Public Pensions Lose Big on GameStop Fiasco?
The nation has been captivated by revelations of millions of amateur traders collectively through social media and online trading platforms taking on Wall Street’s highest cost, highest risk, most secretive money managers and winning—at least in the short term. These individual investors have piled into a David-versus-Goliath trade around the stock of GameStop, a troubled video game retailer. Hedge funds and other professional money managers were shorting GameStop’s shares, betting that its stock would fall in value while retail investors were banding together to buy shares and options betting the stock would go up.
The consensus seems to be that retail investors should not be banding together and gambling their hard-earned savings in this way and the SEC has said it is “actively monitoring the ongoing market volatility.”
If you’re a taxpayer or a government worker depending upon a state pension fund for your retirement security, you may be alarmed to learn that nearly all state pensions engage in high-risk strategies, including shorting stocks like Gamestop all the time. Paying lavish fees to hedge fund and other alternative investment managers to recklessly gamble workers’ retirement savings is bad enough. Worse still, the officials that oversee state pensions have no idea which stocks are being shorted by which external managers at any given time (perhaps even acting in concert) or the total amount of pension assets at risk.
That’s because state pensions routinely agree to be kept in the dark about alternative investment portfolio holdings and strategies. For reasons that have always been incomprehensible at least to me, state pensions demand transparency regarding their most liquid (publicly-traded) investments but readily consent to a complete lack of transparency regarding their riskiest, blithely accepting assurances by Wall Street that secrecy is required to achieve market-beating returns. This complicity between state pensions and Wall Street eviscerates state access to public records laws since the pensions conveniently have no information regarding their riskiest investments to disclose in response to pesky public records requests.
With state pensions already severely underfunded, allocating 26 percent to as much as 50 percent of their assets to alternative investment strategies including long-short equity poses enormous risk. Bear in mind, the ability to engage in short selling is not limited to hedge funds. Most other alternative investment managers are largely unconstrained in their investment strategies—they can invest in almost anything at any time. As a result, on any given day a private equity fund may be 100 percent invested in gold, the next 100 percent in silver, the next, 100 percent shorting GameStop.
For over a decade I have implored the SEC to examine alternative investment secrecy demands and questionable investment practices in connection with public pensions. Unlike the GameStop speculators today who at least know what they’re buying and selling, massive public pensions—supposedly sophisticated institutional investors handling trillions in retirement savings—have agreed to be kept clueless in the dark.
Let me state off the bat, this is a terrible article, one of Ed Siedle's worst comments, it demonstrates a total ignorance on how and why pensions invest in hedge funds.
First, most sophisticated pensions use portable alpha strategies to enhance their returns:
In a portable alpha strategy, market exposure (beta) is obtained synthetically through derivatives. Market investments are associated with passive fund strategies, which aim to track the performance of benchmark indices.
Alpha, meanwhile, refers to excess returns above what the market offers, and measures the value added by active fund management or superior strategies.
One of the major risks of portable alpha strategies is that they rely heavily on derivatives and borrowed funds, which means they can bring on hefty losses if markets make sudden downward turns. This risk is partly mitigated by the fact that portable alpha strategies add diversification to overall portfolios, since the alpha component is separate from the market fund.
Another restriction on the success of portable alpha strategies is that sources of alpha seem increasingly hard to come by. And alpha sources are quickly taken advantage of when they do appear, as fund managers race to exploit them.
Additionally, fund managers tend to charge high fees for portable alpha strategies.
So, how does portable alpha work in practice? A pension will swap into a bond index which literally costs a few basis points to track the "beta" of the bond index and then invest in hedge funds to add "alpha" over the index.
Back in the day when Ron Mock was in charge of investing Ontario Teachers' massive hedge fund portfolio, he explained it to me like this:
"...beta is cheap, you can swap into any index for a few basis points. Real alpha is worth paying for. At Teachers', we look to add T-bills + 500 basis points over he index we swap into, year in year out."
Now, since Teacher's invested roughly 10% of its portfolio in hedge funds back then (2000), that T-bills + 500 basis points target translated into 50 basis points of alpha (0.5%) that Ron's group consistently added over the index every year. And over many years, that 50 basis points really adds up (because it is compounded).
In a portable alpha strategy, the trick is to deliver that alpha over the benchmark consistently. And to do this, Teachers' focused mostly on market neutral strategies back then (arbitrage, multi-strategy, market neutral stock investing, etc.).
Ron Mock was also petrified of hedge fund blowups, so he invested in over 100 hedge funds at the time to limit operational risk.
Now, without going into too many details, I agreed with some but not everything Ron was doing back then. At the time, I was in charge of overseeing the directional portfolio of hedge funds at the Caisse, which consisted of global macros, L/S Equity, CTAs and a few short sellers.
So, I love directional risk, still do, especially when it generates great returns. I remember telling Ron to look into investing in Bridgewater back then and forget about all the market neutral stuff (they did invest in Bridgewater, everyone did).
Long story short, Ontario Teachers' hedge fund portfolio has evolved over the years. They don't invest as much in hedge funds as they used to but along with CPPIB, they're still considered the top hedge fund investor in Canada (back in 2000, Desjardins had the biggest portfolio of external hedge funds run by Jacques Lussier but it blew up in 2008 and Monique Leroux put an end to it, which was foreseeable but not wise longer term...they needed to have the right people manage that portfolio and Lussier is brilliant but not the best manager of hedge funds!!).
Anyway, fast forward to 2021, Ontario Teachers', CPPIB, CDPQ invest in hedge funds using a managed account platform called Innocap based here in Montreal.
Through non disclosure agreements, hedge funds provide Innocap with their positions at the end of the day, and the folks at Innocap load it all up and make sure everything adds up.
It's an extra layer of risk transparency, but there most definitely is transparency, and some US state pensions are also using this managed account platform (or Lyxor, their larger competitor).
Now, to be sure, transparency without liquidity is useless, which is another reason why I love directional hedge fund strategies because they typically invest in liquid instruments (large and mid cap stocks, futures, etc).
Still, after many years of being clobbered by the stock market and because there is so much competition in the hedge fund space, returns have been lackluster in the hedge fund industry, and many pensions (like CalPERS) have bailed, preferring private equity funds where they get a better alignment of interest even if returns have been coming down there too (co-investments have helped reduce fee drag and that is the approach Canada's large pensions have mastered).
But Ed Siedle stating "on any given day a private equity fund may be 100 percent invested in gold, the next 100 percent in silver, the next, 100 percent shorting GameStop," well that's just rubbish!!
I can assure you the top private equity funds large pensions and sovereign wealth funds are investing in NEVER engage in such activities and for Siedle to state this in Forbes, well, it's a crock of horse manure!
The big story last week was Melvin Capital blew up losing more than 50% shorting GameStop.
It's not the only one, others got clobbered too shorting GameStop, and the big worry now is many private and public pensions investing in hedge funds are going to feel the sting from these hedge fund losses.
It wouldn't surprise me if a few large and sophisticated pensions invested with Gabriel Plotkin, an SAC alumni who was indicted for fraud back in 2013.
But don't be fooled, before this GameStop blowup, Plotkin was considered a "god", a star money manager who was posting double-digit returns every year.
It's easy to get bamboozled by these hedge fund sharks, and truth be told, I might have even invested in Melvin Capital if I was at the Caisse, but I would have also ripped him a new one for total lack of risk management on this short position, redeemed and never looked back again.
Yes, he has a high water mark, can eventually recoup these losses, but it's a matter of principle, you're a bloody hedge fund for Pete's sake, a well-known one, how the hell did you not manage your risk accordingly???
I guarantee you nobody at Millennium was shorting GameStock, and if they did, Izzy Englander has already fired them (lose 2%, you're on notice, lose 5%, you're fired!!).
There is always going to be hedge fund blowups. Back in my time, it was Amaranth, a muti-strategy fund that lost more than $6 billion betting the wrong way on natural gas.
There were plenty of others, and everyone remembers LTCM chronicled in the book When Genius Failed (God I love that book!).
Will the GameStock fallout impact more hedge funds and spill over into pensions?
Maybe and maybe not, the media loves sensationalizing these things (read my last comment, YOLOers of the world, unite).
I can tell you the Reddit-WallStreetBets crowd helped Ontario Teachers Pension Plan as it sold its 16.4% stake in US mall owner Macerich for US$500 million (C$638 million) after the company’s shares soared, according to regulatory filings obtained by Bloomberg News.
Good move, Teachers' large stake in Macerich (MAC) was dragging down its portfolio returns for years and it needed to dump it.
Did Teachers' invest in Melvin Capital? I don't know, just like I don't know if CDPQ or CPPIB did, and to be honest, I don't really care. If they lost money there, it will sting but in terms of their overall hedge fund portfolio, it's meaningless over the long run.
One thing I would like is for Canada's large, sophisticated pensions to engage with the Securities and Exchange Commission (SEC) to advise them on drafting better regulations to make sure that hedge funds or bank prop trading desks are not engaging in questionable activities like over-shorting a stocks with low float, or gamma squeezing stocks so they melt up.
If anything, the GameStop saga has exposed the nonsense going on in the stock market, and that stuff not only turns small and large investors off, it scares them. The SEC needs to make sure everyone follows the rules and that everything is kosher (don't hold your breath)
Lastly, let's stop fueling myths that all short sellers are evil criminals. That's just rubbish!!
The best short sellers add value and liquidity into the stock market, but unfortunately, most of them have been infected with monetary coronavirus and are in hiding after this GameStock fiasco:
Coincidence? Stocks with the highest #shortinterest have pulverized stock market darlings ever since the #Covid19 crisis erupted and central banks stepped in with unprecedented amounts of #stimulus. via @zerohedge pic.twitter.com/cE8hSyBP2J— jeroen blokland (@jsblokland) February 1, 2021
So, stop cursing "evil short sellers", most of them are getting clobbered in these liquidity-driven markets dominated by mini manias (not all, some are posting great returns).
Also, take it from me, most Long/Short Equity funds suck at shorting stocks, really badly!!
Alright, let me wrap it up there, you're going to read a lot of stuff in the media about pensions getting hurt from the GameStop debacle, take it with a grain of salt. Wait for the dust to settle.
Below, Bianco Research president Jim Bianco weighs in on the battle between the individual investors and hedge funds, arguing that business practices on Wall Street 'have to start to change.
I agree with Jim on the need for better regulations, not so much on hedge fund collusion.
No doubt, there is a lot of collusion in the hedge fund industry but trust me, most of them are still cannibalizing each other and if they smell blood in the water, they'll go for the jugular.
Also, take the time to watch today's CNBC Half Time Report and listen to Stephen Weiss (around minute 12) speak about L/S hedge funds and how most of them are terrible at shorting (I concur!).