunded liabilities that if you were to properly account for them like they do the $20 trillion national debt, total US debt would exceed $100 trillion. Let's just say it's a national shit sandwich that only the elites can afford to eat, but obviously don't want to.
But even after blasting Buffett, Gates and their ilk, this person admitted to me that Berkshire Hathaway shares (BRK-B) are his largest holdings (good move!).

In terms of Buffett and bonds, this person shared this with me:
Buffett isn't so much a top down Macro investor as he is a bottom up investor.

Bonds and stocks are one and the same to him, in that his perception of a 10 year US Treasury bond is that it's no different than the stock of a Co. with a 10 year life and a constant earnings yield of 2.5%, which to him means the instrument has a P/E of 40 (1/40 = 2.5% yield). There's no way he's going to pay 40 times earnings for something with zero growth potential when he can buy common stocks with reasonably predictable growing earning streams at much lower multiples, which makes sense.

How does he handle the specter of deflation? I suppose he looks at it as a constant battle between deflation and inflation. To protect himself against inflation, he buys hard assets like his railroad and the utilities. For deflation, he's always sitting on a ton of cash (currently $85 billion), so if the market takes a hit, he's got the cash to take advantage of crazy deflated prices. It's the best of both worlds. Carnegie and Frick ran Bethlehem Steel in a similar fashion. They always bought state-of-the-art technology to ensure they were always the low cost commodity producer, and they made sure they were always cash rich because they knew downturns were inevitable and they would always have the cash on hand to buy up a competitor on the cheap.

Your friend's estimate that there will be 100 million people unemployed in the US in 20 years. By my back-of-the-envelope calculations, we could easily be close to that today. The US is in dire need of some sort of GI Bill like there was post-WW2 and Korea. When it was announced in 1944, it wasn't meant to be some sort of perk/reward for returning vets. It wasn't from the goodness of his heart that FDR created the GI Bill, it was because there was a great fear that the economy would slip back into a depression given that the war economy would shut down and you suddenly had an influx of returning vets into an already crowded labor pool. The GI Bill was to reduce competition in the labor force by keep these men off the market; you could almost describe it as a form of "hidden unemployment".

That said, the GI Bill turned out to be a blessing because it was an agent of meritocracy for these returning vets who took advantage of it. Both my father and a brother became doctors courtesy of the Canadian GI Bill, while another brother became a Chemical Engineer (MIT) courtesy of the US GI Bill (Korea). If the US could re-create a modern day version of the GI Bill to give people in need of employment some marketable skills for today's economy, I have no doubt it would be a blessing that would pay huge dividends to the economy going forward.
I don't know about a GI Bill but I have long warned people the pension Titanic is sinking and that these six structural factors will ensure a long deflationary period, something Warren Buffeet will likely not experience but Bill Gates will:
  • The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full-time jobs with good wages and benefits are being replaced with part-time jobs with low wages and no benefits.
  • Demographics: The aging of the population isn't pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
  • The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. It's not just the demographic shift, as people retire with little or no savings, they consume less, governments collect less sales taxes and they pay out more in social welfare costs. This is why I'm such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
  • Rising inequality: Rising inequality is threatening the global recovery. As Warren Buffett once noted, the marginal utility of an extra billion to the ultra wealthy isn't as useful as it can be to millions of others struggling under crushing poverty. But while Buffett and Gates talk up "The Giving Pledge", the truth is philanthropy won't make a dent in the trend of rising inequality which is extremely deflationary because it concentrates wealth in the hands of a few and does nothing to stimulate widespread consumption.
  • High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary.
  • Technology: Everyone loves shopping on-line to hunt for bargains. Technology is great in terms of keeping productivity high and prices low, but viewed over a very long period, great shifts in technology are disinflationary and some say deflationary (think Amazon, Uber, etc.).
This brings me to an important point, the question Warren Buffett asked at the top of this comment, who in their right mind would buy a 30-year bond?

Well, in turns out a lot of pensions and insurance companies managing assets and liabilities are buying these long bonds. And if the US Treasury starts issuing 50 or 100-year bonds, I suspect many pensions will snap those up too, just like they did in Canada.

[Note: One president of a large Canadian pension plan told me they would buy 50-year US bonds, not the 100-year ones because their liability stream doesn't go out that far.]

In my outlook 2017 earlier this year, I warned my readers to ignore the reflation chimera and prepare for some fireworks later this year. I just don't buy that it's the beginning of the end for bonds, not by a long shot.

I also agree with François Trahan of Cornerstone Macro, investors better prepare for a bear market ahead, but I think his timing is a bit off as there is still plenty of liquidity to drive risk assets higher.

Interestingly, hedge fund titan David Tepper agrees with Buffett, he's still long stocks and still short bonds:
Billionaire hedge fund manager David Tepper told CNBC on Monday he remains bullish on the stock market rally.

"Still long stocks. Still short bonds," Tepper told CNBC's Scott Wapner.

The founder of Appaloosa Management said: "Why are stocks and bonds acting differently? It's as if they're reacting to two different economies."

Since the election, bond prices have been falling, and bond yields have been rising. Stock prices, meanwhile, have been hitting new highs.

But more recently, as of mid-February, bond prices and stock prices have been moving higher together again.

Tepper also asked: "Could be there's too much monetary policy still around the globe? Reaction in markets suggests it's affecting the bond market more."

After Friday's late comeback, the Dow Jones industrial average was riding an 11-day win streak for the first time since 1992, with 11 record closes in a row for the first time since 1987.

Tepper's comments come on the same day as another billionaire investor, Warren Buffett, talked up stocks and bashed bonds.

U.S. stock prices are "on the cheap side" with interest rates at current levels, Buffett told CNBC's "Squawk Box" on Monday morning.

The Berkshire Hathaway chief also said: "It absolutely baffles me who buys a 30-year bond. I just don't understand it."
All these billionaires bashing bonds should read my comments more often because if Buffett feels like he got his head handed to him on Walmart, he will really be kicking himself next year for not buying the 30-year bond at these levels.

Given my views on the reflation chimera and US dollar crisis, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE)  and Financial (XLF) shares on any strength here (book your profits while you still can). The only sector I like and trade now, and it's very volatile, is biotech (XBI) and technology (XLK) is doing well, for now. If you want to sleep well, buy US long bonds (TLT) and thank me later this year.

On biotech, some of the stocks I told you are on my watch list when I went over top funds' Q4 activity are soaring since I wrote that comment (shares of La Jolla Pharmaceutical surged over 80% on Monday and shares of Kite Pharma are flying today, up 24%).

Simply put, I feel like the Rodney Dangerfield of pensions and investments, I get no respect and certainly don't get paid enough to share my wisdom but then again, I don't have Buffett, Soros, Tepper and Dalio's track record or their deep pockets.

Hope you enjoyed this comment, please remember to show your support by donating or subscribing to this blog at the top right-hand side under my picture via PayPal. I thank all of you who support my efforts and if you need to reach me, feel free to email me at LKolivakis@gmail.com.

Below, Warren Buffett told CNBC he can't see any reason for investors to buy 30-year bonds right now. "It absolutely baffles me who buys a 30-year bond, the chairman and CEO of Berkshire Hathaway said on "Squawk Box" on Monday. "I just don't understand it."

Buffett also said stocks could ‘go down 20% tomorrow,’ but we are not in ‘bubble territory’. I certainly hope he's right but as long as the passive (index) beta bubble winds keep blowing, it will get worse down the road. And if deflation strikes America, it's game over for a long, long time.

Also, billionaire hedge fund manager David Tepper told CNBC on Monday he remains bullish on the stock market rally. "Still long stocks. Still short bonds," Tepper told CNBC's Scott Wapner.

All these billionaires bashing bonds, hmm, where have I heard that before? Buffett and Tepper should stick to stocks and leave the bond calls to Gundlach, Gross, Dalio, Soros and me (lol).

Actually, we should all be listening to the bond market, because at the end of the day, nobody trumps the bond market and the move in Treasury yields signals something is about to give.

Monday, February 27, 2017

OMERS Gains 10.3% in 2016

Barbara Shecter of the National Post reports, OMERS investment returns surge 10% as net assets hit $85 billion:
OMERS, the pension plan for Ontario’s municipal employees, posted an investment return of 10.3 per cent for 2016, net of all expenses.

The return beat both the benchmark of 7.9 per cent and the previous year’s return of 6.7 per cent. Net assets grew to $85.2 billion, up $8.1 billion.

“Our strong investment returns in 2016 reflect the value of our well-diversified portfolio of high-quality assets, which we are continuously building,” said Michael Latimer, chief executive of OMERS. “All of our asset classes produced solid returns.”

One of Canada’s largest defined benefit pension plans, OMERS invests and administers pensions for more than 470,000 members from municipalities, school boards, emergency services and local agencies across Ontario.

The pension’s funded status improved last year for the fourth year in a row, increasing to 93.4 per cent. It was boosted by both the strong investment returns and member and employee contributions.

The OMERS portfolio includes investments in public markets, private equity, infrastructure and real estate.

Latimer said OMERS is content with a mix of 45 per cent private and 55 per cent public investments, adding that he feels no pressure to make investments in increasingly competitive sectors such as real estate and infrastructure where many pension, private equity and sovereign wealth funds are chasing the same assets.

Jonathan Simmons, the pension fund’s chief financial officer, said OMERS would be open to investing in infrastructure in Canada under the federal government’s ambitious plan, but only if certain conditions are met.

The projects would have to have scale, the pension fund would need to have governance rights over the asset, and there would have to be specific risk criteria, he said, adding that these specifications have been communicated to the government.

“These are political decisions that need to be made at the political level,” Simmons said.

OMERS executives said diversification will be the key to maintaining a sustainable pension in the current climate of geopolitical uncertainty.

This could involve selling assets in situations where valuations are high.

“We could sell into that markets place — crystallize real capital gains for the fund,” Latimer said.

OMERS executives also plan to continuing pushing into growth areas, such as funding small and medium-sized business loans. The fund’s credit book has grown to $15 billion from $9 billion.

Another large Canadian pension fund, the Caisse de depot et placement du Quebec, reported solid investment gains for 2016. On Friday, the Caisse disclosed a 7.6 per cent gain for the year ended Dec. 31.

Net investment results were $18.4 billion and net deposits totalled $4.3 billion. The fund’s assets totalled $270.7 billion at year end.
Jacqueline Nelson of the Globe and Mail also reports, OMERS mulls best approach for investing in emerging markets:
OMERS is looking to diversify its investments geographically after undergoing a retooling of its public-markets portfolio in the past year. The fund’s total returns got a boost from public market holdings, which produced a 9.5-per-cent return last year, up from just 0.7 per cent in 2015.

To achieve that, the fund reduced its investments in low-yielding government bonds, while boosting its stake in higher-yielding credit investments. It also zeroed in on stable individual stock investments that pay healthy dividends.

OMERS has also worked to spread its assets more evenly between public investments, which now make up 55 per cent of the portfolio, and private investments, which account for 45 per cent. Net assets grew by $8.1-billion in to $85.2-billion as of Dec. 31.

Private investments, including infrastructure, real estate and private equity produced a 12 per cent return in 2016, down from 14.5 per cent in 2015.

“There’s no question that the flow of capital into alternative asset classes continues,” Mr. Latimer said, adding he expects competitive conditions to persist.

OMERS, which manages assets and administers pensions for 470,000 Ontario employees and retirees, paid out $3.6-billion in monthly benefits last year.

The plan also continued to reduce its funding shortfall and is now 93.4 per cent funded as a result of investment returns and member and employer contributions, compared with 91.5 per cent the year before. In 2010, OMERS said it planned to eliminate the deficit by 2025 and this is the fourth consecutive year that the fund has moved towards closing the shortfall gap.
The most important thing OMERS has accomplished under the leadership of Michael Latimer is to reduce its pension deficit significantly.

This is by far the most important thing because as I've mentioned plenty of times, pensions are all about managing assets and liabilities, and some of the sharpest Canadian pension executives argue that funded status is a better measure of success.

I mention this at the top because the news media loves looking at headline figures and how OMERS  reached highest investment return in years, which is true, but it's more important to focus on OMERS's funded status.

Second, the media loves to compare returns of various large pensions in Canada as if they are comparing apples to apples. In his article on the Caisse on Friday, Radio-Canada's Gérald Fillion notes:
C’est vrai que le rendement pour 2016 peut paraître un peu décevant à 7,6 %. C’est une troisième année de baisse, la stratégie d’investissements en actions mondiales a déçu au cours de la dernière année, les obligations rapportent peu et la Caisse fait moins bien que le fonds ontarien OMERS, ce qui est assez rare.
For those of you who do not read French, he notes the overall returns of the Caisse have been falling as bonds bring in little gains and global stock returns disappoint and that the Caisse returned less than OMERS last year which is "rare".

Please repeat after me: "I don't care what AIMCo, bcIMC, OMERS, OTPP, HOOPP, CPPIB, PSP, and others returned relative to each other, it's meaningless." I know we are a society obsessed with making relative comparisons but in this case penis pension envy is just plain dumb.

Why? Well, for one, pensions are all about managing assets and liabilities so if OMERS gains 10% in 2016 and OTPP or HOOPP gained less last year, it doesn't matter because their funded status is better (it should be noted that unlike OTPP and HOOPP, OMERS guarantees inflation protection, and so does OPTrust).

Also, there are key differences in the asset allocation, leverage, F/X hedging policy, benchmarks used to evaluate underlying portfolios at all of Canada's large pensions. OTPP and HOOPP are allowed to use a lot more leverage -- which they use wisely -- than their counterparts. OMERS has a higher allocation to private markets than its counterparts.

What else? Some pensions are managing a lot more assets than others, some are more mature than others and they have different liabilities to contend with as they chart their investment strategy. And some pensions are plans, managing assets and liabilities (OMERS, OTPP, HOOPP, OPTrust, CAAT, etc) while others are pension funds managing assets only keeping liabilities in mind (AIMCo, bcIMC, Caisse, CPPIB, PSP).

In other words, stop comparing the performance of large Canadian pensions, it's just plain stupid because you are comparing apples to oranges. If you look at the clip of Michael Sabia speaking with Mutsumi Takahashi which I embedded in my last comment going over the Caisse's 2016 results, you'll see he tells her "we are focusing on hitting singles, not home runs".

[Note: I updated my last comment on the Caisse's 2016 results to correct some basis point figures I got wrong and added an interview with Macky Tall, executive vice president, infrastructure at Caisse and president and CEO of CDPQ Infra,which you can watch here.]

Back to OMERS, there is no question its 2016 results are excellent. The 2016 net investment return was 10.3% (after all expenses), compared to a benchmark of 7.9%, and a net return of 6.7% in 2015. Net assets grew $8.1 billion in 2016 to $85.2 billion.

Any time a pension beats its benchmark by 240 basis points (2.4%) on any given year and manages to reduce its funding shortfall (or increase its surplus), it's a great year.

You can read OMERS's press release here. The key message is this:
"2016 marks the fourth consecutive year that our funded status has improved," said Jonathan Simmons, Chief Financial Officer. "Good investment performance enabled us to strengthen our balance sheet. We have also reduced the discount rate on our pension obligations by five basis points."


"I am proud of the strong progress OMERS made in 2016 to deliver on our five-year strategy – the key objective being to ensure the long-term sustainability of the Plan for our members," said Mr. Latimer.
It's worth noting, as at December 31, 2015, OMERS maintained its real discount rate at 4.25%, but lowered the assumed future inflation from 2.25% to 2.00% to reflect updated long-term expectations for this assumption (see details here).

In the press release, OMERS breaks down the returns by asset class (click on image below):

As you can see, the mix between Public and Private markets is 55% to 45%, with the net return on Public markets being 9.5% and that in Private markets being 12%, giving an overall net return of 10.3% in 2016.

Within Private Markets, Private Equity delivered net gains of 12.6%, followed by Real Estate (12.4%) and Infrastructure (11%).

The 2016 Annual Report is not out yet (it will be here in roughly a month) but you can read OMERS's 2015 Annual Report which is available here.

From last year's Annual Report, I bring this to your attention the long-term returns (click on image):

Remember, for any pension, it's long-term returns that count most, not the returns on any given year.

What else did I notice from OMERS's 2015 Annual Report? They do not provide details on the benchmarks they use for each asset class (click on image):

Instead they say this: "We measure our performance against an absolute return benchmark, which is an absolute return based on operating plans approved with due regard for risk before or at the beginning of each year by OMERS Administration Corporation Board. Our goal is to earn stable returns for OMERS that equal or exceed these benchmarks."

Even OMERS latest statement of investment policies doesn't provide any details whatsoever on the benchmarks governing each investment portfolio, which is quite odd but I did find the same table from above on page 40 of last year's Annual Report with some more details in a footnote (click on image):

As you can see, in 2015, Real Estate and Infrastructure significantly outperformed their respective benchmarks. So, what are these benchmarks and are they accurately capturing the risks of the underlying portfolio?

Footnote 2 reads: "We measure our performance against an absolute return benchmark approved before or at the beginning of each year by the OAC Board. Our goal is to earn stable returns for OMERS that equal or exceed these benchmarks. Benchmarks are based on absolute return targets by asset class. The benchmark for the RCA Investment Fund is a weighted average blend of 5% FTSE TMX Canada 30-Day T-Bill + 23.75% S&P/TSX 60 Index + 23.75% MSCI EAFE Index + 47.50% MSCI USA All Cap Index."

Are you a bit confused? Yeah, so am I, but it's the way they measure things and I'm not saying it's wrong to have absolute return targets but your asset class benchmarks also need to reflect the risks of your underlying portfolios.

I mention this because in the Globe and Mail article above, Jacqueline Nelson notes:
OMERS is looking to diversify its investments geographically after undergoing a retooling of its public-markets portfolio in the past year. The fund’s total returns got a boost from public market holdings, which produced a 9.5-per-cent return last year, up from just 0.7 per cent in 2015.

To achieve that, the fund reduced its investments in low-yielding government bonds, while boosting its stake in higher-yielding credit investments. It also zeroed in on stable individual stock investments that pay healthy dividends.
So, similar to the Caisse, OMERS reduced its allocation to government bonds and increased credit risk, loading up on corporate debt, and allocated more to high dividend stocks.

That is all fine -- most bond managers take credit risk, not duration risk, to beat their benchmark -- but is it reflected in the benchmark they use to gauge the underlying portfolio? That is far from clear.

And this is important, because compensation is based on value added over the short and long-term (click on image; from 2015 Annual Report):

Anyways, I'm not going to get into a whole discussion on benchmarks, leverage, compensation and other things but it's important to really understand value added is not based on the same benchmarks across Canada's large pensions. Some of them have much harder benchmarks to beat than others.

Having said this, there is no question that OMERS delivered great returns in 2016. I reached out to Michael Latimer to have a chat with him but he declined my request. That's fine, he's a busy man.

Those of you who want to understand the change in OMERS's investment strategy in recent years should look at this April 2014 information session which is excellent and provides a lot of information.

I would suggest Mr. Latimer goes over my recent comment on the CFA Montreal lunch with PSP's André Bourbonnais as I think PSP's "platform approach" is the best way to expand globally and scale up relatively quickly across public and private markets (forget about opening offices around the world and staffing them, just find the right team, seed them with a huge cheque, you own 100% of the platform assets, and let them focus on performance and delivering the required returns).

What other advice can I give to Mr. Latimer? I had a discussion with Réal Desrochers, the head of CalPERS private equity on Friday and he told me "the money pouring into private equity from sovereign wealth funds is unbelievable." This just tells me returns in private equity (and other private asset classes) are coming down in the years ahead.

Below, Satish Rai, CIO of OMERS Public Markets talked with Bloomberg TV Canada's Amanda Lang back in November where he expressed interest in Trudeau's plan for a $35 billion infrastructure bank. But first, he discussed the biggest challenge for money managers these days, which is achieving return in this era of low yield. Great discussion, well worth listening to his views.

Friday, February 24, 2017

La Caisse Gains 7.6% in 2016

The Caisse de dépôt et placement du Québec today released its financial results for calendar year 2016, posting a 10.2% five-year annualized return:
La Caisse de dépôt et placement du Québec today released its financial results for the year ended December 31, 2016. The annualized weighted average return on its clients’ funds reached 10.2% over five years and 7.6% in 2016.

Net assets totalled $270.7 billion, increasing by $111.7 billion over five years, with net investment results of $100 billion and $11.7 billion in net deposits from its clients. In 2016, net investment results reached $18.4 billion and net deposits totalled $4.3 billion.

Over five years, the difference between la Caisse’s return and that of its benchmark portfolio represents more than $12.3 billion of value added for its clients. In 2016, the difference was equivalent to $4.4 billion of value added.

Caisse and benchmark portfolio returns

“Our strategy, focused on rigorous asset selection, continues to deliver solid results,” said Michael Sabia, President and Chief Executive Officer of la Caisse. “Over five years, despite substantially different market conditions from year to year, we generated an annualized return of 10.2%.”

“On the economic front, the fundamental issue remains the same: slow global growth, exacerbated by low business investment. At the same time, there are also significant geopolitical risks. Given the relative complacency of markets, we need to adopt a prudent approach.”

“However, taking a prudent approach does not mean inaction, because there are opportunities to be seized in this environment. Through our global exposure, our presence in Québec, and the rigour of our analyses and processes, we’re well-positioned to seize the best opportunities in the world and face any headwinds,” added Mr. Sabia.



The strategy that la Caisse has been implementing for seven years focuses on an absolute-return management approach in order to select the highest-quality securities and assets, based on fundamental analysis. La Caisse’s strategy also aims to enhance its exposure to global markets and strengthen its impact in Québec. The result is a well-diversified portfolio that generates value beyond the markets and brings long-term stability.

Bonds: performance in corporate credit stands out

The Bonds portfolio, totalling more than $68 billion, posted a 3.9% return over five years, higher than that of its benchmark. The difference is equivalent to value added of $1.6 billion. Securities of public and private companies and the active management of credit spreads in particular contributed to the portfolio’s return.

In 2016, despite an increase in interest rates at year-end, the portfolio posted a 3.1% return. It benefited from continued investment in growth market debt and from the solid performance of corporate debt, particularly in the industrial sector.

Public equity: sustained returns over five years and the Canadian market rebound in 2016

Over the five-year period, the annualized return of the entire Public Equity portfolio reached 14.1%. In addition to demonstrating solid market growth over the period, the return exceeded that of the benchmark, reflecting the portfolio’s broad diversification, its focus on quality securities and well-selected partners in growth markets. The Global Quality, Canada and Growth Markets mandates generated, respectively, annualized returns of 18.6%, 10.6% and 8.1%, creating $5.8 billion of value added.

For 2016, the 4.0% return on the Global Quality mandate reflects the depreciation of international currencies against the Canadian dollar. The mandate continued to be much less volatile than the market. The Canada mandate, with a 22.7% return, benefited from a robust Canadian market, driven by the recovery in oil and commodity prices and the financial sector’s solid performance, particularly in the second half of the year.

Less-liquid assets: globalization well underway and a solid performance

The three portfolios of less-liquid assets – Real Estate, Infrastructure and Private Equity – posted a 12.3% annualized return over five years, demonstrating solid and stable results over time. During this period, investments reached more than $60.1 billion. In 2016, $2.4 billion were invested in growth markets, including $1.3 billion in India, where growth prospects are favourable and structural reforms are well underway. The less-liquid asset portfolios are central to la Caisse’s globalization strategy, with their exposure outside Canada today reaching 70%.

More specifically, in Real Estate, Ivanhoé Cambridge invested $5.8 billion and its geographic and sector-based diversification strategy continued to perform. In the United States, the Caisse subsidiary acquired the remaining interests in 330 Hudson Street and 1211 Avenue of the Americas in New York and completed construction of the River Point office tower in Chicago. In the residential sector, the strategy in cities such as London, San Francisco and New York and the steady demand for residential rental properties generated solid returns. In Europe, Ivanhoé Cambridge and its partner TPG also completed the sale of P3 Logistic Parks, one of the largest real estate transactions on the continent in 2016. In Asia-Pacific, Ivanhoé Cambridge acquired an interest in the company LOGOS, its investment partner in the logistics sector, alongside which it continues to invest in Shanghai, Singapore and Melbourne.

In Private Equity, la Caisse invested $7.8 billion over the past year, in well-diversified markets and industries. Through the transactions carried out in 2016, la Caisse developed strategic partnerships with founders, families of entrepreneurs and operators that share its long-term vision. In the United States, it acquired a significant ownership stake in AlixPartners, a global advisory firm. La Caisse also acquired a 44% interest in the Australian insurance company Greenstone and invested in the European company Eurofins, a world leader in analytical laboratory testing of food, environmental and pharmaceutical products. In India, la Caisse became a partner of Edelweiss, a leader in stressed assets and specialized corporate credit. It also invested in TVS Logistics Services, an Indian multinational provider of third-party logistics services.

In Infrastructure, la Caisse partnered with DP World, one of the world’s largest port operators, to create a $5-billion investment platform intended for ports and terminals globally. The platform, in which la Caisse holds a 45% share, includes two Canadian container terminals located in Vancouver and Prince Rupert. In India’s energy sector, la Caisse acquired a 21% interest in Azure Power Global, one of India’s largest solar power producers. Over the year, la Caisse also strengthened its long-standing partnership with Australia’s Plenary Group by acquiring a 20% interest in the company. Together, la Caisse and Plenary Group have already invested in seven social infrastructure projects in Australia.

Impact in Québec: a focus on the private sector

In Québec, la Caisse focuses on the private sector, which drives economic growth. La Caisse’s strategy is built around three main priorities: growth and globalization, impactful projects, and innovation and the next generation.

Growth and globalization

In 2016, la Caisse worked closely with Groupe Marcelle’s management team when it acquired Lise Watier Cosmétiques to create the leading Canadian company in the beauty industry. It also supported Moment Factory’s creation of a new entity dedicated to permanent multimedia infrastructure projects, and worked with Lasik MD during an acquisition in the U.S. market. Furthermore, by providing Fix Auto with access to its networks, la Caisse facilitated Fix Auto’s expansion into China and Australia where the company now has around 100 body shops.

Impactful projects

In spring 2016, CDPQ Infra, a subsidiary of la Caisse, announced its integrated, electric public transit network project to link downtown Montréal, the South Shore, the West Island, the North Shore and the airport. Since then, several major steps have been completed on the Réseau électrique métropolitain (REM) project, with construction scheduled to begin in 2017.

In real estate, Ivanhoé Cambridge and its partner Claridge announced their intention to invest $100 million in real estate projects in the Greater Montréal area. La Caisse’s real estate subsidiary also continued with various construction and revitalization projects in Québec, including those underway at Carrefour de l’Estrie in Sherbrooke, Maison Manuvie and Fairmont The Queen Elizabeth hotel in Montréal, as well as at Place Ste-Foy and Quartier QB in Québec City.

Innovation and the next generation

In the new media industry, la Caisse made investments in Triotech, which designs, manufactures and markets rides based on a multi-sensorial experience; in Felix & Paul Studios, specialized in the creation of cinematic virtual reality experiences; and in Stingray, a leading multi-platform musical services provider. La Caisse also invested in Hopper, ranked among the top 10 mobile applications in the travel industry. Within the electric ecosystem, la Caisse reinvested in AddÉnergie to support the company’s deployment plan, aimed at adding 8,000 new charging stations across Canada in the next five years.

In the past five years, la Caisse’s new investments and commitments in Québec reached $13.7 billion, with $2.5 billion in 2016. These figures do not include the investment in Bombardier Transportation and the $3.1-billion planned commitment by la Caisse to carry out the REM project. As at December 31, Caisse assets in Québec totalled $58.8 billion, of which $36.9 billion were in the private sector, which is an increase in private assets compared to 2015.


La Caisse’s operating expenses, including external management fees, totalled $501 million in 2016. The ratio of expenses was 20.0 cents per $100 of average net assets, a level that compares favourably to that of its industry.

The credit rating agencies reaffirmed la Caisse’s investment-grade ratings with a stable outlook, namely AAA (DBRS), AAA (S&P) et Aaa (Moody’s).

Caisse de dépôt et placement du Québec (CDPQ) is a long-term institutional investor that manages funds primarily for public and parapublic pension and insurance plans. As at December 31, 2016, it held $270.7 billion in net assets. As one of Canada's leading institutional fund managers, CDPQ invests globally in major financial markets, private equity, infrastructure and real estate. For more information, visit cdpq.com, follow us on Twitter @LaCDPQ or consult our Facebook or LinkedIn pages.
You can view this press release and other attachments here at the bottom of the page. You can also read articles on the results here.

I think the overall results speak for themselves. The Caisse outperformed its benchmark by 180 basis points in 2016, and more importantly, 110 basis points over the last five years, generating $12.3 billion of value added over its benchmark for its clients.

There is no Annual Report available yet (comes out in April), but the Caisse provides returns for the specialized portfolios for 2016 and annualized five-year returns (click on image):

As you can see, Fixed Income generated 2.9% in 2016, beating its benchmark by 110 basis points, and 3.7% annualized over the last five years, 60 basis points over the benchmark.

The press release states:
The Bonds portfolio, totalling more than $68 billion, posted a 3.9% return over five years, higher than that of its benchmark. The difference is equivalent to value added of $1.6 billion. Securities of public and private companies and the active management of credit spreads in particular contributed to the portfolio’s return.

In 2016, despite an increase in interest rates at year-end, the portfolio posted a 3.1% return. It benefited from continued investment in growth market debt and from the solid performance of corporate debt, particularly in the industrial sector.
In other words, Bonds returned 3.1% or 140 basis points over its index, accounting for $1.6 billion of the $4.4 billion of value added in 2016, or 36% of the value added over the total fund's benchmark last year.

That is extremely impressive for a bond portfolio but I would be careful interpreting these results because they suggest the benchmark being used to evaluate the underlying portfolio doesn't reflect the credit risk being taken (ie. loading up on emerging market debt and corporate bonds and having a government bond index as a benchmark).

I mention this because this type of outperformance in bonds is unheard of unless of course the managers are gaming their benchmark by taking a lot more credit risk relative to that benchmark.

Also worth noting how the outperformance in real estate debt over the last year and five years helped the overall Fixed Income returns. Again, this is just taking on more credit risk to beat a benchmark and anyone managing a fixed income portfolio knows exactly what I am talking about.

It's also no secret the Caisse's Fixed Income team has been shorting long bonds over the last few years, and losing money on carry and rolldown, so maybe they decided to take on more emerging market and corporate debt risk to make up for these losses and that paid off handsomely. Also, the backup in US long bond yields last year also helped them if they were short.

Now, before I get Marc Cormier and the entire Fixed Income team at the Caisse hopping mad (don't want to get on anyone's bad side), I'm not saying these results are terrible -- far from it, they are excellent -- but let's call as spade a spade, the Caisse Fixed Income team took huge credit risk to outperform its benchmark last year, and this needs to be discussed in detail in the Annual Report when it comes out in April.

Going forward, the Caisse thinks the party is over for bonds:
Caisse de Depot et Placement du Quebec, Canada’s second-largest pension fund manager, is reducing its bond holdings and devoting more resources to corporate credit and real estate debt.

“The party is over, that’s why we are going to restructure this portfolio to lower investment in traditional bonds and increase and diversify our investment in credit,” Chief Executive Officer Michael Sabia said in Montreal Friday.

He said the Caisse will reduce the amount of fixed income in its portfolio and increase over the next few years the share of less liquid assets. The fixed-income portfolio will be broken into two portions: traditional fixed income -- federal and provincial Canadian bonds -- which will become “significantly smaller,” and another section based on credit, such as corporate credit and real estate debt, he said.

“We’re going to put more priority on building that portfolio because we think that can offer us still a relatively low level of risk but somewhat higher returns,” he said of the credit-focused plan. Investment in Canadian provincial and federal bonds will shrink “not dramatically, but bit by bit,” he said.
[Note: I like private debt as an asset class but disagree, it's not the beginning of the end for bonds]

Apart from Bonds, what else did I notice? Very briefly, excellent results in Real Estate, outperforming its benchmark by 320 basis in 2016. Over the last five years, however, Real Estate has slightly underperformed its benchmark by only 40 basis points.

Again, a word of caution for most people that do not understand how to read these results correctly. The benchmark the Caisse uses to evaluate its Real Estate portfolio is much harder to beat than any of its large peers in Canada.

I've said it before and I'll say it again, the Caisse's Real Estate subsidiary, Ivanhoé Cambridge, is doing a truly excellent job and it is one of the best real estate investors in the world.

As far as Infrastructure, CDPQ Infra marginally beat its benchmark in 2016 by 30 basis points, but it's trailing its benchmark by 250 basis points over the last five years.

Again, the benchmark in Infrastructure is very hard to beat (infrastructure benchmark has lots of beta in it which makes it much tougher to beat when markets are surging), so I don't worry about this underperformance over the last five years. Just like in Real Estate, the people working at CDPQ Infra are literally a breed apart, infrastructure experts in brownfield and greenfield projects.

When Michael Sabia recently came out to defend the Montreal REM project, he was being way too polite. I set the record straight on my blog and didn't hold back, but it amazes me how many cockroaches are still lurking out there questioning the "Caisse's governance" on this project (what a joke, they have a blatant agenda against the Caisse and this unique project but Michael Sabia's mandate was renewed for four more years so he will have the last laugh once it's completed and operational).

In Private Equity, the outperformance over the index in 2016 was spectacular (520 basis points or 5.2%) but over the last five years, it's a more modest outperformance (120 basis points). Like other large Canadian pensions, the Caisse invests in top private equity funds all over the world and does a lot of co-investments to reduce overall fees.

[Note: Andreas Beroutsos who formerly oversaw all of La Caisse’s private equity and infrastructure investment activities outside Quebec is no longer there (heard some unsubstantiated and interesting stories). In April, the Caisse reorganized infrastructure and private equity units under new leaders.]

In Public Equities, a very impressive performance in Canada, outperforming the benchmark by 260 basis points in 2016 and by 160 basis points over the last five years. The Global Quality portfolio edged out its benchmark by 30 basis points in 2016 but it still up outperforming it by almost 500 basis points over the last five years.

Again, I question this Global Quality portfolio and the benchmark they use to evaluate it and I've openly stated if it's that good, why aren't other large Canadian pension funds doing the exact same thing? (Answer: it doesn't pass their board's smell test. If these guys are that good, they should be working for Warren Buffet, not the Caisse)

That is it from me, I've already covered enough. Take the time to go over the 2015 Annual Report as you wait for the 2016 one to appear in April. There you will find all sorts of details like the benchmarks governing the specialized portfolios (click on image):

Like I said, there are no free lunches in Real Estate and Infrastructure benchmarks but there are issues with other benchmarks that do not reflect the risks being taken in the underlying portfolios (Bonds and Global Quality portfolios, for example).

Net, net, however, I would say the benchmarks the Caisse uses are still among the toughest in Canada and it has delivered solid short-term and more importantly, long-term results.

It's a tough job managing these portfolios and beating these benchmarks, I know, I've been there and people don't realize how hard it is, especially over any given year. This is why I primarily emphasize long-term results, the only ones that truly count.

And long-term results are what counts in terms of compensating the Caisse's senior managers (from 2015 Annual Report, click on image):

Again, Mr. Beroutsos is no longer with the Caisse and neither is Bernard Morency. You can see the members of the Caisse's Executive Committee here (one notable addition last year was Jean Michel, Executive Vice-President, Depositors and Total Portfolio; he has a stellar reputation and helped Air Canada's pension rise from the ashes to become fully funded again).

The other thing worth mentioning is the Caisse's executives are paid fairly but are still underpaid relative to their peers at large Canadian funds (fuzzy benchmarks at other shops play a role here but also the culture in Quebec where people get jealous and mad if senior pension fund executives managing billions get paid million dollar plus packages even if that's what they are really worth).

Lastly, one analyst told me that the Caisse's ABCP portfolio has contributed roughly 0.5% annualized to the overall results since 2010 stating "this paper was sold at 45 cents to the dollar and now trades at $1 to the dollar". No doubt ABCP has come back strongly after the crisis, but I cannot verify his figures (will leave that up to you!).

I will embed clips from the Caisse's press conference as they become available so come back to revisit this comment. If you have anything to add, please email me at LKolivakis@gmail.com.

Below, Michael Sabia speaks with Mutsumi Takahashi in the CTV News Montreal studios, on December 20, 2016. Listen carefully to what he says about the REM project, addressing the critics, and what he says about Quebec companies operating in global markets. Excellent discussion here.

Also, Macky Tall, executive vice president, infrastructure at Caisse and president and CEO of CDPQ Infra, Caisse’s infrastructure unit, talks with P&I reporter Rick Baert about plans to build a light rail system in Montreal and CDPQ Infra’s overall investment strategy. Watch this interview here.

And Scott Rechler, RXR Realty CEO, was on CNBC this morning talking about why it makes sense to fund infrastructure projects through PPPs. Very interesting discussion, at one point, toward the end, he said it cost $500 million per mile to construct a subway in Paris and Tokyo but it cost $2 billion per mile to construct the last two subways in New York City because of all the regulations and bureaucracy.

Update: The Caisse's 2016 Annual Report is now available. Take the time to read it carefully. It typically comes out in late April. You can read my comments on the compensation at the Caisse for 2016 here. Take the time to read that comment to understand the factors behind how compensation is determined.

Thursday, February 23, 2017

Gotham Better Hedge Fund Fees?

Hema Parmar of Bloomberg reports, Gotham Hedge Fund Explores Shifting fees to Tie Pay to Returns:
Gotham Asset Management, the $6 billion money manager run by Joel Greenblatt and Robert Goldstein, is exploring a new fee structure that ties more of the fund’s pay to performance.

The firm is in talks with some investors for its Gotham Neutral Strategies hedge fund about charging one fee: the greater of a 1 percent management fee or 30 percent of returns that exceed the fund’s benchmark, according to two people familiar with the matter. The equity fund currently charges 1.5 percent of assets in management fees and 20 percent of profits, one of the people said.

Hedge funds have been trimming and altering their fees amid a backlash over lackluster returns and criticism that the standard model of charging a 2 percent management fee and a 20 percent incentive fee is too expensive. Most hedge funds charge investors too much for the performance they deliver, Greenblatt, who is Gotham’s co-chief investment officer, told Bloomberg Television in a May 2014 interview.

The Gotham Neutral Strategies fund gained 7.5 percent last year, according to another person familiar with the matter. The HFRI Market Neutral Index was up about 2 percent in that time. Since inception in July 2009, the fund has gained an annualized 7 percent.

If the new fee structure is adopted, Gotham would join Hong Kong-based hedge fund Myriad Asset Management and others in moving to the 1-or-30 model, which has been championed by investors including the Teacher Retirement System of Texas.

As of mid-February, at least 16 multi-billion-dollar hedge funds worldwide are either in the process of implementing or have implemented the 1-or-30 fee structure that was introduced to the industry in the fourth quarter of 2016, Jonathan Koerner of Albourne Partners said in a telephone interview on Feb. 16.

“The objective of ‘1 or 30’ is to more consistently ensure that the investor retains 70 percent of alpha generated for its investment in a hedge fund,” Koerner wrote in a white paper published in December by Albourne, which advises clients on more than $400 billion of alternative investments globally. The management fees charged in a year when the fund underperforms the benchmarks are deducted from the following year’s performance fee payment, making it, in effect, a prepaid performance fee credit, he said last month.

The Gotham Penguin Fund, which wagers on and against U.S. stocks, gained 25 percent last year, according to one of the people familiar with the matter, compared with a 5.4 percent rise in the HFRI Equity Hedge Index. Since inception in 2013, the fund has returned an annualized 15 percent.

A representative for the firm declined to comment.
So what is this all about? Basically, Joel Greenblatt of Gotham is right, most hedge funds charge investors too much for the performance they deliver, and he is proposing something to better align interests with his investors.

Why isn't every big hedge fund doing this? In short, because they don't want to, perfectly content shafting their investors with insane fees no matter how they're performing, or they don't need to because they're performing just fine and have a "take it or leave it" attitude when it comes to their fees.

In the past, it was always underperfoming hedge funds what would propose lower fees to investors. But here we have a well-known, highly respected hedge fund manager who has performed well over the years stating the gig is up and he's proposing something better to his investors.

Unfortunately, I'm not sure this wonderful "1 OR 30" fee structure is going to gain traction, no matter how much sway Albourne has.

I had an exchange with Dimitri Douaire, formerly of OPTrust, on this topic on LinkedIn (click on image below);

Now, I might disagree with Dimitri on whether or not giving better terms to emerging hedge funds is a "subsidy" or whether multi-billion-dollar hedge funds should charge any management fee at all, but he's right, unless the majority of investors start implementing this fee structure across all their investments, it's not going to gain traction.

You can read more on Albourne's "1 or 30" fee structure here. In theory, it makes perfect sense, we just have to wait a decade to see if it gains any traction.

Below, an older (2011) Fortune interview where Joel Greenblatt talks about how to beat the market (see transcript here). Listen carefully to his comments, very interesting, and remember, I track Gotham's portfolio every quarter along with those of other legendary investors when I go over top funds' activity.

Last year, Greenblatt also talked with Morningstar about choosing active managers. You can watch that interview here and read the transcript as well. It's excellent and well worth listening to.

Lastly, it isn’t often that a very successful hedge fund manager with a winning strategy closes up shop, but that is exactly what Joel Greenblatt did in 1995. It’s equally unusual to get back in the business more than a decade later with a dramatically altered strategy. Greenblatt appeared on WealthTrack in 2014 to discuss his big change in portfolio strategy, from a very concentrated approach to broad diversification. Watch this interview below. 

Wednesday, February 22, 2017

CalPERS's Private Equity Disaster?

In a recent blog comment, Yves Smith of Naked Capitalism laments, CalPERS’ Private Equity Portfolio Continues to Earn Way Too Little for the Risk:
We’ve said for the last couple of years that private equity has not been earning enough to compensate for its extra risks, that of high leverage and lack of liquidity.

One of the core tenets of finance is that extra risk-taking should be rewarded with higher returns over time. But for more than the last decade, typical investor portfolios of private equity funds haven’t delivered the additional returns, typically guesstimated at 300 basis points over a public equity benchmark like the S&P 500.

We’ve pointed out that even that widespread benchmark is too flattering. Private equity firms invest in companies that are much smaller than the members of the S&P 500, which means they are capable of growing at a faster rate over extended periods of time. The 300 basis point (3%) premium is a convention with no solid analytical foundation. Some former chief investment officers, like Andrew Silton, have argued that a much higher premium, more like 500 to 800 basis points (5% to 8%) is more appropriate. And that’s before you get to other widespread problems with measuring private equity returns, such as the fact that they are routinely exaggerated at certain times, namely right before a new fund is being raised by the same general partner, late in a fund’s life, and during bear markets, all of which goose overall results.

And that’s before you get to the fact that some investors use even more flattering benchmarks. As Oxford professor Ludovic Phalippou pointed out by e-mail, in the last two years, more and more investors have switched from using the already-generous S&P 500 to the MSCI World Index as their benchmark. Why? Per Phalippou: “Because the S&P 500 has been doing very well over the last three years, unlike the MSCI World Index.”

So why hasn’t private equity been producing enough over the past decade to justify the hefty fees? The short answer is too much money chasing deals. Private equity’s share of global equity more than doubled from 2005 to 2014.

And you can see how this looks in CalPERS’ latest private equity performance update, from its Investment Committee meeting last week (from page 14 of this report). In fairness, CalPERS does have a more strict private equity benchmark than many of its peers (click on image):

Since that chart is still mighty hard to read (by design?), let’s go through the sea of read ink.

The only period in which CalPERS beat its benchmark was for the month before the measurement date of December 31, 2016, and that by a whopping 3 basis points. In all other measurement periods, the shortfall was hundreds of basis points:

3 months (219)
Fiscal YTD (283)
1 year (994)
3 years (132)
5 years (479)
10 years (286)

To its credit, CalPERS has been cutting its private equity allocation. CalPERS had a private equity target of 14% in 2012 and 2013; it announced last December it was reducing it from 10% to 8%. Like so many of its peers, CalPERS hoped that private equity would rescue it from its underfunding, which came about both due to the decision to cut funding during the dot com era, when CalPERS was overfunded, and to the damage it incurred during the crisis. At least CalPERS is finally smelling the coffee.

However, even with these appalling results, CalPERS does have another avenue: it could pursue private equity on its own, which would virtually eliminate the estimated 700 basis points (7%) it is paying to private equity fund managers. CalPERS confirmed this estimate by Ludovic Phalippou in its November 2015 private equity workshop. Since at that point it had gathered private equity carry fee data, that means the full fees and costs are at least that high; it would presumably have reported a lower number or flagged the figure as an high plug figure. Getting rid of the fee drag would mean much more return to CalPERS and its retirees, and would make private equity more viable.

CalPERS has two ways it could go. One would be a public markets replication strategy, which would target the sort of companies private equity firms buy. Academics have modeled various implementations of this idea, and they show solid 12-14% returns. However, as we’ve discussed at length, and some pubic pension funds have even admitted, one of the big attractions of private equity is…drumroll…the very way the mangers lie about valuations, particularly in bad equity markets! Private equity managers shamelessly pretend that the value of their companies falls less when stocks are in bear territory, giving the illusion that private equity usefully counters portfolio volatility. Anyone with an operating brain cell knows that absent exceptional cases, levered equities will fall more that less heavily geared ones. So the reporting fallacy of knowing where you really stand makes this idea unappetizing to investors.

The other way to go about it would be to have an in-house team that does private equity investing. A group of Canadian public pension funds has gone this route and not surprisingly, reports markedly better results net of fees than industry norms. And this is becoming more mainstream, as Reuters reported last Friday (hat tip DO):
Some of the world’s biggest sovereign wealth funds are increasingly striking their own private equity deals rather than relying on external fund managers, in a drive to cut costs and gain more control.

With some $6.5 trillion in assets, sovereign investors already account for 19 percent of capital committed to private equity, according to data from research firm Preqin.

But mega-funds such as the Abu Dhabi Investment Authority (ADIA), Saudi Arabia’s Public Investment Fund (PIF) and Singapore’s GIC, are hiring specialists to find or vet deals – enabling them to negotiate with private equity firms from a position of strength or to go it alone.

In 2012 sovereign investors participated in just 77 direct private equity deals. By 2016, that had risen to 137, Thomson Reuters data shows. Deal value more than trebled to $45.2 billion from $14.8 billion….

This allows funds to better protect their interests when markets go south. One sovereign investor who spoke on condition of anonymity said that during the global financial crisis, some external funds behaved irrationally.

“They had different liability streams than us, so they were under pressure to sell at a time when they should have been investing more,” the source said. “Going more direct means you don’t have to worry about whether your interests are aligned with other investors’.”
And to its credit CalPERS is considering joining this trend…after having been deterred from leading it. From a 2016 post:
In 1999, CalPERS engaged McKinsey to advise them as to whether they should bring some of their private equity activities in house. My understanding was that some board members thought this issue was worth considering; staff was not so keen (perhaps because they doubted they had the skills to do this work themselves and were put off by the idea of being upstaged by outside, better paid recruits).

In hearing this tale told many years later, I was perplexed and a bit disturbed to learn that the former managing partner of McKinsey, Ron Daniel, presented the recommendations to CalPERS of not to go this route. Only a very few directors (as in the tenured class of partner) continue at McKinsey beyond normal retirement age; one was the head of the important American Express relationship at the insistence of Amex. Daniel served as an ambassador for the firm as well as working on his former clients. Why was he dispatched to work on a one-off assignment that was clearly not important to McKinsey from a relationship standpoint, particularly in light of a large conflict of interest: that he was also the head of the Harvard Corporation, which was also a serious investor in private equity?

Although the lack of staff enthusiasm was probably a deal killer in and of itself, the McKinsey “no go” recommendation hinged on two arguments: the state regulatory obstacles (which in fact was not insurmountable; CalPERS could almost certainly get a waiver if it sought one), and the culture gap of putting a private equity unit in a public pension fund. Even though the lack of precedents at the time no doubt made this seem like a serious concern, in fact, McKinsey clients like Citibank and JP Morgan by then had figured out how to have units with very divergent business cultures (investment banking versus commercial banking) live successfully under the same roof. And even at CalPERS now, there is a large gap between the pay levels, autonomy, and status of the investment professionals versus the rank and file that handles mundane but nevertheless important tasks like keeping on top of payments from the many government entities that are part of the CalPERS system, maintaining records for and making payments to CalPERS beneficiaries, and running the back office for the investment activities that CalPERS runs internally.

Why do I wonder whether McKinsey had additional motives for sending someone as prominent as Daniel to argue forcefully (as he apparently did) that CalPERS reject the idea of doing private equity in house? Clearly, if CalPERS went down that path, then as now, the objective would be to reduce the cost of investing in private equity. And it would take funds out of the hand of private equity general partners.

The problem with that is that McKinsey had a large and apparently not disclosed conflict: private equity funds were becoming large sources of fees to the firm. By 2002, private equity firms represented more than half of total McKinsey revenues. CalPERS going into private equity would reduce the general partners’ fees, and over time, McKinsey’s.

In keeping, as we pointed out in 2014, McKinsey acknowledged that the prospects for private equity continuing to deliver outsized returns were dimming. That would seem to make for a strong argument to get private equity firms to lower their fees, and the best leverage would be to bring at least some private equity investing in house, both to reduce costs directly and to provide for more leverage in fee discussions. Yet McKinsey hand-waved unconvincinglyabout ways that limited partners could contend with the more difficult investment environment, and was discouraging about going direct despite the fact that the Canadian pension funds had done so successfully.
Better late than never. Let’s hope CalPERS pursues this long-overdue idea.
Yves Smith, aka Susan Webber of Aurora Advisors, is back at it again, going after CalPERS' private equity program, enlisting "academic experts" like this professor at Oxford who sounds credible but the problem is like so many academics, he doesn't have a clue of what he's talking about, and neither does Yves Smith, unfortunately.

Before Ludovic Phalippou, there was a blogger who warned the world of bogus benchmarks in illiquid asset classes and keeps hammering the point that it's all about benchmarks stupid! This blogger even did a short stint on Yves' blog, Naked Capitalism, before leaving to write for another popular blog for a brief while, Zero Hedge (I now post my comments only on my blog and I'm much happier. My advice to bloggers is not to routinely post anywhere else even if they are popular blogs.).

My views on benchmarking illiquid assets have evolved because I realize how hard it is to benchmark these assets properly (never mind what Yves and Phalippou think), but that doesn't mean we shouldn't pay attention to these benchmarks (we most certainly should).

Ok, let me be fair here, Yves' comment above is not ALL nonsense, but there are so many gaps here and the way the information is presented is so blatantly and foolishly biased that a relatively informed reader might read this comment and think CalPERS should just nuke its multi-billion PE program just like it nuked its hedge fund program a couple of years ago.

Knowing what was going on at CalPERS's hedge fund program, I actually agreed with that decision. CalPERS never staffed that team appropriately, they didn't know what they were doing and the program produced very disappointing returns, year in, year out, net of billions in fees they were doling out to their lousy external hedge fund managers.

Private equity at CalPERS was also one HUGE mess prior to the arrival of Réal Desrochers in May 2011 to head that group. Basically, up until then, CalPERS was everyone's private equity cash cow, giving everyone and their mothers an allocation. Their program became one giant PE benchmark for the entire industry.

The problem with that approach is it simply doesn't work, especially in private equity where there is a huge dispersion of returns between top funds and bottom funds and there is evidence of performance persistence (although the evidence is somewhat mixed pre and post-2000).

When Réal Desrochers took over CalPERS PE program, he did what he did at CalSTRS, namely, clean it up, getting rid of underperformers and focusing on having a concentrated portfolio of a few top-performing funds. In others words, allocate more money in fewer and fewer funds, and watch them like a hawk to see if it's worth reinvesting in new funds they raise.

It's fair to say Réal Desrochers and his team inherited one huge private equity mess because they're still cleaning up that portfolio, years after he got in power (that is something Yves neglects to mention).

Still, private equity is an important asset class, one that has delivered excellent returns for CalPERS over the last 20 years, net of fees (click on image):

As far as its benchmark, CalPERS started mulling over a new PE benchmark two years ago and I reviewed the latest publicly available annual PE program review (November, 2015) which states the current policy benchmark of 2/3 FTSE US = 1/3 FTSE ROW (rest of world) + 300 basis points "creates unintended active risk for the Program, as well as for the Total Fund." (click on image):

Now, instead of reading nonsense on Naked Capitalism, take the time to read this attachment on private equity that CalPERS put out in November 2015, it's excellent and discusses performance persistence and the problems benchmarking private equity.

I have long argued that the benchmark should be the S&P 500 + 300 basis points but the truth is the deals are increasingly outside the US and that 300 basis points spread to capture illiquidty and leverage is a bit high and this benchmark does expose the program and the Total Fund to active risk (ie. risk it underperforms its benchmark by a considerable amount) on any given year (not over the long run).

Having said this, when I went over CalPERS fiscal 2016 results back in July, I said they weren't good and that they were smearing lipstick on a pig:
Lastly, and most importantly, let's go over CalPERS's news release, CalPERS Reports Preliminary 2015-16 Fiscal Year Investment Returns:

The California Public Employees' Retirement System (CalPERS) today reported a preliminary 0.61 percent net return on investments for the 12-month period that ended June 30, 2016. CalPERS assets at the end of the fiscal year stood at more than $295 billion and today stands at $302 billion.

CalPERS achieved the positive net return despite volatile financial markets and challenging global economic conditions. Key to the return was the diversification of the Fund's portfolio, especially CalPERS' fixed income and infrastructure investments.

Fixed Income earned a 9.29 percent return, nearly matching its benchmark. Infrastructure delivered an 8.98 percent return, outperforming its benchmark by 4.02 percentage points, or 402 basis points. A basis point is one one-hundredth of a percentage point.

The CalPERS Private Equity program also bested its benchmark by 253 basis points, earning 1.70 percent.

"Positive performance in a year of turbulent financial markets is an accomplishment that we are proud of," said Ted Eliopoulos, CalPERS Chief Investment Officer. "Over half of our portfolio is in equities, so returns are largely driven by stock markets. But more than anything, the returns show the value of diversification and the importance of sticking to your long-term investment plan, despite outside circumstances."

"This is a challenging time to invest, but we'll continue to focus on our mission of managing the CalPERS investment portfolio in a cost-effective, transparent, and risk-aware manner in order to generate returns for our members and employers," Eliopoulos continued.

For the second year in a row, international markets dampened CalPERS' Global Equity returns. However, the program still managed to outperform its benchmark by 58 basis points, earning negative 3.38 percent. The Real Estate program generated a 7.06 percent return, underperforming its benchmark by 557 basis points. The primary drivers of relative underperformance were the non-core programs, including realized losses on the final disposition of legacy assets in the Opportunistic program.

"It's important to remember that CalPERS is a long-term investor, and our focus is the success and sustainability of our system over multiple generations," said Henry Jones, Chair of CalPERS Investment Committee. "We will continue to examine the portfolio and our asset allocation, and will use the next Asset Liability Management process, starting in early 2017, to ensure that we are best positioned for the future market climate."

Today's announcement includes asset class performance as follows (click on image):

Returns for real estate, private equity and some components of the inflation assets reflect market values through March 31, 2016.

CalPERS 2015-16 Fiscal Year investment performance will be calculated based on audited figures and will be reflected in contribution levels for the State of California and school districts in Fiscal Year 2017-18, and for contracting cities, counties, and special districts in Fiscal Year 2018-19.

The ending value of the CalPERS fund is based on several factors and not investment performance alone. Contributions made to CalPERS from employers and employees, monthly payments made to retirees, and the performance of its investments, among other factors, all influence the ending total value of the Fund.

The Board has taken many steps to sustain the Fund as part of CalPERS' Asset Liability Management Review Cycle (PDF) that takes a holistic and integrated view of our assets and liabilities.
You can read more articles on CalPERS's fiscal 2015-2016 results here. CalPERS's comprehensive annual report for the fiscal year ending June 30, 2015 is not yet available but you can view last year's fiscal year annual report here.

I must admit I don't track US public pension funds as closely as Canadian ones but let me provide you with my insights on CalPERS's fiscal year results:
  • First, the results aren't that bad given that CalPERS's fiscal year ends at the end of June and global equity markets have been very volatile and weak. Ted Eliopoulos, CalPERS's CIO, is absolutely right: "When 52 percent of your portfolio is achieving a negative 3.4 percent return, that certainly sets the main driver for the overall performance of the fund." In my last comment covering why bcIMC posted slightly negative returns during its fiscal 2016, I said the same thing, when 50% of the portfolio is in global equities which are getting clobbered during the fiscal year, it's impossible to post solid gains (however, stocks did bounce back in Q2).
  • Eliopoulos is also right, CalPERS and the entire pension community better prepare for lower returns and a lot more volatility ahead. I've been warning about deflation and how it will roil pensions for a very long time. 
  • As far as investment assumptions, all US public pensions are delusional. Period. CalPERS and everyone else needs to lower them to a much more realistic level. Forget 8% or 7%, in a deflationary world, you'll be lucky to deliver 5% or 6% annualized gains over the next ten years. CalPERS, the government of California and public sector unions need to all sit down and get real on investment assumptions or face the wrath of a brutal market which will force them to cut their investment assumptions or face insolvency. They should also introduce risk-sharing in their plans so that all stakeholders share the risks of the plan equally and spare California taxpayers the need to bail them out.
  • What about hedge funds? Did CalPERS make a huge mistake nuking its hedge fund program two years ago? Absolutely not. That program wasn't run properly and the fees they were doling out for mediocre returns were insane. Besides, the party in hedge funds is over. Most pensions are rightly shifting their attention to infrastructure in order to meet their long dated liabilities. 
  • As far as portfolio returns, good old bonds and infrastructure saved them, both returning 9% during the fiscal year ending June 30, 2016. In a deflationary world, you better have enough bonds to absorb the shocks along the way. And I will tell you something else, I expect the Healthcare of Ontario Pension Plan and the Ontario Teachers' Pension Plan to deliver solid returns this year because they both understand liability driven investments extremely well and allocate a good chunk into fixed income (HOOPP more than OTPP).
  • I wasn't impressed with the returns in CalPERS's Real Estate portfolio or Private Equity portfolio (Note: Returns in these asset classes are as of end of March and will end up being a bit better as equities bounced back in Q2). The former generated a 7.06 percent return, underperforming its benchmark by 557 basis points and suffered relative underperformance in the non-core programs, including realized losses on the final disposition of legacy assets in the Opportunistic program. CalPERS Private Equity program bested its benchmark by 253 basis points, earning 1.70 percent, but that tells me returns in this asset class are very weak and the benchmark they use to evaluate their PE program isn't good (they keep changing it to make it easier to beat it). So I'm a little surprised that CalPERS new CEO Marcie Frost is eyeing to boost private equity.
In a nutshell, those are my thoughts on CalPERS fiscal 2015-16 results. Is CalPERS smearing lipstick on a pig? No, the market gives them and everyone else what the market gives and unless they're willing to take huge risks, they need to prepare for lower returns ahead.

But CalPERS and its stakeholders also need to get real in terms of investment projections going forward and they better have this conversation sooner rather than later or risk facing the wrath of the bond market (remember, CalPERS is a mature plan with negative cash flows and as interest rates decline, their liabilities skyrocket).
CalPERS latest annual report for 2015-2016 is now available here. I stand by remarks that CalPERS Private Equity program is delivering paltry returns, but the truth is these are treacherous times for private equity and there is gross misalignment of interests going on.

Even Canada's mighty PE investors aren't returning what they used to in this asset class despite having developed much better capabilities to co-invest with their general partners (GPs) in larger transactions to lower overall fees. 

Here is something else Yves and her academic friend don't understand about what exactly is going on at Canada's large pensions and large sovereign wealth funds in terms of direct investments in private equity. The bulk of direct investing at Canada's large pensions is in the form of co-investments after they invested billions in comingled funds where they pay 2 & 20 in fees, not in the form of purely direct (independent) private equity investments where they source their deals on their own, invest in a private company and fix up its operations.

I explained the key points on private equity at large Canadian pensions in this comment:
  • Private equity is an important asset class, making up on average 12% of the total assets at Canada's large public pensions. 
  • All of Canada's large public pensions invest in private equity primarily through external funds which they pay big fees to and are then able to gain access to co-investment opportunities where they pay no fees. In order to gain access to these co-investments, Canada's large pensions need to hire professionals with the right skill set to analyze these deals in detail and have quick turnaround time when they are presented with opportunities to co-invest.
  • Some of Canada's large public pensions, like Ontario Teachers and OMERS, engage in purely direct (independent) private equity deals where they actually source deals on their own and then try to improve the operational efficiency of that private company. Apart from paying no fees, the added advantage of this approach is that unlike PE funds who try to realize gains in three or four years, pensions have a much longer investment horizon on these investments (ten++ years) and can wait a long time before these companies turn around.
  • However, the performance of these type of purely direct (independent) deals is mixed with some successes and plenty of failures. Also, we simply don't have independently verifiable information on how much is truly allocated in independent direct deals versus fund investments and co-investments, and how well these independent direct deals have done over the long run relative to fund investments and co-investments.
  • The reality is that despite their long investment horizon, Canada's large public pensions will never be able to compete effectively with the large private equity titans who are way more plugged into the best deals all around the world.
  • This is why CPPIB, Canada's largest pension, focuses purely on fund investments and co-investments all around the world in their private equity portfolio. They will never engage in independent direct deals like they do in infrastructure. Their philosophy, and I totally agree with them, is that they simply cannot compete on direct deals with premiere private equity funds and it's not in the best interests of their beneficiaries.
  • Under the new leadership of André Bourbonnais, PSP Investments is also moving in this direction, as Guthrie Stewart's private equity team sells any independent direct stakes to focus its attention solely on fund investments and co-investments to reduce overall fees (again, I agree with this approach in private equity).
  • CPPIB and PSP will be the world's top private equity investors for a very long time as they both have a lot of money coming in and they will be increasingly allocating to top credit (private debt) and private equity funds that can make profitable long-term private investments all over the world. 
  • Ontario Teachers, the Caisse, bcIMC, OMERS and other large Canadian pensions will also continue to figure prominently on this list of top global private equity investors for a long time but they will lag CPPIB and PSP because they are more mature pensions with less money coming in. Still, private equity will continue to be an important asset class at these pensions for a long time.
Last week, at the CFA Montreal lunch with PSP's André Bourbonnais, PSP's CEO stated these key points on their private equity program:
  • Real estate is an important asset class to "protect against inflation and it generates solid cash flows" but "cap rates are at historic lows and valuations are very stretched." In this environment, PSP is selling some of their real estate assets (see below, my discussion with Neil Cunningham) but keeping their "trophy assets for the long run because if you sell those, it's highly unlikely you will be able to buy them back."
  • Same thing in private equity, they are very disciplined, see more downside risks with private companies so they work closely with top private equity funds (partners) who know how to add operational value, not just financial engineering (loading a company up with debt to then sell assets).
  • PSP is increasingly focused on private debt as an asset class, "playing catch-up" to other large Canadian pension funds (like CPPIB where he worked for ten years prior to coming to PSP). André said there will be "a lot of volatility in this space" but he thinks PSP is well positioned to capitalize on it going forward. He gave an example of a $1 billion deal with Apollo to buy home security company ADT last February, a deal that was spearheaded by David Scudellari, Senior Vice President, Principal Debt and Credit Investments at PSP Investments and a key manager based in New York City (see a previous comment of mine on PSP's global expansion). This deal has led to other deals and since then, they have deployed $3.5 billion in private debt already (very quick ramp-up).
  • PSP also recently seeded a European credit platform, David Allen‘s AlbaCore Capital, which is just ramping up now. I am glad Miville asked André about these "platforms" in private debt and other asset classes because it was confusing to me. Basically, hiring a bunch of people to travel the world to find deals is "operationally heavy" and not wise. With these platforms, they are not exactly seeding a hedge fund or private equity fund in the traditional sense, they own 100% of the assets in these platforms, negotiate better fees but pump a lot of money in them, allowing these external investment managers to focus 100% of their time on investment performance, not marketing (the more I think about, this is a very smart approach).
  • Still, in private equity, PSP invests with top funds and pays hefty fees ("2 and 20 is very costly so you need to choose your partners well"), however, they also do a lot of co-investments (where they pay no fees or marginal fees), lowering the overall fees they pay. André said "private equity is very labor intensive" which is why he's not comfortable with purely direct investments, owning 100% of a company (said "it's too many headaches") and prefers investing in top funds where they also co-invest alongside them on larger transactions to lower overall fees (I totally agree with this approach in private equity for all of Canada's mighty PE investors). But he said to do a lot of co-investments to lower overall fees, you need to hire the right people who monitor external PE funds and can analyze co-investment deals quickly to see if they are worth investing in (sometimes they're not). He gave the example of a $300 million investment with BC Partners which led to $700 million in co-investments, lowering the overall fees (that is fantastic and exactly the right approach).
The reality is CalPERS, CalSTRS and other large US pensions do not have people that can analyze these co-investment deals quickly to invest and lower fees. Why? Because their compensation is low and they cannot attract the talent to do a lot more co-investments to lower overall fees and boost the performance of their private equity program.

But there is no question that PSP and other large Canadian pensions still invest a huge chunk of their private equity assets with top funds where they pay big fees in comingled funds to gain access to larger co-investment opportunities.

In fact, at the end of the lunch, Neil Cunningham, PSP's Senior Vice President, Global Head of Real Estate Investments, shared his with me:
On private equity fees, he agreed with André Bourbonnais, PSP doesn't have negotiating power with top PE funds because "let's say they raise a $14 billion fund and we take a $500 million slice and negotiate a 10 basis reduction on fees, that's not 10 basis points on $500 million, that's 10 basis points on $14 billion because everyone has a most favored nation (MFN) clause, so top private equity funds don't negotiate lower fees with any pension or sovereign wealth fund. They can just go to the next fund on their list."
Whether you like it or not, in order to invest properly in private equity, and make big returns over any public market benchmark over the long run, you need to pay big fees to the private equity kingpins.

But if you're smart like Canada's large pensions, you will tell them "Ok boys, we're going to invest a lot of money in your PE funds, pay the big fees like everyone else, but you'd better give us great co-investment opportunities to lower our overall fees."

Sounds easy but in order for CalPERS and other large US pensions to pursue this long-overdue idea, they need to get the governance and compensation right at their shops to attract qualified people to analyze co-investment opportunities quickly and diligently. And that isn't easy.

Below, Maria Bartiromo interviews CalPERS CIO Ted Eliopoulos on Fox Business Network's Mornings with Maria. Listen carefully to what he says about what they can and cannot bring in-house.