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Pension Pulse: Diving Deeper Into Caisse’s Big 2014

The median U.S. public pension fund returned 6.8 percent in 2014.

But north of the border, one of Canada’s largest public funds blew that figure away.

Caisse de depot et Placement du Quebec, Canada’s second-largest pension fund, posted investment returns of 12 percent in 2014, nearly doubling the returns of its U.S. peers.

Over at Pension Pulse, Leo Kolivakis dives deep into Caisse’s 2014 results. What did he find? The post is re-printed below.

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By Leo Kolivakis, Pension Pulse

You can gain more insights on the Caisse’s 2014 results by going directly on their website here. In particular, the Caisse provides fact sheets on the following broad asset classes:

Keep in mind that unlike other major Canadian pension funds, the Caisse has a dual mandate to promote economic activity in Quebec as well as maximizing returns for its depositors.

In fact, the recent deal to handle Quebec’s infrastructure needs is part of this dual mandate. Some have criticized the deal, questioning whether the Caisse can make money on public transit, but this very well might be a model they can export elsewhere, especially in the United States where CBS 60 Minutes reports infrastructure is falling apart.

Whether or not the Caisse will be successful in exporting this infrastructure model to the United States remains to be seen but if you follow the wise advice of Nobel laureate Michael Spence on why the world needs better public investments, public pensions investing in infrastructure could very well be the answer to a growing and disturbing jobs crisis plaguing the developed world.

As far as the overall results, they were definitely solid, with all portfolios contributing to the overall net investment of $23.77 billion (click on image below):

Of course, what really matters is value-added over benchmarks. After all, this is why we pay Canadian pension fund managers big bucks (some a lot more than others).

In fact, in its press release, the Caisse states in no uncertain terms:

“[its] investment strategy centers on an absolute return approach in which investment portfolios are built on strong convictions, irrespective of benchmark indices. These indices are only used ex post, to measure the portfolios’ performance. The approach is based on active management and rigorous, fundamental analysis of potential investments.”

I’ve already discussed life after benchmarks at the Caisse. So how did their active management stack up? For the overall portfolio, the 12% return edged out the fund’s benchmark which delivered an 11.4% gain, adding 60 basis points of value-added last year (do not know the four year figure).

Below, I provide you with the highlights of the three main broad asset classes with a breakdown of individual portfolios (click on each image to read the highlights):

Fixed Income:

Inflation-Sensitive:

Equities:

Some quick points to consider just looking at these highlights:

Declining rates helped the Fixed Income group generate strong returns in 2014 but clearly the value-added is waning. In 2014, Fixed Income returned 8.4%, 10 basis points under its benchmark which gained 8.5%. Over the past four years, the results are better, with Fixed Income gaining 5.6%, 70 basis points over its benchmark which gained 4.9%. Real estate debt was the best performing portfolio in Fixed Income over the last year and four years but on a dollar basis, its not significant enough to add to the overall gains in Fixed Income.
There were solid gains in Inflation-Sensitive assets but notice that both Real Estate and Infrastructure underperformed their respective benchmarks in 2014 and the last four years, which means there was no value-added from these asset classes. The returns of Infrastructure are particularly bad relative to its benchmark but in my opinion, this reflects a problem with the benchmark of Infrastructure as there is way too much beta and perhaps too high of an additional spread to reflect the illiquid nature and leverage used in these assets. More details on the Caisse’s benchmarks are available on page 20 of the 2013 Annual Report (the 2014 Annual Report will be available in April).
In Equities, Private Equity also slightly underperformed its benchmark over the last year and last four years, but again this reflects strong gains in public equities and perhaps the spread to adjust for leverage and illiquidity. U.S Equity led the gains in Equities in 2014 but the Caisse indexes this portfolio (following the 2008 crisis) so there was no value-added there, it’s strictly beta. However, there were strong gains in the Global Quality Equity as well as Canadian Equity portfolios relative to their benchmarks in 2014 and over the last four years, contributing to the overall value-added.

If you read this, you might be confused. The Caisse’s strategy is to shift more of its assets into real estate, private equity and infrastructure and yet there is no value-added there, which is troubling if you just read the headline figures without digging deeper into what makes up the benchmarks of these private market asset classes.

The irony, of course, is that the Caisse is increasingly shifting assets in private markets but most of the value-added over its benchmarks is coming from public markets, especially public equities.

But this is to be expected when stock markets are surging higher. And as a friend of mine reminded me: “It about time they produced value-added in Public Equities. For years, they were underperforming and so they came up with this Global Quality Equity portfolio to create value.”

Also, keep in mind private markets are generating solid returns and as I recently noted in my comment on why Canadian pensions are snapping up real estate:

… in my opinion the Caisse’s real estate division, Ivanhoé Cambridge, is by far the best real estate investment management outfit in Canada. There are excellent teams elsewhere too, like PSP Investments, but Ivanhoe has done a tremendous job investing directly in real estate and they have been very selective, even in the United States where they really scrutinize their deals carefully and aren’t shy of walking away if the deal is too pricey.

There is something else, the Caisse’s strategy might pay off when we hit a real bear market and pubic equities tank. Maybe that’s why they’re not too concerned about all the beta and high spread to adjust for leverage and illiquidity in these private market benchmarks.

But there are skeptics out there. One of them is Dominic Clermont, formerly of Clermont Alpha, who sent me a study he did 2 years ago showing the Caisse’s alpha was negative between 1998 and 2012. Dominic hasn’t updated that study (he told me he will) but he shared this:

I had done a study two years ago that showed that the Caisse’s alpha was close to -1% and close to statistically significantly different from zero and negative. Part of that regular value lost is compensated by taking a lot more risk than its benchmark by being levered. That leverage means doing better than the benchmark when the markets do perform well, and being in a crisis when the market tanks…

I asked him to clarify this statement and noted something a pension fund manager shared with me in my post on the highest paid pension fund CEOs:

Also, it’s not easy comparing payouts among Canada’s large DB plans. Why? One senior portfolio manager shared this with me:

“First and foremost, various funds use more leverage than others. This is the most differentiating factor in explaining performance across DB plans. In Canada, F/X policy will also impact performance of past 3 years. ‎It’s very hard to compare returns because of vastly different invest policies; case in point is PSP’s huge equity weighting (need to include all real estate, private equity and infrastructure) that has a huge beta.”

Dominic came back to me with some additional thoughts:

I would love to do proper performance attribution, but I had limited access to data. But we can infer a lot with published data. We do have historical performance for all major funds like the Caisse, CPP, Teachers, PSP, etc. in their financial statements. They also publish the performance of their benchmark.

I agree that because of different investment policies, it is difficult to compare one plan to the next. But we can compare any plan to itself, i.e. its benchmark.

Again, I like to do proper performance attribution in a multivariate framework and that is one area of expertise to me. To do it on a huge plan like the Caisse would require a lot of data which I do not have access to. But a simple CAPM type of attribution would give some insight. In this case, the benchmark is not an equity market as in the base case of CAPM, but the strategy mix of the Caisse.

Thus if we regress the returns (or the excess returns over risk free rate) of a plan, over its benchmark return (or excess over RF rate), we would obtain a Beta of the regression to be close to one if the plan is properly managed with proper risk controls. That is what I obtain when I do this exercise with the returns of a well-known plan – well known for its quality of management, and its constant outperformance.

When I do this for the Caisse, I get a Beta of the regression significantly greater than 1 – close to 1.25. It looks like the leverage of the Caisse over the 15 years of the regression was on average close to 25% above its benchmark! Now part of that as you mentioned and as I explain in my study could come from:

Investment in high Beta stocks,

Investment in levered Private equity

Investment in levered Real Estate and Infrastructure

Investment in longer duration bonds

Leveraging the balance sheet of the plan: Check Graphic 1 on the link: http://www.clermontalpha.com/cdpq_15ans.htm

It shows the leverage of the Caisse going from 18% in 1998 to 36% in 2008! So my average of 25% excess Beta is in line with this documented leverage.

The chart also shows Ontario Teachers’ and OMERS’ leverage. The difference is that Teachers’ leverage is IN its benchmark, while the Caisse is NOT. Thus the Caisse is taking 25% more risk than its clients’ policy mix! You would think that all these clients risk monitoring would be complaining… They are not.

Of course, that leverage is good when markets return positively and you can see that on the colored chart. But that leverage is terrible when the markets drop 2008, 2002, 2001. When that happen, it is time to fire the management, restart with a new one and blame the previous management for the big loss. Some of those big losses were also exaggerated by forced liquidation accounting (we all remember the ABCP $6 billion loss reserve which was almost fully recovered in the following years inflating the returns under the new administration).

By not doing proper attribution, we are not aware of the continuous loss (negative alpha) hidden by the excess returns not obtained by skilled alpha, but by higher risk through leverage. The risk-adjusted remains negative… And we are not focusing our energies into building an alpha generating organisation with optimal risk budgeting. Why bother, the leverage will give us the extra returns! But that is not true alpha, not true value added.

Which brings me to the alpha of the regression. I told you that this other great institution which does proper risk controls, gets a Beta close to one. They also get a positive alpha of the regression which is statistically significant (t stat close to 2). Not surprising, they master the risk budgeting exercise, and they understand risk controls.

For the Caisse, the Alpha of the regression is close to -1% per year and it is statistically significant. Nobody in the private market could sustain such long period of negative alpha. Nobody could manage a portfolio with 25% more risk than what is requested by the client.

In my report, I also talk about the QPP contribution rate. When Canada created the CPP in the mid-60s, Quebec said “Hey, we want to better manage our own fund.” That led to the creation of the Caisse de Depot and it was an excellent decision as the returns of the QPP were much better because they were managed professionally in a diversified portfolio (vs provincial bonds for the CPP). Unnoticed by everyone in Quebec, the contribution rate started to increase in 2012 and will continue to increase up until 2017 at which time Quebecers will pay 9% more than the rest of Canadians for basically the same pension plan (some tiny differences). And the explanation is this negative alpha.

I also explained that with proper risk budgeting techniques at all levels, the Caisse could deliver an extra $5 billion with 20% less risk! Instead of increasing the contribution rate of all CDPQ clients QPP, REGOP, etc., we could have kept them at the same level or lower. And part of that extra $5B return every year would find its way into the Quebec government coffer through reduced contributions and higher taxes (the higher contributions to QPP, Regop, etc. that Quebecers pay are tax deductible…)

For how long are we going to avoid looking at proper attribution? For how long are we going to forfeit this extra $5B per year in extra returns?

I shared Dominic’s study with Roland Lescure, the CIO of the Caisse, who shared this with me:

You are right, we have significantly lowered leverage at the Caisse since 2009. Leverage is now solely used to fund part of our real estate portfolio and the (in)famous ABCP portfolio which will be gone by 2016. As you rightly point out, most Canadian pension funds use leverage to different degrees. Further, we also have significantly reduced risk by focusing our investments on quality companies and projects, which are less risky than the usual benchmark-driven investments. And those investments happen to have served us well as they did outperform the benchmarks significantly in 2014. You probably have all the details for each of our portfolios but I would point out that our Canadian equity portfolio outperformed the TSX by close to 300 bps. And the global quality equity portfolio did even better.

I thank Dominic Clermont and Roland Lescure for sharing their insights. Dominic raises several excellent points, some of which are politically sensitive and to be honest, hard to verify without experts really digging into the results of each and every large Canadian pension. Also, that increase in the contribution rate for public sector workers is part of tackling Quebec’s pension deficits, slowly introducing more risk-sharing in these plans.

Again, this is why even though I’m against an omnipotent regulator looking at systemic risks at pensions, I believe all of Canada’s large pensions need to provide details of their public and private investments to the Bank of Canada and we need to introduce uniform comprehensive performance, operational and risk audits at all of Canada’s major pensions.

These audits need to be conducted by independent and qualified third parties that are properly staffed to conduct them. The current auditing by agencies such as the Auditor General of Canada is simply too flimsy as far as I’m concerned, which is why we need better, more comprehensive audits across the board and the findings should be made public for all of Canada’s large pensions.

And let me say while the Caisse has clearly reduced leverage since the ABCP scandal which the media keeps covering up, it is increasingly shifting into private markets, introducing more illiquidity risk that can come back to haunt them if global deflation takes hold.

As far as stocks are concerned, I see a melt-up occurring in tech and biotech even if the Fed makes a monumental mistake and raises rates this year (read the latest comment by Sober Look to understand why market expectations of Fed rate hikes are unrealistic). It will be a rough and tumble year but my advice to the Caisse is to stay long U.S. equities (especially small caps) and start nibbling at European equities like Warren Buffett. And stick a fork in Canadian equities, they’re cooked!

Will the liquidity and share buyback party end one day? You bet it will but that is a topic for another day where I will introduce you to a very sharp emerging manager and his team working on an amazing and truly unique tail risk strategy.

As far as U.S. equities, I think the Caisse needs to stop indexing and start looking at ways to take opportunistic large bets using some of the information I discussed when I covered top funds’ Q4 activity. This would be above and beyond the information they receive from their external fund managers.

By the way, if you compare the Caisse’s top holdings to those of the Bill and Melinda Gates Foundation, you’ll notice they are both long shares of Waste Management (WM), one of the top-performing stocks in the S&P 500 over the last year.

I’ll share another interesting fact with you, something CNBC’s Dominic Chu discussed a few days ago. Five stocks — Apple (AAPL), Amazon (AMZN), Biogen Idec (BIIB), Gilead (GILD), and Netflix (NFLX) — account for all of the gains in the Nasdaq this year. If that’s not herd behavior, I don’t know what is!!

Lastly, it takes a lot of time to write these in-depth comments and you won’t read this stuff in traditional media outlets which get hung up on headline figures and hardly ever dig deeper. Please take the time to contribute to my blog on the top right-hand side, or better yet, stop discriminating against me and hire the best damn pension and investment analyst in the world who just happens to live in la belle province!

Below, Michael Sabia, CEO of the Caisse, discusses the Caisse’s 2014 results with TVA’s Pierre Bruneau (in French). Michael also appeared on RDI Économie last night where he was interviewed by Gérald Filion. You can view that interview here and you can read Filion’s blog comment here (in French).

Also, some food for thought for the Caisse’s real estate team. A new report from Zillow shows that rents across the U.S. are increasing, and not just in the expected regions of New York City, San Francisco and Boston. Overall, rents increased 3.3% year-over-year as of January. But many cities outpaced that, including Kansas City, which saw rent grow more than double the national average, jumping 8.5% year-over-year. St. Louis saw rent increase by 4.5% over the same period. Rents in Detroit grew by 5.0% and rents in Cleveland grew by 4.2%.

Photo credit: “Canada blank map” by Lokal_Profil image cut to remove USA by Paul Robinson – Vector map BlankMap-USA-states-Canada-provinces.svg.Modified by Lokal_Profil. Licensed under CC BY-SA 2.5 via Wikimedia Commons – http://commons.wikimedia.org/wiki/File:Canada_blank_map.svg#mediaviewer/File:Canada_blank_map.svg

New Orleans Pension Considers Index Investing After 2014 Performance Lags

The New Orleans Municipal Employees Retirement System returned less than 5 percent in 2014, a number that is pushing some board members – including the city’s finance director – to consider a more passive investment strategy.

Trustee and city finance director Norman Foster argued this week that the fund should be investing in funds that passively follow indices like the S&P 500, which saw double digit returns in 2014.

From NOLA.com:

Several board members expressed some frustration with the fund’s investment performance, none more than Norman Foster, the city’s finance director.

Foster argued that the city would have been better served by investing in index funds, passive investment vehicles that track the market and eliminate costly management fees. “I’ve made the case for passive investment, and I’ll be making it more and more,” he said.

[…]

Some of the performance lag can be attributed to the fund’s asset mix. Like many pension systems, the retirement system invests heavily in bonds, a strategy that minimizes risk but also limits returns during market booms.

Foster pointed out, however, that even when the asset mix is taken into account, the fund’s performance fell short of index benchmarks by nearly 3 percent, which means the managers failed to beat the market, despite collecting handsome fees.

Ian Jones, who advises the retirement system on investment issues, warned against dumping its asset managers based on one year’s worth of data.

The fund assumes a 7.5 percent annual return.

Over the past seven years, the fund’s returns have averaged 4.21 percent annually.

Photo by www.SeniorLiving.Org

Leo Kolivakis on Paying Pension Executives

cut up one hundred dollar bill — Photo by TaxCredits.net

This week, the Financial Times released a list of the highest-paid pension CEOs, and interviewed observers from several corners who criticized the high compensation totals.

On Wednesday, Leo Kolivakis of Pension Pulse weighed in on pension executive pay in an extensive piece. The post is re-printed below.

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By Leo Kolivakis, Pension Pulse

It’s about time the media and non-profit organizations start scrutinizing executive pay at public pension funds. I’ve been covering the good, the bad and downright ugly on executive compensation at Canada’s large public pension funds since the inception of this blog back in June 2008.

In fact, my very first post was on the ABCP of pension governance where I wrote:

If compensation is tied to performance and benchmarks, doesn’t the public have a right to know whether or not the benchmarks used to evaluate this performance accurately reflect the risks taken by the investment manager(s)?

The dirtiest secret in the pension fund world is that benchmarks used to reference the performance of private investments and hedge fund activities in public pension funds are grossly underestimating the risks taken by the managers to achieve their returns. Moreover, most of the “alpha” from these investment activities is just “beta” of the underlying asset class. Why are pension executives being compensated for what is essentially beta?!?!?

There is a disconnect between public market benchmarks and private market benchmarks. Most pension funds use well known public market benchmarks like the S&P 500 to evaluate the performance of their internal and external managers. Public market benchmarks are well known and for the most part, they accurately reflect the risks that investment managers are taking (the worst example was the ABCP fallout at the Caisse which the media keeps covering up).

But there are no standard private market benchmarks; these investments are illiquid and valued on a quarterly basis with lags. This leads to some serious issues. In particular, if the underlying benchmark does not reflect the risk of private market investments, a pension fund can wipe out its entire risk budget if real estate or private equity gets hit hard in any given year, which is not hard to fathom in the current environment.

I followed up that first blog comment with my second comment on alternative investments and bogus benchmarks where I used the returns and benchmarks of real estate investments at a few of Canada’s large public pension funds to demonstrate how some were gaming their benchmarks to claim “significant outperformance and value-added” in order to justify their multimillion compensation packages even as their funds lost billions during the crisis.

In April 2009, I went to Parliament Hill where I was invited to speak at the Standing Committee on Finance on matters relating to pensions (after that hearing, I was even confronted by Claude Lamoureux, the former CEO at Ontario Teachers largely credited for starting this trend to pay top dollars to senior pension fund managers, which then spread elsewhere). There, I discussed abuses on benchmarks and how pension fund managers routinely game private market benchmarks to create “value-added” in their overall results to justify some seriously hefty payouts for their senior executives.

This brings me to the list above (click on image at the top). Where is Gordon Fyfe, the man who you can all indirectly credit for this blog? He should be right up there at the top of this list. He left PSP for bcIMC this past summer right on time to evade getting grilled on why PSP skirted foreign taxes, embarrassing the federal government.

In fact, over the ten years at the helm of PSP Investments, a federal Crown corporation that is in charge of managing the pensions of people on the federal government’s payroll, Gordon Fyfe and his senior executives literally made off like bandits, especially in the last few years. This is why I poked fun at them when I covered PSP’s FY 2014 results but was dead serious when I wrote this:

And why are benchmarks important? Because they determine compensation. Last year, there was an uproar over the hefty payouts for PSP’s senior executives. And this year isn’t much different.

[Click here for picture].

As you can see, PSP’s senior executives all saw a reduction in total compensation (new rules were put in place to curb excessive comp) but they still made off like bandits, collecting millions in total compensation. Once again, Mr. Fyfe made the most, $4.2 million in FY 2014 and a whopping total of close to $13 million over the last three fiscal years.

This type of excessive compensation for public pension fund managers beating their bogus private market benchmarks over a four-year rolling return period really makes my blood boil. Where is the Treasury Board and Auditor General of Canada when it comes to curbing such blatant abuses? (As explained here, the Auditor General of Canada rubber stamps financial audits but has failed to do an in-depth performance audit of PSP).

And don’t think that PSP’s employees are all getting paid big bucks. The lion’s share of the short-term incentive plan (STIP) and long-term incentive plan (LTIP) was paid out to five senior executives but other employees did participate.

But enough ranting about PSP’s tricky balancing act, I’ve covered that topic ad nauseum and think the Auditor General of Canada really dropped the ball in its 2011 Special Examination which was nothing more than a sham, basically rubber stamping the findings of PSP’s financial auditor, Deloitte.

Nothing is more contentious than CEO pay at public sector organizations. The Vancouver Sun just published an article listing the top salaries of public sector executives where it states:

Topping this year’s salary ranking is former bcIMC CEO Doug Pearce, with total remuneration of $1.5 million in 2013, the most recent year for which data is available. That’s a 24-per-cent jump from his pay the year before of $1.2 million.

It could be the last No. 1 ranking for Pearce, who has topped The Sun’s salary ranking several times: he retired in the summer of 2014 and was replaced by Gordon Fyfe.

Wait till the socialist press in British Columbia see Fyfe’s remuneration, that will really rattle them!

It’s worth noting however even in Canada, compensation of senior public pension fund managers varies considerably. On one end of the spectrum, you have Jim Leech and Gordon Fyfe, and on the other end you have Leo de Bever, Michael Sabia and Doug Pearce, Fyfe’s predecessor at bcIMC (Ron Mock currently lies in the middle but his compensation will rise significantly to reflect his new role).

Mark Wiseman and André Bourbonnais, PSP’s new CEO, actually fall in the upper average of this wide spectrum but there’s no doubt, they also enjoyed hefty payouts in FY 2014 (notice however, Wiseman and Bourbonnais made the same amount, which shows you their compensation system is much flatter than the one at PSP’s).

Still, teachers, police officers, firemen, civil servants, soldiers, nurses, all making extremely modest incomes and suffering from budget cuts and austerity, will look at these hefty payouts and rightfully wonder why are senior public pension fund managers managing their retirement being compensated like some of Canada’s top private sector CEOs and making more than their private sector counterparts working at mutual funds and banks?

And therein lies the sticking point. The senior executives at Ontario Teachers, CPPIB, PSP, bcIMC, AIMCo, OMERS, Caisse are all managing assets of public sector workers that have no choice on who manages their assets. These public sector employees are all captive clients of these large pensions. I’m not sure about the nurses and healthcare workers at HOOPP but that is a private pension plan (never understood why it is private and not public but the compensation of HOOPP’s senior executives is in line with that at other large Canadian pension funds, albeit not as high even if along with Teachers, it’s arguably the best pension plan in Canada).

Of course, all this negative press on payouts at public pension funds can also be a huge distraction and potentially disastrous. Importantly, Canada’s large public pension funds are among the best in the world precisely because unlike the United States and elsewhere, they got the governance and compensation right, operating at arms-length from the government and paying people properly to deliver outstanding results in public and private markets.

And let’s be clear on something, the brutal truth on defined-contribution plans is they simply can’t compete with Canada’s large defined-benefit pensions and will never be able to match their results because they’re not investing across public and private markets, they don’t have the scale to significantly lower costs and don’t enjoy a very long investment horizon. Also, Canada’s large pensions invest directly in public and private assets and many of them also invest and co-invest with the very best private equity, real estate funds and hedge funds.

In other words, it’s not easy comparing public pension fund payouts to their private sector counterparts because the skills required to manage private investments are different than those required to manage public investments.

I’ll share something else with you. I remember having a conversation with Mark Wiseman when I last visited CPPIB and he told me flat out that he knows he’s being compensated extremely well. He also told me even though he will never be able to attract top talent away from private equity funds, CPPIB’s large pool of capital (due to captive clients), long investment horizon and competitive compensation is why he’s able to attract top talent from places like Goldman Sachs.

In fact, Bourbonnais’s successor at CPPIB, Mark Jenkins, is a Goldman alumni but let’s be clear, most people are still dying to work at Goldman where compensation is significantly higher than at any other place.

But we need to be very careful when discussing compensation at Canada’s large pensions. The shift toward private assets which everyone is doing — mostly because they want to shift away from volatile public markets and unlock hidden value in private investments using their long investment horizon, and partly because they can game their private market benchmarks more easily — requires a different skill set and you have to pay up for that skill set in order to deliver outstanding long-term results.

Also, as I noted above, Canadian pensions invest a significant portion of their assets internally. This last point was underscored in an email Jim Keohane, CEO of HOOPP, sent me regarding the FT article above where he notes (added emphasis is mine):

You have to be careful with this type of simple comparison of Canadian pension plans with their US, European and Australian counterparts. It is a bit like comparing apples to oranges because the Canadian pension funds operate very different business models. The large Canadian funds use in house management teams to manage the vast majority of their assets, whereas most of these foreign funds mentioned outsource all or a significant portion of their assets to third party money managers. They are paying significantly larger amounts to these third party managers to run their money as compared to the amounts that Canadian pension funds pay their internal staff. As a result, their total implementation costs are significantly higher than Canadian funds. The right metric to compare is total implementation costs, and on this metric, Canadian funds are among the most efficient in the world.

We have very low implementation costs, with investment costs of approximately 20bps and total operating costs including the admin side between 30 and 35bps. We hire top investment managers to run our money and need to pay market competitive compensation to attract and retain them. I would agree that our long term nature and captive capital make us an attractive place to work so we don’t have to be the highest payer to attract talent, but we need to be in the ballpark. Running our money internally is significantly cheaper than the outsourcing alternative. It also allows you to pursue strategies that would be very difficult to pursue via an outsourcing solution, and it enables much more effective risk management.

One of the main reasons why Canadian pension plans have been successful is the independent governance structures that have been put in place. This enables funds like HOOPP to be run like a business in the best interest of the plan members. It is in the members best interest to implement the plan at the lowest possible cost. The cheapest way for us to run the fund is using an in-house staff paying them competitive compensation rather than outsource which would be much more costly. To put this in perspective, a few years ago we had 15% of our fund outsourced to third party money managers, and that 15% cost more to run than the other 85%!

Many of the international funds used for comparison in the article have poor governance structures fraught with political interference *which makes it politically unpalatable to write large cheques to in-house managers, so instead they write much larger cheques to outside managers because it gets masked as paying for a service. This is not in plan members best interests.

I agree with all the points Jim Keohane raises in regard to the pitfalls of making international comparisons.

But does this mean we shouldn’t scrutinize compensation at Canada’s large public pensions? Absolutely not. A few weeks ago when I discussed whether pensions are systemically important with Jim, I said we don’t need to regulate them with some omnipotent regulator but we definitely need to continuously improve pension governance:

… I brought up the point that in the past, Canadian public pensions have made unwise investment decisions, and some of them could have exacerbated the financial crisis. The ABCP crisis had a somewhat happy ending but only because the Bank of Canada got involved and forced players to negotiate a deal, averting a systemic crisis. And we still don’t know everything that led to this crisis because the media in Quebec and elsewhere are covering it up.

I also told him we need to introduce uniform comprehensive performance, operational and risk audits at all of Canada’s major pensions and these audits need to be conducted by independent and qualified third parties that are properly staffed to conduct them. I blasted the Auditor General of Canada for its flimsy audit of PSP Investments, but the truth is we need better, more comprehensive audits across the board and the findings should be made public.

Another thing I mentioned was maybe we don’t need any central securities regulator. All we need is for the Bank of Canada to have a lot more transparency on all investment activities at all of Canada’s public and private pensions. The Bank of Canada already has information on public investments but it needs more input, especially on less liquid public and private investments.

This is where I stand. I think it’s up to Canada’s large public (and private) pension funds to really make a serious effort in explaining their benchmarks, the risks they take, the value-added and how it determines their compensation in the clearest, most transparent terms but I also think we need independent overview of their investment and operational activities above and beyond what their financial auditors and public auditors currently provide us.

Importantly, there’s a huge gap that needs to be filled to significantly improve the governance at Canada’s large pensions, even if they are widely recognized as having world-class governance.

Finally, I remind all of you that it takes a lot of time and effort to share these insights. I’ve paid a heavy price for being so outspoken but I’m proud of my contributions and rest assured, while we can debate compensation at Canada’s large pensions, there’s no denying I’m THE most underpaid, under-appreciated senior pension analyst in the world!

Benchmarks, Transparency Could Bring More Pension Funds to Infrastructure, Says Group

The European Association of Paritarian Institutions (AEIP) last week called for greater transparency and more performance data in the infrastructure sector.

These changes, according to the AEIP, could help attract more pension funds to the sector.

From Investments and Pensions Europe:

Infrastructure markets need to be more transparent, with greater emphasis placed on the development of sector benchmarks, according to the European Association of Paritarian Institutions (AEIP).

Setting out its views on infrastructure, the association said that while pension funds were long-term investors – and therefore well-suited to invest in the asset class – they first and foremost needed to abide by their fiduciary duties to members.

“The reality is that infrastructure represents a valuable asset class and for sure a viable option for long-term investors, but these latter face several hurdles to access it,” the AEIP’s paper noted.

It said the lack of comparable, long-term data was one of the hurdles facing investors and that the absence of infrastructure benchmarks made it difficult to compare the performance of the asset class.

It also identified an organisation’s scale as problematic to taking full advantage of the asset class.

“Direct investments, those that yield the most interesting returns, are the most difficult to pursue, as their governance and monitoring require skilled individuals and a strict discipline regulating possible conflicts of interests,” it said.

“National regulation does not always simplify direct investments, and pension regulators in some cases limit the use of the asset class in a direct or indirect way.”

The association called on governments to play their part in making infrastructure accessible.

“Often the lack of infrastructure investments is not due to a lack of projects but not finding the right match with investors,” the AEIP added. “Some form of standardisation might be investigated.”

Read the paper here.

Public Pension Hedge Fund Portfolio Returns vs. Benchmarks in 2014

Here’s a chart listing the strongest-performing hedge fund portfolios over the 12 month period ended September 30, 2014.

You can also see whether or not the portfolio outperformed its benchmark, and the percentage of system assets dedicated to hedge funds.

Chart credit: Pensions & Investments

Yves Smith on CalPERS’ Private Equity Review: Is It Enough?

On Thursday, Pensions & Investments broke the story that CalPERS was putting its private equity benchmarks under review.

Beginning with the end of last fiscal year, the fund’s private equity portfolio has underperformed benchmarks over one year, three-year, five-year and ten-year periods [see the chart embedded in the post below].

CalPERS staff says the benchmarks are too aggressive – in their words, the current system “creates unintended active risk for the program”.

Yves Smith of Naked Capitalism has published a post that dives deeper into the pension fund’s decision – is the review justified? And is it enough?

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By Yves Smith, originally published at Naked Capitalism

The giant California pension fund roiled the investment industry earlier this year with its decision to exit hedge funds entirely. That decision looked bold, until you look at CalPERS’s confession in 2006 that its hedge funds had underperformed for three years running. Its rationale for continuing to invest was that hedge funds delivered performance that was not strongly correlated with other investments. Why was that 2006 justification lame? Because even as of then, it was widely acknowledged in the investment community that hedge funds didn’t deliver alpha, or manager performance. Hedgies nevertheless sought to justify their existence through the value of that supposedly-not-strongly-correlated performance, or “synthetic beta”. The wee problem? You can deliver synthetic beta at a vastly lower cost than the prototypical 2% annual fee and 20% upside fee that hedge funds charge. Yet it took CalPERS eight more years to buck convention and ditch the strategy. Admittedly, CalPERS did keep its investments in hedge funds modest, at a mere 2% of its portfolio, so it was not an enthusiast.

By contrast, CalPERS is the largest public pension fund investor in private equity, and generally believed to be the biggest in the world. And in the face of flagging performance, CalPERS, like Harvard, appeared to be rethinking its commitment to private equity. In the first half of the year, it cut its allocation twice, from 14% to 10%.

But is it rethinking it enough? Astonishingly, Pensions & Investments reports that CalPERS is looking into lowering its private equity benchmarks to justify its continuing commitments to private equity. Remember, CalPERS is considered to be best of breed, more savvy than its peers, and able to negotiate better fees. But look at the results it has achieved:

And the rationale for the change, aside from the perhaps too obvious one of making charts like that look prettier when they are redone? From the P&I article:

But the report says the benchmark — which is made up of the market returns of two-thirds of the FTSE U.S. Total Market index, one-third of the FTSE All World ex-U.S. Total Market index, plus 300 basis points — “creates unintended active risk for the program, as well as for the total fund.”

In effect, CalPERS is arguing that to meet the return targets, private equity managers are having to reach for more risk. Yet is there an iota of evidence that that is actually happening? If it were true, you’d see greater dispersion of returns and higher levels of bankruptcies. Yet bankruptcies are down, in part, as Eileen Appelbaum and Rosemary Batt describe in their important book Private Equity at Work, due to the general partners’ success in handling more troubled deals with “amend and extend” strategies, as in restructurings, rather than bankruptcies. So with portfolio company failures down even in a flagging economy, the claim that conventional targets are pushing managers to take too many chances doesn’t seem to be borne out by the data.

Moreover, it looks like CalPERS may also be trying to cover for being too loyal to the wrong managers. Not only did its performance lag its equity portfolio performance for its fiscal year ended June 30, which meant the gap versus its benchmarks was even greater. A Cambridge Associates report also shows that CalPERS underperformed its benchmarks by a meaningful margin. CalPERS’ PE return for the year ended June 30 was 20%. By contrast, the Cambridge US private equity benchmark for the same period was 22.4%. But the Cambridge comparisons also show that private equity fell short of major stock market indexes last year, let alone the expected stock market returns plus a PE illiquidity premium.

The astonishing part of this attempt to move the goalposts is that the 300 basis point premium versus the stock market (as defined, there is debate over how to set the stock market benchmark) is not simply widely accepted by academics as a reasonable premium for the illiquidity of private equity. Indeed, some experts and academics call for even higher premiums. Harvard, another industry leader, thinks 400 basis points is more fitting; Ludovic Philappou of Oxford pegs the needed extra compensation at 330 basis points

So if there is no analytical justification for this change, where did CalPERS get this self-serving idea? It appears to be running Blackstone’s new talking points. As we wrote earlier this month in Private Equity Titan Blackstone Admits New Normal of Lousy Returns, Proposes Changes to Preserve Its Profits:

Private equity stalwarts try to argue that recent years of underwhelming returns are a feature, not a bug, that private equity should be expected to underperform when stocks are doing well. To put that politely, that’s novel.

The reality is uglier. The private equity industry did a tsunami of deals in 2006 and 2007. Although the press has since focused on the subprime funding craze, the Financial Times in particular at the time reported extensively on the pre-crisis merger frenzy, which was in large measure driven by private equity.

The Fed, through ZIRP and QE didn’t just bail out the banks, it also bailed out the private equity industry. Experts like Josh Kosman expected a crisis of private equity portfolio company defaults in 2012 through 2014 as heavily-levered private equity companies would have trouble refinancing. Desperation for yield took care of that problem. But even so, the crisis led to bankruptcies among private equity companies, as well as restructurings. And the ones that weren’t plagued with actual distress still suffered from the generally weak economic environment and showed less than sparkling performance.

Thus, even with all that central help, it’s hard to solve for doing lots of deals at a cyclical peak. The Fed and Treasury’s success in goosing the stock market was enough to prevent a train wreck but not enough to allow private equity firms to exit their investments well. The best deals for general partners and their investors are ones where they can turn a quick, large profit. Really good deals can typically be sold by years four or five, and private equity firm have also taken to controversial strategies like leveraged dividend recapitalizations to provide high returns to investors in even shorter periods.

Since the crisis, private equity companies have therefore exited investments more slowly than in better times. The extended timetables alone depress returns. On top of that, many of the sales have been to other private equity companies, an approach called a secondary buyout. From the perspective of large investors that have decent-sized private equity portfolios, all this asset-shuffling does is result in fees being paid to the private equity firms and their various helpers….

As the Financial Times reports today, the response of industry leader Blackstone is to restructure their arrangements so as to lower return targets and lock up investor funds longer. Pray tell, why should investors relish the prospect of giving private equity funds their monies even longer when Blackstone is simultaneously telling them returns will be lower? Here is the gist of Blackstone’s cheeky proposal:

Blackstone has become the second large buyout group to consider establishing a separate private equity fund with a longer life, fewer investments and lower returns than its existing funds, echoing an initiative of London-based CVC.

The planned funds from Blackstone and CVC also promise their prime investors lower fees, said people close to Blackstone.

Traditional private equity funds give investors 8 per cent before Blackstone itself makes money on any profitable deal – a so-called hurdle rate.

Some private equity executives believe that in a zero or low interest rate world, investors get too sweet a deal because the private equity groups do not receive profits on deals until the hurdle rate is cleared.

Make no mistake about it, this makes private equity all in vastly less attractive to investors. First, even if Blackstone and CVC really do lower management fees, which are the fees charged on an annual basis, the “prime investors” caveat suggests that this concession won’t be widespread. And even if management fees are lowered, recall how private equity firms handle rebates for all the other fees they charge to portfolio companies, such as monitoring fees and transaction fees. Investors get those fees rebated against the management fee, typically 80%. So if the management fees are lower, that just limits how much of those theoretically rebated fees actually are rebated. Any amounts that exceed the now-lower management fee are retained by the general partners.

The complaint about an 8% hurdle rate being high is simply priceless. Remember that for US funds, the norm is for the 8% to be calculated on a deal by deal basis and paid out on a deal by deal basis. In theory, there’s a mechanism called a clawback that requires the general partners at the end of a fund’s life to settle up with the limited partners in case the upside fees they did on their good deals was more than offset by the dogs. As we wrote at some length, those clawbacks are never paid out in practice. But the private equity mafia nevertheless feels compelled to preserve their profits even when they are underdelivering on returns.

And the longer fund life is an astonishing demand. Recall that the investors assign a 300 to 400 basis point premium for illiquidity. That clearly need to be increased if the funds plan slower returns of capital. And recall that we’ve argued that even this 300 to 400 basis points premium is probably too low. What investors have really done is give private equity firms a very long-dated option as to when they get their money back. Long dated options are very expensive, and longer-dated ones, even more so.

The Financial Times points out the elephant in the room, the admission that private equity is admitting it does not expect to outperform much, if at all:

The trend toward funds with less lucrative deals also represents a further step in the convergence between traditional asset managers with their lower return and much lower fees and the biggest alternative investment companies such as Blackstone.

So if approaches and returns are converging, fees structures should too. Private equity firms should be lowering their fees across the board, not trying to claim they are when they are again working to extract as much of the shrinking total returns from their strategy for themselves.

Back to the present post. While the Financial Times article suggested that some investors weren’t buying this cheeky set of demands, CalPERS’ move to lower its benchmarks looks like it is capitulating in part and perhaps in toto. For an institution to accept lower returns for the same risk and not insist on a restructuing of the deal with managers in light of their inability to deliver their long-promised level of performance is appalling. But private equity industry limited partners have been remarkably passive even as the SEC has told them about widespread embezzlement and widespread compliance failure. Apparently limited partners, even the supposedly powerful CalPERS, find it easier to rationalize the one-sided deal that general partners have cut with them rather than do anything about it.

Photo by TaxRebate.org.uk

Pension Funds: Hedge Funds Should Meet Benchmarks Before Charging Fees

Pension funds and other investors called for changes Tuesday in the way hedge funds charge fees.

The proposed changes were outlined in a statement by the Alignment of Interests Association (AOI), a hedge fund investor group to which many pension funds belong.

The group said that hedge funds should only charge performance fees when returns beat benchmarks, and that fee structures should better link fees to long-term performance.

More details from Bloomberg:

The Teacher Retirement System of Texas and MetLife Inc. are among investors that yesterday called on managers to beat market benchmarks before charging incentive fees in a range of proposals that address investing terms. Funds should base performance fees on generating “alpha,” or gains above benchmark indexes, and impose minimum return levels known as hurdle rates before they start levying the charges, said the Alignment of Interests Association, a group that represents investors in the $2.8 trillion hedge fund industry.

“Some managers are abiding by the principals to some extent but we are hoping to move everyone toward industry best practices,” said Trent Webster, senior investment officer for strategic investments and private equity at the State Board of Administration in Florida. The pension plan, a member of the association, oversees $180 billion, of which $2.5 billion is invested in hedge funds.

[…]

To better link compensation to longer-term performance, the AOI recommended funds implement repayments known as clawbacks, a system in which incentive money can be returned to clients in the event of losses or performance that lags behind benchmarks. The group said performance fees should be paid no more frequently than once a year, rather than on a monthly or quarterly basis as they are at many firms.

AOI also called on the hedge fund industry to lower management fees – or make operating expenses more transparent so higher management fees can be justified. From Bloomberg:

Management fees, which are based on a fund’s assets, should decline as firms amass more capital, the investor group said.

“We need good managers, not asset gatherers,” Webster said. “The incentives are currently skewed.”

[…]

Firms should disclose their operating expenses to investors so they can assess the appropriateness of management fee levels, the group said.

“Management fees should not function to generate profits but rather should be set at a level to cover reasonable operating expenses of a hedge fund manager’s business and investment process,” the AOI said.

The fees should fall or be eliminated if a manager prevents clients from withdrawing money, according to the group.

Hedge funds typically utilize a “2 & 20” fee structure; but in the second quarter of 2014, hedge funds on average were charging “1.5 & 18”.

Photo by TaxRebate.org.uk via Flickr CC License