Pension360

This post is authored by Leo Kolivakis and was originally published at Pension Pulse.

Kolivakis is a blogger, trader, economist and consultant — you can find him on Twitter or at his blog, Pension Pulse.

The Canadian Press reports, Canada Pension Plan Investment Board teams up on $2.9 billion stake in U.K.’s top ports manager:

The Canada Pension Plan Investment Board and a British partner are spending about $2.9 billion to acquire at 30% stake in one of Britain’s top ports managers.

The deal with Hermes Infrastructure to acquire a share of Associated British Ports may increase by a further 3.33% subject to pre-emption rights.

ABP is the U.K.’s leading ports group and owns and operates 21 ports in England, Scotland, and Wales as a landlord port owner and operator.

CPPIB and Hermes Infrastructure, part of Hermes Investment Management, are acquiring the stake from GS Infrastructure Partners and Infracapital.

Borealis Infrastructure and Government of Singapore Investment Corporation (GIC) will remain ABP shareholders. The transaction is conditional on customary clearances and is expected to close in the summer.

The CPPIB already has a large presence in the U.K., with about $14.3 billion in investments in several sectors as of Dec. 31, 2014.

Earlier this month, the board bought a portfolio of 40 student residences across the United Kingdom for $2.1 billion.

David Paddon of the Canadian Press also reports, Canada Pension Plan board partners for $2.9B stake in U.K. ports:

The Canada Pension Plan Investment Board and a British partner are spending about $2.9 billion (Cdn) to acquire at least 30 per cent ownership in a company that owns and operates 21 ports in England, Scotland, and Wales.

The board and Hermes Infrastructure are buying their initial stake in Associated British Ports from GS Infrastructure Partners and Infracapital. They could potentially buy an additional 3.33 per cent, which would make them one-third owners of ABP.

Borealis Infrastructure, which is an arm of the Ontario-based OMERS plan for current and retired employees of Ontario municipal governments, will remain one of ABP’s shareholders as well as the Government of Singapore Investment Corp.

CPPIB will be providing a “majority” of the money for the ABP deal, said Cressida Hogg, global head of infrastructure for the Toronto-based fund manager. She declined to be more specific.

The board has bid before on port assets but had been unsuccessful until ABP which Hogg said was a “must-have asset.”

“What we see is that growth is really picking up in the U.K,” Hogg said in an interview from London.

“We think that the volumes of port traffic in and out of the country are going to be sustainable for the very long term and ABP will benefit from that.”

CPPIB invests money that’s not currently required to pay beneficiaries of the Canada Pension Plan.

The Associated British Ports deal is the second major investment in the United Kingdom this month by CPPIB, which manages about $238.8 billion in assets on behalf of the Canada Pension Plan, including $13.1 billion on global infrastructure.

The board already had a large presence in the U.K., with about $14.3 billion in investments in several sectors as of Dec. 31, 2014. Earlier this month, the CPPIB bought a portfolio of 40 student residences across the United Kingdom for $2.1 billion.

Bloomberg reports that Goldman Sachs Group Inc. and Prudential Plc agreed to sell a stake in Associated British Ports, the U.K.’s leading port operator to CPPIB and Hermes. Deutsche Bank AG and Macquarie Capital acted as financial advisers to CPPIB and Hermes.

CPPIB is following the Caisse which just announced a huge deal with Hermes as well, buying a 30% stake in Eurostar, owner of the “Chunnel” rail service between London and Paris.

At this rate, Canada’s large pension funds will pretty much own all of the UK’s major infrastructure assets, which will raise a few eyebrows in England. But hey, if they are selling stakes in prime infrastructure assets, why shouldn’t our big funds be buying them?

What do I think of the Associated British Ports deal? I’m not as enthusiastic as Cressida Hogg on this “must have asset” or on the growth prospects of the UK where inflation just hit zero for the first time in 55 years, and fears of an economic slowdown sent the pound tumbling lower.

Of course, infrastructure assets have an extremely long investment horizon, much longer than private equity and real estate, which is why pensions that pay out long dated liabilities are clamoring to buy stakes in them regardless of current economic conditions.

Still, ports make me nervous at this time. Earlier this month, the Hellenic Shipping News reported, Baltic Dry Index: Is This Powerful Indicator Signaling A Global Recession?:

Although memories of the Great Recession linger, a case can be made that better days lie ahead.

That’s because central banks around the world are pursuing bold stimulus measures. And the United States is looking solid enough for the Federal Reserve to contemplate its first interest rate hike in nearly a decade.

Moreover, gas prices have fallen sharply, which aids consumers, and the stock market is way up, having nearly tripled from recession lows.

But this is no time for investor complacency: indeed a key economic indicator suggests trouble may be brewing just beneath the surface.

The index in question: the Baltic Dry Index.

As a composite measure of worldwide daily shipping prices for commodities like iron ore, steel, cement and coal, the BDI provides insight into manufacturer demand for the raw materials that, literally and figuratively, form the foundation of the global economy.

Typically, a rising BDI coincides with stronger demand from producers, who’ll need raw materials to generate energy and manufacture a variety of things, from roads and bridges to cars and machinery.

This is what makes the BDI such a compelling indicator. It provides information about core economic activity that has yet to take place.

The thing is, the BDI crashed from 2013 highs and now sits around 30-year lows.
The sheer magnitude of the decline should grab every investor’s attention.

My colleague Dave Sterman recently expressed concerns of the growing likelihood of financial distress for dry bulk shippers , which has broad domestic implications, but I am equally concerned about what it means for the global economy.

While the plunge doesn’t necessarily portend a market crash, know that the BDI has shown persuasive correlations with severe market downturns before. It happened in 1999, just ahead of the 2000 dot-com bust. And in 2008, the BDI plunged a stunning 90% in less than half a year. That move occurred soon before the 2008 stock market rout was fully underway.

If the BDI was able to forecast the worst of the past two market crashes, might the current plunge also signify trouble ahead?

I think it may… but with a caveat.

As Dave Sterman recently noted, “Dry bulk shippers ordered a lot of new ships in 2013, many of which started plying the waters in the past 12 months.” In fact, the industry’s new ship orders more than tripled to 947 in 2013, from 267 the year before, because coal imports were expected to rise dramatically.

When the big increase didn’t occur, the shipping industry was left with a major oversupply problem — “too many ships chasing too little market action,” as David puts it. The oversupply has triggered aggressive, industrywide shipping price cuts. For example, the average daily capesize rate, the charge for ships that carry up to 150,000 metric tons of cargo, is now around $6,600, compared with as much as $20,000 per day a year-and-a-half ago.

A similar trend is underway in the oil industry. There, too, crashing prices have much to do with a supply glut (brought on mainly by soaring U.S. production), and the glut makes it harder to tell how much of the crash is due to falling demand. This dilutes oil’s value as a leading economic indicator.

Because of the shipping glut, something similar is probably happening with the BDI.

That said, the BDI’s plunge is likely giving a strong signal about the demand side of the equation. By now, most investors are well aware of the many drags on demand for commodities. European and Japanese economies are in turmoil, a recession is underway in Russia and Canada and Australia may also be entering into recession.

Many analysts consider China to be the single-biggest factor in weakening raw materials, simply because its economy is now so large. No country buys as much iron ore as China, yet its imports of the commodity are only expected to rise 7.5% this year, the slowest pace of growth in five years.

So despite the large supply component that’s in play, I still think the BDI has an important message about the global economy. It’s probably not signaling the dire economic conditions a 30-year low might suggest, but investors should be prepared for the possibility of the global economy slowing down and perhaps even slipping dangerously close to recession.

When it comes to shipping follow the Greeks, they own the largest merchant shipping fleet in the world and know what is going on. In fact, my brother sent me an article yesterday from Robert Wright of the FT, Shipowner warns private equity to stop backing new vessels:

One of Greece’s highest-profile shipowners has warned private equity firms they risk “destroying” markets if they continue to finance new vessels, after excessive deliveries have driven down cargo rates.

Private equity, which until the past few years was only a minor contributor to shipping finance, has invested at least $5bn in shipping every year since 2010 and funded about 10 per cent of deals.

The cash rescued many companies after the collapse in rates and banks’ growing caution towards shipping lending after the financial crisis.

However, much of the new capital was used to order new vessels at cut rates from desperate shipyards, rather than buying existing vessels from other shipowners.

The tactic flooded first the tanker markets and subsequently the market for ships carrying coal, iron ore and other dry bulk. Average charter rates for a Capesize, the largest dry bulk carrier type, were languishing on Monday at $4,301 a day, well below the roughly $13,000 cost of operating and financing a typical ship.

“We welcome private equity in our business,” said Nikolas Tsakos, chief executive of Tsakos Energy Navigation. “But there are 10,000 second-hand ships. For their own good, it would be better if they invested in second-hand ships, rather than destroying the markets they want to invest in.”

Mr Tsakos, who listed TEN on the New York Stock Exchange in 1993 and is also the chairman of Intertanko, the tanker owners’ trade body, nevertheless praised private equity firms’ “cool, logical approach”, which he contrasted with shipowners’ traditional stance.

“We shipowners tend to be very sentimental and stupid,” he said.

He expressed hope that private equity firms might sell assets quickly and at a discount if necessary when they decided to exit shipping, to avoid the prolonged haggling that can scupper sales.

Many private equity investors are unable to escape their shipping investments without recognising substantial losses.

“When you’re negotiating with a traditional shipowner, every $100,000 in the price of a ship — the deal can break,” Mr Tsakos said.

TEN, which owns 64 tankers, suffered from a slump in earnings for crude oil and oil product tankers to nearly nothing for much of 2013. But a sharp recovery over the past six months has raised rates for the largest commonly-used crude tankers, known as Very Large Crude Carriers, to around $54,000 a day.

Supply and demand came into balance only after new orders dried up, Mr Tsakos pointed out.

“People stopped ordering ships because there was no future for them,” he said.

The troubles in shipping are only going to be exacerbated by a prolonged global economic slowdown, especially if global deflation materializes. With the China bubble going parabolic, I’m starting to get very nervous on ports and other infrastructure assets which are simply plays on global economic growth.

As always, the pricing of these deals matters a lot, and as I stated above, they are very long-term assets which match well with pension liabilities and they’re easily able to weather through tough economic cycles. But they’re not immune to a major global economic slowdown and there are other risks involved with infrastructure assets (currency, regulatory, political, illiquidity risks).

Also, I’d like to see a lot more transparency on the terms of these deals. What were the multiples paid and just how profitable are the Associated British Ports? Saying we (along with Hermes which put up a lot less than CPPIB) paid $3 billion for a “must have asset” doesn’t exactly reassure me. CPPIB and others should provide the public with a lot more specifics on these multibillion infrastructure deals, especially given the amounts they’re investing.

Finally, the Ontario Teachers’ Pension Plan announced solid returns for 2014, gaining 11.8% last year. I will cover these results later this week after I have a chance to speak with Ron Mock, Teachers’ President and CEO.

 

Photo by  Hilts uk via Flickr CC License

Stephanie Eschenbacher of the Wall Street Journal reports, Swiss Investor Calls for Big Cut in Hedge Fund Fees:

One of Europe’s biggest hedge fund investors, Unigestion, is pushing hedge funds to scrap management fees in place of a bigger slice of profits as investors attempt to crack down on high charges.

Nicolas Rousselet, head of hedge funds at the $16.7 billion investor, which has $1.9 billion invested in hedge funds, said that a zero management fee in exchange for a higher performance fee of 25% was “a great fee structure”. Hedge funds typically charge a 2% management fee and a 20% performance fee although better performing, more established managers can charge much higher fees. These top managers tend to attract investors easily, often having to turn away new ones, and can dictate terms to investors.

Mr. Rousselet said Swiss-based Unigestion had been pushing for a “transformation of fees”, that his team had successfully negotiated lower management fees with some hedge fund managers last year, and in two instances secured rates of lower than 1%.

Among those were both newer managers and more established ones that wanted to work with Unigestion on a new share class or fund.

Mr. Rousselet said: “If [a hedge fund manager] truly believes in his ability to perform, he should take my deal.” However, he acknowledged that low fees could pose a business issue for the hedge fund manager and conceded that the main challenge for investors was that the best-performing funds were oversubscribed.

He said that this transformed fee structure encouraged hedge fund managers to take on more risk, but that hedge fund investors like Unigestion needed to ensure that funds were prepared to take some risks. The aggressive stance is the latest development in a long-running fee debate between hedge funds and investors.

Data released earlier this month by Deutsche Bank Global Prime Finance showed that the success rate of fee negotiations was only gradually improving: some 37% of investors that negotiated fees were successful in one out of every two negotiations. This rate has increased from 35% a year ago, and 29% the year before that.

Investors are usually able to negotiate fees if they can commit a larger investment, and agree to invest for the longer term.

Deutsche Bank said that the most successful negotiators interviewed for its survey, which spanned 435 investors who have $1.8 trillion worth of investments in hedge funds, had an average of $5.6 billion invested in hedge funds. They agreed to invest on average $70 million for at least one year.

Institutional investors are finally openly discussing hedge fund fees and terms. Earlier this month, Ian Prideaux, CIO of the Grosvenor Family Investment Office, Marc Hendricks, CIO of Sandaire Investment Office and Simon Paul, Partner at Standhope Capital, wrote a letter to the FT on how the hurdle rate should apply to hedge fund industry as it does in private equity:

Sir, Sir John Ritblat makes a good point regarding hedge fund fees (Letters, March 2). Hedge fund managers should only be rewarded with an incentive fee for delivering performance that exceeds a “normal” hurdle.

For internal benchmarking purposes, many investors use an absolute return measure such as the return on short-dated Treasury bills plus 4 per cent. We should like to see a hurdle at a similar level adopted by the hedge fund industry generally, which by so doing would accept that it expected to deliver a “super return” in exchange for its incentive fee, as its highly talented managers no doubt consider themselves capable of producing. Otherwise investors can find themselves in the depressing position of paying an incentive fee on any positive performance however small.

If one assumes the “standard” — but by no means ubiquitous — 2 per cent plus 20 per cent fee structure, then a 5 per cent gross return to the fund is whittled down to a 2.4 per cent net return to the investor. A hurdle rate — typically of 8 per cent — is standard in the private equity fund sphere and only when the manager has delivered this return to the investor can he help himself to a share of the surplus. Why should the hedge fund industry not follow suit?

Good point, hurdles for hedge funds is something I discussed back in October, 2014. As far as fees, you know my thinking, it’s about time a lot of overpaid hedge fund managers follow other wiser managers and chop fees in half.

I know there is still plenty of dumb pension money piling into hedge funds, especially the larger ones all those useless investment consultants are in love with, but the gig is up. Hedge funds have been exposed by none other than Soros and Buffett as outrageously expensive money managers that typically underperform the market.

I can hear hedge fund managers protesting: “Leo, Leo, Leo, you don’t understand! We have ‘niche strategies’ and mitigate against downside risk. We need to charge hefty fees to all those dumb pension and sovereign wealth funds you mention on your blog so we can maintain our lavish lifestyle and make it on the Forbes’ list of the rich and famous. It’s expensive competing with Russian oligarchs and royalty from the Emirates for prime real estate in London and Manhattan. Not to mention the cost of Ferraris, yachts, private jets, fine art, and plastic surgery for our vain trophy wives is skyrocketing up in a world of ZIRP and QE!!”

Oh, cry me a river! When I was investing in hedge funds at the Caisse, one of the running gags was if we had a dollar every time some hedge fund schmuck told us he had “a niche strategy that’s uncorrelated to the market,” we’d all be multi-millionaires!

Thank god I’m no longer in that business because I’d be the biggest pension prick grilling these grossly self-entitled hedge fund prima donnas charging alpha fees for leveraged beta. And most hedge funds are still underperforming the market! No wonder hedge funds saw their worst year in closures since 2009 last year and a few top funds don’t want to be called hedge funds anymore. Most hedge fund managers absolutely stink and should follow Goldman’s fallen stars and pump away!

Alright, enough ranting on crappy hedge funds. Let’s get serious. I think it’s high time we critically examine what hedge funds and private equity funds offer pensions and other institutional investors. And by critically examine, I don’t mean some puffy article written in Hedgeweek, extolling the virtues of hedge funds using sophisticated and (mostly) irrelevant mumbo jumbo. I mean “where’s the beef baby?” and why should we pay these guys (it’s still an industry dominated by testosterone) all these hefty alpha fees so they become nothing more than glorified asset gatherers on their way to becoming part of the world’s rich and famous?

As far as fees are concerned, I don’t fully agree with Unigestion’s Nicolas Rousselet. I don’t want hedge funds to be compensated by taking higher risks, I want them to be properly compensated by taking on smarter risks. There’s a huge difference and incentives have to be properly aligned with those of investors looking to consistently achieve some bogey, however illusory it might be.

As I’ve stated, there’s a bifurcation going on in the hedge fund and private equity industry. The world’s biggest investors are looking for “scalability” which is why they’re increasingly focusing on the larger funds and using their size to lower fees. But they’re still paying huge fees, which takes a big bite out of performance over the long-term.

As far as the smaller funds, they typically (but not always) focus on performance but they need to charge 2 & 20 to survive. Big pension and sovereign wealth funds aren’t interested in seeding or investing in them, which is a shame but very understandable given their limited resources to cover the hedge fund universe. Typically, smaller endowment or family offices or a former hedge fund billionaire boss are their source of funding.

If I can make one recommendation to the Institutional Limited Partners’ Association (ILPA) as well as the newer Alignment of Interests Association (AOI) is to stop schmoozing when you all meet and get down to business and come up with solid recommendations on hedge fund and private equity fees and terms.

What do I recommend? I think hedge funds and private equity funds managing multi billions shouldn’t be charging any management fee — or they should charge a nominal one of 25 basis points, which is plenty to pay big salaries — and the focus should instead be on risk-adjusted performance. The alternatives industry will whine but the power isn’t with them, or at least it shouldn’t be. It should be with big investors that have a fiduciary duty to manage assets in the best interests of their stakeholders and beneficiaries.

I still maintain that most U.S. public pension funds are better off following CalPERS, nuking their hedge fund program. They will save big on fees and avoid huge headaches along the way. And forgive my bluntness but most pensions don’t have a clue of the risks they’re taking with hedge funds, but they’re all following the herd, hoping for the best, managing career risk even if it’s to the detriment of their plan’s beneficiaries.

On that note, I leave you with something else to chew on. Neil Simons, Managing Director of Northwater Capital’s Fluid Strategies sent me a comment on operational risk, A Hedge Fund Manager, an Astronaut and Homer Simpson walk into a bar…:

We would like to propose a question to you: Is it possible for an investment management firm to operate with the same level of precision and reliability found in industries where failure is simply not an option?

To answer this question, we looked at operational practices in industries such as nuclear power, space travel, aviation and healthcare, which face the prospect of catastrophic failure on a daily basis and have the highest standards for reliability and quality – after all, failure in these industries is a matter of life or death. While the consequences of success or failure in the investment management industry may not be quite as extreme, we do believe that investment managers must treat their investors’ dollars with the same level of respect and thus operate to the same standards.

In this post, we explore what investment management would look if we applied the same level of operational excellence found in these industries. Investment management is a business of precision, yet far too often you hear rumours of ‘fat-finger’ execution errors, or other more serious issues due to operational failures. And these are only the failures that you hear about – what about the failures that go unreported to clients, or even worse, failures that the investment manager itself is not aware of? What it all comes down to is that errors in investment management, no matter how small, are a sign of a lack of quality, and with a lack of quality there is a potential for loss and deviation from strategy.

Are Current Best Practices Sufficient?

Most major operational deficiencies (lack of proper oversight and separation of duties, for example) can often be uncovered by traditional manager due diligence activities. However, many approaches to manager due diligence are conducted through the use of questionnaires which are often built around a series of “check boxes” to ensure that nothing large falls through the cracks. This process places little attention to the quality and repeatability of investment operations. Third party due diligence firms conduct more detailed reviews, but can only see so far into the manager’s processes.

Most practitioners would agree that the intricacies of processes are a potential source of operational risk. For example, frequent small errors could be a reason why a fund might deviate from its benchmark or intended strategy. These errors may also reflect a general lack of attention to detail in the manager’s organization. But most importantly, they conspire to provide the investor with something other than what they are paying for – quality service and predictability of returns.

The Next Level: Systematic and Detailed Examination

Passing a due-diligence audit is a good first step, but managers have the ability to hold themselves to a higher standard. When we at Northwater think about operational deficiencies, we look at all potential failures that can occur throughout the investment process, e.g., inside the details of reconciliation processes, trade execution and model updates. It is only at the finest level of granularity that one can assess errors that may go unnoticed. A systematic method is needed in order to investigate, prioritize and the resolve potential failures.

Failure Mode and Effects Analysis (FMEA) is one technique that we have implemented to assess quality and to reduce the probability of smaller errors, not just to prevent large, obvious ones. FMEA was originally developed by reliability engineers and is widely used today in many non-financial industries. To implement FMEA concepts, we have taken an in-depth look at our own processes to identify areas that can be improved, examine the potential results of errors that can occur, develop highly-documented processes to ensure accuracy and consistency, and continually review and improve these processes.

Nuclear power plants, airlines and hospitals have all adopted strict and well-documented quality control processes that prevent not just large errors, but the potential for a small error to propagate through a system with the potential to push a system beyond its tipping point.

Acknowledge the Human Element

Other industries explicitly acknowledge and manage the human factor and acknowledge that human error rates are not zero even for the simplest task.  Consider a study conducted by NASA to understand human error rates when performing relatively simple tasks; cognitive scientists have found that humans have base error rates in performing even the simplest tasks such as the classification of even vs. odd numbers or identification of triangles.

Despite the best intentions of employees, an underlying issue in investment management is that firms are made up of people and people make mistakes – it is inevitable. Even if the average employee isn’t Homer Simpson, the pilots from “Airplane!”, or the cast from TV’s “Scrubs”, the staff at these organizations face legitimate challenges such as time availability, stress levels, distractions, and even ergonomics and office culture. As such, a lot can be assessed from a review of the processes in place to manage the ‘human factor.’

At Northwater, we have explicitly acknowledged the human element within our processes as well as the performance shaping factors that can impact human performance. Automating processes is a standard method for minimizing the probability of an operational error. It is also possible to redesign processes to reduce complexity. This reduction in complexity helps to minimize the probability of error when a human is involved with a process. We believe that this is an important aspect of our approach to the minimization of operational risk.

By looking to other industries, investment managers can achieve a higher operational standard. If you are interested in learning more about our novel approach to understanding and minimizing operational risk, please contact us.

Neil followed up with these comments for my blog readers:

As discussed, we probably didn’t go into sufficient detail in the post. We did quite a few things in our opinion to reduce operational risk.

One, as mentioned, was the implementation of the FMEA methodology. Requires all the people involved in daily trading (PM’s, ops people, model people) to systematically map all processes and then brainstorm on how processes can fail. Then rank how failures can cause problems by severity and ultimately prioritize and implement changes to processes to eliminate or significantly reduce the probability of those failures.

FMEA is a standard practice in many other industries to assess operations but you don’t seem to hear about it in finance.

We believe that standard op risk practices are important and useful for finding issues associated with investment management firms. They play an important role in helping investors. This topic is more about assessing quality and repeatability of operations. And achieving the highest possible quality, resulting in minimizing the probability of an operational issue associated with day to day portfolio management.

We believe that the third party operational risk firms can’t ever go into as much detail as the management firm itself. It is only the people involved in the actual processes that can really understand how processes could fail. Benchmarking and big picture best practices are done well by the third party people but I don’t believe they can do a good job at assessing the real quality of the processes.

Financial firms typically strive to implement industry best systems. However, at times, these systems require workarounds and spreadsheets. As well, many of these workaround can be operated by junior people and we believe they are accidents waiting to happen. It is just assumed that these people won’t make mistakes or it is up to these people to show sufficient “attention to detail” to never make a mistake. But to us, that is an unrealistic assumption.

Humans make mistakes.

The next aspect that helped us was acknowledgement of the human side. Once you read some of the literature on how humans screw up simple things, you realize it is just a matter of time until someone makes a mistake while operating a process. Humans have small, but non zero error rates for even the simplest tasks. As task complexity increases, the error rate increases.

If a diligent person does 20 simple tasks per day and they do that every day for a year, then you should consider the potential error rate of those tasks. A 1 in 1,000 error rate will cause errors to become a reality for the case of 20 tasks per day for an entire year. If the potential consequences of one of those errors is severe then you have a real problem.

When humans are involved in a process, make their tasks as simple as possible. This accounts for increasing error rates that occur as task complexity increases.

Obviously automation is a well-known solution. Some tasks can’t be automated or at times, systems require some human intervention, and at times a human must intervene in the instance of an exception. These are the instances when the human element should be considered.

We have implemented many more checklists and improved existing checklists for clarity. Implemented many more double checks for tasks involving humans and have also strived to make the independent double checks truly independent. i.e., two people sitting beside each other looking at the same information at the same time is not an independent test since they will potentially influence one another and reduce effectiveness of what is supposed to be an independent check.

We have also implemented a daily pre-trading huddle with people involved with trading, model updates, operations in order to understand the portfolio management tasks for the day. This mirrors the huddles that are more frequently used in operation rooms before a procedure starts (see “Checklist Manifesto”, book by Gawande below).

Again other industries recognize some of these human elements and try mitigate. Finance doesn’t seem to do that, most just assume that humans involved in processes perform their tasks perfectly.

We intentionally also modified our working environment. During portfolio management model updates and trading times we do not permit any interruptions of the portfolio management team. We place an indicator in the office that says tells other people in the office that the portfolio management process is taking place and to stay away and do not interrupt the portfolio management team (operations, model updates, reconciliation, trading). An open office (most trading rooms) is great for communication, sharing ideas, etc. but a disaster waiting to happen if you consider how humans perform when they are interrupted or bothered while performing tasks. Again, other industries are aware of these issues.

The FMEA process changes need to be considered within that context. Obviously automation is key, but humans are involved in most processes at some point along the line. Making the human involvements as simple as possible and having safety modes that can catch failures is also key. FMEA is a manner for understanding all of that.

Implementing FMEA and also reading all about how humans make errors changes our way of thinking. We believe we have improved operational efficiency and minimization of operational risk.

Those of you who are interested in finding out more about the FMEA process and Northwater Capital’s Fluid Strategies should contact Neil directly at nsimons@northwatercapital.com. As someone who has invested in many hedge funds, I can unequivocally tell you human mistakes happen more often than investors and funds want to acknowledge and there should be a lot more rigorous industry standards to mitigate against operational risk.

As always, feel free to contact yours truly (LKolivakis@gmail.com) if you have any insights you want to share on transforming hedge fund fees and mitigating operational risks. I don’t pretend to have the monopoly of wisdom on these important topics and even though I come off as an arrogant cynical prick, I’m a lot nicer in person (just don’t piss me off with your bogus niche strategy and if you ever want to meet me, the least you can do is subscribe or donate to my blog!).

One astute hedge fund investor shared his insights with me after reading my comment:

The challenge is that the managers who know they can deliver sustainable alpha (ie the only ones it is worth investing in under the current fee structure paradigm), are still not negotiable today unless you are prepared to write 10 figure tickets and underwrite business risk yourself. There is a considerable capacity shortage for quality alpha generators. In rare instances, 2% and 20% might not be enough!

However, in many instances, 0% and 25% is too much if you factor in all the operational risks that you face.

Unfortunately, the biggest problem brought by high fees is borne by managers as a whole in the form of abnormal attrition rates. High attrition rates exist partly because investors cannot tolerate drawdowns from high management expense ratio operation. That triggers a window dressing exercise, whether it is voluntary or policy driven.

I think if managers rewarded long-term investors by reducing the fee paid by an investor by a notch on each of its investment anniversary, attrition rates would stabilize. It would be less psychologically painful to re-underwrite a losing fund if the fee structure comes down every year. The only risk from the manager view point is that if he is really successful, after a few years, every investor stuck around and now its entire capital base is charged below market rates. But there are ways to circumvent that second order problem.

That’s one approach we have tried to implement without success due to existing MFNs but we never lose an occasion to talk about that.

Ironically, MFNs signed by large investors who are members of high profile investor associations that supposedly promote better alignment of interest is what makes it almost impossible for managers to consider alternative fee structures where the economics are less skewed in favor of the manager.

Below, CNBC’s Kate Kelly reports on the new players in hedge funds leading corporate activism. I’ve got a great young activist fund manager looking to get seeded in a world where everyone is hot and horny for big hedge funds. If you’re interested, contact me directly (LKolivakis@gmail.com).

Second, a discussion on alternative investing strategies amid changing trends in interest rates, with Colbert Narcisse, Morgan Stanley Wealth Management head of Alternative Investments Group.

As my friend Brian Romanchuk points out in his blog, investors are making mountains out of molehills on the Fed lift-off. In his latest comment, Brian critically examines why the Fed is keeping rates low looking at former Fed Chairman Bernanke’s first blog comment (for me, it’s simple, raising rates now would be a monumental mistake but don’t ever discount huge policy blunders!).

Lastly, Jamie Dinan, York Capital founder and CEO, shares his global economic forecast for Europe, Japan and China. He’s a lot more optimistic than I am on Europe, Japan and China but I’m still playing the mother of all carry trades fueling the buyback and biotech bubbles everyone is fretting about.

As always, I work extremely hard to provide you with the very best insights on pensions and investments. The least you can do is show your financial support by donating any amount or by subscribing via the PayPal buttons on the top right-hand side (under click my ads pic). I thank those of you who have contributed and ask others to follow suit.

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The chief investment officer of the Ontario Teachers’ Pension Plan (OTPP) indicated this week that the pension fund is searching for physical energy assets – and, at the same time, looking to draw down its exposure to energy-related derivatives.

From Reuters:

“We do have our natural resource group out there looking for real assets,” said Neil Petroff OTPP’s chief investment officer, in a media briefing [this week].

“The current price of oil, I think gives us an opportunity to look for platform companies, where we can grow,” he said. “We looked at $100 oil and we have looked at it at $50 oil, and we’ve got that allocation in derivatives that could well move to real assets in the next three to five years.”

Petroff, who is set to retire as of June 1, said historically the fund has used derivatives in order to gain exposure to oil and gas. But given the cost to be in derivatives and given that these instruments create liquidity and mark-to-market requirements, its natural resource group was created back in 2013 to buy into real assets.

[…]

The new investment focus on physical energy assets comes at a time when pension funds like Teachers are more often running into bidding wars and heightened competition for infrastructure and real estate assets, as sovereign wealth funds and long-life private equity funds now vie for these assets long coveted by pension funds, due to their steady cash flows.

“We have relationships globally, because often times these relationships will reveal unique deals and opportunities that are not put out to auction and we find that is a very important source of good risk adjusted returns,” Ron Mock, Teachers’ chief executive, said during the media briefing.

OTPP posted an 11.8 percent return on investment in 2014. The fund manages $121.5 billion in pension assets.

 

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The Canada Pension Plan Investment Board has teamed up with a British investment firm to buy a 30 percent stake in Associated British Ports, which owns and operates nearly two-dozen ports across the U.K.

The stake is worth $2.36 billion, according to Reuters.

More from the Daily Courier:

CPPIB is buying its initial stake in Associated British Ports in partnership with Hermes Infrastructure. They could potentially buy an additional 3.33 per cent, which would make them one-third owners of ABP.

Borealis Infrastructure, which is an arm of the Ontario-based OMERS pension plan, will remain one of ABP’s shareholders as well as the Government of Singapore Investment Corp.

CPPIB and Hermes are acquiring their stake in ABP from GS Infrastructure Partners and Infracapital.

[…]

The CPPIB already had a large presence in the U.K., with about $14.3 billion in investments in several sectors as of Dec. 31, 2014. Earlier this month, the CPPIB bought a portfolio of 40 student residences across the United Kingdom for $2.1 billion.

The deal is expected to close sometime during the summer, according to Reuters.

CPPIB manages about $187 billion (USD) in assets.

 

Photo by  Louis Vest via Flickr CC License

New Jersey planned on contributing $1.3 billion to its pension system in 2016.

But a court ruling has thrown a wrench in that plan, as a judge said last month the state needed to make its full pension payment as specified in a 2011 pension reform law that Chris Christie himself signed.

New Jersey is appealing the ruling, but if the state loses, its 2016 pension contribution could rise to nearly $3 billion.

That extra money hasn’t been budgeted for – and the state’s Treasurer on Monday testified to lawmakers that the ensuing budget cuts would have an “unacceptable impact” on New Jersey residents.

From NJ.com:

Gov. Chris Christie’s treasurer said Monday that the administration has reached out to lawmakers to comply with a judge’s orders to work together to restore $1.6 billion to this year’s pension payment, but stressed that actually doing that would mean lots of budget pain for New Jersey residents.

[…]

“Coming up with $1.6 billion in the last few months of the fiscal year would impose incredible and I believe universally unacceptable impacts upon our residents here in New Jersey,” [Treasurer Andrew Sidamon-Eristoff] said.

He also responded to criticism over the fees New Jersey’s pension fund pays to outside investment firms. From NJ.com:

Committee members also drilled down on the fees New Jersey pays its consultant to manage the pension fund’s alternative investments, about 15 percent of fund’s portfolio.

“It seems to me we need to review how we’re managing that 15 percent,” Assemblyman John Burzichelli (D-Gloucester) said.

Sidamon-Eristoff challenged reports that suggest the state spent $600 million in fees in 2014. Less than half of that figure is paid in management fees, he stressed, while the rest are performance bonuses for the investment managers.

The state’s decision to report that number in a 2014 annual report released earlier this year should be recognized as “enhanced transparency and not an opportunity to distort facts,” he said.

The treasurer addressed a handful of other issues over the course of his testimony. You can read the testimony here.

 

Photo credit: “New Jersey State House” by Marion Touvel – http://en.wikipedia.org/wiki/Image:New_Jersey_State_House.jpg. Licensed under Public domain via Wikimedia Commons – http://commons.wikimedia.org/wiki/File:New_Jersey_State_House.jpg#mediaviewer/File:New_Jersey_State_House.jpg

In Pennsylvania, public officials who are convicted of a job-related crime are still eligible to collect pension benefits.

One activist group, Rock The Capital, says that shouldn’t be the case.

Other states have passed laws similar to what Rock the Capital is suggesting.

In late 2014, Illinois passed a law stripping pensions from public officials convicted of felonies relating to their public duty.

Watch the video above for more.

 

Video credit: ABC27

Photo by TaxCredits.net

Due to a gag order, there is very little information circulating about the status of Rhode Island’s pension settlement.

Retirees and union members voted on the settlement last week, and will continue doing so this week.

But Gov. Gina Raimondo threw her full support behind the deal on Monday, saying the settlement would be “a good thing for everybody”.

Raimondo also said she was unconcerned about the costs of the settlement.

From the Providence Journal:

[Raimondo] acknowledged in a brief interview Monday with The Journal about the prospects for the pre-trial settlement proposal: “I hope it happens.”

Asked why, she said it would be “a good thing for everybody if we could have finality … take the risk off the table … take the uncertainty off the table. Just close the chapter and move on.”

[…]

When asked about the projected $31.6-million annual increase in costs to state and local taxpayers of the concession package, Raimondo said: “Basically, it’s small. At the end of the day, we are still saving billions of dollars over [a] long period of time and the system is fundamentally restructured.

“We increased the retirement age. We moved to the defined-contribution. The COLA is still based on the investment rate of return… . So it is still a substantial, long-term reform. And what we tried to do was make some smaller changes to address the biggest concerns of the plaintiffs.”

The settlement rolls back some aspects of the 2011 pension changes that originally spurred the long-running lawsuit.

If the settlement is approved, retirees will receive large COLAs at a more frequent rate.

The deal also increases benefits for long-time state employees (20+ years of service).

 

Photo by By Jim Jones (Own work) [CC BY-SA 3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

Within weeks of taking Illinois’ governor’s office, Bruce Rauner released a proposal that suggested allowing municipalities to use bankruptcy as a strategy to tame pension debt.

The idea is for towns and cities to use bankruptcy as a last resort to shed pension liabilities.

And even if they never ended up declaring bankruptcy, the threat of such an action could give them leverage in pension negotiations with workers.

Now, a bill in the Illinois House aims to implement the proposal and allow municipalities to file for Chapter 9 federal bankruptcy.

[Read the text of House Bill 298 here.]

The bill, filed by Representative Ron Sandack (R-Downers Grove) got a hearing last week before being referred back to the Rules Committee.

From the Chicago Tribune:

“House Bill 298 would allow desolate and debt-ridden municipalities in Illinois to seek bankruptcy protections through the federal bankruptcy law,” said Sandack. “As more and more municipalities are looking for relief and ways to deal with rising pension liabilities and other costs, this is a tool that can help them stabilize and reorganize financial affairs in ways that benefit taxpayers.”

[…]

“I hear regularly from municipal leaders who worry about their ability to pay their bills and meet other debt requirements,” said Sandack. “This bill would provide one more tool that municipalities could have at their disposal to address their financial futures in a reasonable and taxpayer-friendly manner.”

Across the country, thirty-seven local governments have filed for municipal bankruptcy since 2010.

The bill is co-sponsored by Rep. Jeanne M Ives.

 

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