Are US Public Pensions The Next Crisis?

Katherine Chiglinsky of Bloomberg reports, Next Crisis in Finance May Be Public Pensions, $1.2 Trillion Asset Manager Says:

What’s on the list of concerns for a man who runs a $1.2 trillion asset manager? Swelling shortfalls in U.S. public pensions, according to PGIM Chief Executive Officer David Hunt.

“If you were going to look for what’s the possible real crack in the financial architecture for the next crisis, rather than looking in the rearview mirror, pension funds would be on our list,” Hunt said Friday in an interview. Pressure on municipalities and states will intensify in a downturn when local tax revenues decline and unemployment worsens, he said. “So we’re worried about those pension obligations.”

Lawmakers from New Jersey to Illinois to California are struggling to fill shortfalls. U.S. public pensions had 71.8 percent of assets required to meet obligations to retirees as of the fiscal year ended June 2016, according to a report by the Center for Retirement Research at Boston College.

PGIM, owned by Newark, New Jersey-based Prudential Financial Inc., counts 147 of the 300 largest global pension funds among its clients. Hunt said that corporate funds generally do a better job than their public counterparts.

Hunt acknowledged that it’s harder in the public pension space where lawmakers set the benefits and the fund managers are tasked with generating enough return to cover those promises. Still, he said he has advised public-pension clients to stop looking for the highest-return hedge fund and “start doing what the corporate folks have long been doing, which is to find ways to minimize the deficit and to take risk gradually off the table.”

Hunt joined Prudential in 2011 from McKinsey & Co. He’s doubled assets under management, renamed the business PGIM and bought a Deutsche Bank AG unit to expand in India.

In the interview, Hunt also said he’s seeing a shift in equities markets as more firms pursue private funding and initial public offerings “remain remarkably muted.” The number of publicly traded U.S. companies shrank from more than 8,000 in 1996 to about 4,300 in 2016, according to Ernst & Young.

“More than any other period in our history we’re going to have companies that are owned by private equity rather than the public equity markets,” Hunt said. “The dynamism and growth of the economy is now more and more being captured privately and by institutions rather than actually available for you to own in your 401(k) account or for other public markets.”

Hunt said he doesn’t expect a wave of combinations among asset managers, even as some have predicted that fee pressure could provoke more tie-ups such as the merger of Janus Capital Group Inc. and Henderson Group Plc. Even as the equity business suffers, it hasn’t gotten bad enough to spur more mergers and acquisitions, he said.

“If you’re a modestly scaled equity business right now you’re having a hard time, but you’re not losing money yet,” he said. “You’re more likely to have what I’ve kind of called the field of zombies. You have these firms, they don’t disappear. They stop growing and maybe they’re even shrinking, but they carry on.”

I love these Bloomberg articles that discuss pensions and never mention me or my blog. Anyway, it was almost a year ago that I discussed whether collapsing US pensions will fuel the next crisis and followed that comment up with a discussion on the $400 trillion pension time bomb.

There are big problems at US public pensions. Illinois has one of the worst public pension systems but there are plenty of others that aren't far behind.

More worrisome, US public pensions are taking increasingly dumb risks to achieve their unrealistic investment targets based on rosy investment forecasts. Gregory Zuckerman, Gunjan Banerji and Heather Gillers of the Wall Street Journal report, Harvard, Hawaii Gambled on Market Calm—Then Everything Changed:

A decade of low bond yields pushed some of the most stability-minded investors to dabble in risky investments that depended on markets being orderly. Now, those bets are looking problematic.

You can read the entire article here but there's nothing shocking in it except that endowment funds and public pensions were betting the silence of the VIX would continue indifinitely and they basically got their head handed to them like many others picking up pennies in front of a steamroller.

In my market comment last Friday looking at whether it's a correction or something worse, I stated this:

You will notice I avoided discussing the blowup in the XIV and a bunch of nonsense short-volatility ETNs because quite frankly, I'm happy this garbage died as the silence of the VIX came to a screaming halt.

As far as other vol blowups this week, I think AQR's Cliff Asness nailed it in his tweet below:

The vol fund story is subtler than what we hear. It is not shocking that funds that explicitly bet on calm by selling tail insurance get creamed, even wiped out, in a big sell-off. It is shocking, at least to me, how small the event that killed them was. This was not 10/19/87.

— Clifford Asness (@CliffordAsness) February 7, 2018

Karl Gauvin of OpenMind Capital here in Montreal shared similar views with me in an email yesterday:

Amazing how peoples don't know how to manage VIX futures! If you manage a short VIX strategy you need to have a Stop Loss set at 2 points of Vol to avoid going belly up. Using this with Volatility Regime is an additional feature that adds value. And even more important, the short VIX futures position should always be covered by a long deep out of money call option on the VIX...with at least 3-month maturity.

With our vol signal, we would have bought back all our VIX futures last Friday. Too bad I have stop trading this strategy last year.

You can read Karl's volatility regime update on LinkedIn here.

All this to say, stop reading hyper sensational scary stories on Zero Hedge about how the volatility blowups will cause the next market crash. If anything, these blowups are a good thing, got rid of a lot of garbage that needed to be exterminated, and allows the market to resume its long-term uptrend on more solid footing.

There are a lot of US public pensions that have no clue what they're doing shorting volatility and I'm not sure the geniuses at Harvard's mighty endowment fund are any better.

They definitely should talk to Karl Gauvin and Paul Turcotte at OpenMind Capital who have solid quantitative experience in this space and have worked at large pensions and asset management firms.

Another guy they should talk to is Bryan Wisk of Asymmetric Return Capital. Bryan worked at top hedge funds and is an expert in structuring trades to properly hedge against disaster risk without bleeding returns. He sent me this message last night:

The sad irony of the Arc mission is that some pension funds not only didn’t care to hedge, they doubled down on short vol.  The only blessing is that these articles are being written in the context of a minor correction. Imagine an actual bear market.  Hopefully, these funds have time to at least redeem from the frauds who sold the trustees on these strategies as a way to make up for the return shortfall elsewhere in the portfolio.

I'm not shocked that US public pensions are taking increasingly dumber risks. Canada's large public pensions have been piling on the leverage but the difference is they know what they're doing and aren't shorting volatility outright through the XIV (who knows, maybe some did but I doubt it).

What shocks me is that they're right back at it, selling volatility (shorting it), ignoring the danger of irrational complacency. This is what I find quite disturbing, especially given my Outlook 2018: Return to Stability, where Francois Trahan and I warned investors to hunker down, get more defensive and prepare for higher volatility.

Below, Gregory Zuckerman, Wall Street Journal special writer, looks into pension funds and how fund managers are taking more risks with volatility trading. Listen to what he says, very interesting and quite disturbing.

And Quadratic's Nancy Davis, who predicted that the popular low volatility trade would implode, says the market will remain turbulent for some time. "It's created a very large exposure of short volatility, and I think it's created a huge opportunity for actually owning volatility," said Davis, Quadratic's managing partner and chief investment officer. "The market's not settled down, we're not in smooth sailing anymore. People are still in the buy-the-dip mentality."

Mrs. Davis isn't the only guru who thinks the current market calm is an illusion. We'll see, after a rocky week, the VIX has plunged back down below 20 as stocks have taken off again, but it's too early to tell whether volatility will remain low for the remainder of the year (I wouldn’t bet on it).