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Fiduciary Capitalism, Long-Term Thinking and the Future of Finance

John Rogers, CFA, penned a thoughtful article in a recent issue of the Financial Analysts Journal regarding the future of finance – and how pension funds and other institutional investors could usher in a new era of capitalism.

From the article, titled “A New Era of Fiduciary Capitalism? Let’s Hope So”:

From my perspective, a new era of capitalism is emerging out of the fog. What I define as fiduciary capitalism is gathering strength and needs to become the future of finance. An era of fiduciary capitalism would be one in which long-term-oriented institutional investors shape behavior in the financial markets and the broader economy. In fiduciary capitalism, the dominant players in capital formation are institutional asset owners; these investors are legally bound to a duty of care and loyalty and must place the needs of their beneficiaries above all other considerations. The main players in this group are pension funds, endowments, foundations, and sovereign wealth funds.

Fiduciary capitalism has several attractive traits. It encourages long-term thinking. As “universal owners,” fiduciaries foster a deeper engagement with companies’ management teams and public policymakers on governance and strategy. In textbook terms, they seek to minimize negative externalities and reward positive ones. Because reducing costs is easier than generating alpha, we can expect continued pressure on financial intermediaries to reduce costs. To be sure, there are considerable gaps to bridge between today’s landscape and fiduciary capitalism. Transparency and disclosure, governance of fiduciaries, agency issues, and accountability are all areas that need more work.

On barrier in the way of fiduciary capitalism: lack of transparency. From the article:

Too many institutional investors are secretive and do not disclose enough about their activities. Their beneficial owners (including voters, in the case of sovereign funds) need more information to make reasonable judgments about their operations. Similarly, far more transparency is needed in the true costs of running these pools of assets. Investment management fees and other expenses often go unreported. Too much time and energy is spent comparing returns with market benchmarks, and not enough is spent defining and comparing the organizations’ performances against their liabilities—or against adequacy ratios.

Pension governance itself needs to be improved. As Ranji Nagaswami, former chief investment adviser to New York City’s $140 billion employee pension funds, has observed, public pension trustees are often ill equipped to govern platforms that are effectively complex asset management organizations. Compensation remains a complicated issue. In the public sector, paying for great pension staffers ought to be at least as important as a winning record on the playing field, yet in 27 of the 50 US states, the highest-paid public employee is the head coach of a college football team.

Rogers concludes:

The future of finance needs to be less about leverage, financial engineering, and stratospheric bonuses and more about efficiently and cleanly connecting capital with ideas, long-term investing for the good of society, and delivering on promises to future generations. In the public policy arena, governments that promote long-term savings, reduce taxes on long-term ownership, and require transparency and good fiduciary governance can help hasten this welcome change in our financial markets.

The era of finance capitalism wasn’t all bad, and an era of fiduciary capitalism wouldn’t be all good. In a time when leadership in finance is desperately lacking, fiduciaries have the potential to reconnect financial services with the society they serve. Let’s hope it’s not too late.

Read the entire article, which is free to view, here.

Chart: The Rise of Hedge Funds In Pension Portfolios

In recent years, hedge funds have solidified themselves as a big part of pension portfolios by two measures:

1) More pension funds than ever are investing in hedge funds

2) Those pensions are allocating more money towards hedge funds than ever before

That bears itself out in the above graphic, and this next one:

A recent Preqin report had this to say about the numbers:

“There are more US public pension funds than ever before allocating capital to hedge funds, and these investors are investing the most they ever have in the asset class. Public pension funds have increasingly recognized the value of hedge funds as part of a diversified portfolio, and although CalPERS’ withdrawal from the asset class will spark some investors to look more closely at their current allocation model, the importance of hedge funds as a source of risk-adjusted returns for these investors is likely to continue to prove attractive for US retirement schemes.

Preqin’s recent research highlights that investors are not using hedge funds to produce outsized returns, but instead to produce uncorrelated, risk-adjusted returns. Over short and longer time frames, hedge funds have in general met investor needs for risk-adjusted returns. However 2014 has been a period of relatively turbulent returns when looking at Preqin’s monthly benchmarks; in times like this, investor calls for changes in fee structures and better alignment of interests become more vocal, and this clearly has had an impact on CalPERS’ decision.”

Chart Credit: Preqin

Kolivakis: Time To Tear Down Private Equity’s “Iron Curtain”

Leo Kolivakis runs the blog Pension Pulse, which tightly covers the world of pensions and investments.

Kolivakis recently commented on Gretchen Morgenson’s New York Times story, “Behind Private Equity’s Curtain”. Here’s what he had to say:

There is still way too much secrecy in the private equity industry, and much of this is deliberate so that PE kingpins can profit off…public pension funds that hand over billions without demanding more transparency and lower fees. This is why I played on the title and called it an “iron curtain.”

Go back to read my comment on the dark side of private equity where I discussed some of these issues. I’m not against private equity but think it’s high time that these guys realize who their big clients are — public pension funds! That means they should provide full transparency on fees, clawbacks and other terms. They can do so with a sufficient lag as to not hurt their “trade secrets” but there has to be laws passed that require them to do so.

And what about the Institutional Limited Partners Association (ILPA)? This organization is made up of the leading private equity investors and it has stayed mum on all these transparency issues. If they got together and demanded more transparency, I guarantee you all the big PE funds would bend over backwards to provide them with the information they require.

Interestingly, all the major private equity funds have publicly listed stocks, many of which have sold off recently during the market rout (and some offer very juicy dividends!). Go check out the charts and dividends of Apollo Global Management (APO), Blackstone (BX), Carlyle Group (CG), and Kohlberg Kravis Roberts & Co. (KKR).

On its Q3 conference call, Blackstone’s management pointed out that during the past four years, its growth had been limited only by how much capital it can manage efficiently, not by how much capital investors have been willing to provide.

But as valuations keep inflating, it will be even more difficult for these alternative investment managers to find deals that are priced reasonably. And if deflation settles in, I foresee very difficult days ahead for all asset managers, including alternative investment managers.

Read the entire post here.

Arizona Pension Scolded After Racking Up $1.76 million Legal Bill In 2013-14

The Public Safety Personnel Retirement System (PSPRS) racked up $1.76 million in legal bills in fiscal year 2013-14.

To put that legal tab in context, consider the legal bills accrued by the state’s largest pension fund, the Arizona State Retirement System: ASRS is four times as big as PSPRS, but only paid $1.24 million in legal bills.

The state’s Attorney General’s Office is now saying that enough is enough. From now on, the Office says it must approve any legal work outside investment advice.

From the Arizona Republic:

The Arizona Attorney General’s Office has cracked down on the use of outside legal counsel by the financially troubled Arizona public-safety pension fund after the fund paid out $1.76 million to the Kutak Rock law firm last fiscal year.

The Public Safety Personnel Retirement System also is represented by the Attorney General’s Office and recently hired a full-time investment attorney who makes $215,000 annually. The pension fund has relied on Kutak Rock for administrative, litigation and investment advice, records show.

Under the Attorney General’s directive, Kutak Rock now may only provide investment advice. Any additional work must be approved by the Attorney General’s Office.

Eric Bistrow, chief deputy attorney general, recently wrote PSPRS that engaging outside counsel “when there is no need to do so constitutes a breach of fiduciary responsibilities.” Bistrow noted that he has instructed staff members to “be vigilant in requiring” PSPRS to adhere to proper standards.

Of the $1.76 million billed by Kutak Rock last year, just more than one-third related to investment advice, records show. The balance related to administrative and litigation matters.

[…]

“We took this action because they (Kutak Rock) were doing too much and were well beyond the scope,” said Stephanie Grisham, spokeswoman for Attorney General Tom Horne. “Basically, they (PSPRS) were using them instead of us, and that was not okay.”

Bistrow bluntly told PSPRS that large outside legal tabs would no longer be tolerated. He said in his directive that the same services “can be obtained with as much, if not more, expertise and at a much lower cost, at this office.”

Jared Smout, PSPRS interim administrator, said the pension fund is “working to make everything right. We are trying to figure out the balance. The AG’s Office will now provide review of public records requests, open meetings laws and personnel matters.”

What caused the high legal bills? The pension fund offers an explanation:

PSPRS has been particularly busy in [several] legal areas over the past 18 months. The system has been locked in litigation with former employees who allege it engaged in questionable financial practices, and its director retired this summer after The Arizona Republic disclosed that illegal raises had been paid to some staffers.

Those problems have invited close scrutiny by journalists and the FBI, which is investigating some of the whistle-blowers’ allegations.

Smout said PSPRS has until now relied on outside counsel because the trust’s investments expanded during the past decade and the agency needed legal expertise.

“We’ve only had competent in-house counsel since August,” Smout said.

Read more coverage of Arizona’s PSPRS, and the controversies surrounding the fund, here.

Philadelphia Pension Board Now Asking Investment Firms To Disclose Political Spending

For the first time, investment firms will be asked to submit campaign disclosure documents before managing money for the Philadelphia Board of Pensions.

Reported by PhillyDeals:

Over the opposition of Mayor Michael Nutter’s appointees, a majority of the trustees of Philadelphia’s $4.8 billion city pension plan have agreed to “request” dozens of private firms that are paid to manage city money — from giants like KKR and Barclays to local investors like Ted Aronson’s AJO Partners — to “disclose their political spending,” and will send current and future managers campaign finance disclosure requests, starting Jan. 1.

The move was cheered by city controller Alan Butkovitz, who had recommended this disclosure, noting the city has previously urged similar disclosures by the publicly-traded companies it invests in. “We will be asking for all donations from everybody,” including federal and state as well as city contributions, Butkovitz told me in a statement.

The four trustees representing city police, fire, white-collar and blue-collar workers joined Butkovitz in supporting the disclosure request, outvoting Nutter’s vote-no faction.The move follows the Securities and Exchange Commission’s first-time-ever order that a private money manager, Wayne-based TL Ventures, return $300,000 in state and city pension fees after founder Robert Keith gave cash gifts to Pa. Gov. Tom Corbett and Philadelphia Mayor Michael Nutter while getting paid to manage state and city pension funds, in violation of a 2010 federal law limiting contributions to officials with influence over pension boards.

Investment firms won’t be forced to disclose their spending – but they will be “urged” to by trustees.

The resolution can be read here.

Interview: Hedge Fund Mogul Talks CalPERS’ Pullout, Manager Selection and Justifying Fees

Forbes released an interview Thursday morning with Anthony Scaramucci, founder and co-managing partner of alternatives investment firm SkyBridge Capital.

The interview touched on CalPERS’ hedge fund exit, how the pension fund picked the wrong managers and how to pick the right ones. Later, Scaramucci touched on justifying the industry’s fee structure.

On CalPERS’ pullout:

Steve Forbes: Thank you, Anthony, for joining us. To begin, in terms of hedge funds, as you know the overall performance of hedge funds has lagged the market in recent years. CalPERS, the largest hedge fund in the country, made headlines by saying, “We’re getting out of this.” What is that a sign of? Either the hedge fund industry is going away and is only sustained because there’s nothing else around that’s suppressing interest rates or is this a sign of the bottom? When a big one gets out does that mean this is the time to get in?

Anthony Scaramucci: Well, so, the question’s is it going to get easier or harder from here? That was a good start, Steve. But the short answer is that there’s a lot of reasons why the industry’s underperformed. The main one has to do with something you often talk about, which is Federal Reserve monetary policy.

So, the policy since March of 2009 has been to hammer down the rates, artificially stimulate the market. This makes it impossible for about 40% of the hedge fund managers to perform. If you look at the overall hedge fund manager index, 40% of it is in long-short managers.

And so if you’re long something, you’re doing great in this market. But I’ve got to tell you something, Steve. If you’re short something, even if you’re right on the security analytics, you’re going to be wrong on the momentum of the market. And so what’s happened to the long-short managers is the longs are going up, the shorts are going up, and they have this little tight spread. They’re making 3%, 4%, 5% when the market’s rip roaring and the media is writing all these nasty articles about them.

But there are places to make money. There’s structured credit, activism. There’s a whole host of distressed guys that have done well over the last six years. But I think the media has been justified in pointing out that, in general, the hedge funds have not done well.

The CalPERS thing is a little different. They only had 1.5% of their assets there. Joe Dear, who was a legendary guy at CalPERS, when he passed I think it became one of those things where they weren’t going to get bigger for political reasons, and so they decided to get way smaller. But I don’t think it’s a death knell of the industry yet. In fact, I’ll make a prediction that we’ll look back two or three years from now and say that they caught the bottom of the hedge fund performance market.

On manager selection:

Forbes: You said that they [CalPERS] picked the wrong hedge fund managers.

Scaramucci: Yes.
Forbes: How do you pick the right ones? Because it’s fine to say, “Well, if you look at the top 10%, you would have done nifty.”

Scaramucci: Yes.

Forbes: But, like, the top 10% of stocks, how do you do it on a consistent basis?

Scaramucci: Well, okay. So, not to use a baseball analogy, but just think of it this way.

Forbes: You can, I’m a fan.

Scaramucci: Okay. So, well then you’ll probably know this from the Bill James Abstracts. Sixty percent of the everyday players are batting .260 or below, yet every midsummer classic we see 40 guys on the field that are Hall of Famers or the top of what they do. And I think that’s indicative of most industries, frankly, whether it’s the media, the hedge fund industry or, you know, political landscape and so forth. And so there are certain metrics that you can use to identify who’s going to do well. But the number one metric is the macro environment.

If you tell us what the economic dashboard looks like over the next 12 to 18 months, we have pretty high capabilities on the prediction side of what sectors are going to do well. As an example, 2009, if you and I were having this conversation, I would have told you that the residential mortgage-backed security market was going to do very, very well. Those assets were distressed. They were technically oversold by the large institutions. The Federal Reserve monetary policy at that time with Helicopter Ben bringing things down so aggressively, that was going to be an easy place to make money.

And so if you looked at SkyBridge at that period of time, we had about 45% of our assets there. So, the first factor is the macroeconomic factor. The second factor then is, once you figured out what sector you’re going to be in, who are the best guys in that sector and why are they the best? And frankly, a lot of them will be different depending on different markets. Some guys are longer than others. They’ll always be longer. Lee Cooperman is an example of that. If you’re a bull on the market, Lee’s a good bet. It’s that sort of thing.

On the fee structure of hedge funds:

Forbes: You’re a fund of funds, so to speak.

Scaramucci: Yes. Yes.

Forbes: And you know the rap, hedge funds 2%, 20%.

Scaramucci: Sure.

Forbes: Now your fees 1.5%, whatever it is, on top of that.

Scaramucci: Yes. Yes.
Forbes: How do you justify your existence?

Scaramucci: Well, listen. We’re up there with child molesters with most people, so I’ve got a hard time in justifying my existence at times. But I tell people the same thing that I think you would tell them if you were in my seat. Focus on net performance.

If you’re worried about fees, well then you certainly shouldn’t be in the hedge fund industry. But I think what we’ve proven, if you look at our long-term track record, we can help clients get to their actuarial goals by taking less risk, or less beta, if you will.

And so our performance is high single-digit, low double-digit over the last ten years with relatively low volatility. And so I think we’ve been able to justify that. But we did shift our model. I often talk about hedge fund fund of funds 3.0 in the sense that we’re viewing ourselves more like a multi-strat now. We look at the macro environment rather than trying to hug the index, like some of our peers.

The typical fund of funds got a bad rap because they weren’t doing the due diligence. And then they give you 50 managers. They’d give you a 2% in each of those managers. And you’d be hugging the index on your way to mediocrity. What we’ve tried to do, is we’ve tried to concentrate our portfolio on things that we think are working. We have a dynamic approach, where we will move out of securities or move out of hedge funds quickly if we think the market environment has changed. And we believe in concentration.

So, the top ten managers for us, Steve, are about 65% of the assets. And I think that’s differentiated us from our peer group. One last point, if you don’t mind me making it is that, if I’m giving a billion dollars out to somebody, if SkyBridge is giving out a billion dollars, we’re asking for fee concessions. And so we pass those on to our investors. So, even though we have all these loaded fees, so to speak, we’re giving back 75, 80 basis points a year in fee concessions, which I think is meaningful.

The entire interview can be read here.

Fort Worth Firefighters To Sue City Over Benefit Cuts

The Fort Worth firefighters union announced plans Tuesday to file a lawsuit against the City Council over a series benefit cuts that would scale back retirement benefits for new hires.

The union claims the cuts represent a breach of contract and a violation of the Texas constitution.

From the Star-Telegram:

The president of the Fort Worth Professional Firefighters said Tuesday night that the group plans to move forward with a lawsuit against the city over the benefit reductions that the City Council approved by a 6-3 vote.

“When these pension changes go into effect, it will be a taking. We will be joining the police officers in that federal suit,” said Jim Tate, the association’s president. The group must vote on filing the lawsuit, Tate said.

The cuts will affect firefighters hired before Jan. 10, 2015, and include reducing the multiplier used to calculate benefits from 3 percent to 2.5 percent, using the high five years instead of three years to determine retirement pay, and eliminating overtime that is not built into a firefighter’s salary from calculations.

[…]

The lawsuit accuses the city of contract impairment, violation of due process, unlawful taking of property, and violating the U.S. and Texas constitutions in reducing pension benefits for future service. The council reduced the multiplier used to calculate benefits, raised the number of years for retirement pay and eliminated overtime from calculations.

City Manager David Cooke said that the situation between the two groups is not “combative” but that “we both agreed to let the courts decide who is right.”

“One of the challenges certainly is we are in litigation with the police over our ability to do what we already did. The firefighters have simply said they are going to join the police and see what the courts will actually decide,” Cooke said.

City Council members, who passed the benefit cuts by a 6-3 vote, weighed in on both sides of the issue. From the Star-Telegram:

“It does put the fire on par with the rest of our employees, and going forward this is all going to get resolved in federal court. We believe that putting them in the same plan with the rest of our employees is the proper thing to do at this time,” said Councilman W.B. “Zim” Zimmerman, who voted for the reductions.

Council members Jungus Jordan, Ann Zadeh and Kelly Allen Gray voted against the changes.

“On the vote to make changes for new hires, it was a little easier for me. But making changes to people who already have pensions they are depending on in place, that is a little bit harder for me to do,” Zadeh said.

Tate said the reductions will force firefighters to retire later to maintain their current benefits. The current average retirement age is 59, he said, but he expects that to jump into the 70s.

“I feel bad not only for the firefighters but for the citizens of this city that the interest of the wealthy business owners takes precedence over the citizens who are going to be served by these elderly firefighters in the years to come,” Tate said.

Union members still must vote to approve the lawsuit.

Louisiana Teacher’s Pension Defends Private Equity Investment With Carlyle

The New York Times recently obtained a copy of private equity limited partnership agreement that demonstrated how opaque the world of private equity is.

The agreement in question was for the Carlyle V fund – a fund that, as Pension360 covered, many public pension funds have invested in.

One such fund is the Teacher’s Retirement System of Louisiana, and it is now defending its private equity investments in light of the New York Times’ story. From the Baton Rouge Business Report:

The Teachers Retirement System of Louisiana…is responding to questions raised by a recent article in The New York Times about one of the private equity funds in which TRSL has invested.

The investigative report, published Sunday, details a “code of secrecy” it says exists between many large private equity funds and the state pension systems that invest in them. According to the story, pension systems are often hit with fees and the tab for hefty legal settlements incurred by the funds, without the knowledge of system members.

The story cites TRSL’s investment in the Carlyle V fund as one such example. It points to provisions in TRSL’s contract with Carlyle V that protects the fund’s partners from certain liabilities that investors—TRSL members—could ultimately have to pay.

TRSL defends its investment in Carlyle V, saying TRSL managers evaluate all investment opportunities and recommend investment only in funds with the best track records, terms and risk/return profiles.

“For the past 10 years, private equity investments have been TRSL’s highest performing asset class,” says Philip Griffith, TRSL chief investment officer. “Carlyle has been one of the system’s better-performing private equity funds.”

Griffith notes that TRSL’s total investment return in FY 2013 was 19.9%, the second-highest in the nation.

“Private equity returns were key to achieving this distinction,” he says.

State Treasurer John Kennedy, who sits on the TRSL board, declines to comment.

TRS Louisiana manages $17.5 billion in assets.

To read a copy of the Carlyle V agreement, click here.

Detroit Announces Trustees For New Pension Investment Committees

One of the final pieces of Detroit’s bankruptcy plan is setting up committees responsible for reviewing investments made by the city’s two major pension funds: the Police and Fire Retirement System and the General Retirement System.

Detroit announced this week the trustees that will sit on those committees. From the Detroit Free Press:

The appointees reflect one of the final steps in reshaping how Detroit’s retiree health insurance benefits are delivered and how two independently controlled pension funds are operated.

The new governance structure for the pension funds and the reduced health benefits for retirees were part of a negotiated settlement to Detroit’s historic Chapter 9 bankruptcy.

Judge Steven Rhodes will rule in the first week of November on whether the city’s plan of adjustment is fair and feasible.

Here are the new appointees, according to a draft version of the city’s eighth amended plan of adjustment, which was filed with the Bankruptcy Court early this morning:

The initial independent members of the committees are:

– Police and Fire Retirement System investment committee: Mark Diaz, Sean Neary, Louis Sinagra, Mike Simon, Woodrow S. Tyler, McCullough Williams III, Robert C. Smith, Joseph Bogdahn and Rebecca Sorenson.

– General Retirement System investment committee: Kerrie VandenBosch, Doris Ewing, Robert Rietz, David Sowerby, Thomas Sheehan, June Nickleberry and Ken Whipple.

As of fiscal year 2012-13, the General Retirement System managed over $2 billion in assets and the Police and Fire Retirement System managed $3.4 billion in assets.

With $40 Million Pension Payment Looming, Jacksonville Mayor Says He Won’t Raise Taxes To Pay Down Pension Shortfall

The city of Jacksonville agreed earlier this year to pay $40 million annually for the next 10 years to its Police and Fire Pension Fund.

But the city hasn’t yet decided where it will get that money. But Mayor Alvin Brown made it clear Wednesday that a tax increase is not in the cards.

From the Jacksonville Daily Record:

How will the city pay an additional $40 million each year to more quickly pay down its unfunded liability?

If it’s up to Mayor Alvin Brown, it won’t be a sales tax. Or a property tax. Or any tax for that matter.

If council ends up seeking the Legislature’s approval to put such a funding mechanism on the ballot, Brown would not support it.

“No, sir. I wouldn’t sign it,” Brown responded when council member John Crescimbeni asked if he’d support a bill for a tax referendum.

Brown later went a step further, telling council member Bill Gulliford he’d veto any such attempt.

“I don’t think we have to do any taxes to solve this,” Brown said.

[…]

Brown and Police and Fire Pension Fund administrator John Keane struck a deal this year that has the city paying a total of $400 million over the next 10 years make the stabilize the plan. That $40 million each year would be determined annually by a newly formed committee. For months, council members have said not having an identified source is a chief concern — sentiments that spilled into Wednesday’s almost four hours of talks.

Council member Lori Boyer said not having the source identified was “totally irresponsible.” The burden, she said, would come back to council for the financial wrangling “and everyone (else) can stay hands off.”

Brown told the group he and his administration are “working on it.” Chris Hand, Brown’s chief of staff, said there isn’t a dedicated funding source “yet.” The JEA proposal is the only one the administration has pitched as a funding source to this point.

The Jacksonville Police and Fire Pension Fund is 43 percent funded and is shouldering $1.6 billion of unfunded liabilities.

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