Author: Leo Kolivakis

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Tom DiChristopher of CNBC reports, The 2 and 20 hedge-fund model is dead:

The compensation model that has enriched hedge fund managers for years is not long for this world, CalSTRS Chief Investment Officer Christopher Ailman said Monday.

To find yield in the current low-interest-rate environment, CalSTRS has invested in select hedge funds. But Ailman said the pension fund is not paying the alternative investment class’s notoriously high fees.

“Two and 20 is dead. People have to understand that. That model has been broken,” he said during an interview on the sidelines of the Milken Institute Global Conference on CNBC’s “Squawk on the Street.” Ailman was referring to the typical hedge fund fee structure in which portfolio managers charge 2 percent of total asset value and 20 percent of the portfolio’s returns.

Investors pulled more than $15 billion from hedge funds in the first three months of the year, making it the worst quarter for managers in seven years, the Financial Times reported last month.

To be sure, CalSTRS has considerable heft to negotiate, being the nation’s second-largest pension fund with a portfolio valued at about $186.8 billion as of March 31.

“We have a size advantage,” Ailman said. “We already are negotiating. Our staff has put on their boxing gloves and gone in there and just laid it out, what we’re looking for.”

Ailman acknowledged that new funds will continue to ask small investors to pay 2 and 20, but said in most cases the split has come down.

CalSTRS is currently pursuing a risk-mitigation strategy, but not because it is worried about the broader market, he added.

“It’s all back to that point of having a balanced portfolio, being exposed to GDP growth, but then also having some balance on the other side because we are going to have U.S. recessions and we’re going to have global recessions,” he said.

“This is a low patch, but we think, overall, growth will come through.”

In my last comment on hedge funds under attack, I discussed why I think it’s insane to give any multibillion hedge fund 2 & 20 to manage assets, especially in a deflationary world where ultra low and negative rates are here to stay.

Paying 2 & 20 is even more insulting when hedge fund aren’t delivering on their promise. And when you have brand name fund like Tiger Global’s flagship Onshore fund declining 22% (gross) in the first quarter, it really stings to have to pay these guys any management fee whatsoever (long gone are the days where the Tiger fund was burning bright and I warned you to stop chasing after “Chase Coleman” and other hedge fund superstars getting crushed).

No wonder New York state’s pension leader is calling hedge fund fees ‘unfair’:

The chief investment officer of the New York state pension fund doesn’t like the fees hedge funds charge to manage money.

Vicki Fuller, who oversees the $185 billion New York State Common Retirement Fund, said the hedge fund industry’s “2 and 20” fee model is “unfair.”

“We’re looking at alternative structures,” Fuller told The Post on Wednesday while attending the Milken Institute Global Conference here.

While Fuller declined to provide specifics, some big pensions are feeling pressure to cut costs and have pushed hedge funds to lower their fees. Others including CalPERS, the largest US public pension plan, have pulled their money from hedge funds.

Traditionally, hedge funds pocket a 2 percent annual management fee and take an additional 20 percent of performance gains.

The New York state pension, the country’s third-largest, spent $113 million on hedge fund management fees in the fiscal year ended March 31, 2015. During that period, the pension had 4.5 percent of its assets in hedge funds, which generated a 5.9 percent return.

The hedge funds the pension has investments in include Bridgewater Associates, D.E. Shaw, GoldenTree Asset Management, Paulson & Co., Trian Fund Management and ValueAct Capital.

Unlike New York City’s public employee pension, which voted to exit its hedge fund portfolio, the state pension isn’t planning to yank its money from hedge funds, Fuller said.

Not sure Fuller’s team really knows what they’re doing when it comes to hedge funds. If I were her, I’d seriously consider bailing from hedge funds too and let these billionaires sell their summer homes to pay off the fees they’ve stolen accumulated over the years from their (no longer) patient clients.

I have strong views when it comes to hedge fund and private equity fund fees (at least PE funds have a hurdle rate and a clawback). I believe in paying for performance, not asset gathering. Period. I couldn’t care less who the manager is, how long they’ve been in business, how rich and famous they are. All this is irrelevant to me as I truly believe a lot of the good times are over for the world’s hedge fund and private equity billionaires which got away with murder for many years.

Now that hedge fund managers are losing their swagger, and institutional investors are waking up and redeeming from individual funds and funds of funds charging an extra layer of fees, it’s going to be  a lot tougher for hedge funds to justify their fees.

I will let you listen to Chris Ailman’s remarks below. He’s right, large pensions aren’t paying 2 & 20 anymore (more like 1 or 1.5 & 15 if they have leverage to negotiate hard). This is especially true when it comes to investing in large, multibillion, liquid hedge funds strategies.

However, when it comes to an emerging hedge fund, it only makes sense to give them a 2% management fee to help them get off and running and cover fixed costs. Also, a lot of the less liquid strategies will still charge hefty fees because they won’t grow past a few hundred million dollars of assets under management (typically their investors are large family offices or small endowments looking for very niche strategies).

Lastly, and a bit critically, I don’t consider CalSTRS an expert in hedge funds. They were very late in the game, which is fine, and they certainly don’t have an external hedge fund program that matches more mature ones at Ontario Teachers’ Pension Plan or other large hedge fund investors in Canada who actually know what they’re doing in hedge funds.

I used to invest in CTAs, global macros and L/S Equity funds. I don’t think they’re the best way to generate consistent alpha in hedge funds. In fact, if you look at the last few years, the best hedge funds were multi-strategy funds (this year is much tougher for them). I understand why CalSTRS is investing in CTA and global macro funds for scalable “non-correlated” alpha but I think they need to review their entire hedge fund program which is still in its infancy.

By the way, all of you paying 2 & 20 to any hedge fund should carefully read my last comment on billionaires bearing stock tips.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Barbara Shecter of the National Post reports, Canadians shouldn’t confuse CPP investment gains with higher pensions:

The Canada Pension Plan’s investment arm may be racking up impressive gains, but Canadians are mistaken if they think the portion they will be getting in retirement is growing at the same rate, says a new paper from the Fraser Institute.

“Unlike individual RRSP, TFSA, or pension accounts, there is no direct relationship between the rates of return earned in the CPPIB (Canada Pension Plan Investment Board) and the benefits received by eligible retirees,” authors Jason Clement and Joel Emes say in the paper to be released Thursday.

The Canada Pension Plan Investment Board invests money that is not needed to pay current CPP benefits. As such, its returns will provide indirect benefits to individuals who will ultimately retire, such as by reducing the need to raise contribution rates to sustain the pension scheme, the paper says.

An individual’s annual retirement benefits, however, are calculated based on a complex formula that takes into account, among other things, the contributions each worker makes to the CPP over the course of their working life, from age 18 to 65. The benefits are also capped at an average income level below what many recipients earned during their working lives.

So while the CPPIB has performed “reasonably well,” reporting an average rate of return of 7.9 per cent since 2000, the authors calculate that someone born after 1955, and who retires in 2021 or later, will receive a “modest” annual return on their contributions of around three per cent.

Any CPP-eligible worker born after 1971, and retiring in 2037 or later, will receive an annual return of just 2.1 per cent in retirement, the paper says.

These returns are far lower than the CPP investment arm’s 10-year real rate of return of 6.2 per cent, after expenses, and also below the four per cent real rate of return the Chief Actuary of Canada says is necessary for the CPP to remain sustainable.

“It’s fairly easy for average Canadians to confuse the returns earned by the CPP Investment Board (CPPIB), which is tasked with actively investing the investable funds of the CPP, with what they themselves might actually earn from their contributions to the CPP in the form of retirement benefits,” the authors write.

“Indeed, some advocates for the expansion of the CPP have conflated, or at least not clearly differentiated between, the rates of return earned by the CPPIB and the actual returns received by individual Canadian workers in the form of CPP retirement benefits.”

The recently elected federal Liberal government of Justin Trudeau ran on a platform of enhancing the national pension program to ensure all Canadians have an adequate standard of living in retirement.

The maximum CPP retirement benefit for new recipients at age 65 is $1,092.50 a month. The benefit is meant to replace about 25 per cent of pre-retirement income but reaches a maximum around $12,000 a year.

The Trudeau victory kick-started talk about enhancing the Canada Pension Plan, which Ottawa and the provinces discussed seriously in 2010.

When an agreement could not be reached, the Conservative government of the day subsequently studied targeted voluntary contributions to CPP, adhering to the view that mandatory national expansion could hurt the economy by placing a burden on businesses that would be forced to contribute.

If the CPP program is not expanded by 2018, Ontario’s Liberal government has pledged to forge ahead with the creation of a separate provincial pension plan that would bolster the national scheme.

The Fraser Institute paper published this week is the latest from the think-tank to question the rationale for expanding the national pension scheme. Recent papers challenged the view that the Canada Pension Plan is a low-cost operation due to economies of scale, and suggested Canadians already save adequately for retirement.

In the review and analysis of returns on CPP contributions, this week’s paper found that older Canadians — those who reached retirement between 1970 and 1979 — did substantially better than more recent retirees.

Their contribution rates were lower and workers at that time were required to contribute to the program for a shorter period, allowing these retirees to enjoy a rate of return of 27.5 per cent, according to the paper’s authors.

The figures used to calculate returns don’t take into account payments received beyond base retirement benefits, such as survivor’s pension or death benefits.

You can read the full report by the Fraser Institute here. This report follows another one questioning the costs of running the CPP. I ripped into that report as did other pension experts who stated that study was deeply flawed.

Now we get another study from the Fraser Institute claiming Canadians don’t really see the benefits of expanding the CPP. Let me briefly give you my thoughts on this study:

• The first thing you should note is that the Fraser Institute is a right-wing think thank which is against “big government’ and “big CPP”. As such, you need to read all their studies bearing this in mind because they’re funded by Canada’s powerful financial services industry which doesn’t want to see an expanded CPP (some bankers with a long term vision actually do see the benefits).
• Second, and quite comically, the authors do admit the CPPIB has performed “reasonably well,” reporting an average rate of return of 7.9 per cent since 2000. Reasonably well? How many Canadian mutual funds can boast the same average annualized risk-adjusted return (after fees) as CPPIB and other large Canadian DB pensions since 2000? The answer is very few because unlike mutual funds, CPPIB and its large peers can invest across public and private markets as well as invest in the best hedge funds throughout the world. And they often invest directly in private markets, lowering the costs of their operations by foregoing fees to external managers.
• Third, CPPIB offers safe predictable returns that benefit all Canadians. Sure, unlike individual RRSP, TFSA, or pension accounts, there is no direct relationship between the rates of return earned in the CPPIB and the benefits received by eligible retirees, but the authors also miss an important point. Unlike TFSAs and RRSPs, your benefits from CPP are guaranteed for life (you won’t run the risk of outliving your savings) and not subject to the vagaries of public markets. This means if you retire in a year like 2008 when stock markets got crushed, you won’t have to worry about your CPP benefits. Also worth bearing mind, most Canadians don’t invest enough in RRSPs or TFSAs and even when they do, they won’t do a better job over the very long term than CPPIB (yeah, you might have outperformance in any given year but not over a long period, especially if you invest in mutual funds instead of exchange-traded funds as fees will eat away most your long term gains).
• Fourth, CPPIB has one job: to maximize returns on contributions without taking undue risk. Period. If they keep up their stellar long term performance, it will allow the finance ministers of each province to sit down with their federal counterpart to discuss raising the benefits or lowering premiums. This last point was made by Ed Cass, Senior Vice President and Chief Investment Strategist at CPPIB, in my comment on building on CPPIB’s success.
• Fifth, it doesn’t surprise me that those born after 1971 are going to receive less annual return from the CPP than previous generations. Why? Well, for one thing, ultra low rates are here to stay and the Governor of the Bank of Canada even warned pensions to brace for the new normal of lower neutral rates citing the demographic pressures of the baby boom generation retiring in droves. In other words, given historic low rates and the fact that there will be more retired workers than active workers, many of whom are living longer, it’s entirely logical that the current and future generations will receive less (proportionally) than previous generations.
• Sixth, and most importantly, given how brutal the investment environment is and will be over the next decade(s), I think now more than ever we need real change to Canada’s pension plan by enhancing the CPP so more Canadians can retire in dignity and security. Studies by the Fraser Institute are grossly biased and never highlight the brutal truth on defined-contribution plans or how bolstering defined-benefit plans (like CPP) will bolster our economy providing it with solid long term benefits.

Having said all this, I will concede something to the authors of this latest Fraser Institute study, we need a lot more transparency on the way CPP benefits are determined (apart from a simple video) and there should be an open discussion on whether benefits should be increased or premiums reduced (of course, enhancing the CPP means higher premiums and higher benefits).

I believe in prudent management of the CPP, which basically means saving for a rainy day (and there will be plenty of them in the future), but I also believe in fairness and transparency. For example, if someone is working well past 65 years old and contributing to the CPP, why are their benefits capped and why shouldn’t people who contribute more, receive more? These are all policy questions which need to be addressed by our provincial and federal governments, not the people managing the CPPIB.

I reached out to Bernard Dussault, Canada’s former Chief Actuary, to get his views on this study. Bernard was kind enough to share this with me:

By definition, the rate of return in respect of a cohort of contributors is the discount rate that renders the present value of all contributions made for this cohort during its active life equal to the present value of all benefits paid to this cohort during its whole retirement benefits period (i.e. ending with the death of the last survivor of the cohort).

Generally speaking (e.g. assuming stabilized conditions), if a pension plan is financed on:

• a fully funded basis, then thee rate of return corresponds to the average (over the period running from the first contribution made to the last pension benefit paid) rate of return on the concerned fund;
• a partial funded basis, let say p% (for the CPP “p” is close to 15%), then the rate of return corresponds to [ (p)*i + (1-p)*e ], where:

• “i” corresponds to the average (over the period running from the first contribution made to the last pension benefit paid) rate of return on the concerned “partial” fund;
• “e” correspond to the average (over the active contribution period) rate of increase in the contributory employment earnings of the concerned cohort (i.e. the compounded increase of the salary and the population increase rates).

As indicated in Table 21 on page 49 of the 26th actuarial report on the CPP (http://www.osfi-bsif.gc.ca/Eng/Docs/cpp26.pdf), the nominal internal return for the cohort of CPP contributors born in 2010 amounts to 4.5%, while the nominal rate on the CPP fund is 6.2% (i.e. the sum of the 4% real rate plus the 2.2% inflation rate).

The 4.5% return on CPP contributions is obviously less than what it would be, i.e. 6.2%, if the CPP were fully funded. It is not because from 1966 to 1995 contributions to the CPP were made at a level lower than the CPP full cost rate, i.e. about 6%.

Besides, I consider that a lifetime guaranteed return of 4.5% is much appreciable:

• not only because it applies to all members of the 2010 cohort taking into account the absence of longevity risk;
• but also because few individuals (if any), irrespective of their investment expertise, would be in a position to achieve a 4.5% rate of return on average from age 18 to death.

I thank Bernard for sharing his expert insights with my readers.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Saijel Kishan of Bloomberg reports, Hedge Funds Under Attack as Steve Cohen Says Talent Is Thin:

In less than seven days, hedge funds have been subject to a three-pronged attack by some of the biggest names in finance.

Steve Cohen, the billionaire trader whose former hedge fund had racked up average annual returns of 30 percent before pleading guilty to securities fraud three years ago, became the latest critic of the business, saying he’s astounded by its shortage of skilled people.

“Frankly, I’m blown away by the lack of talent,” Cohen said at the Milken Institute Global Conference in Beverly Hills, California, on Monday. “It’s not easy to find great people. We whittle down the funnel to maybe 2 to 4 percent of the candidates we’re interested in. Talent is really thin.”

‘Very Hard’

Cohen’s comments come after billionaire Warren Buffett said over the weekend that large investors should be frustrated with the fees they pay hedge funds, which fail to match the returns of index funds. Daniel Loeb, founder of hedge fund Third Point, said last week that industry performance this year was “catastrophic” and that funds were in the early stages of a “washout.”

Cohen, who had started his hedge fund SAC Capital Advisors in 1992, said the business has “gotten crowded” with too many managers following similar strategies. Hedge funds seem to think that by hiring skilled people, they can “magically” generate returns, he said.

“It’s very hard to maximize returns and maximize assets,” said Cohen, who runs $11 billion Point72 Asset Management. It’s difficult to balance size with carefully managing an organization and delivering good risk-adjusted returns, he added.

Cohen rarely speaks publicly at industry events. He made the comments on a panel discussion with money managers Cliff Asness and Neil Chriss.

’Cost of Being Excellent’

SAC Capital agreed to return outside money to clients as part of a 2013 agreement with U.S. prosecutors targeting insider trading on Wall Street. The firm was renamed Point72 and now manages Cohen’s fortune. He wasn’t accused of wrongdoing.

Point72 President Doug Haynes said in October that there could be more closures and money pulled out of the hedge fund business as the “cost of being excellent” in the industry keeps rising.

Cohen said at the conference one of his biggest worries last year was that his firm might become the victim of an indiscriminate market selloff as other funds endured troubles and reduced risk. He said his worst fears were realized in February when his firm lost 8 percent. Global stocks fell about 1 percent that month.

Earlier Monday, hedge funds came under criticism at the conference on the heels of Buffett’s comments at his firm’s annual shareholder meeting on Saturday.

High Pay

Chris Ailman, who runs investments at the $187 billion California State Teachers’ Retirement System, said in a Bloomberg Television interview that the hedge fund industry’s fee model is “broken” and “off the table” for large institutional investors. Chriss, founder of hedge fund Hutchin Hill Capital, said investors will pull out of funds that aren’t giving them returns to justify the fees.

Jagdeep Singh Bachher, chief investment officer of the University of California’s $97.1 billion of endowment and pension assets, said paying high hedge fund fees for mediocre performance is “absurd.”

The only money managers worth high fees are those who have uncovered “unique situations” in financial markets, he said Monday at a meeting of the Board of Regents’ investment committee. The endowment said it’s consolidating managers in its $4.7 billion absolute return portfolio.

The $8.7 billion endowment lost 4.2 percent in the first nine months of the fiscal year through March 31, staff told trustees. Private equity gained 9.2 percent while absolute return was down 5.4 percent.

‘Giant Ripoff’

Janus Capital Group Inc.’s Bill Gross joined the chorus, tweeting Tuesday that “hedge fund fees exposed for what they are: a giant ripoff. Forget the 20 – it’s the 2 that sends investors to the poorhouse.”

Hedge fund managers are among the highest paid in the finance industry, traditionally charging clients 2 percent of assets as a management fee and taking 20 percent of profits generated. Buffett described the fee structure as “a compensation scheme that is unbelievable” to him.

Since the global financial crisis, some managers have cut fees in exchange for getting larger investments from clients and locking their money up for longer periods. Even so, New York City’s pension fund for civil employees voted last month to end investing in hedge funds, determining that they didn’t perform well enough to justify high fees.

American International Group Inc., the insurer burned by losses on hedge funds, is scaling back from those investments. It has submitted notices of redemption for $4.1 billion of those holdings through the end of the first quarter.

Worst Start

Cohen said he was amazed that investors aren’t more demanding, while noting the irony of his remark since he now runs a family office. He said pension plans and endowments tend to follow trends instead of being forward thinking.

The $2.9 trillion hedge fund business is having its worst start to a year in terms of returns and client withdrawals since 2009, when financial markets were reeling from the global financial crisis. Managers including Bill Ackman, John Paulson and Crispin Odey posted declines of at least 15 percent in the first three months in some of their funds.

Loeb said in a quarterly letter that most money managers were “caught offsides at some or multiple points” since August. That month, China’s surprise currency devaluation sent shock waves across markets.

Cohen said most people at his Stamford, Connecticut-based firm are not very good at timing when to invest or exit markets, though they are adept at picking stocks. He said external hires account for 20 percent of headcount at Point72, which prefers to groom analysts and money managers internally.

The Point72 founder said there are parts of the world where there are opportunities to generate more alpha, which are profits above a benchmark index, than in the U.S. His firm has offices in cities including Hong Kong and London.

Cohen, who under a settlement with regulators could manage outside capital again as soon as 2018, said he didn’t see the crowding problem in the hedge fund business easing any time soon.

“This industry has been around in a real way for 25, 30 years and excess profits get competed away in one way or another,” he said. “More people are going to enter the business and drive it down. It’s starting to happen now and will probably continue to happen. That’s a normal industry cycle.”

Steve Cohen is right, there’s a tremendous amount of competition in the hedge fund world and real talent is thin (or enjoying the freedom of blogging after a long stint at SAC Capital). But he’s laying it on thick here for marketing reasons for his new fund which he will eventually manage (just like Ray Dalio does when he touts radical transparency and his Navy SEALs at Bridgewater).

Interestingly, one of my buddies in Montreal who left the pension industry and got a Masters of Science in Predictive Analytics from Northwestern University now works in the insurance industry and tells me he sees SAC and other top hedge fund recruiters at data analytics conferences along with those from Google and Amazon. He already has a Masters in Finance and a CFA but tells me straight out: “Top hedge funds don’t care about these qualifications, they are looking for specific qualifications and don’t really like traditional finance types.”

Anyways, back to Steve Cohen’s remarks. I was utterly shocked to learn his personal fund was down 8% in February but it shows you how brutal this environment is even for the perfect hedge fund predator. When you see top multi strategy funds like Cohen’s, Ken Griffin’s Citadel and Izzy Englander’s Millennium losing big in one month, you know it’s beyond brutal out there for top hedge funds.

What are some of the structural issues plaguing these top hedge funds? One of them most definitely is crowding. Cohen said hedge fund crowding caused his fund’s major February loss:

Billionaire investor Steven Cohen said that too many hedge funds placing the same types of bets contributed to sharp losses for his $11 billion Point72 Asset Management earlier this year.

“One of my biggest worries is that there are so many players out there trying to do similar strategies,” Cohen said Monday, speaking at the Milken Institute Global Conference in Los Angeles.

“If one of these highly levered players had a rough run and took down risk, would we be collateral damage?” Cohen said. “In February we drew down 8 percent which for us is a lot. My worst fears were realized.”

Point72 has rebounded to a return of approximately zero for the year, according to a person familiar with the situation.

Cohen also commented on the hedge fund industry’s relatively large size and meager recent returns, saying that both investors and their clients were willing to tolerate lower performance.

“When this business started, guys took pride in the returns that they generated. Guys would make 20, 25, 30 percent,” said Cohen, known for generating similar returns himself. “Now it’s about trying to figure the intersection between assets under management and what investors would be willing to accept.”

In a world of ultra low and negative rates, hedge fund superstars can kiss those 20, 25 and 30 percent returns of the past goodbye, it’s never going to happen. They too have to prepare for lower returns which is why pensions need to brace for the new normal of lower neutral rates and squeeze hedge funds hard on fees.

That brings me to the other structural factor plaguing mostly large, well-known hedge funds. If the deflation tsunami I’ve been warning about comes true, and ultra low or negative rates are here to stay, this means these large hedge funds are going to have to deal with unimaginable volatility in public markets. This is the type of volatility that has confounded the best of them in the past and size is an issue when you’re trying to deliver great risk-adjusted returns in this environment.

Let me be more blunt. I think a lot of hedge funds are getting way too big for their own good and more importantly, for that of their investors. When Cohen says “now it’s about trying to figure the intersection between assets under management and what investors would be willing to accept,” he’s absolutely right.

What he neglects to say is that many of the bigger hedge funds deliberately focus a lot more on growing assets under management than their risk-adjusted returns and that’s what frustrates their investors which dole out 2 & 20 or 1.5 and 20 in management and performance fees (in his heyday, Cohen was charging 3 & 50 to his investors). It’s that 2% management fee on multibillions which really stings when managers are underperforming.

Earlier this week we learned AIG, burned by losses on hedge funds, submitted notices of redemption for $4.1 billion of those holdings through the end of the first quarter. Last month, New York City’s largest pension followed CalPERS and shut down its hedge fund program, telling managers to sell their summer homes and pay back all those hefty fees.

And to add insult upon injury, the Oracle of Omaha launched an epic rant against Wall Street tearing into hedge funds, their fees and the entire investment consulting and pension industry to pieces:

Just before lunch at the Berkshire Hathaway annual meeting on Saturday, Warren Buffett unloaded what he called a “sermon” about hedge funds and investment consultants, arguing that they are usually a “huge minus” for anyone who follows their advice.

The Berkshire chairman has long argued that most investors are better off sticking their money in a low-fee S&P 500 index fund instead of trying to beat the market by employing professional stockpickers. He used the annual meeting to update the tens of thousands in attendance—and others watching via a webcast–about his multi-year bet with hedge fund Protege Partners. The bet, initiated by the New York fund back in 2006, was that over a decade, the cumulative returns of five fund-of-funds picked by Protege would outperform a Vanguard S&P 500 index fund, even when including fees.

Mr. Buffett showed a chart comparing the cumulative returns of the two sides of the bet since 2008. As of the end of 2015, the S&P 500 index fund had a cumulative return of 65.7%, outdoing the hedge fund teams’s 21.9% return. The S&P has outperformed in six of the eight individual years of the bet too.

The chart was preamble to the real point Mr. Buffett wanted to make: that passive investors can do better than “hyperactive” investments handled by consultants and managers who charge high fees.

“It seems so elementary, but I will guarantee you that no endowment fund, no public pension fund, no extremely rich person” wants to believe it, he said. “They just can’t believe that because they have billions of dollars to invest that they can’t go out and hire somebody who will do better than average. I hear from them all the time.”

But he was just getting started.

“Supposedly sophisticated people, generally richer people, hire consultants, and no consultant in the world is going to tell you ‘just buy an S&P index fund and sit for the next 50 years.’ You don’t get to be a consultant that way. And you certainly don’t get an annual fee that way. So the consultant has every motivation in the world to tell you, ‘this year I think we should concentrate more on international stocks,’ or ‘this manager is particularly good on the short side,’ and so they come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in the American business without cost. And then those consultants, after they get their fees, they in turn recommend to you other people who charge fees, which… cumulatively eat up capital like crazy.”

Mr. Buffett said he’s had a hard time convincing people of this case.

“I’ve talked to huge pension funds, and I’ve taken them through the math, and when I leave, they go out and hire a bunch of consultants and pay them a lot of money,” he said, earning a laugh from the crowd. “It’s just unbelievable.”

“And the consultants always change their recommendations a little bit from year to year. They can’t change them 100% because then it would look like they didn’t know what they were doing the year before. So they tweak them from year to year and they come in and they have lots of charts and PowerPoint presentations and they recommend people who are in turn going to charge a lot of money and they say, ‘well you can only get the best talent by paying 2-and-20,’ or something of the sort, and the flow of money from the ‘hyperactive’ to what I call the ‘helpers’ is dramatic.”

A passive investor whose money is in an S&P 500 index fund “absolutely gets the record of American industry,” he said. “For the population as a whole, American business has done wonderfully. And the net result of hiring professional management is a huge minus.”

Mr. Buffett has long had a testy relationship with Wall Street, and he’s positioned himself for decades as an outsider to the world of New York finance. In addition to repeatedly attacking the fees charged by hedge funds and investment professionals, he’s criticized the tactics of activist shareholders, the danger of derivatives and the heavy use of debt by private-equity firms.

The antipathy can run in the opposite direction as well. As our Anupreeta Das noted in an article last year, many on Wall Street believe the Berkshire chairman to be a hypocrite. They accuse him of hiding behind the image of a folksy, benevolent investor while pursuing some of the tactics and investing in some of the companies that are the targets of his attacks.

On Saturday, Mr. Buffett worked in a fresh plug for a book he’s been recommending for decades, “Where Are the Customers’ Yachts?,” by Fred Schwed. The title comes from the story of a visitor to New York who was admiring all the nice boats in the harbor, and was told that they belonged to Wall Street bankers. He naively asked where the bankers’ clients kept their boats. The answer: They couldn’t afford them.

“All the commercial push is behind telling you that you ought to think about doing something today that’s different than you did yesterday,” Mr. Buffett told his shareholders. “You don’t have to do that. You just have to sit back and let American industry do its job for you.”

Berkshire Vice Chairman Charlie Munger jumped in to offer a counterpoint, of a sort:

“You’re talking to a bunch of people who have solved their problem by buying Berkshire Hathaway,” he said. “That worked even better.”

From 1965 through the end of last year, Berkshire shares have risen 1,598,284%, compared to the 11,355% return on the S&P 500.

“There have been a few of these managers who have actually succeeded,” Mr. Munger said. “But it’s a tiny group of people. It’s like looking for a needle in a haystack.”

Mr. Buffett conceded that point, but concluded the first half of the day’s proceedings by saying that Wall Street was better at salesmanship than investing.

“There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities,” he said. “There are a few people out there that are going to have an outstanding investment record. But very few of them. And the people you pay to help identify them don’t know how to identify them. They do know how to sell you.”

I couldn’t agree more with Buffett and Munger on that last point and I too have railed against useless investment consultants that have hijacked the entire investment process at U.S. public pensions, typically recommending hot hedge funds their clients should be avoiding.

But while I don’t pity hedge fund managers, I think Buffett’s epic rant was somewhat harsh for a few reasons:

• That famous bet he made and is winning big on is part luck too. He made it back in 2006 before the financial crisis and profited from a huge beta thrust in the years following that crisis as central banks pumped extraordinary liquidity into the financial system.
• More importantly, this is a dumb bet to begin with. Why? By definition, hedge funds hedge or are suppose to hedge, which means they’re not always long the market even if most of them are net long and have way too much beta in their strategies. So it’s hard to conceive how a portfolio of hedge funds are going to beat the S&P after fees when rates dropped to record lows as central banks fight deflation. If we get a prolonged period of deflation, maybe then a portfolio of top hedge funds will outperform the S&P over a long period (maybe but I doubt it).
• Also, big pensions and insurance companies don’t invest in hedge funds as an alternative to the S&P 500, they do so as an alternative to bonds. They typically swap into some bond index and use the money to invest (overlay) in market neutral, L/S, global macro, CTA or multi-strategy hedge funds (but even bonds are beating them hands down this year!).

Still, there’s no denying Buffett made devastating points when he slammed hedge funds, consultants and pensions hard in his epic rant

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Attracta Mooney of the Financial Times reports, The US public pensions crisis ‘is really hard to fix’:

Eighteen months after Rahm Emanuel, a former White House chief of staff, became mayor of Chicago, he addressed a news conference about his priorities.

“[Number] one is retirement security and pension reform so we can give taxpayers and the public employees retirement security, which is something we can’t say today,” the mayor said in November 2012.

In the following three and a half years, Chicago’s public pension system, which estimates suggest has a funding hole of between $20bn and $32.5bn, has cast a long shadow over the mayor.

There have been rows with unions, court battles and finally a credit downgrade for the city, all linked to the Chicago’s public pensions.

Similar stories are playing out across the US. Although the funding deficits might not be as extreme as in Chicago, many cities and states are struggling under the weight of their pension plans, which oversee the retirement incomes of current and past public sector employees.

The scale of this pension crisis, as it has been dubbed, is huge. The Hoover Institution, a think-tank at Stanford University, estimates that US public pensions collectively have a $3.4tn funding hole. More conservative numbers put the funding gap at around $1tn.

Few public pension plans are fully funded, meaning they do not have enough money to pay current and future retirees. And the situation is getting worse.

According to Wilshire Consulting, an investment advisory company, state-sponsored pension plans in the US had just 73 per cent of the assets they needed in mid-2015, down from 77 per cent in 2014. Turbulent market conditions in the latter part of 2015 and early 2016 probably made this number even worse.

The big questions are if and how the large funding holes that have emerged in the US public pension system can be fixed.

Chris Tobe, an investment consultant and author of Kentucky Fried Pensions, a book examining problems in Kentucky’s retirement system, says the shortfalls in most US public pension plans are fixable, but there are exceptions, such as Chicago.

However, fixing the schemes will require a lot of work and is likely to have unpleasant consequences for retirees, employees, taxpayers and politicians.

One area where this is apparent is when state and local governments increase or introduce taxes, using the money raised to plug pension shortfalls. Several cities, including Chicago and Philadelphia, have taken this route.

But higher taxes or the issuance of bonds, another option used by local governments to raise money in order to reduce pension deficits, often proves unpopular with taxpayers.

Tamara Burden, principal at Milliman Financial Risk Management, an investment adviser to pension funds, says: “Raising taxes and issuing bonds means a vote, and a lot of public entities have seen those initiatives not pass.

“[The large-scale underfunding of public pensions] is really hard to fix.”

In Chicago, Ed Bachrach, chairman of the Center for Pension Integrity, a non-profit organisation, estimates that to ensure the city’s pension plans are fully funded within 20 years, Chicago’s property tax would have to be increased 85 per cent. But he warns that “crippling tax increases” could drive taxpayers and businesses away.

Mr Bachrach adds: “In troubled jurisdictions, officials cannot raise taxes fast enough to prevent the erosion of fund assets, and the enormous pension payments required are crowding out expenditure for vital public services and crumbling infrastructure.”

There are other options available to improve the outlook for public pension plans. One is making changes within pension funds that would help to drive funding deficits down, such as cutting the fees retirement plans pay to asset managers. Some pensions are pushing into riskier assets in the hope that this will increase returns.

Alternatively, state and local governments could reduce benefits for current or future retirees, or cap the maximum retirement benefit that can be paid to an individual. These measures are illegal in some states and have proved unpopular with unions and public sector workers.

Public sector workers could also be forced to increase their contributions, or moved into defined contribution plans, which do not guarantee a level of income on retirement. This would, in turn, reduce the strain on local government budgets.

Any attempt to fix the pension shortfall is likely to involve a combination of these solutions. But there seems to be an unwillingness to fix the problems, according to Olivia Mitchell, a professor at the Wharton School at the University of Pennsylvania.

Unions, public sector employees and retirees do not want to give up the benefits promised to them, politicians do not want to impose tax hikes that could cost them votes, and taxpayers are reluctant to part with more cash to prop up the system.

Ms Mitchell says: “Politicians and taxpayers have shown themselves unwilling to take their public pension shortfalls seriously.”

Mr Bachrach adds: “Fixing this problem requires shared sacrifice from all parties: public employees, retirees and taxpayers. It requires courage on the part of elected officials.”

If the problems are not fixed, the consequences could be dire.

Some pension funds, including two of Chicago’s plans, are on course to run out of money within a matter of years. This means that either the retirees will not get paid the money they are owed, or, more likely, the cities and states that back the pension plans will have to cover the retirement payments.

This would leave cities and states with less money to spend on services such as education. In some cases, cities may go bankrupt. This has already happened in Detroit in Michigan and San Bernardino in California, where large public pension shortfalls contributed to the cities’ defaults.

“I do believe that US cities and towns will continue to suffer [because of their pension funding holes], and there will be additional bankruptcies following the examples of Detroit,” said Ms Mitchell earlier this year.

Some pension officials are hoping the federal government will step in and prop up problematic retirement funds. But Devin Nunes, a US Republican congressman, is trying to make sure this does not happen.

He proposed a bill in March to ensure the federal government cannot rescue insolvent public pension funds. “Cities and states should run [pension funds] in a financially sustainable way. That is what my bill encourages, particularly by prohibiting federal bailouts of distressed funds,” he says.

Even without the bill, Steven Hess, an analyst at Moody’s, the rating agency, says states and cities will have to fix their own pension problems. “We don’t think the federal government will come to the rescue of municipal plans,” he says.

Phil Angelides, a former state treasurer for California who used to sit on the board of Calpers and Calstrs, the US public pension schemes, says: “[The public pension deficit] is manageable if society begins to address it. A few pension funds may have immediate issues, but they face long-term challenges and there is still time to address them.”

As for Chicago, the future of its pension funds remains unclear. In March, Illinois’s Supreme Court ruled against Mr Emanuel’s plans to stabilise the pension funds by requiring larger employee contributions and cutting pension benefits in return for bigger contributions from the city.

In the wake of this ruling, a spokesperson for the mayor says: “We are currently evaluating a number of pension reform proposals.”

The mayor, it seems, faces an uphill battle to plug the city’s pension deficit.

US public pensions: ‘There is no young blood coming in’

The large funding holes that have emerged at US public pension plans have been decades in the making.

A combination of factors, ranging from demographics to current low interest rates, has left pension plans nursing big deficits.

In some cases, cities and state governments have not contributed as much as they should have to public pension plans, leaving funds without the money they needed to invest and plug any developing funding holes.

Another factor is that public pension plans have been underestimating how much money they would need in future, says Olivia Mitchell, a professor at the Wharton School at the University of Pennsylvania.

Public plans typically have high return targets of between 7 and 8 per cent, which are used to forecast how much money a pension fund will need to pay current and future retirees. Private sector pension plans, in contrast, typically use lower rates of 2.5 per cent on average to calculate future liabilities, says Ms Mitchell.

Every time a public pension plan misses the return target, their liabilities jump. They then need far stronger performance the following year in order to correct the problem.

An ageing public sector population is not helping matters. “There is no young blood coming in to keep their plans going,” says Ms Mitchell.

I’ve already covered why U.S. public pensions are doomed. It’s a slow motion train wreck and while demographics and historic low rates aren’t helping, in my opinion, terrible pension governance is equally if not a more important determinant of the U.S. public pension crisis.

Here are some of the points I noted on why this crisis isn’t going away:

The critical point to remember is that when rates are at historic lows, every drop in global long bond yields represents a huge increase in future liabilities for pensions. Why? Because the duration of liabilities is a lot bigger than the duration of assets which means that every drop in bond yields disproportionately impacts pension deficits.

This is why you see Canada’s large public pensions scrambling to buy infrastructure assets like London City Airport at a hefty premium. They need to find assets that are a better match to their long dated liabilities. We can argue whether Canada’s mighty pensions are paying too much for these “premium infrastructure assets” (I think so) but this is the approach they’re taking to defy volatile public markets and find a better suitable match for their long dated liabilities.

And unlike the United States, Canada’s large public pensions have the right governance to go out to do these direct investments in infrastructure. Also, unlike their U.S. counterparts, Canada’s large public pensions have realistic investment assumptions and are better prepared for an era of lower returns.

In the U.S., public pensions are delusional, firmly holding on to the pension rate-of-return fantasy. They’re also held hostage by useless investment consultants that shove them in the same brand name private equity funds and hedge funds. This doesn’t always pan out well for these public pensions but it enriches private equity titans and hedge fund gurus who collect outrageous fees no matter how well they perform.

It’s worth noting none other than Warren Buffett came out this weekend to state hedge funds are getting ‘unbelievable’ fees for bad results:

“There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities,” Buffett said Saturday during Berkshire’s annual meeting in Omaha, Nebraska.

I couldn’t agree more. I don’t pity any hedge fund manager, especially those “superstars” managing multibillions, collecting a big management fee no matter how poorly they’re performing.

The amount of nonsense governing hedge fund investments at U.S. public pensions is a byproduct of a few things: 1) delusional public pension fund managers who don’t know the first thing about managing a portfolio off hedge funds and 2) this irrational thirst for yield at all cost believing that hedge funds can offer great risk-adjusted returns in all cycles.

Dan Loeb is right, we are in the ‘1st inning of  a washout in hedge funds’ and the reason is simple: deflation is coming, which means low rates and huge market volatility are here to stay. Most hedge funds are going to get obliterated in this environment and large public pensions are quickly realizing this which is why they’re redeeming from even brand name funds.

In Canada, large public pensions are increasingly looking to invest directly in infrastructure assets around the world and at home. I don’t see them chasing after hedge funds or even private equity funds which charge enormous fees and deliver lackluster results.

But in the United States, you don’t have the right pension governance, which means you can’t attract and retain qualified pension fund managers to bring assets internally to invest directly across public and private markets, as well as engage in internal absolute return strategies instead of farming them out and getting clobbered on fees.

Warren Buffett is right, there is a tremendous amount of salesmanship going on in Wall Street and fees matter a lot, especially over a long period. But U.S. public pensions remain undeterred, feeling that investing in hedge funds will help them navigate the future a lot better (they’re in for a nasty surprise).

Now, forget hedge funds, let’s talk about the pension fixes discussed in the article above. When a public pension is severely underfunded, either you increase taxes, emit more pension bonds, increase the contributions or cut benefits. Or you can pray that monetary authorities will resurrect global inflation and interest rates will shoot up and all these public pension deficits will magically disappear (a higher discount rate means lower future liabilities).

Unfortunately, I have bad news for pensions that believe higher interest rates are coming. I’ve been warning them for a long time of the deflation tsunami and that ultra low rates and the new negative normal are here to stay.

In fact, last week, Bank of Canada Governor Stephen Poloz warned pensions to brace for a new normal of lower rates. I would go a step further and tell pensions to brace for negative rates and truly understand what they are (Sober Look published a great comment looking at misconceptions surrounding negative rates).

Again, maybe I’m too negative, maybe oil will experience a multi-year bull run even if the Saudis are hedging their bets, maybe Jamie Dimon is right on Treasuries, maybe Soros is wrong and China’s pension gamble will pay off, maybe the yen’s surge won’t trigger another Asian financial crisis, maybe monetary authorities can resurrect global inflation and maybe the quants and algos can engineer ever higher stock prices so we can escape the Great Crash of 2016.

Or maybe the bulls are drinking way too much Koolaid because from my vantage point, nothing has changed on a structural basis to change my Outlook 2016 as to why the global deflation tsunami is coming and it will wreak havoc on global pensions (all the big moves in risk assets leveraged to global growth were related to weakness in the U.S. dollar which will change abruptly in the second half of the year as the rest of the world slows down big time).

Something else you should all bear in mind. All these pension fixes being proposed, whether it’s cuts to benefits, increasing taxes and contributions, or worse still, shifting them into defined-contribution plans, are all very deflationary.

But hey, if you believe in fairy tales and think the world is going to magically grow its way out of these problems, be my guest. I prefer reality which is why I think the big money in the second half of the year will be shorting all these risks assets leveraged to global growth that benefited from the (temporary) weakness in the U.S. dollar.

As far as fixing U.S. public pensions, the problem is huge, much bigger than U.S. policymakers can possibly grasp and there are powerful special interests who don’t want to change the status quo (basically hedge funds, private equity funds and the rest of the Wall Street mob milking public pensions dry).

In my humble opinion, if America wants a real revolutionary retirement plan, it has to stop looking at Wall Street for solutions and start bolstering Social Security by adopting Canadian pension governance and the risk-sharing model which is working all over the world.

That’s the brutal truth. There is no magic fix for what is ailing U.S. public pensions and the problem is going to get a lot worse over the next decade(s) and it will hurt the U.S. economy in profound ways.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Andy Blatchford of the Canadian Press reports, Pensions should brace for new normal of lower neutral interest rates:

Bank of Canada governor Stephen Poloz is recommending pension funds get ready for a new normal: neutral interest rates lower than they were before the financial crisis.

Poloz told a Wall Street audience Tuesday that the fate of neutral rates — the levels he said will prevail once the world economy recovers — remain unknown, but they will almost certainly be lower than previously thought.

The central banker made the comment during a question-and-answer period that followed his speech on global trade growth.

Among the reasons, Poloz pointed to the more-pessimistic outlook for potential long-term global growth. The forecast was lowered to 3.2 per cent from four per cent, he said.

“That downgrade means the neutral rate of interest will be lower for sure — for a very long time,” said Poloz, who added it could go even lower if economic “headwinds” continue.

“Those in the pension business need to get used to it. They need to adapt to it.”

Since the 2008 global financial crisis, pension funds around the world have had to contend with market uncertainty, feeble growth and record-low interest rates.

Pension funds use long-term interest rates to calculate their liabilities. The lower the rates, the more money plans need to have to ensure they will be able to pay future benefits.

A December report by the Organization for Economic Co-operation and Development said the conditions have “cast doubts on the ability of defined-contribution systems and annuity schemes to deliver adequate pensions.”

To cushion the Canadian economy from the shock of lower commodity prices, Poloz lowered the central bank’s key rate twice last year to 0.5 per cent — just above its historic low of 0.25.

Poloz linked the higher neutral interest rates of the past to the baby boom, which he described as a 50-year period of higher labour-force participation and better growth.

“Well, that’s behind us,” Poloz told the meeting of the Investment Industry Association of Canada and the Securities Industry and Financial Markets Association.

“We don’t have numbers for all this, but you need to be scenario-testing those pension plans and the needs of your clients because the returns simply won’t be there.”

But with all the unpredictability Poloz said it remains possible current headwinds could convert into positive forces that would push interest rates back to “more-normal levels” seen prior to the crisis.

Earlier Tuesday, Poloz’s speech touched on another aspect of the post-crisis world.

He told the crowd they shouldn’t expect to see a return of the “rapid pace of trade growth” the world saw for the two decades before the crisis.

Poloz was optimistic, however, that the “striking weakness” in international trade wasn’t a sign of a looming global recession.

He said the renewed slowdown in global exports is more likely a result of the fact that big opportunities to boost global trade have already been largely exploited.

As an example, he noted China could only join the World Trade Organization once.

Poloz expressed confidence that most of the trade slump will be reversed as the global economy recovers — even if it’s a slow process.

“The weakness in trade we’ve seen is not a warning of an impending recession,” said Poloz, a former president and CEO of Export Development Canada.

“Rather, I see it as a sign that trade has reached a new balance point in the global economy — and one that we have the ability to nudge forward.”

He said there’s still room to boost global trade through efficiency improvements to international supply chains, the signing of major treaties such as the Trans-Pacific Partnership and the creation of brand new companies.

Poloz’s speech came a day after Export Development Canada downgraded its outlook for the growth of exports.

EDC chief economist Peter Hall predicted overall Canadian exports of goods and services to expand two per cent in 2016, down from a projection last fall of seven per cent.

Well, if President Trump takes over after President Obama, you can expect more protectionism and trade wars, which isn’t good for global trade.

But Bank of Canada Governor Stephen Poloz is absolutely right, pensions need to brace for a new normal of lower neutral interest rates. I’ve long warned my readers that ultra low rates are here to stay and if global deflation sets in, the new negative normal will rule the day.

Thus far, Canada has managed to escape negative rates but this is mostly due to the rebound in oil prices. If, as some claim, oil doubles by year-end, you can expect the loonie to appreciate and the Bank of Canada might even hike rates (highly doubt it). On the other hand, if the Great Crash of 2016 materializes, oil will sink to new lows and the Bank of Canada will be forced to go negative.

Interestingly,  on Wednesday, the Australian dollar plunged almost 2 per cent after a lower-than-expected inflation print  and deflation fears put a rate cut back on the agenda for next week’s Reserve Bank meeting. Keep an eye on the Aussie as it might portend the future of commodity prices, deflation and what will happen to the loonie.

You should also read Ted Carmichael’s latest, Why Does the Bank of Canada Now Believe that Fiscal Stimulus Works?. I agree with him, all this talk of fiscal stimulus is way overblown and in my opinion, it’s a smokescreen for what really lies behind the Bank of Canada’s monetary policy: it’s all about oil prices. And like it or not, the loonie is a petro currency, period.

[As an aside, Ted also shared this with me: “I’d be ok with the budget if they stuck with carefully thought out infrastructure with private sector and/or pension fund participation, but they have blown up the deficit with middle income transfers and operational spending.”]

The rise in oil prices alleviates the terms of trade shock and if it continues, the Bank of Canada won’t need to cut rates this year. It’s that simple, no need to torture yourself trying to figure out the Bank of Canada’s monetary policy, it’s all about oil, not fiscal policy.

South of the border, the Fed will do a cautious dance to avoid volatility:

The Fed is expected to do a cautious dance when it releases its statement Wednesday, as it leaves the door open for a rate hike in June but is not signaling one.

After two days of meetings, the Fed will release a 2 p.m. statement Wednesday. The statement is not expected to be much changed from its last one, but Fed watchers say the nuances will be important. There is no press conference where Fed chair Janet Yellen can provide further clarification, so markets will have only the statement to respond to.

The Fed is expected to be dovish in its statement, but the bond market clearly has been fearing it will be a bit more hawkish, and yields have been rising. Market expectations are for the next rate hike to come early next year, but the Fed has said it expects two rate hikes before then, so there is tension around any statement it would make.

“I don’t think they’re going to tip their hand on the policy section of it. I think the hawkishness might come in their description of the economy, because credit spreads have come back and are no longer a worry. The stock market is no longer down 10 percent on the year. Even the G-20 was less concerned about the economic outlook for the world,” said Chris Rupkey, chief financial economist at MUFG Union Bank.

But the U.S. economic data has been spotty, with more than a few misses recently. Durable goods was weaker than expected Tuesday, and first quarter GDP, expected Thursday, is predicted to be just barely positive.

Fed officials have also been sending mixed messages about rate hikes. For instance, Boston Fed President Eric Rosengren, viewed as a dove, has said the markets have it wrong and are not pricing in enough rate hikes.

“The problem is you’ve got disagreement. The gap has widened,” said Diane Swonk, CEO of DS Economics. “You’ve got dissents. When you have dissents, you have volatility.” Cleveland Federal Reserve President Loretta Mester is expected to join Kansas City Fed President Esther George in dissenting Wednesday, as they object to the Fed’s lack of rate hikes.

“I don’t think they can put the balance of risk back in, because they can’t agree what the balance of risks are,” said Swonk. “It just means continued uncertainty, continued uncertainty for the market.”

Michael Arone, chief investment strategist at State Street Global Advisors, also said the Fed is unlikely to suggest that risks are balanced.

“If they tell you it’s nearly balancing, that’ll be a signal that June is on the table,” said Arone, adding he does not expect to see that.

Arone said the Fed will want to leave options open. “I don’t think this Fed, and Yellen in particular, likes to paint themselves into a corner,” said Arone. “The statement will acknowledge that growth in the economy is modest. They haven’t seen the flow through to inflation and they’ll remain data dependent going forward.”

He said he will be watching to see if Yellen’s view is dominant in the statement. “My view is what Yellen did with her Economic Club of New York speech (March 29), she was saying: ‘I’m the chairperson. This is my view. We’re going to go slow and gradual.’ At the time, other Fed officials were talking about how April was still on the table,” Arone said. “I think what markets are going to be looking to see is if that remains the message or if we’re back in this kind of limbo.”

It will also be important to see if the Fed gives any nod to stability in international markets now that China has calmed some of the fears around its economy.

Besides the Fed, there is the trade deficit data at 8:30 a.m. EDT and pending home sales at 10 a.m. EDT. There is a 10:30 a.m. EDT government inventory data on oil and gasoline, and the Treasury auctions seven-year notes at 1 p.m. auction.

Earnings before the bell include Boeing, Comcast, GlaxoSmithKline, Mondelez, United Technologies, Anthem, Northrop Grumman, Dr Pepper Snapple, Nasdaq OMX, Nintendo, State Street, Tegna, Garmin, Six Flags and General Dynamics. After the bell, reports are expected from Facebook, PayPal, Marriott, SanDisk, Cheesecake Factory, La Quinta, Rent-A-Center, First Solar, Texas Instruments and Vertex Pharmaceuticals.

The only earnings that matter on Wednesday are those of Apple (AAPL). Its shares are down 7% at this writing as it feels the pain of the end of iPhone 6 cycle (they better come up with a great marketing campaign for iPhone 7 to bring the stock back over $120 this fall).

As far as the Fed, I don’t expect any major surprises today but who knows how markets react if the statement turns out to be more hawkish than expected.

More interestingly, Jeffrey Gundlach, the reigning bond king, visited Toronto recently and spoke with Financial Post reporter Jonathan Ratner. Here is an edited version of their discussion which you all MUST read as Gundlach talks about why debt deflation is a real threat, why the Fed capitulated in March and why negative rates are ‘horror’ (read this interview carefully).

Lately, Gundlach has been legging into Treasuries which shows you he’s not worried about any rout in the bond market.

So, if low rates are here to stay, how are pensions going to adapt? More hedge funds? Good luck with that strategy. More private equity, real estate and infrastructure? This seems to be the reigning strategy but pensions have to be careful taking on illiquidity risk, especially if global deflation sets in. And when it comes to private equity funds, they have to monitor fees and performance carefully and also realize real estate has its own set of challenges in this environment.

This is why in Canada, large public pensions are gearing up to bankroll domestic infrastructure, ignoring critics calling this the great Canadian pension heist. By investing directly in mature and greenfield infrastructure, Canada’s large public pensions can put a lot of money to work in assets that offer stable, predictable long-term cash flows, essentially better matching assets with their long dated liabilities without paying huge fees to private equity funds and without taking currency or regulatory risks (still taking on huge illiquidity risk but they have a long horizon to do this).

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Andrew Coyne of the National Post warns, Funding government projects through public pension plans a terrible idea:

The federal government, it is well known, is determined to spend $120 billion on infrastructure over the next 10 years. If traditional definitions of infrastructure are insufficient to get it to that sum, then by God it will come up with whole new definitions.

Ah, but whose money? From what source? The government would appear to have three alternatives. One, it can pay for it out of each year’s taxes. Two, it can borrow on private credit markets. Or three, it can finance capital projects like roads and bridges by charging the people who use them. Once these would have been known as user fees or road tolls; in the language of today’s technocrats, it’s called “asset monetization” or “asset recycling.”

Governments at every level and of every stripe have been showing increasing interest in this option, and with good reason. Pricing scarce resources encourages consumers to make more sparing use of them, while confining ambitious politicians and bureaucrats to providing services people actually want and are willing to pay for.

Moreover, by charging users where possible, scarce tax dollars are freed up to pay for the things that can only be paid for through taxes: public goods, like defence, policing and lighthouses.

Of course, if it is possible to charge users, it raises the question of whether the service need be provided, or at least financed, by the state at all. Rather than front the capital for a project themselves, governments can open it to private investors to finance, in return for some or all of the revenues expected to flow from it. As with user fees, this need not be limited to new ventures: “asset recycling” can also mean selling existing government enterprises — what used to be called “privatization.”

Again, there’s much to recommend this. If a project can be financed privately, it usually should, as this provides a truer measure of the cost of capital. (This point eludes many people: since the government has the best credit and pays the lowest interest rate, they ask, doesn’t it make sense to borrow on its account? But by that reasoning we should get the government to borrow on everybody’s behalf. If not, then it is privileging some investments over others, in the same way as if it were to directly subsidize them, and subject to the same critiques.)

The further removed from government, moreover, the less the chances of politicization. There’s a reason we set up Crown corporations at arm’s length from the government of the day, in the hopes of insulating them from politically-minded meddling.

Privatization simply takes that one step further. At the same time, a company in private hands can be regulated in a more disinterested fashion, without the inherent conflict of interest of a government, in effect, regulating itself. Last, experience teaches that when people own something directly, and have an interest in its value, they tend to take better care of it — whereas when the state owns something, no one does.

Yet government and private sector alike are too willing to blur this distinction. Rather than simply put a project out to private tender, with investors bearing all of the risk in return for all of the profit, public and private capital are frequently commingled. All too often, this means public risk for private profit.

That, alas, seems where we are headed — with an extra twist of malignancy. For, as the Canadian Press recently reported, the “private” investors the feds have their eyes on are in fact the country’s public pension plans, notably the Canada Pension Plan’s $283-billion investment fund and Quebec’s Caisse de dépot et placement — much as the Ontario government had earlier suggested it would use its planned provincial equivalent.

This is a truly terrible idea. On the one hand, it offers governments a way to finance their spending on the quiet, without subjecting their plans to the scrutiny of either the credit markets or Parliament. On the other hand, it opens pension funds to pressure to invest in ways that may not be in the best interest of pensioners, but rather of their political “partners.”

I know, I know: the public pension plans are independent of government, at arms’ length, and all that. But the history of the Caisse is rather less than reassuring in this regard, while the presence of the CEOs of both the Caisse and the CPP Investment Board on the Finance minister’s new economic advisory council does not quite scream independence.

Even more disquieting is the Caisse’s latest venture, a $5.5-billion light rail project in Montreal, of which the Caisse itself would put up a little more than half — with the remainder, it hopes, to come from the federal and provincial governments.

Is it too hard to imagine, in the negotiations to come, the governments in question suggesting a little quid pro quo: we’ll fund yours if you’ll fund ours?

Well now. If I lend you $100 and you lend me $100, are either of us $1 better off? Now suppose you and I are basically the same person, and you have some idea of the nonsense involved here. The pension plans will fund government infrastructure projects with the money they make on investments funded in part by governments out of the return on investments that were financed by the pension plans and so on ad infinitum.

A government that borrows from others acquires a liability, but a government that borrows from itself may be accounted a calamity.

Poor Andrew Coyne, he just doesn’t get it. Before I rip into his idiotic comment, let’s go over another equally idiotic comment by an economist called Martin Armstrong who put out a post, Asset Recycling – Robbing Pensions to Cover Govt. Costs:

We are facing a pension crisis, thanks to negative interest rates that have destroyed pension funds. Pension funds are a tempting pot of money that government cannot keep its hands out of. The federal government of Canada, for example, is looking to reduce the cost of government by shifting Canada’s mounting infrastructure costs to the private sector. They want to sell or lease stakes in major public assets such as highways, rail lines, and ports. In Canada, they hid a line in last month’s federal budget that revealed that the Liberals are considering making public assets available to non-government investors, such as public pension funds. They will sell the national infrastructure to pension funds, robbing them of the cash they have to fund themselves. This latest trick is being called “asset recycling,” which is simply a system designed to raise money for governments. This idea is surfacing in Europe as well as the United States, especially among cash-strapped states.

This is the other side of 2015.75; the peak in government (socialism). Everything from this point forward is a confirmation that these people are in crisis mode. They are rapidly destroying Western culture because they are simply crazy and the people who blindly vote for them are out of their minds. They are destroying the very fabric of society for they cannot see what they are doing nor where this all leads. Once they wipe out the security of the future, the government will crumble to dust to be swept away by history. We deserve what we blindly vote for.

Wow, “peak government socialism”, “destroying the very fabric of society”, and all this because our federal government had the foresight to approach Canada’s big, boring public pension funds to invest in domestic infrastructure?

These comments are beyond idiotic. Forget about Martin Armstrong, he sounds like a total conspiratorial flake worried about the end of humanity as we know it (not surprised to see him publishing doom and gloom articles on Zero Hedge).

Let me focus on Andrew Coyne, the resident conservative commentator who also regularly appears on the CBC to discuss politics. People actually listen to Coyne, which makes him far more dangerous when he spreads complete rubbish like the article he penned above (to be fair, I prefer his political comments a lot more than his economic ones).

In my last comment on pensions bankrolling Canada’s infrastructure, I praised the federal government’s initiative of “asset recycling” and stated why it makes perfect sense for Canada’s large pensions to invest in domestic infrastructure:

• Federal, provincial and municipal governments are cash-strapped and they need funds to invest in infrastructure. Increasing taxes to do this is simply not a viable option when the economy is weak.
• Unlike other investments, investing in infrastructure has huge long-term economic benefits to any country and infrastructure jobs pay well, which means there is an important multiplier effect to the overall economy from these jobs.
• Pensions need yield. They can invest in public and private markets or in hedge funds. Increasingly, they’re avoiding volatile public markets where bond yields are at historic lows and they’re even starting to shun hedge funds which promise absolute returns but have failed to keep up with simple stock and bond indexes.
• Where are pensions turning to? Private equity, real estate and infrastructure. But unlike private equity, Canada’s large pensions invest directly in infrastructure, avoiding hefty fees to general partners (GPs), and unlike real estate, the duration of infrastructure assets is a better match to the duration of their long dated liabilities which typically go out 75+ years.
• What else? infrastructure assets are highly scalable, meaning these large pensions can put a huge chunk of money to work in one infrastructure investment instead of many private equity or hedge funds which charge big fees and don’t offer safe, predictable returns.
• Most of Canada’s large public pensions target an actuarial rate of 6.3% (nominal), so if Michael Sabia is right and infrastructure offers a stable, predictable and low-risk return of 7-9%, then why not invest directly in infrastructure? It makes perfect sense.
• Canada’s large public pensions are internationally renowned infrastructure investors, investing in airports, highways, ports, and other infrastructure investments all around the world. Their focus has mainly been in Britain and Australia where the rule of law is similar to the one in Canada.
• But if the federal government makes public infrastructure available to them here, either through long-term leases or outright sales, then why not invest in domestic projects, foregoing any currency risk or foreign regulatory risk? Again, it makes perfect sense, it’s simple logic, not rocket science.
• Of course, if the federal government opens public infrastructure assets to Canada’s large pensions, it has to do so for international mega pension and sovereign wealth funds too, introducing competition and leveling the playing field.
• Typically Canada’s large pensions invest in mature infrastructure investments that have been operational for years and offer well-known cash flows, avoiding riskier greenfield projects with uncertain cash flow projections.
• But the Caisse is dipping into greenfield projects here in Quebec. It can do so because it has hired an experienced team of infrastructure professionals with actual operational experience who have project management experience and have overseen previous greenfield projects.

I also stated the following:

No doubt, greenfield infrastructure projects carry bigger risks but they also offer bigger rewards down the road. Will everything go smoothly in this project? Of course not, there isn’t one major greenfield infrastructure project that goes off without a hitch but the people working on this project have actual operational experience and a track record of delivering on such projects below budget (which isn’t easy) easing my concerns about recouping operating and capital costs.

So, I would tell the media and critics to ease up and have faith in Macky Tall and his team at CDPQ Infra. They are all very experienced and highly ethical individuals who will deliver on this and other greenfield projects if they are asked to in the future. And trust me, there will be no Charboneau Commission on this project which is great news for Quebec’s taxpayers.

Now, let’s get back to Coyne’s article. He states the following:

This is a truly terrible idea. On the one hand, it offers governments a way to finance their spending on the quiet, without subjecting their plans to the scrutiny of either the credit markets or Parliament. On the other hand, it opens pension funds to pressure to invest in ways that may not be in the best interest of pensioners, but rather of their political “partners.”

And follows up right away with this:

I know, I know: the public pension plans are independent of government, at arms’ length, and all that. But the history of the Caisse is rather less than reassuring in this regard, while the presence of the CEOs of both the Caisse and the CPP Investment Board on the Finance minister’s new economic advisory council does not quite scream independence.

First of all, it’s arm’s length, but leaving that typo aside, what is Coyne talking about? Canada’s large public pensions have a fiduciary mandate to invest in the best interests of their beneficiaries by maximizing their return without taking undue risk. It is stipulated in the law governing their operations and it’s part of their investment policy and philosophy.

Second, Canada’s large public pensions operate at arm’s length from the government precisely because they want to eliminate government interference in their investment process. Importantly, the federal government isn’t forcing Canada’s large public pensions to invest in infrastructure, it’s consulting them to see if they can strike a mutually beneficial policy which will allow the government to deliver on its promise to invest in infrastructure and public pensions to meet their actuarial target rate of return by investing in domestic as opposed to foreign infrastructure (lest we forget their liabilities are in Canadian dollars and there is less regulatory risk investing in domestic infrastructure).

Here you have world class pension experts investing directly in infrastructure assets all around the world and Andrew Coyne thinks it’s shady that Mark Wiseman and Michael Sabia are sitting on the Finance Minister’s economic advisory council? If you ask me, our Finance Minister would be a fool if he didn’t ask them and others (like Leo de Bever, AIMCo’s former CEO and the godfather of investing in infrastructure) to sit on his advisory council.

In the height of the 2008 crisis, I was working as a senior economist at the Business Development Bank of Canada (BDC) and I clearly remember our team preparing that organization’s former CEO, Jean-René Halde, for his Friday morning discussions with then Finance Minister Jim Flaherty. Other CEOs of major Crown corporations (like Steve Poloz the current Governor of the Bank of Canada who was the former CEO of Export Development Canada), were on that call too looking at ways to help banks provide credit and invest in small and medium sized enterprises. There was nothing shady about that, it was a very smart move on Flaherty’s part.

Speaking of shady activity, I have more confidence in the people at the Caisse overseeing the $5.5 billion light rail project than I do with anyone working in the municipal, provincial or federal government in charge of our infrastructure assets. If you want to cut the risk of corruption, you are much better off having the tender offers go through CPDQ Infra than some government organization which isn’t held accountable and doesn’t have skin in the game.

That brings me to another topic. Canada’s large public pensions aren’t in the charity business, far from it. If they’re investing in domestic infrastructure, it’s because they see a fit to meet their long dated liabilities and make money off these investments. And let’s be clear, they all want to make money taking the least risk possible because that is how they justify their hefty compensation.

The notion that any provincial or even the federal government is forcing public pensions to invest in infrastructure is not only ridiculous, it’s downright laughable and shows complete ignorance on Coyne’s part as to the governance at Canada’s large public pensions and their investment mandate and incentive structure.

Andrew Coyne should stick to political commentaries. When it comes to public pensions and the economy, he’s just as clueless as the hacks over at the Fraser Institute claiming CPP is too costly. It isn’t, we should build on CPPIB’s success.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Andy Blatchford of the Canadian Press reports, Liberal government to consider public pension funds to help bankroll mounting infrastructure costs:

The federal government has identified a potential source of cash to help pay for Canada’s mounting infrastructure costs — and it could involve leasing or selling stakes in major public assets such as highways, rail lines, and ports.

A line tucked into last month’s federal budget reveals the Liberals are considering making public assets available to non-government investors, like public pension funds.

The sentence mentions “asset recycling,” a system designed to raise money to help governments bankroll improvements to existing public infrastructure and, possibly, to build new projects.

For massive, deep-pocketed investors like pension funds, asset recycling offers access to reliable investments with predictable returns through revenue streams that could include user fees such as tolls.

“Where it is in the public interest, engage public pension plans and other innovative sources of funding — such as demand management initiatives and asset recycling — to increase the long-term affordability and sustainability of infrastructure in Canada,” reads the sentence in the new Liberal government’s first budget.

Asset recycling is gaining an increasing amount of international attention and one of the best-known, large-scale examples is found in Australia. The Australian government launched a plan to attract billions of dollars in capital by offering incentives to its states and territories that sell stakes in public assets.

Like the Australian example, experts believe monetizing Canadian public assets could generate much-needed funds for a country faced with significant infrastructure needs.

The Liberal budget paid considerable attention to infrastructure investment, which it sees as way to create jobs and boost long-term economic growth. The Liberals have committed more than $120 billion toward infrastructure over the next decade.

Proponents of asset recycling say enticing deep-pocketed investors to join can help governments avoid amassing debt or raising taxes.

“Asset recycling is a way to attract private-sector investment into activities that were formerly, exclusively, in the public realm,” said Michael Fenn, a former Ontario deputy minister and management consultant who specializes in the public sector.

“It’s something that we should pay a lot of attention to and I’m really pleased to see the federal government is looking seriously at it.”

Fenn serves as a board member for OMERS pension fund, which invests in public infrastructure around the world. He stressed he was not speaking on behalf of OMERS or its investments.

Two years ago, Fenn wrote a research paper for the Toronto-based Mowat Centre think-tank titled, Recycling Ontario’s Assets: A New Framework for Managing Public Finances.

In Canada, he said there have been a few examples that resemble asset recycling, including Ontario’s partnership with Teranet to manage its land registry system and the province’s more recent move to sell part of the Hydro One power company.

For the most part, Canada’s big pension funds have been focused on international infrastructure investments because few domestic opportunities have been of the magnitude for which they tend to look.

Australia’s asset-recycling model has been praised by influential Canadians such as Mark Wiseman, president and chief executive of the Canada Pension Plan Investment Board.

“With growing infrastructure deficits worldwide … we often reference this model with our own government and others as one to follow to (incentivize) and attract long-term capital,” Wiseman said in prepared remarks of a September speech in Sydney to the Canadian Australian Chamber of Commerce.

The massive CPP Fund had $282.6 billion worth of assets at the end of 2015. Wiseman’s speech noted more than 75 per cent of its investments were made outside Canada, including about $7 billion in Australia.

Last month, Wiseman was named to Finance Minister Bill Morneau’s economic advisory council, which is tasked with helping the government map out a long-term growth plan. The council also includes Michael Sabia, CEO of Quebec’s largest public pension fund, the Caisse de dépôt et placement du Québec.

In a prepared speech last month in Toronto, Sabia said financial institutions like pension plans have tremendous potential to drive growth through infrastructure investment. For the investor, Sabia said that infrastructure offers stable, predictable, low-risk returns of seven to nine per cent.

A spokeswoman for Morneau’s office was asked about Ottawa’s interest in asset recycling, but she referred back to the budget and said there was nothing new to add on the issue, for the moment.

Last year, I discussed this idea of opening Canada’s infrastructure floodgates. Since then, the idea has taken off and there has been a vigorous push from Ottawa to court pensions on infrastructure.

Why does this initiative of “asset recycling” make sense? I’ve already mentioned my thoughts here but let me briefly make a much simpler case below:

• Federal, provincial and municipal governments are cash-strapped and they need funds to invest in infrastructure. Increasing taxes to do this is simply not a viable option when the economy is weak.
• Unlike other investments, investing in infrastructure has huge long-term economic benefits to any country and infrastructure jobs pay well, which means there is an important multiplier effect to the overall economy from these jobs.
• Pensions need yield. They can invest in public and private markets or in hedge funds. Increasingly, they’re avoiding volatile public markets where bond yields are at historic lows and they’re even starting to shun hedge funds which promise absolute returns but have failed to keep up with simple stock and bond indexes.
• Where are pensions turning to? Private equity, real estate and infrastructure. But unlike private equity, Canada’s large pensions invest directly in infrastructure, avoiding hefty fees to general partners (GPs), and unlike real estate, the duration of infrastructure assets is a better match to the duration of their long dated liabilities which typically go out 75+ years.
• What else? infrastructure assets are highly scalable, meaning these large pensions can put a huge chunk of money to work in one infrastructure investment instead of many private equity or hedge funds which charge big fees and don’t offer safe, predictable returns.
• Most of Canada’s large public pensions target an actuarial rate of 6.3% (nominal), so if Michael Sabia is right and infrastructure offers a stable, predictable and low-risk return of 7-9%, then why not invest directly in infrastructure? It makes perfect sense.
• Canada’s large public pensions are internationally renowned infrastructure investors, investing in airports, highways, ports, and other infrastructure investments all around the world. Their focus has mainly been in Britain and Australia where the rule of law is similar to the one in Canada.
• But if the federal government makes public infrastructure available to them here, either through long-term leases or outright sales, then why not invest in domestic projects, foregoing any currency risk or foreign regulatory risk? Again, it makes perfect sense, it’s simple logic, not rocket science.
• Of course, if the federal government opens public infrastructure assets to Canada’s large pensions, it has to do so for international mega pension and sovereign wealth funds too, introducing competition and leveling the playing field.
• Typically Canada’s large pensions invest in mature infrastructure investments that have been operational for years and offer well-known cash flows, avoiding riskier greenfield projects with uncertain cash flow projections.
• But the Caisse is dipping into greenfield projects here in Quebec. It can do so because it has hired an experienced team of infrastructure professionals with actual operational experience who have project management experience and have overseen previous greenfield projects.

On this last point, the Caisse announced plans on Friday for its Réseau électrique métropolitain (REM), an integrated, world-class public transportation project. Jason Magder of the Montreal Gazette reports, Electric light-rail train network to span Montreal by 2020:

It will be the biggest transit project since the Montreal métro, but this one will be built and mostly funded by a pension fund.

The Caisse de dépôt et placement du Québec, the province’s pension fund manager, unveiled on Friday a light-rail network it intends to build, with the first stations coming online in 2020.

“Every time you take this train, you’ll be paying into your retirement,” said Michael Sabia, the CEO of the Caisse.

Answering decades of demands for an airport link from downtown, the $5.5-billion Réseau électrique métropolitain will be a vast network linking the South Shore, the West Island and Deux-Montagnes to both the airport and the downtown core.

“What we’re announcing today is the most important public transit project in Montreal in the last 50 years,” said Macky Tall, the president of CDPQ Infra, the Caisse’s infrastructure arm.

Leaving from Central Station, the 67-kilometre network will use the track running through the Mount Royal tunnel, taking over the Deux-Montagnes line — which already runs electric trains — from the Agence métropolitaine de transport. New tracks will be built over the new Champlain Bridge, and link to the South Shore, ending near the intersection of Highways 30 and 10 in Brossard. Two other dedicated tracks will be built, branching off from the Deux-Montagnes line, where Highway 13 meets Highway 40. One track will head to Trudeau airport, with a stop in the Technoparc in St-Laurent. Another will follow Highway 40 toward Ste-Anne-de-Bellevue. The existing Vaudreuil-Dorion train line won’t be affected by the project.

Light rail trains are smaller and carry fewer passengers, but the service will be more frequent than the current AMT service, Tall said.

This is not the pension manager’s first foray into public transit. The Caisse is one of the builders of the Canada Line, a train that links Vancouver’s airport to the downtown area and the suburb of Richmond. It was built in time for the 2010 Olympic Games.

However, Sabia admitted this project represents a much greater risk, since the Caisse is the principal investor and has to recoup both its capital investment and its operating costs. But he’s confident the Caisse will achieve “market competitive returns” on the project.

“We are taking the traffic risk here,” Sabia said. “This is unusual because generally, it’s governments that take that risk.”

Matti Siemiatycki, an associate professor of urban planning at the University of Toronto, said this is a first for Canada, so it’s an untested funding model.

“Internationally, there have been privately funded and financed commuter rail lines, but in most cases, they don’t recover their operating costs, let alone their capital costs,” Siemiatycki said.

He said because it has holdings in engineering, train manufacturing and train operating companies, the pension fund does have an advantage. But he’s not sure it will be enough.

“It’s possible they can realize economies, but it doesn’t take away the fact that most transportation systems in North America are not recovering their operating costs, let alone their capital costs, so that will be the Caisse’s challenge,” he said.

Sabia said the Caisse intends for most of the revenue to come from fares, which he said will be similar to the ones currently charged by the AMT.

“That’s a big chunk of it but, of course, as you know municipalities today have made a public policy decision to encourage people to use public transit,” Sabia said. “We would expect that current practice would continue and contribute to the overall financing of the project.”

Because the trains will be fully automated, Sabia said the operating cost of the network will be low.

The Caisse, which has a real-estate investment division, will also try to recoup some of the investment through development along the line, but Sabia said the bulk of the revenue will come from ridership. The Caisse expects a daily ridership of 150,000, compared with 85,000 that currently use the Deux-Montagnes line, the 747 airport bus and buses across the Champlain Bridge.

The Caisse has promised trains will leave every three to six minutes from the South Shore and every six to 12 minutes on the West Island and Deux Montagnes Line, for the duration of its 20-hour operation schedule from 5 a.m. to 1:20 a.m. The Caisse estimates it will take 40 minutes to take the train from either Ste-Anne-de-Bellevue or Deux-Montagnes to downtown. It will take 30 minutes to go from Central Station to the airport. It will take between 15 and 20 minutes to travel from Brossard to downtown.

Tall said the decision to follow Highway 40 was made because of work going on in the Turcot Interchange. That work would have prevented crews from building dedicated lines for the next five years. He said building along that corridor would also cost $1 billion more because it would require a track dedicated to passenger traffic.

The thorny issue of parking remains unsolved, however. Currently, many stations along the Deux-Montagnes line are over capacity and there is no space to build new parking spots.

Tall said the Caisse will speak with municipalities about this issue and hopes to come up with a solution.

Michael Sabia has gone from being an outsider to a rainmaker in Quebec. When he took over the provincial pension fund, it was $40 billion in the hole. He’s managed to grow its asset base by $130 billion since then and is now looking to invest directly in Quebec’s infrastructure with this “risky” foray into a greenfield project.

I put “risky” in quotations because unlike that associate professor of urban planning quoted in the article above, I’m more optimistic and think he is underestimating Macky Tall, CEO of CDPQ Infra and his senior team, many of whom have worked on greenfield infrastructure projects and know what they’re doing when it comes to managing such large scale projects. No other large Canadian pension fund has as much operational experience when it comes to greenfield infrastructure projects, which is why they typically avoid them.

So, while Sabia garners all the attention, there are a lot of people under him who deserve credit and praise for this huge project. One of them is a friend of mine who has nothing but good things to say about Michael Sabia, Macky Tall, CDPQ Infra’s team and the Caisse in general.

No doubt, greenfield infrastructure projects carry bigger risks but they also offer bigger rewards down the road. Will everything go smoothly in this project? Of course not, there isn’t one major greenfield infrastructure project that goes off without a hitch but the people working on this project have actual operational experience and a track record of delivering on such projects below budget (which isn’t easy) easing my concerns about recouping operating and capital costs.

So, I would tell the media and critics to ease up and have faith in Macky Tall and his team at CDPQ Infra. They are all very experienced and highly ethical individuals who will deliver on this and other greenfield projects if they are asked to in the future. And trust me, there will be no Charboneau Commission on this project which is great news for Quebec’s taxpayers.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Adam Mayers of the Toronto Star reports, CPP’s success may signal bigger pensions ahead:

The Canada Pension Plan expects to have assets worth $1 trillion before the middle of this century.

As recently as 17 years ago, in the first year of the plan’s Investment Board, there was just $18 million in the bank. All that money was invested in Canadian government bonds. The CPP Investment Board was a coupon clipper.

Today, our national retirement scheme is a global giant, closing in on $300 billion. By 2030 it projects to be worth $500 billion. Two-thirds of all it owns is outside Canada and there isn’t a corner of the globe where it doesn’t look for opportunity.

We get royalties from intellectual property, dividends from public and private investments. Its biggest single public stock holding worth $2.3 billion is in IMS Holdings, an American company that provides IT services to the global healthcare industry. Number two is Apple.

Our plan invests in Japanese drug companies, owns nursing homes in France and seniors’ apartments in Florida. There are 17 ports in Britain, Ontario’s 407 ETR and toll roads in Chile. Its real estate holdings include prestige shopping centres and office towers in many global capitals. There is income from investments in farmland, software and internet and telecom networks. It owns stakes in electrical utilities and water treatment plants.

Based on this success — and our contributions — the CPPIB’s actuaries believe there will be enough money to pay pension obligations at current levels for the next 75 years. That’s an enviable position when many national pension plans are in trouble.

But the CPP wants to go further. It wants an even better return. So, it’s changing the mix of its investments to add more stocks and private companies, and fewer government and corporate bonds.

It’s a “modest evolution” being done in a “prudent and gradual manner,” says the CPPIB’s senior managing director Ed Cass, who is responsible for the CPPIB’s overall investment strategy.

He says it can be done safely because the CPP has deep pockets and a perpetual time horizon: The “next quarter” is 25 years, not three months.

This may eventually mean a bigger pension, or lower CPP premiums for us. Cass can’t say. The CPPIB’s mandate is to safely and profitably invest on our behalf. Ottawa and the premiers decide how much we get and how much we pay into the plan. Their third option is do nothing and keep the additional funds for a rainy day.

We sat down with Cass, who at 53 is as eclectic as the CPP’s holdings: He holds a degree in theoretical physics from Queen’s University and a law degree from Osgoode Hall.

Here’s an edited version:

What can average investors learn from the CPP?

Well, they can’t replicate what we do because we have advantages of size and scale.

But there are three things. The most important is risk tolerance. A 27-year-old should be able to take a lot more risk than a 91-year-old. We have a 75 year time horizon and so our assumptions are based on that.

The second is diversify. Diversification is the one free lunch.

It’s true, we can go to a level that’s impossible for the small investor. But there’s a ton of things individuals can do. Through Exchange Traded Funds (ETFs) you can get access to the U.S., European and Japanese stock markets. Importantly, you get diversification in terms of currency exposure.

The last thing is patience. If you can afford to be patient, be patient. If you’re changing your portfolio frequently it’s likely you’re incurring a lot of costs. Having a plan and sticking to it is very important.

What is your view of the economic outlook?

There are a number of forces that give us a lot of optimism. We think the gradual convergence of emerging market economies with developed markets is a positive development.

We think low rates may persist in the short term, but not over the long term. We see growth coming back. Not quite what we experienced in previous decades, but something approaching that.

What about interest rates?

The new normal for the overnight bank rate might be 3.50 per cent or 3.75 per cent. (That rate is currently 0.5 per cent and determines consumer rates.)

When might this happen?

Forecasting the path of rates is fraught with danger. We are confident that over our horizon, which is decades, things will normalize.

Why are you buying ports and university dorms?

They are things that are similar to bonds and have very predictable payments. As an example, take the Highway 407 (40 per cent owned by CPP). It is very easy to predict cash flow over time and it has a high income yield. That looks a lot like a bond.

The CPPIB has decided to take more investment risk. What does that mean?

Risk appetite is linked to investment horizon. We have a very long horizon, somewhere in the order of 75 years. That’s how far we look out.

Our default reference was 65 per cent equities and 35 per cent bonds, which is the (default) of an average investor. But our capacity to prudently take risk is greater than an average investor. So, we want to move to 85 per cent equities and 15 per cent bonds.

What it means is that we want a very diversified portfolio, a very safe portfolio, but one that targets a higher risk appetite than in the past.

Why now?

This is not a reaction to the current environment. This is something more fundamental. It’s predicated on those longer term views.

When you say “why now” you must place it in the context of an organization that is on an enduring path. We have undertaken several transitions since that first transfer of funds 17 years ago.

We’ve gone from 100 per cent bonds to a diversified portfolio, and from all domestic to truly global. We’ve grown from $18 million to over $280 billion today. We accomplished this in less than two decades.

So, when you consider the shift along the return/risk spectrum in this light, it is really a modest evolution. We have an exceptionally long horizon, as well as a certainty of assets. As a result, the Board concluded we can and should seek higher returns prudently.

Does that mean better pensions?

If the fund is widely successful you could increase benefits, or reduce contributions. Those are the two most logical things, but that’s a policy decision. Our statutory objective is to maximize returns without undue risk of loss.

A good interview with Ed Cass who was appointed to the position of Senior Vice President and Chief Investment Strategist at CPPIB a little over two years ago.

Mr. Cass is obviously a very smart guy, holding a Bachelor of Science (Honours) degree in Theoretical Physics from Queen’s University and a Bachelor of Laws from Osgoode Hall Law School, but the message he lays out here is very simple and clear: CPPIB is a global powerhouse with deep pockets and a very long investment horizon and can take risks in public and private markets and patiently sit through any economic cycle.

Now, I think it’s important Canadians understand some of the key takeaways from this brief interview (I will add some insights):

• CPPIB is a global powerhouse that invests across public and private assets. It invests and co-invests with top private equity funds, top hedge funds, and invests directly in real estate, infrastructure and natural resource assets all over the world. This diversification across geographies and public and private markets and the ability to invest directly in large transactions is something that no individual Canadian investor and even mutual fund can do at the scale and scope of CPPIB.
• CPPIB has huge comparative advantages over mutual funds, private equity funds, and even other large Canadian pension funds. You can read about these advantages here.
• CPPIB is massive but cost efficient. Never mind that flimsy and grossly biased study from the Fraser Institute claiming it is an extremely costly plan. Real experts who understand large pensions like Keith Ambachtsheer and his partners at KPA Advisory Services tore into that study as did I for its dumb comparisons and faulty conclusions (word to the wise: never blindly trust anything that comes out of the Fraser Institute which is bankrolled by Canada’s powerful financial services industry that has its own agenda on pensions).
• CPPIB is opportunistic and very patient. Go back to read my comments on CPPIB bringing good things to life and a more recent one on CPPIB going on a massive agri hunt. These are huge, scalable deals that no Canadian mutual fund can engage in and to be honest, apart from PSP Investments, very few other large Canadian pension funds can engage in.
• CPPIB has a great leader at its helm. I won’t hide it, I like Mark Wiseman and think very highly of him. We don’t always see eye to eye on everything but when I talk to him and listen carefully to what he says, he comes across as an exceptionally bright, nice, hard-working leader who really understands and believes in the long view and has done an outstanding job leading this mammoth pension fund. He has put in place the right people to lead his teams and they are all doing a great job.

As far as what Ed Cass says on interest rates, I beg to differ as I think ultra low rates and the new negative normal are here to stay for years, especially once the global deflation tsunami hits us.

Then again, with China manipulating its stock market and central banks fighting deflation tooth and nail, things might be a lot better in the global economy than meets the eye. I trade stocks every day and I’m baffled at some the moves in the resource sector.

For example, shares of Teck Resources (TCK) are up another 9% at this writing on Wednesday mid-day (click on image):

Amazingly, the share price of Teck hit a low of $2.56 (USD; I only trade U.S. shares even though it was best to buy this one in Canada earlier this year) on January 13th and is now breaking out and in a position to make a new 52-week high if this momentum carries through.

And it’s not just Teck, a sample of stocks I track leveraged to global growth are indeed acting as if oil will double this year and the global economic recovery is well under way (click on image):

I remain highly skeptical of all these counter-trend rallies no matter how powerful they are and think they’re largely driven by algos and momo traders. Having said this, one Canadian hedge fund manager told me this morning: “Things have changed, adapt and leave it alone.”

Maybe things have changed, maybe the world is in much better shape than we think, or maybe we are all smoking some hopium like those nuns I mentioned in my last comment on China’s pension gamble, believing in fairy tales and unicorns. I don’t know but since mid-January the explosive moves have been in emerging markets (EEM), Chinese shares (FXI), energy (XLE), metals and mining (XME) and industrials (XLI).

So, Ed Cass is right, focus on ETFs, diversify and rebalance your portfolio when there are huge market dislocations like we had at the start of the year. Unlike him, I prefer to play U.S. ETFs (I am long USD over a very long period because I think the U.S. has the best economy by far) and I would say rebalance every time an ETF goes way above it 200-day moving average or way below its 400-day moving average (for oversold trends, I prefer using the 400-day moving average).

As far as books, I have about 300 books on finance but the ones I recommend to individuals are classics like William Bernstein’s The Four Pillars of Investing and The Intelligent Asset Allocator or Marc Litchenfeld’s Get Rich With Dividends. Of course, a simple and cheap classic to read on stocks is Peter Lynch’s One Up on Wall Street (a real classic). 

On that note, it’s back to the stock market for me and trying to make sense of these schizoid markets driven by algos, high frequency traders and unscrupulous hedge fund sharks.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

The Wall Street Journal reports on China’s Pension Gamble:

Beijing recently announced that it will allow state pension funds to invest in stocks, with the hope of lifting returns and aiding equity-market liquidity. This might even be a good idea, assuming China follows through on other market reforms.

State pensions have been restricted to bank deposits and government bonds, but China Daily reports that they will now be able to invest up to 30% of individual accounts in equities, funded by mandatory employee contributions. The move could channel some 600 billion yuan ($92.64 billion) into stocks.

State pensions lack adequate funding to support the country’s rapidly aging population, and investing in assets with higher returns could help make up the shortfall. A 2013 study by the Shanghai Institute of Finance and Law estimated that 8.2 trillion yuan must be pumped into pension funds merely to support civil-service retirees over the next 30 years. Meanwhile, their yields have dipped as low as 2%.

Institutional investors could also reduce volatility in China’s markets, which are still dominated by retail investors. Most small investors are inexperienced, with more then half having a high-school education or less.

The immediate impact on both pension funds and the stock market will be slight. Chinese stocks have been on a roller coaster, so regulators are expected to release funds gradually and restrict initial investments to blue chips. Provincial pension funds are also reluctant to shift money from banks, where investments give them leverage over lending decisions.

The policy’s impact will also be reduced if entrepreneurial companies can’t list on stock exchanges. The China Securities Regulatory Commission approves all initial public offerings and determines their pricing and timing. So it isn’t surprising that IPOs have been marked by corruption and rent-seeking. Three CSRC officials handling IPO approvals were arrested in 2015 for suspected graft.

A two-year reform plan toward a more transparent and fair registration-based system was expected to start earlier this year. But new CSRC chairman Liu Shiyu announced last month that the reforms will be done “in a gradual manner,” without providing a timeline. Funneling pension cash into stocks could be dangerous if reforms stall and pension funds become another tool for the government to manipulate stock prices.

Since markets tumbled in June, the government has been on a buying frenzy. Two entities owned by China’s securities regulator and sovereign-wealth fund spent 1.8 trillion yuan buying stocks between June and November, according to Goldman Sachs. Individual investors have come to believe that regulators will rescue the market when prices decline. This perception will grow when state pensions are involved.

Creating a mature stock market requires more than pumping in additional funds. China’s capital markets need wholesale reforms that minimize political interference more than they need pension money.

Last July, I covered China’s pension fund to the rescue, stating the following:

My advice to China’s policymakers, stop tampering with the markets, you’re only going to turn a steep correction into a deep depression. Your pension funds can invest in Chinese equities but if they don’t have the right governance and are told when to buy and sell equities, they’re doomed to fail and they will lose a pile of dough which will create an even bigger problem down the road.

I’m far more worried about China now than anything else. If its stock market bubble bursts in a spectacular fashion, it will wreak havoc on China’s real economy and reinforce global deflation pressures.

In fact, China’s central bank has already admitted defeat in war on deflation. At a time of slowing economic growth and massive corporate debts, a deflationary spiral would be China’s worst nightmare. It  could potentially spell doom for developed economies as China’s deflation will reinforce the Euro deflation crisis and potentially create global deflation that eventually hits the United States.

The global reflationists remain unfettered.  They say get ready for global reflation. I think they’re way too optimistic and confusing short-term trends due to currency fluctuations, neglecting to understand that the long-term deflationary headwinds are picking up steam. There is a reason why 30-year U.S. bond yields are plunging and it’s not just Greece. China and global deflation are much more worrisome.

Last week, I discussed whether the surging yen will trigger another crisis and then followed that up with a comment on whether we should worry about another Asian financial crisis.

A lot of people are getting excited about global growth given how oil prices rebounded after the collapse of Doha talks but I think they’re completely missing the bigger macro risks out there.

What are those bigger macro risks? I’ve been warning you about them ever since I wrote my Outlook 2016, going over the risks of further deflation in emerging markets, especially in Asia, and how a full-blown currency war there will export deflation to the rest of the world.

At this writing, the NASDAQ just went red, biotechs are getting slammed, but the yen is weakening, which is generally good news for global risk assets. The stock market is extremely volatile. Meanwhile, the yield on the 10-year U.S. Treasury bond hasn’t really budged, it’s still hovering around 1.78% which tells you the bond market isn’t getting to excited about oil’s rebound following Doha.

In fact, while Jamie Dimon is warning that the Treasury rally will turn to a rout, Bill Gross is warning investors that China growing at 6% is one of many investor delusions which will be exposed.

And Jeffrey Gundlach, the widely followed investor who runs DoubleLine Capital, said on a webcast last week that the Federal Reserve’s rate hike cycle “increasingly likely” looks like a one and done scenario this year:

Gundlach, who oversees $95 billion for Los Angeles-based DoubleLine, said the Fed should be cautious with raising rates because of the “gentle downward” trajectory in nominal gross domestic product.

The U.S. economy is growing at a pace below 1 percent in the first quarter, according to the Atlanta Federal Reserve’s GDPNow forecast model.

Already, Federal Reserve chair Janet Yellen has been “talking conservatively” about interest rates because it is an election year in the United States, Gundlach said.

Gundlach said the Standard & Poor’s 500 index will struggle and trade “sideways” because earnings continue to be persistently downgraded.

Last year, Gundlach correctly predicted that oil prices would plunge, junk bonds would live up to their name and China’s slowing economy would pressure emerging markets. In 2014, Gundlach correctly forecast U.S. Treasury yields would fall, not rise as many others had expected.

Gundlach said he is still avoiding junk bonds. “The easy money has been made,” Gundlach said. He said the high-yield downgrades resemble the cycle in 1998 and 2007-2008.

DoubleLine has been purchasing Puerto Rico municipal debt as well as commercial mortgage-backed securities.

I’m not even sure the Fed will proceed with a one and done rate hike this year. In fact, if deflationary pressures increase in China, Singapore, South Korea, Indonesia, Malaysia and Japan, you might see the Fed stand pat for the rest of the year, worried that any increase in rates could trigger a crisis in Asia.

And while Gundlach is avoiding junk bonds, I’m increasingly worried of the unprecedented boom in China’s $3 trillion corporate bond market which is starting to unravel:

Spooked by a fresh wave of defaults at state-owned enterprises, investors in China’s yuan-denominated company notes have driven up yields for nine of the past 10 days and triggered the biggest selloff in onshore junk debt since 2014. Local issuers have canceled 61.9 billion yuan ($9.6 billion) of bond sales in April alone, and Standard & Poor’s is cutting its assessment of Chinese firms at a pace unseen since 2003.

While bond yields in China are still well below historical averages, a sustained increase in borrowing costs could threaten an economy that’s more reliant on cheap credit than ever before. The numbers suggest more pain ahead: Listed firms’ ability to service their debt has dropped to the lowest since at least 1992, while analysts are cutting profit forecasts for Shanghai Composite Index companies by the most since the global financial crisis.

“The spreading of credit risks is only at its early stage in China,” said Qiu Xinhong, a Shenzhen-based money manager at First State Cinda Fund Management Co. “Many people have turned bearish.”

It’s no wonder a top adviser to the Chinese government has warned that Beijing risks a currency blow-up akin to Britain’s traumatic ordeal in 1992 and is openly calling for a 15% devaluation of the yuan.

Great, just what the world needs, another Big Bang out of China will will clobber global risk assets and send everyone scurrying back to the safety of good old U.S. bonds.

But investors remain undeterred, dipping back in emerging markets (EEM) even if some analysts are warning it’s a head fake. Indeed, the rally in emerging markets (EEM), Chinese shares (FXI), energy (XLE), metals and mining (XME) and industrials (XLI) since the start of the year vindicate a lot of funds who bet big on a global recovery last year.

Just look at a sample of stocks leveraged to global growth and the move in Industrials (XLI) since the start of the year below and you’d be hard pressed to worry about any global economic shock (click on images):

My take? I think there are a lot of short sellers who got burnt in Q1 but if you think these rallies in sectors leveraged to global growth are going to continue in the second half of the year, you should be smoking up with the nuns growing medical marijuana, which is the image I embedded above.

On that note, I wish central bankers, Chinese interventionists, and global greenshoots the best of luck navigating this market as we head into the second half of the year. Keep your eyes peeled on the U.S. dollar, the yen and emerging market currencies. Something is going to break and it’s not going to be pretty.