The Great Pension Heist

World markets soared today on easing of interbank lending rates. And wait, if my vested interests theory is right, this rally has got ways to go before hedge funds, mutual funds, and pension funds can breath easier. They are all underperforming so badly that they will be buying this sucker up on every dip.

Today I want to write about the Great Pension Heist. The great what? The Great Pension Heist is a sad chapter in financial history that is still unfolding.

Let me explain. I came across this article today discussing how hedge fund, private equity and real estate fund managers collected huge fees from the New Jersey Division of Investment despite underperforming their benchmarks:

Hedge fund managers and other private investment specialists made $62 million last year handling a small portion of New Jersey's retirement accounts -- nearly seven times what the state paid its own employees to manage a much larger basket of holdings, a new state report shows.

The Division of Investment tally of professional fees covers the fiscal year ending June 30, 2007, and is the first accounting of such payments since New Jersey in 2005 launched a controversial program to shift billions of dollars in retirement funds from traditional stocks to hedge funds, real estate and other "alternative investments."

The payments to 50 private investment firms included $22 million in performance bonuses, despite the fact their returns did not meet earnings benchmarks the state uses to gauge investment performance, the report shows.

Hedge funds, for example, returned 13.2 percent, compared with a benchmark of 14.3 percent. Real estate holdings returned 16.5 percent compared with an 18.3 percent benchmark.

The state-managed stock portfolio, meanwhile, made 21 percent -- a tick better than its 20 percent benchmark, the Standard & Poor's composite index, returned in the same period.

The report does not reflect the recent stock market plunge, which has hurt both the state's traditional stock investments and hedge funds. The budget year that ended June 30, 2007, featured robust returns across the stock market.

Critics of the shift to private managers say the hefty fees show the strategy was ill-advised.

"Who made the money off this?" asked Rae Roeder, a state workers union leader who led the campaign against the alternative investments. "Certainly not the members of the pension fund."

But state officials counter that the real benefit to the new policy was seen earlier this year, when private managers headed off $2.25 billion in potential losses by shifting investments away from traditional stocks as the stock market began to sour.

State officials also said New Jersey was unique among large retirement funds in its refusal to use outside managers before last year. "Every major public fund, corporation and endowment has a diversified portfolio that uses managers/partners," said Tom Vincz, Treasury Department spokesman.

Vincz said New Jersey's late entry into using such alternatives "has cost the state literally billions of dollars in potential investment returns over the last decade."

Orin Kramer, chairman of the State Investment Council, which sets state investment policy, said several studies show the New Jersey accounts were worse performers and higher-risk than other state funds before they were diversified through the private managers.

The $62 million in fees was divided among 50 private firms, according to records obtained by The Star-Ledger through the state Open Public Records Act.

Overall, the private managers shared $40 million in base fees and $22 million in performance bonuses for handling $3.7 billion in state funds. State employees with the Division of Investment, in contrast, cost $9.3 million to manage $93 billion in state funds.

Vincz said it is unfair to compare the private managers' pay scale with that of state workers.

"The type and scope of work is entirely different," he said in an e-mail. "The managers/partners run companies, own and manage real estate holdings and have an entirely different level of skill sets and responsibilities than internal analysts who make trades in our equity and fixed income portfolios ... and the managers/partners are paid negotiated management fees that are competitive with any other public fund."

According to the Treasury Department information, the biggest 2007 payout went to Och-Ziff Capital Management, a New York-based hedge fund manager that has handled $150 million in state funds since early 2006.

The investment gained 16 percent, or about $25 million, in 2006, enough to earn Och-Ziff a $5.3 million bonus on top of a $2.4 million management fee, the state records show. Since then, the fund has lost a fraction of the gains, monthly state reports show.

Next in line were Goldman Sachs, which earned $3.3 million in management fees and bonuses for handling $300 million of the state's money, and Angelo Gordon & Co., which earned $3.2 million for handling a $150 million state stake.

Gov. Jon Corzine was chairman of Goldman Sachs before entering politics, and two other prominent members of his administration once worked for the firm. The state's new investment strategy was initiated by former Gov. James E. McGreevey.

The market is now dramatically lower than at the mid-2007 cutoff date for the report's findings. Since then, four of the firms that collected performance bonuses lost the 2007 gains and more in a market collapse that has sapped billions from the state funds, according to Treasury Department reports.

Treasury Department officials say they have not yet calculated how much they paid the private managers during the most recent budget year that ended June 30. And there are no comparisons available between the privately managed funds and the state stock investments during the recent stock market plunge. The report on funds for the year that closed June 30, 2008, isn't expected until next year.

The lion's share of the state investments are for retirement accounts. They were valued at $76 billion at the end of August, a drop of $6.5 billion since June 2007.

The returns on state investments are significant because the more they earn, the fewer tax dollars must be put into the retirement system each year. Taxpayers contributed about $2 billion into the retirement accounts this year, still about $1 billion shy of what actuaries say is needed.

New Jersey still relies less on private managers than neighboring New York and Pennsylvania, public records show.

In 2007, Pennsylvania's School Employees Retirement Fund paid private managers $307 million to handle $11.3 billion in assets, fees that work out to 2.73 percent of the money handled. New York's Common Pension Fund paid private managers $276 million to handle $27.7 billion, a rate of 1 percent. New Jersey's managers collected fees amounting to 1.67 percent of the assets they handled last year.

WOW! Where do I begin? First of all, it does not matter that external managers make more than internal managers. This will always be the case and it has nothing to do with the size of the assets you manage but with your investment objectives and the skill set required with the investment activity.

If you produce true alpha, you should be compensated for it (remember, it's performance net of fees that counts). The problem is that most of these "sophisticated" managers wouldn't know true alpha if it hit them across the head. They claim to be alpha generators but all they do is collect huge fees for selling beta as alpha.

What matters here is that fees were paid despite the fact that the managers did not meet their investment objectives. This is ludicrous and highlights a serious weakness in the investment policy. Unfortunately, when I went to download the investment policy, the website says "coming soon".

The second thing that struck me was the high benchmark returns: "Hedge funds, for example, returned 13.2 percent, compared with a benchmark of 14.3 percent. Real estate holdings returned 16.5 percent compared with an 18.3 percent benchmark."

Their fiscal year ends June 30th, one quarter after that of PSP Investments and Canada Pension Plan Investment Board (March 30th). Nonetheless, I did not see the latter pension funds' private real estate benchmarks anywhere near 18 percent and their hedge fund benchmarks are not even disclosed!

I started off this blog because I was sickened by the flagrant benchmark abuses that I saw in the pension fund industry, especially in alternative investments.

When it comes to evaluating your fund managers, make sure they are using appropriate benchmarks for each internal and external investment activity. If you don't, you risk getting fleeced, allowing them to reap huge bonuses as they claim of adding value which is really cheap disguised beta.

The third thing that struck me is the bogus diversification argument. "Every major public fund, corporation and endowment has a diversified portfolio that uses managers/partners."

How many times have I heard "Harvard did it...Yale did it...Ontario Teachers did it..." So what? Who cares what Harvard does, Yale does or Teachers does!?!? You can try mimicking them all you want but you won't replicate their returns, especially not Harvard's or Yale's.

Let me repeat what I have stated countless times: Diversification does not work in a systemic crisis where all asset classes are deflating at the same time. POP GOES THE ALTERNATIVE INVESTMENT BUBBLE!

So who got fleeced in New Jersey? "Who made the money off this?" asked Rae Roeder, a state workers union leader who led the campaign against the alternative investments. "Certainly not the members of the pension fund."

He got that right. They were all fleeced like millions of other unsuspecting workers who have no clue about The Great Pension Heist taking place right under their nose.

The problem is that in most pension funds, spending is not scrutinized and when it is, you might be shocked at how the money is spent:

The Kansas City Star has an extensive report today on spending practices of the Public School and Education Employee Retirement Systems of Missouri. The revelations include a $600-a-night hotel stay, an open bar at Christmas parties for board members, and the company cars and free gasoline that top receive as a perk.

Perhaps the most serious matter is the lack of a policy regarding gifts from investment managers. As one Star story says:

In many states it’s illegal for pension fund board members and executives to accept gifts and gratuities from the investment managers they are in charge of hiring and firing.

But for the Public School and Education Employee Retirement Systems of Missouri, it’s business as usual.

Expect public-employee pensions to become a hot issue in the next couple of years. Most pension funds have suffered serious losses in the recent stock-market meltdown, and that’s likely to increase pension costs to taxpayers going forward.

A hot issue for the next couple of years? How about the issue of the next decade? Public pension funds will cost taxpayers billions of dollars and while governments move to regulate financial markets, they'd better have a closer look at the health of their public pension funds.

I also noticed that many investors are throwing in the towel on hedge funds. According to Reuters, the once high-flying hedge fund industry shrank 11 percent during the third quarter as investors punished managers for poor performance and pulled out a record $31 billion:

Hedge funds around the world now manage an estimated $1.72 trillion, down from $1.93 trillion at the end of June, Chicago-based tracking firm Hedge Fund Research said.

This marks the largest quarterly decline in assets ever, HFR said.

From July through September, the average hedge fund's returns fell 8.85 percent, HFR data show.

For the year, returns are down roughly 18 percent, and investors and industry experts are bracing for the loosely regulated industry to put up more disappointing numbers in the coming weeks.

"With losses continuing through October, it appears that 2008 will be the worst year on record for both hedge fund performance and industry asset flows," said Kenneth Heinz, president of HFR.

The tracking firm said redemptions and market losses reduced industry assets by $210 billion during the third quarter -- more than investors put into hedge funds during all of 2007.

Even though mutual fund losses are bigger than hedge fund losses -- the average U.S. stock fund is down 34.17 percent according to Lipper Inc -- investors are pulling money out to protest high fees and guard against fresh problems.

This just confirms that hedge funds are reeling and they will do everything they can to make sure the final quarter of the year is nowhere near as dismal as the third quarter. Mutual funds and pension funds will tag along , trying to make up for their losses as well.

Finally, before we beat up on hedge funds, let's stop and look at private equity's poor returns:

Financial services provider State Street Corporation said private equity industry returns fell deeper into negative territory in the second quarter due to building global economic pressures.

The State Street Private Equity Index internal rate of return, based on quarterly statistics garnered from more than 1,400 private equity partnerships with a total value of $1.3 trillion, fell to -1.51 percent in the three months to end June 2008, deepening from -0.87 percent the previous quarter.

"Overall, private equity is feeling some of the same economic pressures as the public markets," said Gerard J. Labonte, vice president, State Street Corporation.

"Private company valuations may not necessarily exhibit the volatility of the public markets, but the ability to finance deal flow and achieve exits has been severely constrained by the recent market shakeup," he said.

Labonte said the distressed fund segment, which is positioned to take advantage of the impact of the economic downturn, achieved positive results over the quarter.

Worse still for private equity funds is that Big Brother won't give them money for nothing.

But I am not crying for hedge funds, private equity funds and real estate funds. Both smart and dumb managers made a fortune during the Great Pension Heist.

No, what worries me is that the massive alternatives bubble burst, the financial system is teetering on collapse, pension deficits will explode and if obligations are not met, increasingly poorer taxpayers will be asked to foot the bill.

This is the great tragedy of our era. On that depressing note, I am off to get some shut-eye.