Wednesday, April 25, 2018

Are Vestcor's Benchmarks a 'Joke'?

Robert Jones of CBC News reports, Exaggerated success: Province's pension managers profit from 'joke' target, analysts say:
A key measurement used to calculate bonuses for executives of the firm managing New Brunswick government employee pension funds produces exaggerated rewards and needs to be reviewed, say two pension analysts asked to look at the issue by CBC News.

"That benchmark is a joke and you can quote me on that," said Leo Kolivakis about the yardstick used by New Brunswick's Vestcor Investment Management Corporation to judge its managers' achievements handling what are called "absolute return" funds.

The absolute return investments have been generating modest gains for pensioners served by Vestcor but producing major bonuses for its pension executives, including an estimated $600,000 in bonus pay in 2016.

That's primarily because returns managers have to beat to win extra pay from its absolute return portfolio are set at less than one per cent.

"If I was sitting on their board, I would be asking why and I think you have every right to ask why are you compensating people based on (that) benchmark," said Kolivakis, who writes about Canadian pension funds in his publication, Pension Pulse.

Big bonuses

Vestcor, formerly the New Brunswick Investment Management Corporation, looks after more than $15 billion in retirement and other funds for public bodies in New Brunswick, including pension money for teachers, judges, civil servants, hospital workers, University of New Brunswick staff, NB Power employees and others.

Incentive pay has become increasingly important to Vestcor executives. During 2016 its top five managers, led by president John Sinclair, received a combined $1.7 million in bonuses, significantly more than the $1.2 million they were paid in base salary.

Most of those bonus payments are rewards for Vestcor management beating industry average returns, or benchmarks, on investments over a rolling four-year period. And although many of the benchmarks are tough to beat, that has not been the case for its "absolute return" investments.

In the latest four-year period documented in Vestcor's current annual report, the benchmark return managers needed to exceed on absolute return funds to generate bonus pay was just 0.77 per cent — less than the rate of inflation

Managers generated a modest annualized return on the funds of 4.78 per cent, but the difference between the two is so great it flooded management's bonus pool with an estimated $600,000 in rewards in 2016 alone.

Poorly set target

Kolivakis said beating a benchmark by that kind of a margin is normally the sign of a poorly set target, not exceptional investing.

"If I keep seeing investment managers trouncing their benchmarks, if you trounce your benchmarks in any investment activity, there's an issue," said Kolivakis.

Absolute fund investing has become increasingly favoured by Vestcor managers, who nearly quadrupled the amount of money dedicated to it over four years from $353 million to $1.1 billion.

Vestcor's board of directors did not respond to a request for information on why the organization sets the benchmark for management to beat on absolute return investments, and generate bonus pay, below the rate of inflation.

'I could do that'

But Thomas Schneeweis, a professor emeritus of finance at the Isenberg School of Management in Amherst Massachusetts, said the benchmark is inappropriately low and beating it the way Vestcor managers have been suggests it's being over rewarded.

"You don't impress me when you made four per cent. I expect that (from absolute return funds). I could do that," said Schneeweis.

"All markets are amazingly efficient and there is almost no evidence of outperformance over time – if properly measured."

According to Schneeweis, the objective of absolute fund investigating is to generate constant or absolute returns, whether markets rise or fall.

That is done by pairing up investments that tend to move in opposite directions — like betting on both heads and tails during a coin flip — but with enough of an edge built in either way any outcome will still generate a positive return.

But the exercise is not without risk, according to Schneeweis, and that is not reflected in the benchmark Vestcor is letting its managers beat.

"Your benchmark should reflect the risk of your particular portfolio," he said.

"The truth is very few people really understand the alternative investment industry."

There is a general expectation — even at Vestcor — that a properly executed absolute return strategy will generate a return in the area of four per cent per year, and both Schneeweis and Kolivakis say that is the benchmark Vestcor managers should be beating to win their bonus pay.

"I agree there should be tough questions asked about the benchmark returns of absolute return strategies not reflecting the risks they're taking," said Kolivakis.

Schneeweis agrees.

"They (management) have a tendency to say why they are great and it's up to the board of directors to get another point of view on why in certain conditions they aren't so great and where there may be a little puffery," he said.
On Tuesday, I was trading, looking at markets and researching my comment on CAAT Pension Plan when I received an email from Vestcor's CIO Jon Spinney asking me if we can talk about this article and my thoughts on asbolute return benchmarks.

I was taken aback because I spoke to this reporter on January 15th and forgot all about our conversation (he did email his article but it went to my spam folder).

When I read the article, I was surprised he took my blog picture and more importantly, I felt like he took things out of context so let me begin by sharing with you our email exchange which took place January 15th (click on three images to enlarge and read our exchange):




I want to begin with this exchange to put things in proper context because when you read the article you think to yourself: "There goes Leo, flying off the handle again about Vestcor, the benchmarks they use in absolute return strategies and the compensation they dole out to their senior managers based on bogus benchmarks."

In that sense, I really appreciate Jon Spinney being polite and reaching out to talk to me and bringing this article to my attention and let me put things in proper context (truth be told, I come across as a total arrogant jerk in this article so Jon could have harbored resentment toward me and never reached out).

In particular, I want to emphasize some things I stated in my email exchange:
  • On the specific issues you raised, there is no industry standard in terms of evaluating Absolute Return strategies (ie. hedge fund strategies) in a Public Market portfolio. The same goes for Private Equity and Real Estate in Private Markets.Benchmarks are all over the place but typically they involve a spread over public market benchmark to reflect liquidity concerns.
  • In the case of Vestcor, they seem to be doing what HOOPP is doing, focusing on three internal absolute return strategies based on fundamental, event-driven, and quantitative strategies. This is smart as it keeps costs low (no fees to external hedge funds). 
  • A benchmark of T-bills + 350 bps makes sense as I am pretty sure that Ontario Teachers' now uses a similar spread (returns have come down in arb strategies).
  • As far as compensation, overall I'd say they are in line and even on the low-end of their peer group (see here for details). 
  • I don't see conflicts of interest arising in this group if governance is solid. It's up to the Board to make sure comp is in line with the objectives stated and to be frank if they can consistently achieve 5%+ returns with low volatility in this portfolio as it grows and do it using no external hedge funds (high fees, high potential conflicts of interest), that is a very good thing for the plans' stakeholders and beneficiaries
  • The benchmark for absolute return strategies should be T-bills + 350 bps or something comparable, not just T-bills. Still, the performance is good and their overall comp is on the low end.
Nowhere in the email exchange did I state the benchmark Vestcor uses for Absolute Returns is a "joke". I've learned over the years to be very careful and balanced with my comments because I tend to put my foot in my mouth sometimes and as I told this reporter, I don't know Vestcor well enough to make detailed comments about the benchmarks they use.

Now, I'm not saying I didn't speak with Mr. Jones or accusing him of lying but he certainly wrote a very slanted article and took my comments out of context to write a hack job on Vestcor (read the comments at the end of his article, of course, the public is pissed!!).

He's right about one thing, I'm a stickler for benchmarks, and every time I see any manager trouncing their benchmark by a very wide margin in any investment activity, my antennas go up because it typically means they’re taking risks which aren’t reflected in the benchmark.

I have written very terse comments in the past about why it's all about benchmarks, stupid!, demystifying pension fund benchmarks, and why we can't properly compare pension funds.

In fact, my two first blog comments back in 2008 were about the ABCPs of pension governance and alternative investments and bogus benchmarks.

I had real issues with PSP's bogus real estate benchmark back then. I vividly remember a Board meeting when I was working at PSP in 2006 where then board members Carl Otto and Jean Lefebvre looked me straight in the eyes and asked me if the benchmark PSP is using for Real Estate reflects the risks of the underlying portfolio.

I froze, looked at Gordon Fyfe who told me: "answer the question". I then looked at Carl and Jean and Paul Cantor who was the Chair of the Board and said: "No, the Real Estate group takes a lot of opportunistic risks which is why they're posting 30%+ gains annualized and the benchmark of CPI + 500 basis points doesn't reflect the risks they're taking."

André Collin who was then head of Real Estate was at that board meeting, and let me tell you if looks can kill, I was dead on the spot. Let's just say that was the beginning of my downfall at PSP because I had a target on my back from that day on.

But I did my job, was put on the spot, and answered truthfully. I had gone head to head with board members on other issues in terms of adding commodities as an asset class (I was vehemently against it) but in the case of the Real Estate benchmark, I was in total agreement with Carl Otto and Jean Lefebvre, it was and remains too easy to beat.

Now, there is a background story as to why PSP uses this benchmark for Real Estate. At that board meeting, after I spilled the beans, I was asked to leave the boardroom for five minutes. I went outside, heard some shouting and screaming, and when I came in, Carl and Jean abstained from the vote on whether to maintain the CPI + 500 bps as a Real Estate benchmark (it was a golden handshake between André Collin and Gordon Fyfe which is why that benchmark survived that vote).

Nowadays, most large pensions use CPI + 500 bps as a real estate benchmark but the difference is they're mostly buying AAA real estate investments, not hotels and other opportunistic real estate investments to trounce their benchmark (with more risk).

Even PSP's Real Estate style has changed considerably since André Collin departed that organization to join Lone Star where all he does is focus on opportunistic real estate deals all over the world to help John Grayken become even richer than he already is.

I have nothing against what Collin and Grayken are doing, all the power to them. Lone Star has delivered incredible returns for its clients over the years engaging in opportunistic real estate deals (relatively quick flips). There is nothing wrong with this, that's what Grayken loves, that's why he hired André and eventually made him president of his firm (it also helped that André invested billions with Lone Star while working at the Caisse and PSP).

But when you're working at a public pension fund, I have an issue with people gaming their benchmark, especially in private markets where things aren't always straightforward when it comes to benchmarks.

Somebody told me that Ontario Teachers' has a "Benchmark Committee" steered by its CEO, Ron Mock, and is made up of him, the CIO and Barbara Zvan, the head of Strategy & Risk. This committee makes sure nobody is gaming their benchmark in any investment activity.

I asked him why doesn't anyone from the Board sit on this committee and he replied: "The Board approves the benchmarks but it's up to management to make sure they are strictly adhered to in terms of risk. If management doesn't do its job, the Board can change the benchmark and even fire the CEO."

Good point. This person also told me that CPI + 400 or 500 bps is a fine benchmark to use in private markets and most deals aim to ensure CPI + 700 to have an "extra cushion". He added: "Private markets aren't liquid, there is a lot of time and energy involved in deals, so it's ok to want an extra premium over benchmark in deals."

As far as the risk, he stated: "The biggest risk in private market deals is permanent loss of capital but if the compensation is structured over a four or five-year rolling return period, the manager is aligned with the organization's objective not to take excessive risk by gaming the benchmark."

That is an important point, there are no perfect benchmarks in alternative investments, you want pension fund managers to take risk but not to go crazy and risk losing a ton of money on any given year. If the compensation is structured to primarily reward long-term performance, you can do away with a lot of these private markets benchmark gaming issues.

And remember, benchmarks can be gamed everywhere, including public markets and hedge funds, it's not just a private markets problem. If a manager is taking excessive or stupid risks, be it liquidity or leverage or whatever, it should be reflected in their benchmark. Period.

Anyway, as far Vestcor,  I apologize if my comments came off as arrogant and spiteful, that certainly wasn't my angle when speaking with Mr. Jones of the CBC.

I honestly don't know Vestcor's operations well enough but after speaking with Jon Spinney, I don't think they're gaming their benchmark nor is it easy to get the full bonus in their internal absolute return strategies, a portable alpha strategy which adds value and lowers overall risk in equities.

Yes, maybe they should use some spread over T-bills or better explain the benchmark and how it ties into long-term results and compensation but I don't think anything sinister is going on here, they just need to better communicate their results and how it ties into compensation (you can read the 2016 Annual Report here for more information).

My comments and those of Thomas Schneeweis are still valid for thinking about benchmarks for alternative investments but my comments were taken out of context here to make it seem as if Vestcor is run by a bunch of clowns who are gaming their benchmark in absolute return strategies, and that simply isn't the case.

I hope this comment clarifies things and I've learned my lesson, always be very careful talking to reporters, they all have an angle, an axe to grind and you don't always know what it is (a friend of mine warned me, reporters always have an angle before writing an article and they’re just looking for quotes to corroborate their angle).

Below, Barry Sternlicht, Starwood Capital Group chairman and CEO, provides insight to the real estate market and where he is seeing opportunity. Great discussion, listen to his views.

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