Wednesday, May 24, 2017

The Big Squeeze?

James Kwak of The Baseline Scenario wrote a comment on how Fees Add Up:
Public pension funds are having a tough time. On the one hand, the average funding ratio (assets as a percentage of the present value of future obligations) is below 80% because of inadequate contributions by sponsors (states and municipalities) and poor investment returns since the collapse of the technology bubble in 2000. On the other hand, because pensions responded to low returns by shifting more of their money into hedge funds and private equity funds, a larger proportion of their assets is siphoned off as investment fees each year.

Unlike some people, I am not against hedge funds and private equity funds in principle. I think it’s highly likely that there are people who can beat the market on a sustained basis—particularly if they are people who are especially good with computers—both for theoretical reasons (someone has to be the first person to discover each relevant piece of information or actionable pattern) and empirical reasons (see Fama and French 2010, for example). Hedge funds have lagged the stock market in recent years, but what critics sometimes overlook is that they are supposed to trail the market in boom periods, because many target a beta of around 0.5. But I am mystified by the fact that, in what is supposed to be a highly competitive and innovative industry, the price of investing in a hedge fund has stayed virtually fixed at 2-and-20 (2% of assets, plus 20% of investment returns) for decades.

The consequences of these high prices are added up in The Big Squeeze, a new report sponsored by the American Federation of Teachers. Because true investment fees are usually not disclosed—fund managers insist that they are confidential and require investors not to divulge them—the report simply quantifies the potential savings from reducing fees from 1.8-and-18 to 0.9-and-9. This may seem arbitrary, but I know anecdotally that some funds, even big ones, are charging something like 1-and-10 even to ordinary investors. Since state pension funds are some of the biggest investors that exist, you would think they would be able to negotiate even lower fees.

Not surprisingly, the numbers involved add up quickly. Lower fees over the past five years would have saved the average pension fund included in the study $1.6 billion; to put things in perspective, it would have improved the aggregate funding ratio for these funds by more than two percentage points, which is nothing to sneeze at.

The important question is why high fees persist despite the potential market power of big pension funds. There are probably multiple explanations. One is a culture of secrecy, which makes it difficult for any fund to find out what other funds are paying. Another is the marketing prowess of fund managers, who are adept at explaining whey their fund is unlike any other in the world and therefore merits its high fees. A third is that pension fund managers are playing with other people’s money (in this case, the other people are the fund’s beneficiaries—teachers, firefighters, and other government employees)—and may be more interested in ingratiating themselves with the asset management industry than with getting the best deal they can. (This is even more likely the case for the investment consultants who match pension funds with asset managers.)
But in a political climate that makes tax increases on rich fund managers unlikely, state governments could achieve the same results by taking a harder line on investment management fees: requiring public disclosure of all fees or even imposing hard fee caps for pension fund investments. With the amount of money involved, it’s hard to imagine that major pension funds couldn’t find anyone competent to take their money for 0.9-and-9.
Let me thank Suzanne Bishopric for sending me this comment.

The Big Squeeze on US public pensions has been going on for decades and it was only a matter of time before someone shined a light on the huge fees being doled out to alternative investment managers, many of which are charging hefty fees for mediocre long-term results.

The first thing I will tell you is to take the time to read the entire report by the American Federation of Teachers. The Big Squeeze is available here and covers a lot of material, including popular myths surrounding the pension crisis and who (it claims) has really benefitted from shifting state pensions' asset mix more into alternative investments.

In her article, Strapped Pension Funds, and the Hefty Investment Fees They Pay, Gretchen Morgenson of the New York Times begins by asking: "Where are the pensioners' yachts?"

Great question. The truth is a select few hedge fund and private equity titans have greatly benefitted from this shift into alternative assets, amassing extraordinary wealth, while US public pension funds keep sinking deeper into a pension albatross, failing to deliver on these and other investments.

Still, despite this reality, US pensions are rushing to invest more into alternatives, fearing a big downturn ahead. It's a total catch-22, damned if you do, damned if you don't.

But as I've warned, the pension storm is here and gathering steam, so no matter how much US public pensions invest in alternatives, it won't make a big difference in terms of their funded status which will inexorably get worse as rates decline to new secular lows.

No doubt, the big squeeze is troubling, but it's important to understand that it's a byproduct of terrible pension governance which basically forces US public pensions to farm out a big chunk of their pension assets to external managers that charge them hefty fees.

The problem isn't paying fees when risk-adjusted performance is met. The problem is paying big fees for subpar or average returns in a low-return environment over a long period as your pension deficit gets worse.

Importantly, in a deflationary world, all those fees add up fast, impinging on the net performance of these external managers and this certainly doesn't help chronically underfunded pensions, many of which still cling to unrealistic return targets.

Very few public pensions were raising a big stink on fees when rates were much higher, performance was decent and their funded status was fully funded or close enough to fully funded status. A little inflation also helped justify these fees.

But in a low yield, low return deflationary world, costs matter a lot more and pensions are focusing on lowering operating costs across the board, including on the fees they pay to external managers.

Of course, we need to be realistic here. Some external managers have delivered great long-term results and therefore have a lot more clout than others. You're not going to go to Blackstone, Bridgewater, or any other brand name fund and dictate the terms of the deal. It's not going to happen because if they make one exception, they need to make it for all their investors which signed a most favored nation clause.

The other thing I'd like to bring to your attention is that a solid case can be made to increase the exposure to alternative, illiquid investments, especially if you can co-invest on bigger deals alongside your external partners to lower the overall fees.

This has been the driving force behind the success of Canada's large public pensions, otherwise known as the mighty PE investors. Where they can, Canadian pensions will invest directly and where they can't, they will invest with external partners and engage in co-investments to lower fees.

However, in order to do this, they implemented world class governance allowing them to operate at arms-length from the government. This allows them to compensate their pension managers properly in order to attract and retain talented individuals who are able to do direct deals independently or (as is more often the case) by co-investing alongside external partners.

More direct investments (either independently or through co-investments) allows Canada's large pensions to lower overall fees of their private equity program.

In the US, there is way too much political interference in public pensions and the results are they cannot pay their public pension fund managers properly to do what their Canadian counterparts do.

Then, one day, the American Federation of Teachers puts out a report highlighting The Big Squeeze, and all of a sudden teachers, police officers and other public-sector workers wake up to the reality that everyone is milking their public pension dry. And by the time they're done milking these pensions, there will be little left to pay the benefits that were promised to them.

I'm being very cynical but there is a lot of truth in the report the teachers put out. If their pensions are doling out huge fees to alternative investment managers, they have a right to know what they're getting in return for all those fees.

Having said this, I want to be balanced here because I maintain the view that good performance is worth paying for. Chronically underfunded US pensions with unrealistic return targets can't expect to make their target rate of return simply by investing in index funds. They need to invest in top-tier managers in the alternatives space to add value over and above their public market benchmarks.

The problem then becomes identifying top-performing external managers and seeing who is worth paying all those fees to. And that isn't as easy as it sounds which is why most pensions use consultants which all tend to recommend the same brand name funds.

Therein lies the structural problem. The top alternatives managers carry enormous clout, and they, not the big institutional investors that invest in them, dictate the terms. Unless the big funds turn around and agree that from now on, 1 and 10 is the new norm, it's never going to happen. And since those chronically underfunded US pensions need these top funds to attain their unrealistic bogeys, everyone stays silent, quietly complaining among themselves.

Anyway, take the time to read The Big Squeeze and let me know what you think via email (LKolivakis@gmail.com).

I will caution everyone, however, to read these reports with a critical eye. If you talk to the pension fund managers at CalPERS, CalSTRS, and other large US pensions, they will tell you private equity is one of the best performing asset classes over a long period, net of all fees. And they're right.

But clearly, we have come to a crossroad on fees paid to alternative investment managers. Last Friday, I went over top funds' Q1 activity, where I stated this:
Bill Ackman who got killed on Valeant Pharmaceuticals just came out to say 2-and-20 doesn’t work anymore for hedge funds. In an effort to garner support from institutional investors fed up with his lousy performance, his fund adjusted its fee structure last year so that clients only pay on profits in excess of 5 percent (a noble move but pretty much a marketing ploy after suffering terrible losses).

The only hedge funds that are delivering consistent returns in these markets are quant funds taking over this world. This is why they're once again at the very top of alpha's rich list.
I will give it to Bill Ackman, at least he gets it from an institutional investor's perspective. Did he do this to stop the hemorrhaging and garner more assets? No doubt, but maybe he's realizing what everyone else already knows, 2 and 20 is dead and is becoming increasingly harder to justify in a low yield, low-return deflationary world.

One final thought, it's very fashionable these days to blame everything on greedy bankers, hedge fund managers, and private equity managers, but from my vantage point, there is plenty of blame to go around when it comes to America's pension crisis. Unions, state and local governments and Wall Street all have unrealistic expectations on return targets, benefits, contribution rates, risk-sharing, and fees.

In the meantime, the pension storm cometh, and unless all these stakeholders come together to figure out a real long-term solution to this crisis, things will only get worse.

On that note, take the time to watch the clips I embedded at the end of my last comment on Ontario easing its pension funding rules. In particular, Ron Mock, OTPP's CEO, being interviewed on CNBC recently discussing their long-term outlook on investing in a changing world.

Below, Robert Shiller, professor of economics at Yale University, explains his call that the markets could go 50% from here and bonds are dangerous here. CNBC's Jim Cramer weighs in.

I respectfully disagree with professor Shiller, especially on bonds. Sure, stocks can continue levitating up as the big beta bubble expands. But when the next crisis hits, and it will, stocks will get clobbered and government bonds will rally like crazy from these levels.

Of course, for chronically underfunded pensions, nothing would be better than stocks going up 50% from here and bond yields soaring (so liabilities decline considerably). Who knows, maybe it will happen, giving these underfunded pensions suffering from the big squeeze some much-needed breathing room.

I just think this is wishful and dangerous thinking because if the opposite happens, a lot of these chronically underfunded US public pensions are in for a rude awakening or something far worse.

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