Big Pensions Against Big Payouts?


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

Euan Rocha of Reuters reports, Fresh opposition to Barrick Gold Corp’s executive pay structure from Canada’s largest pension fund manager:

The Canada Pension Plan Investment Board, the country’s largest pension fund manager, on Friday joined a slew of other investors opposing Barrick Gold Corp’s executive pay structure.

Toronto-based CPPIB said it plans to come out against the advisory vote on executive compensation that Barrick will be having at its annual shareholder meeting next week.

It also said it plans to withhold support from Brett Harvey, one of Barrick’s board members and the chair of its compensation committee. CPPIB own roughly 8.1 million Barrick shares, or less than a per cent of the company’s outstanding stock.

Last week, two smaller Canadian pension funds, the British Columbia Investment Management Corp (BCIMC) and the Ontario Teachers’ Pension Plan Board, said they plan to withhold support from Barrick’s entire board in light of their concerns with Barrick’s executive compensation package.

This marks the second time in three years that Barrick is facing heat over its executive pay. The company lost an advisory vote on its executive pay structure in 2013, prompting it to lay out a new compensation program last year. However, the company’s recent disclosure that Executive Chairman John Thornton was paid $12.9 million in 2014 unleashed fresh complaints.

Barrick contends that with its new pay structure, its senior leaders’ personal wealth is directly tied to the company’s long-term success.

But its detractors including well known proxy advisory firms Institutional Shareholder Services (ISS) and Glass Lewis contend that Thornton’s pay is not clearly tied to any established and measurable long-term performance metrics.

Separately, CPPIB’s much smaller pension fund rival OPTrust also expressed its dismay with Barrick’s pay structure, stating that it also plans to come out against the advisory vote on the pay structure.

“Where it comes to Mr Thornton, we cannot easily discern any link between pay and performance … OPTrust has decided to also withhold votes from returning compensation committee members,” said a spokeswoman for the pension fund manager.

The investor outrage comes amid a growing outcry about large pay packages for senior executives at some Canadian companies.

Canadian Imperial Bank of Commerce lost its advisory vote on its executive compensation structure on Thursday, in the face of blowback over mega payments to two retired executives.

A quick look at Barrick’s five-year chart below tells me these investors are right to question executive pay at this company (click on image):

And it’s not just Barrick. If you look at Canada’s top 100 highest-paid CEOs, you will find other examples of overpaid CEOs whose executive compensation isn’t tied any established and measurable long-term performance metrics. It’s not as egregious as the U.S., where CEO pay is spinning out of control no thanks to the record buyback binge, but it’s getting there.

And Canada’s big pensions aren’t shy to vote against excessive compensation packages. Geoffrey Morgan of the Financial Times reports, CIBC shareholders vote down compensation-plan motion over CEO payout:

CIBC shareholders had their say on executive pay at the bank’s annual meeting Thursday and they let it be known they weren’t happy — voting down the bank’s resolution on its compensation plan.

Shareholders voted 56.9 per cent against the bank’s executive pay plan, but outgoing CIBC chairman Charles Sirois said that he didn’t believe the vote was a commentary “on our overall approach to compensation.”

“Based on feedback, we believe this year’s vote result on CIBC’s advisory resolution was significantly impacted by one specific item: the post-retirement arrangement provided to our former CEO,” Sirois said at the meeting in Calgary, his last with the bank before John Manley takes over as board chair.

CIBC’s former CEO, Gerald McCaughey, was paid $16.7 million this year when the bank accelerated his retirement date. Similarly, the lender paid former chief operating officer Richard Nesbitt $8.5 million when it also sped up his departure from the company.

Analysts and investors have criticized both severance packages.

“Our belief is that shareholders were using the say-on-pay vote to express their dissatisfaction with the severance packages,” CIBC spokesperson Caroline van Hasselt said in an interview.

The vote marks the first time a Canadian company has failed a say-on-pay vote since 2013, according to Osler, Hoskin and Harcourt LLP. Sirois said a special committee would review the results of the vote, which is non-binding.

Two of the banks’ larger shareholders have said as much. The Canada Pension Plan Investment Board, which owns 404,000 shares of CIBC, and the Ontario Teachers’ Pension Plan, with 220,000 shares, voted against the motion.

Teachers said it “did not support the structure of the post-employment arrangements [with McCaughey and Nesbitt], believing them to be overly generous and not in the best interests of shareholders.”

For the same reason, Teachers’ also withheld its votes for the company’s nominated slate of directors – all of whom were re-elected although two with significantly less support than their peers.

Luc Desjardins and Linda Hasenfratz were both re-elected with 86 per cent and 85 per cent support, respectively. By contrast, every other member of the 15-person board was elected or re-elected with more than 90 per cent support.

Hasenfratz chaired the committee that oversaw executive compensation matters, of which Desjardins was also a member.

“We cannot support the members of the Management Resources and Compensation Committee based on our concerns with the succession planning process and post-employment arrangements made to both Mr. McCaughey and Mr. Nesbitt,” a statement from Teachers’ reads.

The CPPIB declined a request for comment.

Despite their dissatisfaction with CIBC’s executive compensation, shareholders voted down three additional resolutions, put forward by Montreal-based Movement d’éducation et de défense des actionnaires, that would have altered the bank’s pay policies.

Shareholders voted more than 90 per cent against resolutions that aimed to close the gap between executive pay and that of frontline staff, rework the retirement benefits of all executives and restrict the use of stock options as compensation.

You might recall CIBC’s outgoing CEO Gerry McCaughey was warning about a retirement savings crisis in Canada and even said Canadians should have the choice to make additional, voluntary contributions to the Canada Pension Plan in order to avoid facing a significant decline in living standards when they retire. Of course, when it comes to his own retirement, Mr. McCaughey doesn’t have to worry one bit. CIBC paid him a nice, cushy package.

Things are slowly but surely changing at Canadian banks. BNN reports that Canada’s new bank CEOs are making less money than their predecessors as banks cut salaries and reduce CEO pensions in the face of shareholder pressure to curb super-sized executive pay:

A report on bank CEO pay by Toronto compensation consulting firm McDowall Associates shows base salaries for the new CEOs of Bank of Nova Scotia, Canadian Imperial Bank of Commerce and Toronto-Dominion Bank are all down 33 per cent compared with the outgoing CEOs’ salaries, while the base salary for the new CEO of Royal Bank of Canada is down 13 per cent compared with his predecessor.

Targeted total direct compensation – which includes grants of share units and stock options – is down between 11 per cent and 25 per cent for all four CEOs, the report shows. For example, the analysis shows Scotiabank CEO Brian Porter earned $8-million in total direct targeted compensation (excluding pension costs) in 2014, which is 25 per cent less than the $10.7-million that predecessor Rick Waugh earned in total targeted compensation in 2013.

Bernie Martenson, senior consultant with compensation firm McDowall Associates and previously vice-president of compensation at Bank of Montreal, said it is too soon to conclude that the banks have permanently lowered CEO pay because it is common for CEOs to get raises as they spend more time in the job.

But she said a number of current pay practices, including reducing the proportion of pay awarded in stock options, suggest overall pay is likely to be lower for the new CEOs over the long-term.

“You would naturally think there would be a difference between someone of long tenure and someone who is new in the role,” Ms. Martenson said.

“But I think the reduction of stock options in the last few years is starting to have an impact in terms of wealth accumulation. If you were to look out eight or 10 years for these new CEOs and compare the value of their total equity to that of their predecessors, I think it would be lower.”

Bank CEOs are still well compensated of course, but restraint is increasingly evident. Ms. Martenson points to the CEO pension plans at all four banks. Toronto-Dominion Bank CEO Ed Clark, for example, has the largest pension of departing CEOs at $2.5-million a year, while his replacement, Bharat Masrani, will have a maximum possible pension of $1.35-million a year when he retires.

At Scotiabank, Mr. Waugh’s pension plan was capped at a maximum of $2-million a year at age 63, while Mr. Porter is eligible for a maximum pension of $1.5-million available at 65. Royal Bank’s Gord Nixon had a $2-million maximum pension at 60, while his successor David McKay will have a maximum pension of $700,000 at 55, increasing to a final maximum of $1.25-million at 60.

Retired CIBC chief executive Gerry McCaughey had no cap on the size of his pension, but his pensionable earnings that formed the base for his pension calculation were capped at $2.3-million. His successor, Victor Dodig, has his annual pension capped at $1-million.

A number of shareholder groups – including the Canadian Coalition for Good Governance – have urged companies to reform pension plans because they create expensive funding obligations that last for decades.

Michelle de Cordova, director of corporate engagement and public policy at mutual fund group NEI Ethical Funds, said bank CEOs continue to have very generous pensions “that most people can only dream of,” but she sees a sense of moderation in the trends.

Ms. de Cordova, whose fund has lobbied the banks to curb their executive pay and link CEO pay increases to those of average Canadians, hopes the pay reductions in 2014 are not a temporary trend.

“It does suggest that there is some sense that the levels that pay and benefits had reached were perhaps too high, and boards have decided they need to do something about that,” she said. “I’d say they are still very generous arrangements, but it does seem that there is a sense that there needs to be some moderation, which is welcome.”

The report says all five of Canada’s largest banks have cut the proportion of stock options they grant their CEOs in recent years.

Banks previously decided how much equity they wanted to grant CEOs each year, and split the amount evenly between grants of stock options and grants of share units. In 2014, however, stock options accounted for 20 per cent of total new equity grants at the median for the five banks, while share units accounted for 80 per cent of new equity grants.

Ms. Martenson said banks faced pressure from regulators to reduce stock options following the financial crisis in 2008 because they were deemed to encourage executives to take risks by quickly pushing up the company’s share price to reap a windfall from quickly exercising options. Share units, which track the value of the company’s shares and pay out in cash, are considered less risky because they must be held for the long-term or even until retirement, creating incentives to build long-term growth.

Anyways, don’t shed a tear for bankers. Having worked as an economist at a big Canadian bank a while ago, I can tell you there are still plenty of overpaid employees at Canada’s big banks, and many of them are hopelessly arrogant jerks working in capital markets or investment banking and the irony is they actually think they merit their grossly bloated payouts (their arrogance is directly proportional to their bonus pool!).

Those of you who want to read more on executive compensation in Canada run amok should read a paper by Hugh Mackenzie of the Canadian Center for Policy Alternatives, All in a Day’s Work?. It’s a bit too leftist for my taste but he definitely raises important points on typing CEO compensation to long term performance.

As far as Canada’s large public pensions putting the screws on companies to rein in excessive executive compensation, I think this is a good thing and I hope to see more, not less of this in the future. Of course, the CEOs and senior managers at Canada’s top ten enjoy some pretty hefty payouts themselves and sizable severance packages if they get dismissed for any other reason than performance.

But nobody is voting on their compensation, some of which is well deserved and some of which is just gaming private market benchmarks to inflate value added over a four year rolling period. Critics will charge these pensions as the pot calling the kettle black. Still, I welcome these initiatives and hope to see other large pension and sovereign wealth funds join in and start being part of the solution to corporate compensation run amok.


Photo by

Pension Pulse: A Shift Toward Smaller Hedge Funds?


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

Matt Wirz of the Wall Street Journal reports, Small Hedge Funds Get Bigger Share of Investors’ Money:

Hedge-fund upstarts attracted as much money as the titans of the industry last year, a shift for investors who have long favored larger firms.

Managers with assets of less than $5 billion took in roughly half of the $76.4 billion committed to hedge funds after collecting 37% of new capital invested in 2013. That reversed an imbalance of the previous four years, when investors put $93 billion into larger funds while pulling $63 billion from small and mid-size funds, according to data collected for The Wall Street Journal by HFR Inc., which first started tracking the flows in 2009.

Some pension funds and endowments said they are investing with smaller managers such as Hutchin Hill Capital LLC and Birch Grove Capital LP in search of better performance and lower fees compared with celebrity-run megafunds that are typically viewed as safer bets.

“I’d rather invest in funds that are small or midsize where managers are highly motivated and more aligned with us,” said Jagdeep Singh Bachher, chief investment officer for the University of California, which has about $91 billion in investment assets.

Mr. Bachher added that he is negotiating investments in two first-time fund managers launching funds of less than $1.5 billion each and is looking for more such opportunities.

Investors aren’t abandoning large hedge funds altogether, and some of the largest, such as Och-Ziff Capital Management Group LLC, continue to get bigger. During periods of economic turmoil in 2009 and 2012, clients pulled money from smaller funds, according to the HFR data.

By some measures, megamanagers are the better performers. Funds managing more than $5 billion have returned 9% on average since 2007, compared with about 6% for funds below that threshold, according to HFR.

But in a separate analysis of 2,827 hedge funds that specialize in stock picking, investment consultant Beachhead Capital Management found that funds with assets of $50 million to $500 million showed returns that were 2.2 percentage points higher over 10 years than larger funds.

“There have been a number of recent studies that have demonstrated consistent outperformance of smaller funds compared with large hedge funds,” said Mark Anson, head of billionaire Robert Bass’s family investment firm. Mr. Anson has more than half of his hedge-fund investments in firms with less than $1 billion in assets.

Long revered in financial circles for their trading smarts, hedge funds have lost some of their exalted status amid a difficult stretch for the industry. They performed better than many investments during the 2008 financial crisis but struggled to repeat that success in recent years. Returns of HFR’s hedge-fund index have trailed the S&P 500 index every year since 2008 by an average of 10.31 percentage points.

Large backers responded by taking a more skeptical look at hedge funds and comparing their performance to more traditional investment managers who charge lower fees. Some decided to pull their investments. The California Public Employees’ Retirement System, the largest U.S. pension plan, said last year it would exit from hedge funds altogether in part because of concerns about expenses. Hedge-fund managers typically charge higher fees than other money managers, historically 2% of assets under management and 20% of profits.

Others are shifting allocations to more diminutive hedge funds even as they cut back.

The Public Employees Retirement Association of New Mexico decided to reduce hedge funds to 4% of assets from 7.7% but give more money to smaller managers because they rely more on performance fees for their own compensation than larger competitors that collect big management fees, said chief investment officer Jonathan Grabel.

The $14 billion public pension system made the adjustments after a review found its absolute-return hedge-fund investments had underperformed a benchmark index by 1.64 percentage points since inception, according to an internal report reviewed by The Wall Street Journal.

“There’s nothing magical in hedge funds,” Mr. Grabel said. “We have to hold them as accountable as any other managers—in fact I think the level of scrutiny has to be higher because of the fees we’re paying them.”

One firm benefiting from the flood of money into smaller funds is Hutchin Hill, founded by former SAC Capital Advisors LP trader and mathematician Neil Chriss in 2008. The New York fund had averaged 11% annual returns since its inception, a person familiar with the matter said, but it wasn’t until last year that inflows took off as assets expanded to $3.2 billion from $1.2 billion.

New launches also are taking advantage of the surge. Jonathan Berger started his Birch Grove Capital hedge fund in August 2013 with $300 million of seed capital.

Since then the fund has more than doubled to over $700 million, “with half the growth from large institutions and family offices attracted by 20 consecutive positive months of performance,” he said.

Smaller funds chasing the influx of new money are committing more on infrastructure to lure big investors. When Mark Black left Tricadia Capital Management LLC in 2013 to start his own firm, Raveneur Investment Group, he spent a year building accounting and disclosure systems and hired his chief financial officer from hedge-fund giant Fortress Investment Group, people familiar with the matter said.

The work delayed launch of the fund to mid-2014 but ensured he could meet the requirements of public pension funds and large asset managers. Blackstone Group Inc. has invested $150 million in Raveneur, the people say.

“Smaller managers understand that in order to attract allocations from bigger investors they have to be more flexible,” said Melissa Santaniello, founder of the Alignment of Interests Association, a nonprofit group that serves hedge-fund investors.

This article raises many excellent points I’ve been hammering away at for a very long time. First and foremost, smaller hedge funds are a lot more focused on performance than asset gathering, which is why they typically outperform their larger rivals over very long periods.

Second, most investment consultants are useless because their focus is exclusively on large well known megafunds. These consultants have hijacked the entire investment process in the United States and they basically cater to the needs of the trustees of U.S. public plans which practice cover-your-ass politics and will rarely if ever take risks with smaller managers. To be fair to these trustees, there is no upside for them to take risks on smaller managers, which is part of a much bigger governance problem at U.S. public pension funds.

Third, it’s high time institutional investors transform hedge fund fees, especially for larger funds run by overpaid hedge fund gurus which are much more focused on gathering assets than on delivering top performance. I have said this plenty of times, many of these large multi billion dollar hedge funds shouldn’t be allowed to charge any management fee whatsoever or a small nominal one (25 basis points or less).

Fourth, take this shift to smaller hedge funds with a grain of salt. The reality is small hedge funds are withering away as the world’s biggest investors don’t have the time or resources to run around after them so they prefer writing large tickets ($100 million+) to large funds which are trading in scalable strategies (like global macro, CTAs, and Long/ Short Equity, or large multi strat funds).

The article above mentions the Public Employees Retirement Association of New Mexico is shifting more of its absolute return program into smaller funds, but when I looked at its latest monthly board meeting packet, I noticed mostly large brand name funds which are well known to most hedge fund investors (from page 33, click on image below):

Now, perhaps they don’t list all their funds, but this group of hedge funds above makes up the bulk of their assets in their absolute return program and most of these funds are very well known, large funds (some are better than others).

At least they publicly publish in detail a list of all their major hedge fund, private equity and real estate partners, along with the performance of the programs, which is a must in terms of transparency. They also publish minutes of their board minutes, which is something else all public pensions should be doing (don’t get me started on good governance, I’ll eviscerate public pension funds, including Canada’s revered top ten which provide none of this information).

As far as Jagdeep Singh Bachher, chief investment officer for the University of California and the former CIO at AIMCo, and Mark Anson, the man who basically launched CalPERS into hedge funds, then moved over to Hermes and now runs Robert Bass’s family investment firm, I think they are both on the right track. Bachher is right to seed new funds which are very hungry and performance driven, and Anson is right to put the bulk of the Bass family’s investments in smaller hedge funds.

Go back to read my comment on Ron Mock when he became Ontario Teachers’ new CEO, where he told me flat out:

the “sweet spot” [for Teachers] lies with funds managing between $500M and $2B. “Those funds are generally performance hungry and they are not focusing on marketing like some of the larger funds which have become large asset gatherers.” He told me the hedge fund landscape is changing and he’s dismayed at the amount of money indiscriminately flowing into the sector. “Lots of pension funds are in for a rude awakening.”

Ron has experienced a few harsh hedge fund lessons so he knows what he’s taking about. And he’s right, a lot of pensions are in for a rude awakening in hedge funds, mostly because they don’t know what they’re doing and are typically at the mercy of their useless investment consultants shoving them in the hottest hedge funds they should be avoiding at all cost.

No doubt about it, there are excellent large hedge funds, but my message to you is don’t get carried away with any superstar hedge fund manager even if their name is Ray Dalio, Ken Griffin, David Tepper or whatever. You’ve got to do your job and keep grilling your hedge fund managers no matter how rich and famous they are. And if they don’t want to meet you, redeem your money fast and find a manager whose head is not up his ‘famous ass’ and is more than happy to meet you and answer your tough questions.

Let me end by plugging an emerging hedge fund manager who I really like and is getting ready to launch his new fund with some super bright people. Gillian Kemmerer of Hedge Fund Intelligence reports, Visium, Sabretooth alum Bryan Wisk preps quant fund with ex-GS, JPM techs:

Former Visium Asset Management and Sabretooth Capital Management alumnus Brian Wisk is prepping a quantitative trading fund that aims to profit from market dislocations. His recently launched firm, Asymmetric Return Capital, has contracted with Kirat Singh and Mark Higgins, the architects of prop desk trading and risk management systems at Bank of America, Goldman Sachs and JPMorgan, to design its risk management system.

“I was one of the last clerks to join the floor of the Chicago Options Exchange in the midst of everything becoming electronic,” Wisk told Absolute Return. “When I went to the buy-side, I found a serious drop-off in the level of technology. It was something people were playing catch-up with, particularly in the options and derivatives space.” Wisk aims to bring the capabilities of a large bank’s derivatives desk to his fund, which will capture data, such as macroeconomic indicators, down to a millionth of a second.

“Many institutional investors are still running their derivatives business in Excel. It’s unfortunate. Our specialized skillset post Dodd-Frank should be available to a large pension fund.”

Wisk began his career as a primary market marker for Citigroup on the Chicago Board Options Exchange. He departed in 2006 for Visium Asset Management, where he served as a senior derivatives trader. He worked as an analyst at Tiger Management-seeded Sabretooth Capital Management in 2011, and departed in 2012, when the fund liquidated, to launch ARC.

According to portfolio manager Adam Sherman, ARC is poised to take advantage of increased volatility across asset classes as quantitative easing measures slow. “We are starting to see market dislocations as central bank policies shift,” he said. “Correlations are starting to break down.”

The fund will trade futures and options across asset classes, including commodities, equity indices, rates, and individual stocks. The portfolio will manage twenty to thirty themes—the differential between commodity and equity volatility was one example given—and will trade multiple securities within that theme (in the previous example, the fund may trade individual options on the S&P 500, WTI and Brent crude oil futures). The fund may hold up to 200 individual positions, and aims to balance exposure across asset classes. The fund will take long-term volatility bets, as well as conduct intra-day and episodic trading around volatility spikes.

Kirat Singh and Mark Higgins—the men Wisk has contracted to design his fund’s trading platform—have modernized Wall Street’s prop desks for over a decade.

Singh was the architect of SecDb (Securities Database) in the late nineties, Goldman Sachs’ framework for real-time derivatives pricing and risk management. SecDb has been touted as one reason why the bank made it through 2008 relatively unscathed, and Higgins co-implemented the platform while running Goldman’s foreign exchange and New York interest rate strategies teams.

The pair departed for JPMorgan Chase in 2006, pioneering the Athena program, a cross-asset trading and risk management system. Singh built the core group that deployed Athena, which began in the fixed income business and was later rolled out across the trading desks in JPMorgan’s investment bank. Higgins implemented the trading system while running the FX, commodities, and global emerging markets (GEM) quantitative research team. The pair parted ways in 2010 when Singh departed for Bank of America Merrill Lynch to design Quartz, a derivatives and securities trading and risk analytics platform. Higgins remained at JPMorgan, rising to co-head of the quantitative research group, and moved to the foreign exchange desk as a managing director in 2012.

The duo reunited in 2014, co-launching Washington Square Technologies, a consulting firm that delivers trading and risk management systems. While the pair are not in-house, they have reached an exclusive deal with Asymmetric Return Capital to design the fund’s risk management infrastructure.

Wisk eyes a June launch for Asymmetric Return Capital, which is based in Manhattan and has five employees, including chief executive Daniel King, who previously served as a managing director and head of the financial institutions group for interest rate sales at Bank of America Merrill Lynch; chief operating officer Steven Gilson, former director of operations at Visium Asset Management; portfolio manager Adam Sherman, who most recently served as a founding partner at Quantavium Management, a systematic fixed income fund; and portfolio manager Andrew Chan, a former portfolio manager at Chicago Trading Company .

The firm will launch with a founder’s share class, the terms of which were not disclosed.

I highly recommend all my institutional readers investing in hedge funds contact Bryan Wisk and the folks at Asymmetric Return Capital. When I first met Bryan in New York City a while ago, I was very impressed with his deep knowledge of the hedge fund industry and the dangers of group think.

Another emerging manager that really impressed me is an activist / event-driven fund manager in Toronto. I met an associate of his yesterday and he told me things are moving along and this manager, who has great experience running a previous fund in California, is on his way to managing his own fund for a big alternatives outfit in Toronto.

As for Quebec, last I heard the SARA fund is closing due to poor performance and they lost a pile of dough for their investors which included the Caisse. This is hardly surprising as these are brutal markets for hedge funds, especially start-ups. And to be brutally honest, most Quebec and Canadian hedge funds stink, they simply can’t compete with the talent pool in the U.S. or England where emerging managers come from pedigree funds (there might be a few exceptions but in general, avoid Canadian hedge funds, they truly stink!).

There is another problem in Quebec and rest of Canada, we simply don’t have the ecosystem to support start-up hedge funds. The Desmarais and Weston families are too busy worrying about mutual funds, insurance companies and their bread and butter businesses, they’re not interested in seeding hedge funds. Canada desperately needs a Bass family but we got a bunch of risk averse billionaires up here and I don’t really blame them given the talent pool just isn’t here.

Having said this, Ontario Teachers is seeding a multi strat fund up here and even though the SARA fund blew up, there is a new initiative going on in Quebec. In particular, Fiera Capital, Hexavest and AlphaFixe Capital set up a $200 million fund to seed Quebec’s emerging managers. It remains to be seen how this new venture will work out but I wish them a lot of success and will be glad to talk to Jean-Guy Desjardins and Vital Proulx about talented managers worth seeding (no bullshit, I’ll give it to them straight up!).

Of course, this is Quebec, and Quebecers are terribly jealous and petty when it comes to people succeeding in finance or business. Look at the media circus surrounding the sale of Cirque du Soleil to private equity firm TPG. Some idiots in Quebec are lambasting the founder Guy Laliberté for cashing out and selling his stake but if I ever see him at LeMéac restaurant again, I’ll be the first to shake his hand and tell him bravo!! (don’t know the man but he sat behind my girlfriend and I one brutally cold winter night a couple of months ago).


Photo by Roland O’Daniel via Flickr CC License

Pension Pulse: On Costs, U.S. Pensions Could Take Page From Canada’s Book


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

Dan Davies, a senior research adviser at Frontline Analysts, wrote a comment for The New Yorker, Is Wall Street Really Robbing New York City’s Pension Funds?:

Most any fee, even a fraction of one per cent, will come to look big if it’s multiplied by tens of billions of dollars. So when New York City Comptroller Scott Stringer wanted to make a point recently about the fees the city’s public-sector pension system had paid to asset managers between 2004 and 2014, he didn’t have to work very hard to find an outrageous number. Over the past ten years, New York City public employees have paid out two billion dollars in fees to managers of their “public market investments”—that is, their securities, mainly stocks and bonds. Gawker captured the implication as well as any media outlet with its headline: “Oh My God Wall Street Is Robbing Us Blind And We Are Letting Them

Stringer’s office was barely more restrained, sending out a press release that called the fees “shocking.” The comptroller also issued an analysis that spelled out the impact of fees on the investment returns of the five pension funds at issue: those of New York’s police and fire departments, city employees, teachers, and the Board of Education. Though the comptroller didn’t specify which firms had managed the funds, they were likely a familiar collection of financial-industry villains. “Heads or tails, Wall Street wins,” Stringer said.

The rhetoric tended to brush past the fact that the pension funds didn’t actually lose money. In the analysis, their performance was being measured relative to their benchmarks, essentially asking, for every different class of asset, whether the funds performed better or worse than a corresponding index fund would have. For reasons unclear, the city’s pension funds have been recording their performance without subtracting the fees paid to managers, but the math shows that New York City’s fund managers outperformed their benchmarks by $2.063 billion across the ten-year period under review, and charged $2.023 billion in management fees.

Compared with the average public pension fund’s experience on Wall Street, this is actually, frighteningly, pretty decent. All too often, when researchers investigate pension-fund performance, they find that management fees have eaten up more than any outperformance the managers have generated. A study published in 2013 by the Maryland Public Policy Institute concluded that the forty-six state funds it had surveyed could save a collective six billion dollars in fees each year by simply indexing their portfolios.

I covered the institutional-fund-management industry as an analyst for ten years, and was never given specific information on the pricing of individual deals, but I would estimate, based on the growth of the funds from 2004 to 2014, the variance in the market (especially the crash of 2008), and the total fees, that New York City paid, on average, about 0.2 per cent, or what a fund manager would call “twenty basis points.” You would expect the trustees of such a large portfolio to strike deals on fees, and indeed twenty basis points is much lower than the average paid to managers of most actively managed mutual funds (between seventy-four and eighty basis points, according to the Investment Companies Institute). It is still far more, though, than the five basis points charged by the Vanguard index tracker fund to large institutional investors.

For extremely large pools, fees for equity funds tend to be between twenty and twenty-five basis points, and those for fixed-income funds potentially reach into the high single digits. New York’s pension portfolio is large and mature, so it ought to have a relatively high fixed-income weighting, which means that the city was probably paying too much. The fact that the funds were reporting their returns with the fees included shouldn’t fill the city’s public pension holders with confidence that the tendering and monitoring process was very sharp, either—$2.063 billion, gross of fees, is an inflated way of presenting the actual gains of forty million dollars, net of fees.

The bigger question is whether New York, and other places dealing with large public pension funds, ought to be paying these kinds of fees at all. The safest alternative, per the Maryland study, would be to index the pension funds at, say, five basis points. Following the presentation used by Stringer, this would mean, with close to certainty, that over a ten-year period New York City’s pension funds would pay five hundred million dollars to Wall Street and get no outperformance—a net cost of five hundred million dollars. A second possibility would be to keep the same fund managers and try to bargain down the fees, say to fifteen basis points. From 2004 to 2014, that would have meant one and a half billion dollars of fees paid for two billion dollars of outperformance, a net benefit of five hundred million dollars. But there would be no guarantee of outperformance in the future, and a considerable risk of underperformance.

There is a third possibility, one that Stringer’s office, in its disdain for Wall Street, might well be considering. To provide a little perspective, if the city’s pension pool were a sovereign wealth fund, its current value—a hundred and sixty billion dollars—would make it the twelfth biggest in the world, just below Singapore’s Temasek and quite a ways above Australia’s Future Fund. When you’re that big, it’s fair to ask why you’re paying external managers at all. (It’s sure not like New York City lacks fund managers to hire.) The Ontario Teachers’ Pension Plan, which is roughly the same size, carries out nearly all of its fund management in-house, and historically it has seen very good results.

Some—notably, Michael Bloomberg, in 2011—have proposed that the city move to a system along these lines. In 2013, Stringer himself identified a “yearning” among union trustees for this. Could it be that by directing public anger toward Wall Street, the comptroller is trying to move the debate in this direction?

There is a catch, though: however the funds are structured, outperformance won’t come cheap. The O.T.P.P. pays high salaries to attract its in-house managers. Its expenses were four hundred and eight million Canadian dollars in 2014 alone, well above the two hundred million dollars the New York funds averaged over ten years. That figure includes investments in private-equity operations such as 24 Hour Fitness and Helly Hansen, but this level of expense isn’t uncommon. Looking at a few sovereign-wealth funds, I didn’t find a single one of comparable size to New York City’s pensions that had paid as little as twenty basis points, whether their management was outsourced or not.

Which is to say that, while bashing Wall Street might help a shift toward another model, the city could end up paying just as much, or more, to generate the returns it wants. And if history teaches us anything, it’s that Americans tend to get upset when public employees are paid millions of dollars—unless, of course, they’re college-football coaches.

I already covered New York City’s fee debacle in my comment on all fees, no beef where I commended the city’s comptroller Scott Stringerfor for providing a detailed study on value added after fees.

In his article above, Davies delves deeper into the subject, looking at just how well New York City’s pensions have performed relative to others and then exploring other alternatives like squeezing external manager fees down to a more appropriate size or adopting an Ontario Teachers’ model where they compensate pension fund managers appropriately to manage more of the assets internally.

This is where I think his analysis is lacking. Instead of exploring the benefits of the Canadian governance model where independent investment boards operating at arms-length from the government oversee our large public pensions, he just glares over it. And this is where his analysis falls short of providing readers the true reason why Canada’s top ten have grossly outperformed their U.S. counterparts over the last ten and twenty years.

Davies states the expenses at Ontario Teachers were twice as much as the average of the New York funds over the last ten years, but he fails to understand the different composition of the asset mix. Ontario Teachers and other large Canadian funds moved into private markets and hedge funds way before these New York City pensions even contemplated doing so.

And despite paying fees to private equity and hedge funds, Ontario Teachers still manages to keep its costs way down:

The plan’s expense rate is a miniscule 0.28 per cent. The average Canadian mutual fund has a management expense ratio of about 2 per cent.

Investment returns account for more than three-quarters, about 78 per cent, of the pension payouts that teachers receive in retirement. Member contributions account for 10 per cent and the Ontario government, as their employer, contributes 12 per cent.

As far as why Ontario Teachers pays fees to external managers at all, it has to do with their risk budgeting which their CIO oversees. Whatever they can do internally, like enhanced indexing or even private equity or absolute return strategies, they will and whatever they can’t replicate, they farm out to external managers and squeeze them hard on fees. Also, given their size and that they manage assets and liabilities, they need to invest in external funds for their liability hedging portfolio.

And because of their hefty payouts, Ontario Teachers’ was able to attract fund managers that have added billions in active management over their indexed portfolio, lowering the cost of the plan and more importantly, keeping the contribution rate low and benefits up. This active management combined with risk-sharing is why the plan enjoys fully funded status. But again, their governance model allowed them to attract top talent to deliver these strong results.

Another world class pension plan in Canada is the Healthcare of Ontario Pension Plan (HOOPP), which pretty much does everything internally and has delivered top returns over the last ten years while remaining fully funded. HOOPP pays virtually no fees to any external managers but as Ron Mock, CEO of Ontario Teachers, explained to me: “if it was twice its size, HOOPP would have a hard time not investing in external managers or maintaining such a high fixed income allocation.”

The discussion on fees is gaining steam. In recent weeks, I’ve covered why it’s time to transform hedge fund fees to better align interests. The same goes for private equity where some think it’s time to stick a fork in it. Even in public markets, a significant chunk of institutional investors plan on increasing their use of exchange-traded funds (ETFs) and exchange-traded notes (ETNs).

What is going on is nothing less than a major awakening. Chris Tobe sent me a paper from CEM benchmarking, The Time Has Come for Standardizing Total Costs in Private Equity, and told me “typically pro industry, CEM used by many public pension plans documents excessive PE fees” and added “the number 382 bps is important.”

An expert in private equity shared these insights with me on CEM’s study:

I look at a partnership as an investment like any other company investment, like for eg. a listed operating company. Does one buy into an IPO and separate the underwriter fee or the CEO and executive team compensation? So the key question is whether you try to make a partnership look like a traditional public securities asset manager, or is it like an operating company whose business is the creation and operation of a portfolio, like a holding company styled business. It’s really about what bias you bring when looking at this. CEM is just following its asset management industry bias, and trying to fit a PE partnership into that model.

Another way to look at things is since all costs in most partnerships must be recovered before carry, the base fee is really an advance against a profit share.

Either way, I find the CEM type of info good to know and measure for sure, but I do not find value in the total “cost” data aggregated across all activities in eg. a pension plan like CEM advocates.

All excellent points but we need to develop standards for reporting fees and performance (internal and external) across all investment portfolios. When it comes to pensions, we need a lot more transparency and accountability across the board.


Photo by c_ambler via Flickr CC License

Pension Pulse: Diving Into CAAT’s 2014 Returns


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

The Colleges of Applied Arts and Technology (CAAT) Pension Plan announced an 11.5% net return  for the year ended December 31, 2014, which increased the Plan’s net assets to $8 billion from $7.1 billion in the previous year with a going-concern funding reserve of $773 million:

The CAAT Pension Plan today announced a 11.5% rate of return net of investment management fees of 77 basis points for the year ended December 31, 2014.The Plan’s net assets increased to $8 billion from $7.1 billion the previous year.

In its valuation filed as at January 1, 2015, the CAAT Pension Plan is 107.2 % funded on a going-concern basis with a funding reserve of $773 million.

During the past five years, the Plan has earned an annualized rate of return of 10.5% net of investment management fees.

Contributions to the CAAT Plan were $417 million in 2014, while net income from investments was $808 million. The Plan paid $369 million in pension benefits for the year.

The CAAT Pension Plan has 40,000 members – 24,700 are employed in the Ontario college system, which comprises 24 colleges and 12 associated employers, and 15,300 members who are retired or have a deferred pension.

The average annual lifetime pension for retired members and survivors is $25,800. In 2014, members on average retired at age 62.4 after 23.3 years of pensionable service.

“We continue to work diligently to earn and keep the trust of members and employers,” says Derek Dobson, CEO of the CAAT Pension Plan. “The security of existing benefits and the sustainability of the pension plan at stable and appropriate contribution rates is our primary focus.”

The 11.5% rate of return net of investment management fees outperformed the policy benchmark by 1.4%, adding value of $96 million.

The CAAT Plan seeks to be the pension plan of choice for single-employer Ontario university pension plans interested in joining a multi-employer, jointly sponsored plan in the sector. The postsecondary education alignment and similar demographic profile of university and college employees makes the university plans an ideal fit with the CAAT Plan’s existing asset and liability funding structures. The CAAT Plan has been in discussions with individual universities, employer and faculty associations, and government officials, about building a postsecondary sector pension plan that leverages the Plan’s infrastructure and experience, reducing costs and risks for all stakeholders.

Created at the same time as the Ontario college system in 1967, the CAAT Plan assumed its current jointly sponsored governance structure in 1995. The CAAT Plan is a defined benefit pension plan with equal cost sharing. Decisions about benefits, contribution rates, and investment risk are also shared equally by members and employers. The Plan is sponsored by Colleges Ontario on behalf of the college boards of governors, Ontario College Administrative Staff Association (OCASA), and Ontario Public Service Employees Union (OPSEU).

The 2014 CAAT Pension Plan Annual Report will be available on the Plan website by May 11.

Read more about the 2015 Valuation
2014 Investment performance
Shared governance is the key to stability

From the three links above, I’d say the key to CAAT’s success is without a doubt their shared risk/ governance model:

The CAAT Pension Plan is a jointly-governed pension plan. This means that employers and employees together share responsibility for the stability and security of the Plan (including the cost). This governance model fosters cooperation and flexibility, and encourages prudent and responsible decision-making.

The Sponsors of the Plan (OCASA and OPSEU representing employees and Colleges Ontario representing employers) appoint representatives to the Board of Trustees and Sponsors’ Committee.

As far as investment performance, net of fees, the Plan managed to deliver a solid return of 11.5% last year, beating its benchmark (policy) portfolio by 1.4%. I want to take a minute here to go over their policy portfolio using information from CAAT’s 2013 Annual Report.

As you can see below, the benchmarks they use for their policy portfolio are very clear and in my opinion, these are the benchmarks all Canadian pensions, including our revered top ten, should be using to gauge value added (click on image below from page 18 of the 2013 Annual Report):

And here was the value added for each asset class in 2013 (click on image below from page 18):

As I was reading CAAT’s 2013 Annual Report last night in bed (I know, I’m weird but I sleep like a baby!), a few things struck me. First, CAAT severely underperformed its Private Equity benchmark in 2013 because the benchmark (MSCI All Cap World Index + 3%) isn’t easy to beat, especially when global stocks are surging. Also, the J-curve effect in Private Equity makes it harder to beat this benchmark because these investments are valued at acquisition-cost and it takes several years to realize gains on these investments.

The second thing I noticed was the strong, if not unbelievable, outperformance of their Canadian equity portfolio in 2013, with a value added of 7.8%. Now, I don’t know which external managers they used to deliver such incredible gains over the S&P/ TSX Composite but one Canadian pension fund manager did tell me that according to Mercer, the median Canadian equity manager outperformed the TSX by 6% in 2013:

Canadian equities returned 7.3 per cent in the fourth quarter which brought the 2013 return to 13.0 per cent. The median returns were 8.3 per cent for the quarter and 19.0 per cent for the year.

For the year:

  • The best performing S&P/TSX sectors were Health Care (+72.1 per cent), Consumer Discretionary (+43.0per cent) and Industrials (+37.5 per cent). The worst performing sectors were Materials (-29.1 per cent), utilities (-4.1 per cent) and Telecom Services (+13.1 per cent).
  • Large cap stocks (S&P/TSX 60 Index) returned 13.3 per cent, outperforming small cap stocks (S&P/TSX SmallCap Index) which returned 7.6 per cent during 2013.
  • Value stocks outperformed growth stocks as measured by the S&P Canada BMI Value and Growth indices, which returned 17.2 per cent and 9.1 per cent respectively in 2013.

What else did Mercer state in its Q4 2013 report? It was a pretty good year for pensions and balanced funds:

A typical balanced pension portfolio returned 12.8 per cent in 2013. The median return offered by managers of the Canadian Pooled Balanced Universe was 6.5 per cent for the quarter and 16.2 per cent for the year.

Of course, if you look closely at CAAT’s asset mix, you will notice they are a lot more diversified than the typical balanced fund. Julie Cays, Kevin Fahey and Asif Haque, my former colleague at PSP, are doing a great job managing investments at CAAT.

Unfortunately, CAAT’s 2014 Annual Report will only be made available by May 11th, which makes it impossible for me to delve deeply into their latest results. I highly recommend CAAT adopts a new approach of making available its annual report at the same time as it releases its results, just like Ontario Teachers’ does (everyone should do this so we can properly examine their results).

Having said this, as you can see below, CAAT has been posting solid returns over the last six years years, beating its policy portfolio (click on image below from page 17 of the 2013 Annual Report, figures are as of end of December, 2013):

And since CAAT is growing but still a relatively small plan, its approach is to farm out most of its investments to external managers. Not surprisingly, one of their biggest investments is an allocation to Bridgewater’s Pure Alpha II Fund which is up 14% so far this year mostly owing to a big bet on the surging greenback (all of which I predicted back in October 2014; Ray is on my distribution list).

CAAT has the advantage of being fairly small relative to its bigger Canadian peers, and unlike HOOPP, its managers have opted to farm out most of their investments (read more about the CAAT and Optrust edge). This strategy works when you are able to choose the right managers but it also poses risks, the least of which is manager selection risk, and they have to make sure they negotiate the fees carefully because as they grow, so do those fees, increasing the costs of the plan.

Even now, CAAT is forking over fees to external managers but if they gt to be ten times their size, those fees can pay some nice salaries to bring some of those assets internally. As the plan grows in size, so will those fees, and so will the pressure to bring more assets internally.

Again, CAAT’s investment team has been posting solid returns, adding value over its policy portfolio over the last five years. Moreover, its governance model has allowed it to beef up its fully funded status, which is what ultimately counts. Also, as Julie Cays, CAAT’s CIO, once told me, there is a lot of knowledge leverage that goes along to allocating money to top global funds.

Late today, Julie shared this with me:

Our fees were 77 basis points – which incidentally includes over 20 basis points paid as fees for outperformance to managers with performance based fee arrangements. Once our annual report is available I’d be happy to chat about 2014.

I look forward to reading CAAT’s 2014 Annual Report when it becomes available by May 11th. Those of you who want to learn more about CAAT should take the time to carefully read its 2013 Annual Report and listen to its senior managers discuss the plan’s results and characteristics here.

Also, CAAT is an excellent multi employer defined-benefit plan which adheres to the highest standards of pension governance. I highly recommend all Canadian universities seriously consider having their defined-benefit plans managed by CAAT. Don’t just look at their returns, which are excellent, think of the advantages of pooling your assets with those of other university pension plans and having those assets managed by professional pension fund managers who will properly diversify across public and private markets.


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 –

Pension Pulse: United Nations of Hedge Funds?


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

Lawrence Delevingne of CNBC reports, World peace through hedge funds? Ask the UN:

One of the largest pension funds in the world is close to using hedge funds, a move many of its peers have already made.

The United Nations Joint Staff Pension Fund, which managed $52.4 billion as of January on behalf of more than 190,000 participants, is in the final stages of deciding how it will add to its mix of alternative investments.

The U.N. is considering investing directly in external money managers or using a broader fund of hedge fund structure—or both—according to a person familiar with the situation. Either way, the pension staff views hedge funds as an important portfolio diversification tool that would add to current alternative investments in private equity funds and a non-hedge fund vehicle managed by Ray Dalio‘s Bridgewater Associates.

Buck Consultants, an external advisor to the pension plan, is set to complete a study as early as this summer that will recommend the best approach to investing in hedge funds for the first time, including in what amount, according to the person.

A spokesman for the U.N. secretary-general declined to comment on the hedge fund plans. Buck, which is owned by Xerox, also declined to comment.

The U.N. has so far stayed clear of hedge funds even as many large institutional investors have embraced them.

The California Public Employees’ Retirement System, the nation’s largest pension fund, made waves in September when it said it planned to cut most of its hedge funds. But industry assets have continued to climb thanks to fresh cash from other pensions, endowments and other institutional investors.

“They would be well served by adding hedge funds,” said Michael Weinberg, a hedge fund expert who teaches a class on pension investing at Columbia Business School. “Many other pensions have already seen their value either to improve returns with the same risk as stocks or bonds, or similar returns to them with less risk.”

Money from institutions represents 66 percent of the capital invested in hedge funds, according to the Managed Funds Association. Pensions represent the highest percentage of that at 39 percent, according to recent Preqin data. Of the pensions that do invest in hedge funds, public plans allocate an average of 7.8 percent of their portfolios to them; for private sector plans it’s 10.5 percent, according to Preqin.

A previous target for alternative investments in the U.N. plan was 6 percent of assets. That figure is being updated by Buck, but a 4 percent allocation to hedge funds, for example, would be more than $2 billion. Tereza Trivell is head of the U.N.’s alternative investing unit.

The U.N. fund, whose investments are led overall by recent appointee Carol Boykin, has 63.5 percent of assets in stocks and 24.5 percent in fixed income, according to a report on the portfolio as of December. It also has 5.2 percent in real assets like real estate, timberland and infrastructure. Just 3 percent is in alternatives, including private equity, commodities and the “risk parity” strategy.

The risk parity allocation is managed by Bridgewater through its All Weather strategy. Dalio pioneered the concept, a conservative mix of asset classes that is designed to perform in any economic environment over the long term. Bridgewater also happens to be the largest manager of hedge funds, which are more trading-oriented and charge higher fees.

A spokesman for Bridgewater declined to comment on if the firm was being considered for the U.N.’s likely hedge fund allocation.

The U.N. pension is more than 90 percent funded, meaning it is still slightly short of having all the cash necessary to fund payments it has promised. That amount is better than many other pensions. The average corporate and public pension plan is about 80 percent funded, according to data from consulting firms Mercer and Wilshire Associates.

The U.N. fund averaged a return of 6.18 percent from 2004 to 2014, according to U.N. materials. That outperformed its policy benchmark return of 5.84 percent (a mix of 60 percent stocks and 31 percent bonds), but was behind global stocks (6.6 percent).

The HedgeFund Intelligence Global Index, representing all hedge fund strategies, gained 5.83 percent net of fees over the same 10-year period.

Funds of hedge funds, the other means in which the U.N. is considering accessing the strategy, are vehicles that allocate to various independent managers for an extra layer of fees. They are a way to gain exposure to multiple hedge funds at once without the hassle of independently selecting and monitoring each manager.

Funds of funds have declined in popularity in recent years given relatively muted returns and concerns around their oversight of managers (some were invested in the Bernard Madoff Ponzi scheme. Click on image below to see funds of funds performance).

The U.N. pension fund was the 71st largest by assets, according to a 2014 Towers Watson ranking (click on image below).

So the United Nations Joint Staff Pension Fund is the latest large pension fund to discover the “diversification benefits” of hedge funds (insert rolls eyes here). I’m sure their consultant will provide them with a polished report touting how great hedge funds are and they will likely invest via a few funds of funds as well as invest directly in brand name funds like Bridgewater to show their board of directors just how responsible they are, investing with a well known global macro fund with a stellar track record.

Don’t get me wrong, Bridgewater is an excellent fund, which is why it’s the largest hedge fund by far. In another CNBC article, Hedge funds take hit playing beat-up oil sector, Delevingne provides YTD performance data on some brand name funds (click on image below):

As you can see, Bridgewater’s Pure Alpha II is up almost 15% thus far this year. Not bad for a global macro fund managing $170 billion in assets. Bridgewater is a wet dream for large global allocators looking for scalability and excellent risk-adjusted returns. This is why Ontario Teachers’ Pension Plan and other large investors are heavily invested with them.

But I get nervous when I see these large mega funds attracting such huge inflows of capital. Maybe Ray Dalio has found the holy grail of investing but in my experience, all hedge funds including Soros Fund Management and Bridgewater, have experienced a serious drawdown at one time or another. This is especially true of so-called hedge fund titans that rise quickly and fall even  quicker.

The other problem I have with Bridgewater, and I’m not shy to state it, is it collects 2 & 20 or 1.5 and 15 (for very large investors) on $170 billion! Do the math, this means Dalio and company collect a little over $3 billion in management fees alone just for turning on the lights. No wonder he’s now the richest man in Connecticut and #60 on the Forbes’ list of billionaires with a net worth of $15.4 billion and growing fast. He can easily afford serious and complex upgrades to the fund’s wooded campus in Connecticut.

So what? He and others at Bridgewater built a great investment fund and deserve the spoils of their hard work, right? Not that easy. As I stated in my interview with The Financial Repression Authority, a lot of these overpaid hedge fund gurus catapulted into the list of billionaires because they were the chief beneficiaries of the financialization of the economy and more importantly, the extraordinary shift of public pension assets into alternative investments.

And as much as I love Ray Dalio — having been among the first in Canada to invest in Bridgewater back in 2002 while working at the Caisse and going head to head with him on why deflation is the ultimate endgame when I worked at PSP back in 2004 — he and many other so-called hedge fund and private equity “gods” are a product of their era. They have ridden this alternatives wave to super fabulous wealth but unlike true entrepreneurs like Ray Kroc, Sam Walton, Bill Gates or Steve Jobs, they offer society very little in comparison. They are glorified by the media but that’s the problem,  they’re just glorified asset gatherers charging huge fees to their clients sometimes offering great returns, sometimes not so great returns. The media loves schmoozing with them but I openly question what they offer in terms of broad economic and social benefits.

Don’t get me wrong, I know they employ many people but on a much larger scale, this employment is insignificant and they are part of the inequality problem pensions and sovereign wealth funds are fueling, which is ultimately very deflationary for our developed economies. The United Nations should smoke that in their hedge fund pipe!

As far as the U.N. pension fund, the long-term performance is nothing great but the problem there isn’t lack of hedge funds, it’s lack of proper governance. If there was ever a place fraught with political interference and unending political meddling by nation states wanting to appoint their candidates to key positions in internal committees or an investment board, the United Nations is it.

So now the U.N. pension fund is going to jump into hedge funds. Big deal! They’re going to be part of the pension herd getting raped on fees with little to show for it (especially if they invest via funds of funds). My advice to the pension fund managers overseeing this activity is to carefully read my comment on Ontario Teachers’ 2014 results. More importantly, if you’re not willing to commit the proper resources to investing in hedge funds, forget about them altogether and focus your attention on investing in top real estate and private equity funds where alignment of interests are much better than hedge funds. But even in these less liquid alternatives, things are frothy and very challenging.

I realize there are outstanding hedge funds and some performed extremely well in 2014. A lot of people will tell me to look at performance net of fees, which is what really counts. True, but if you’re paying hundreds of millions in fees for investment activities you can do internally or should be doing internally, there is something out of whack with your governance model. Period.

Finally, this from a reliable source at the U.N.:

I am not sure how the DRAFT actuarial study was leaked to the press, but it certainly was premature and ill advised. Normally, investment recommendations, including significant changes in the asset allocation, would be made by the RSG or investment professionals in IMD (the Investment Management Division) and discussed in meetings with the Investments Committee. The Investments Committee doesn’t meet until the middle of May and as far as I know, the actuarial report has not been finalized, so the full analysis and discussion of Hedge Funds has yet to take place.

Actuaries give many projections of potential results based on plausible forecasts of the future, but they are all guesses, based on prior statistical data. Their tidy graphs are the result of data smoothing, meaning that actuaries assume away any shocks and jolts that occur in the markets (especially in recent times). Because the actuarial projections are only hypothetical scenarios which are heavily biased to input assumptions, it is dangerous to rely solely on actuarial projections for investment decision-making.

Pension Pulse: Fully Funded OTPP Gains 11.8% in 2014

This post was originally published at Pension Pulse.

Jacqueline Nelson of the Globe and Mail reports, Ontario Teachers posts 11.8% return in 2014, looks abroad for investments:

The Ontario Teachers’ Pension Plan is looking abroad for investment opportunities after posting strong returns in 2014.

The pension plan, which invests on behalf of 311,000 teachers and retirees in Ontario, earned an 11.8-per-cent return on its investments last year and saw its assets grow to $154.5-billion, up from $140.8-billion a year earlier.

This is the second year that Teachers has posted a surplus after a decade of recording annual deficits, with funding levels at 104 per cent at the end of 2014. The plan has $6.8-billion of surplus assets above the estimated liability for providing pensions to members.

Teachers has posted an annualized 10.2-per-cent rate of return since its founding as an independent organization 25 years ago.

The pension plan achieved the results despite turbulent market conditions including the drop in oil prices, a competitive private investment environment and economic uncertainty in Europe, said Ron Mock, chief executive of Teachers, in a press conference announcing the results. And in the past four to five months, Teachers has been re-evaluating its investment strategy with an eye on the coming decade, he said.

“The global environment, the investing environment and quite frankly the sovereign wealth [and] pension environment has changed substantially in the last five to seven years,” Mr. Mock said. “So having a strategy that’s global … and in our case long, long-term investing, is critically important.”

The 2014 financial results included a 13.4-per-cent return on equities and a 22-per-cent return on private capital investments. The fund’s fixed income portfolio, including bonds, had a one-year return of 12 per cent, while the real estate group earned 11.1 per cent, and infrastructure earned 10.1 per cent.

Teachers plans to “adapt and modify” its strategy to include looking for more investment opportunities around the world and building up assets in its target regions. “Teachers will need to have global capabilities in the coming years,” Mr. Mock said.

“In 2014, we also spent time growing our global footprint,” said Neil Petroff, chief investment officer at Teachers. After opening a new Hong Kong office in 2013, Teachers spent the past year hiring more local staff and will look to do more deals in the region.

Late last year, Teachers said it would build out its London office, which opened in 2007 and now has a portfolio of assets worth $22-billion. Major investments in 2014 include buying the half of Bristol Airport it didn’t already own in September, and increasing its stake in Birmingham Airport.

“As we look at our global expansion, we’re a little different than the average fund. We don’t open an office and say let’s go find assets,” said Mr. Petroff, who plans to retire in June of this year. Instead, Teachers would look to establish offices in regions where it has holdings. The next logical move for an office might be South America, said Mr. Petroff, where Teachers has a “critical mass of assets” in several countries.

Still, Teachers plans to keep its bottom-up investment strategy, which eschews thematic investing in favour of analyzing individual stocks.

These evolving investment goals come as the average age of plan members has been steadily increasing since the 1970s, from an average expected mortality rate of 79 to 90 years of age for women. The majority of Teachers members are women, who tend to live longer than men.

Right now, Teachers has 182,000 active members and 129,000 pensioners, but the pensioner population is catching up quickly to working teachers, said Tracy Abel, senior vice-president of member services, noting that 135 of the plan’s pensioners are over the age of 100.

Madhavi Acharya-Tom Yew of the Toronto Star also reports, Teachers’ pension plan posts 11.8 per cent return:

The Ontario Teachers’ Pension Plan posted an 11.8 per cent return for 2014, even as falling oil prices took a bite out of its investment portfolio.

Investment earnings for the year were $16.3 billion, up from $13.7 billion in 2013, the pension fund said on Tuesday.

The strong performance puts the defined benefit pension plan in a surplus position for the second year in a row – it’s currently 104 per cent funded – with its net assets under administration reaching a record $154.5 billion.

“Navigating ourselves through these waters is not an easy task,” president and chief executive officer Ron Mock told reporters at a media conference at Teachers’ head office in North York.

“With continuing low interest rates, intense competition pushing up asset prices, the slide in oil prices and resulting stock market-volatility, 2014 was not an easy year for investment success.”

The pension fund said its managers outperformed the consolidated investment benchmark of 10.1 per cent, adding $2.4 billion in returns to the plan last year.

The pension fund invests on behalf of 311,000 active and retired teachers in Ontario. It has an annualized rate of return of 10.2 per cent since its inception 25 years ago.

The value of the plan’s public and private equity investments reached $68.9 billion as of year-end, up 13.4 per cent from the prior year.

Investments by Teachers’ private capital arm rose 22 per cent last year and the plan’s fixed income holdings rose by 12 per cent.

Investments in natural resources were down 19.4 per cent for the year, executives said.

“The silver lining of this natural resource performance is that commodities are a very small allocation. It hurt our returns, but not very much,” chief investment officer Neil Petroff told reporters.

Energy accounts for six per cent of the plan’s public equity portfolio, and four per cent of its private capital holdings, according to the annual report.

The plan’s expense rate is a miniscule 0.28 per cent. The average Canadian mutual fund has a management expense ratio of about 2 per cent.

Investment returns account for more than three-quarters, about 78 per cent, of the pension payouts that teachers receive in retirement. Member contributions account for 10 per cent and the Ontario government, as their employer, contributes 12 per cent.

The Ontario Teachers’ Pension Plan is a defined benefit plan, meaning that the payouts that members receive in retirement are a set or “defined” amount, based on their salary and length of service. Investment decisions, and risks, are assumed by the plan.

Teachers’ has recently invested in GE Aviation, XPO Logistics, and PODS, a company that provides portable, on-demand moving and storage containers. It has also made investments in airports in Birmingham and Bristol, and Premier Lotteries in Ireland.

The plan opened an office in London in 2007 and another in Hong Kong in 2013. It expects to open a new one in South America, where it has investments in logistics firms, and water treatment plants, in the coming months, executives said.

The average age of a retiree who is collecting a pension from Teachers’ is 70. The average age of its active members is 42. The plan has 182,000 active members and 129,000 pensioners.

“Our pensioner population is catching up quickly to the working teacher population,” Mock said.

The pension plan currently has about 130 pensioners over the age of 100. On average, retirees are expected to collect their pension for 31 years.

Petroff told reporters that his 82-year-old mother, who is a retired teacher, receives a pension from the plan. “Every year she calls me and says, ‘You’re doing a wonderful job, Neil. Keep it up.’”

Petroff is retiring from the Ontario Teachers’ Pension Plan on June 1, the pension fund manager announced this week. There will be an internal and external search for a successor.

Indeed, Neil Petroff is retiring on June 1st and Ron Mock told me the plan has launched a global search to find a new CIO.

You can read a lot more on Ontario Teachers’ 2014 results on their website by clicking here. I highly recommend you read the 2014 Annual Report as well as the Report to Members.

I had a long chat with Ron Mock, Ontario Teachers’ President and CEO, late last week to discuss their 2014 results and dig a lot deeper into how they invest in an increasingly more competitive climate.

Below, I provide you with bullet points on our conversation:

  •  We began by talking about liabilities which are at the heart of every investment decision Teachers undertakes. Ron told me the board sets the discount rate which is mostly determined on mark-to-market basis (keep in mind, the Oracle of Ontario has one of the lowest discount rates in the world and unlike U.S. public pensions, their discount rate isn’t marked-to-fantasy). Once the board sets the discount rate and determines the plan’s liabilities, the sponsors (the government of Ontario and the Ontario Teachers’ Federation) then set the contribution rate and adjust benefits according to he plan’s funded status.
  • In 2010, the plan removed full inflation protection and introduced 60% inflation protection to return it to fully funded status. As Jim Leech, the former president and CEO, noted back then, the liabilities were due to the maturation of the plan. The main driver of liabilities back then was the drop in interest rates, which significantly reduced bond yields and increased liabilities. In the early 1990s, real-return government bonds (RRBs), the backbone of the plan, generated a fixed 4.5% return plus inflation. These rates of return fell down to 1.6% four years ago – closer to historic averages – which meant the plan needed more money then to pay out future liabilities. They have since fallen to near zero percent, adding even more pressure on the plan to find suitable alternatives to match their long duration liabilities. Every decrease of one percentage point in interest rates increased the cost of a pension plan by 20% in 2010 and it hasn’t gotten any better since then. Ron told me the liabilities now swing by $30 billion every time rates go down by 100 basis points (1 percent) and their duration is 22.
  • Adding to OTPP’s challenges is the fact that there are now only 1.4 working teachers for every retiree, and higher life expectancies for their members (ie. more longevity risk). As Ron explained to me, “this means there are fewer active members to absorb a substantial loss” and since members are living longer and the average age of their members is rising, they need to make sure their risk-adjusted returns remain extremely high and that they mitigate against any potentially devastating loss, like 2008 which rattled the plan.
  • Ron explained how critical “path dependence” is to their plan: “When you have 10 active members for every one retiree, you can absorb a $100 loss much easier by increasing the contribution rate and spreading that loss among the active members. But when you have almost as many retirees as active members, you simply can’t afford to sustain a huge loss and because it will significantly impact the cost of the plan and endanger benefits to members.”
  • Ron also said that the base case for the contribution rate is 11%, meaning the sponsors don’t want to see huge volatility in returns which will potentially mean a substantial increase in the plans’ liabilities and the contribution rate. “Our job is to minimize the volatility of that contribution rate and keep it stable for as long as possible and the sponsors can use inflation protection as a relief valve to moderate the plan according to its funded status. For a plan to be sustainable, it needs to be flexible and the sponsors need to share the risk of the plan.” He added: “Now that the plan is fully funded, the sponsors have the option to restore full inflation protection to the plan’s members.”
  • Because of the long duration (22) of the plan’s liabilities and the fact that they simply can’t find enough real returns bonds (RRBs) to match these liabilities, it forces them to swap into Treasury Inflation Protection Securities (TIPS) to make up for this scarcity. But even that’s not enough because there is a duration mismatch and lack of available product so they’re increasingly looking at better matching all their public and public assets with their liabilities to deal with the plan’s sensitivity to rates, especially on the downside.
  • This is where our conversation shifted to asset allocation and how it relates to liabilities. Ron said that bonds serve three functions: 1) they provide a negative correlation to stocks; 2) they provide return and 3) they move opposite to their liabilities. “If rates go up, our liabilities decline by a lot more than the value of our bond portfolio, which is exactly what we want to maintain the plan fully funded.”
  • As far as illiquid assets, Ron said that in real estate Teachers looks for class A malls and office buildings and doesn’t invest in hotels, strip malls, pure condo buildings, or box stores. “The lease of a hotel is one day. We prefer long term leases of ten years with stellar clients such as well known retailers or office tenants like top law and accounting firms.” He added: “Because our liabilities are in Canadian dollars, we have a substantial exposure to Canadian commercial real estate but are also looking in the United States for similar class A real estate because there aren’t enough opportunities up here.” Teachers isn’t alone, many other large Canadian pensions have been busy snapping up U.S. real estate and given my outlook for Canada, I think is is a wise move.
  • In infrastructure, he told me that Teachers and OMERS own high speed trains in Europe and there too, they are looking for quality assets that can provide steady returns for a very long time to match their long dated liabilities. Interestingly, Ron said that many pension and sovereign wealth funds are jumping into infrastructure paying top prices and they don’t have people with operational experience to manage these assets (a buddy of mine in infrastructure totally agrees and says a day of reckoning awaits all these large funds with investment banking types looking to strike their next infrastructure deal). Ron told me that “Teachers’ infrastructure team sticks closely to its pricing discipline even if that often means walking away from an asset they’d really like to own. We also make sure we have board members with operational experience in each of our infrastructure investments.”
  • In private equity too, Teachers is looking for long term deals that can yield nice returns over a very long period. Ron cited the example of the Irish lottery and other deals that they entered looking for solid returns over a long period.
  • In fact, across, public, private and hedge fund assets, Teachers is looking for “the highest Sharpe ratio” in order to match their assets and liabilities as closely as possible. Even in public equities, they moved more into utilities last year to better match assets with liabilities.
  • One area where Teachers got whacked again in 2014 was in natural resources, down 19% mostly due to the poor performance of their passive commodities exposure. I will discuss this below but Ron explained to me that they’ve implemented a Bridgewater type “all-weather portfolio to deal with four economic cycles, including an inflationary environment where commodities outperform” (Teachers has a substantial investment in Bridgewater’s Pure Alpa fund).
  • Our discussion inevitably shifted to benchmarks and compensation. Ron told me their benchmarks are constructed with liabilities in mind and the risks they take in each investment portfolio are closely monitored by the board to make sure they’re in line with the accepted risk parameters. “You won’t see us take opportunistic real estate bets to beat our real estate benchmark.” Maybe not, but whenever I see any Canadian pension fund trouncing its benchmark in any asset class (like Teachers did in real estate and infrastructure in 2014), my antennas immediately go up and I start wondering whether those benchmarks accurately reflect the risks of the underlying investments (admittedly, over the last four years, which is what compensation is based on, the outperformance isn’t as stark in either asset class).

In fact, I want you all to click on the image below (page 13 of Annual Report):

You can scan the results of broad asset classes over the last year and four years. Unlike other large Canadian pensions, Teachers embeds private equity in its Equities asset class, making it harder to determine how much of the outperformance in non-Canadian equity is due to value-added in private as opposed to public markets (my hunch is it’s almost all due to private equity since one of the articles above states Teachers’ private capital arm rose 22% last year).

Also, you will see how well real estate and infrastructure performed over the last year and four years. Note the strong outperformance over the benchmarks of these assets in 2014, mostly due to higher valuations as everyone is jumping on the real estate and infrastructure bandwagon. Over the last four years, the outperformance in real estate isn’t as strong as that of infrastructure.

One big area of investments which isn’t discussed (deliberately) in detail in the Annual Report is hedge funds. Teachers invests a substantial amount in external hedge funds and engages in internal absolute return strategies. From page 17 of the Annual Report:

Teachers’ uses absolute return strategies to generate positive returns that are constructed to be uncorrelated to the returns of the plan’s other assets. These strategies are executed primarily by the Tactical Asset Allocation and Fixed Income & Alternative Investments teams. Internally managed absolute return strategies generally look to capitalize on market inefficiencies. The plan also uses external hedge fund managers to earn uncorrelated returns, to access unique strategies that augment returns and to diversify risk. Assets employed in absolute return strategies totalled $15.8 billion at 2014 year end compared to $12.2 billion the previous year.

I have discussed Teachers’ hedge fund strategy in great detail here and here. A brief recap for those of you who never read those comments:

Ron started the meeting by stating: “Beta is cheap but true alpha is worth paying for.” What he meant was you can swap into any index for a few basis points and use the money for overlay alpha strategies (portable alpha strategies). His job back then was to find the very best hedge fund managers who can consistently deliver T-bills + 500 basis points in any market environment. “If we can consistently add 50 basis points of added value to overall results every year, we’re doing our job.”

He explained to me how he constructed the portfolio to generate the highest possible portfolio Sharpe ratio. Back then, his focus was mainly on market neutral funds and multi-strategy funds but they also invested in all sorts of other strategies that most pension funds were too scared to invest in (strategies that fall between private equity and public markets; that changed after the 2008 crisis). He wanted to find managers that consistently add alpha – not leveraged beta – using strategies that are unique and hard to replicate in-house.

You can view some of the key hedge fund and private equity partners Teachers’ is engaged with on page 70 of the Annual Report (click on image):

On this list you will see familiar names in private equity and hedge funds, but they don’t print a full list of their partners like CPPIB and this is done deliberately to maintain capacity and a competitive advantage over their peers (I personally think they should be forced to disclose all their private equity and hedge fund relationships).

Which hedge funds does Teachers invest in? A lot of well-known multi strategy hedge funds (Citadel, Farallon, Millennium, etc.) I cover in my quarterly updates as well as market neutral funds, but also big players like Bridgewater and AQR. Unlike other pensions, however, Teachers puts most of its external hedge funds on a managed account platform managed by Innocap (where they used their size to squeeze the fees down to a ridiculous level but they are their biggest client by far).

Interestingly, Teachers recently announced it will be an anchor investor in Deimos Asset Management, a new hedge fund led by a group that includes a former Co-CEO of RBC Capital Markets. Deimos said it plans to develop a suite of alternative asset management products, which is expected to include a multi-strategy hedge fund, along with a wide variety of individual hedge fund strategies.

The fact that Teachers seeded this fund is a very strong endorsement and shows you they’re not afraid to enter into deals where others are typically running scared. In my opinion, far too many pensions are too focused on brand name funds and not paying enough attention in seeding emerging managers. In Quebec, the Caisse and other smaller pensions bungled up seeding emerging hedge fund managers through the SARA fund (it’s hemorrhaging money) to the point where Fiera Capital, Hexavest and AlphaFixe Capital had to step in and set up a $200 million fund to seed emerging managers (it remains to be seen how this new venture will work out but I know of one activist manager who is by far the best manager to seed in Canada).

Apart from absolute return strategies, the big money at Teachers is still coming from private equity. In fact, Teachers just announced it is exploring a sale or initial public offering of $2 billion of Alliance Laundry, a commercial laundry-equipment maker:

Based in Ripon, Wisconsin, Alliance Laundry says it’s the world’s largest designer and manufacturer of commercial laundry equipment with brands including Speed Queen and UniMac. Ontario Teachers’ bought the company from Bain Capital Partners in 2005 for $450 million.

Alliance expanded its reach across Europe, the Middle East, and Asia through the 2014 acquisition of Gullegem, Belgium-based Primus Laundry Equipment Group. Alliance reported revenue of $726 million in 2014, up 32% from the previous year, company filings show. It had net income of $29 million for the year.

Ontario Teachers’ also owns a 30% stake in coin-operated laundry machine provider CSC ServiceWorks Inc.

Do the math. Buying a company in 2005 for $450 million and selling it for $2 billion (assuming the deal goes through) is a nice juicy return of more than 3X their initial investment in ten years. And we’re not talking about sexy high-flying hedge funds here. This is a boring company which designs and manufactures commercial laundry equipment. And by doing this deal directly, Teachers saves huge on fees.

It’s this type of internal active management which allows Ontario Teachers to deliver exceptional results over a ten-year period at the lowest possible cost, far lower than any mutual fund and most of their peers (28 basis points of operating costs), with exception of HOOPP, which also delivered exceptional results in 2014 at a fraction of the cost of its peers and mutual funds.

Interestingly, Ron Mock praised all his peers, including HOOPP’s Jim Keohane which he called “brilliant,” but he rightly noted that if HOOPP was as big as OTPP, it too would be forced into managing more of its assets externally and would have “a hard time maintaining such a large fixed income allocation.”

Something else Ron mentioned is unlike most of his peers, which focus all their attention on investments, Teachers is a pension plan which manages assets and liabilities. “Every day we’re fielding calls from members to discuss a death of spouse, a divorce, or something else and we take this service extremely seriously which is why CEM voted us number one again in this area.”

Now, as you can see below from page 28 of the Annual Report, the senior managers at Teachers are compensated extremely well, so don’t shed a tear for them (click on image):

You will also notice that Neil Petroff, who is retiring in June, was the highest paid senior executive at Teachers with a total compensation of $4,481,846, which was even more than Ron Mock’s total compensation of $3,783,039. Ron explained to me that Neil has been working as a CIO for a long time which is why his compensation is higher.

These payouts are hefty by any measure, especially considering their members are Ontario teachers who get paid a modest income for their hard work, but it’s all part of the Canadian governance model which pays senior public pension executives extremely well (some argue outrageously well).

I’m not going to comment on compensation at Teachers except to say that they have delivered a stellar 10.2%  annualized return since its founding and added billions over their benchmarks using internal active management which reduces costs and fees. On the topic of benchmarks, however, I did notice they were excluded from the Annual Report, which is odd and downright stupid, but a complete list of benchmarks is available at

Why are benchmarks important? There are a lot of reasons but the primary one is benchmarks determine value-added and compensation. Even after reading Teachers’ benchmarks, I still don’t understand what benchmark is used to gauge the risks and performance of private equity because it’s embedded under all equities.

In other words, you have to rely on the board of directors to make sure they are doing their job in setting up proper benchmarks for each and every investment activity. Now, I know enough about Jean Turmel, Teachers’ new chair of the board and formerly the board member overseeing all investments, to know he’s not a pushover when it comes to gauging risks and investments. Far from it, you’re not going to pull a fast one on Turmel who is obsessed with mitigating downside risk (sometimes too much so to the point where he doesn’t take enough risks!).

But I do wish Teachers had a section on benchmarks in their Annual Report, explaining in detail how they are determined by the plan’s liabilities and reflect the risks, leverage and beta of all investment activities including private equity and hedge funds.

Importantly, all Canadian pension funds and plans need to do a much better job on explaining how their benchmarks are determined, how they accurately reflect the risks of all investment portfolios, and how they link into compensation. If you want to get paid big bucks based on four-year rolling returns, it’s the least you can do!

Let me end by wishing Neil Petroff a happy retirement and all the best in whatever he decides to do post Teachers. Neil, like his predecessor Bob Bertram, is an exceptionally gifted investment professional with deep knowledge of private, public and hedge fund investments. He convinced Claude Lamoureux to hire Ron Mock to run Teachers’ hedge fund investments and the two men are close friends and have mentored each other in their respective roles at Teachers.

Two of my best blog comments featured Neil Petroff. One was a conversation with Neil on OTPP’s active management back in April 2011 where he discussed Teacher’s opportunistic approach (hope they got out of TransOcean and other drillers long before I warned my readers to short them!) and another was when I visited Toronto with Yves Martin who was looking for seed capital for his commodity fund (which unfortunately subsequently closed due to poor performance in a very tough market for commodities).

I told Neil straight out that I didn’t believe in passive commodities exposure and even recommended against it while working at PSP Investments (saving them a bundle but they fired me after ignoring my dire and timely warnings on the U.S. housing/ credit bubble which ended up costing them billions). I believe even less in passive commodities exposure now that global deflation is a very real possibility.

All this to say that I question why Teachers, a Canadian pension plan with tons of passive exposure to commodity shares and whose liabilities are in Canadian dollars (a petro currency) needs to have such a passive exposure to commodities (better off investing in guys like Pierre Andurand).

And before I forget, my favorite Neil Petroff quote to me: “If U.S. public pension funds used our discount rate, they’d be insolvent!!”.

A final word to Mr. Turmel. In our last conversation, you questioned whether a guy with Multiple Sclerosis can handle the pressure of trading. I know it came from a good place but without realizing it, that is the exact discriminatory mindset which infuriates me and makes me excel in my blogging and trading. I am happy to report that my health is stable and my personal investment performance over the last couple of years, playing the biotech and buyback bubbles, is doing a lot better than your old fund where my former PSP boss, Pierre Malo, also worked and even better than many top funds I regularly track.

You see Mr. Turmel, I might have MS and be blacklisted by every major financial institution in Quebec and Canada — because racist institutions that ignore diversity at the workplace refuse to hire someone with a chronic condition and an outspoken blog — but I’m still the best damn pension and investment analyst in the world and comments like this one prove it. So do me a favor, instead of propagating myths on people with disabilities, try hiring them at Teachers and elsewhere, you might be pleasantly surprised by their incredible work ethic and invaluable contributions.

As for the rest of you, including my old buddy out in Victoria, British Columbia, get to it and donate and/ or subscribe to this blog. If you’re taking the time to read my comments, please join others and take the time to support me through your financial contributions via PayPal at the top right-hand side under the click my ads picture.

Better yet, set your prejudices aside and hire me at your organization ( I’m a tough, cynical and sometimes hopelessly arrogant Greek-Canadian who loves Montreal and the Habs, but I guarantee you that you won’t find a better all-round pension and investment analyst who will work harder than anyone else to prepare you for the risks that lie ahead.

Below, Ontario Teachers’ CEO, Ron Mock, discusses 2014 results on BNN. I didn’t particularly like this interview because it was too short and there were some stupid questions asked (“why are you a major holder of BlackBerry shares“?!?) but I liked Ron’s explanation on the importance of bonds in their portfolio from an asset-liability standpoint.

Let me end by thanking Ron Mock for taking the time to chat with me in-depth on Ontario Teachers’ 2014 results. Ron, you’re a gentleman and a scholar and your insights provide me with a tremendous amount of food for thought. Keep up the great work and always strive to make Teachers’ an even better organization than it already is. If there are any errors in this comment or any additional comments you or others would like to make, please let me know and I will edit it.


Pension Pulse: CPPIB’s Big Stake In the UK’s Top Ports?


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The index in question: the Baltic Dry Index.

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

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

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

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

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

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

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

I think it may… but with a caveat.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Photo by  Hilts uk via Flickr CC License

Pension Pulse: Transforming Hedge Fund Fees?


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Are Current Best Practices Sufficient?

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

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

The Next Level: Systematic and Detailed Examination

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

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

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

Acknowledge the Human Element

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

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

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

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

Neil followed up with these comments for my blog readers:

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

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

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

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

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

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

Humans make mistakes.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[Click here and follow the above instructions to donate to Pension Pulse.]


Photo by  Dirk Knight via Flickr CC License

Pension Pulse: America’s Pensions In Peril?


By Leo Kolivakis

Originally published at Pension Pulse

As you can read [in this CNBC article titled Funding shortfalls put pensions in peril], America’s private and public pensions aren’t in good shape. There are a lot of reasons why this is the case and my fear is the worst is yet to come.

One thing I can tell you, the attack on public pensions continues unabated. Andrew Biggs, a resident scholar for the conservative American Enterprise Institute wrote a comment for the Wall Street Journal, Pension Reform Doesn’t Mean Higher Taxes:

The Pennsylvania State House held a hearing on Tuesday about reforms that would shore up the state’s public-employee pension program. The hearing was overdue. Annual required contributions to the state’s defined-benefit plan have soared to more than 20% of employee payroll from only 4% in 2008. Legislators in the state, like many elected officials nationwide, are looking for a way out.

State Rep. Warren Kampf has introduced a bill to shift newly hired government employees to defined-contribution pensions similar to a 401(k) plan. Defined-contribution pensions offer cost stability for employers, transparency for taxpayers and portability for public employees.

But the public-pension industry—government unions and the various financial and actuarial consultants employed by pension-plan managers—claims that “transition costs” make switching employees to defined-contribution pensions prohibitively expensive. Fear of “transition costs” has helped scuttle past reforms in Pennsylvania, as in other states. But the worry is unfounded.

The argument goes as follows: The Governmental Accounting Standards Board’s rules require that a pension plan closed to new hires pay off its unfunded liabilities more aggressively, causing a short-term increase in costs. Thus the California Public Employees’ Retirement System, known as Calpers, claimed in a 2011 report that closing the state’s defined-benefit plans would increase repayment costs by more than $500 million. Similar claims have been made by government analysts in Minnesota, Michigan and Nevada. The National Institute for Retirement Security, the self-styled research and education arm of the pension industry, claims that “accounting rules can require pension costs to accelerate in the wake of a freeze.”

But GASB standards don’t have the force of law; nearly 60% of plan sponsors failed to pay GASB’s supposedly required pension contributions last year. That includes Pennsylvania, where the public-school-employees plan last year received only 42% of its actuarially required contribution. GASB standards are for disclosure purposes and not intended to guide funding. New standards issued in 2014, GASB says, “mark a definitive separation of accounting and financial reporting from funding.”

In fact, nothing requires a closed pension plan to pay off its unfunded liabilities rapidly, and there’s no reason it should. Unfunded pension liabilities are debts of the government; employee contributions are not used to pay off these debts. Whether new hires are in a defined-contribution pension or the old defined-benefit plan, the size of the unfunded liability and the payer of that liability are the same.

More recently, pension-reform opponents have shifted to a different argument: Once a pension plan is closed to new hires, it must shift its investments toward much safer, more-liquid assets that carry lower returns. Actuarial consultants in Pennsylvania have claimed that such investment changes could add billions to the costs of pension reforms.

This argument doesn’t hold. It is standard practice for a pension to fund near-term liabilities with bonds and to pay for long-term liabilities mostly with stocks. A plan that is closed to new entrants stops accumulating long-term liabilities. As a result, the stock share of the plan’s portfolio will gradually decline. But that’s because the plan’s liabilities have been reduced. Plans would not be applying a lower investment return to the same liabilities. They would apply a lower investment return to smaller liabilities.

Many public pension plans apparently believe that a continuing, government-run pension can ignore market risk, while a plan that is closed to new entrants must be purer than Caesar’s wife. The reality is that all public plans, open and closed, should think more carefully about the risks they are taking. But the difference in investment returns between an open plan and a closed one should be a minor consideration for policy makers considering major pension reforms.

Shifting public employees to defined-contribution retirement plans won’t magically make unfunded liabilities go away. Pension liabilities must be paid, regardless of what plan new employees participate in. But defined-contribution plans, which cannot generate unfunded liabilities for the taxpayer, at least put public pensions on a more sustainable track.

The problem with this Wall Street Journal article is it’s factually wrong. Jim Keohane, CEO of the Healthcare of Ontario Pension Plan (HOOPP), sent me these comments:

I read the clip from the WSJ you included on your blog, and I thought you would be interested in a piece of research on the subject which was completed by Dr. Robert Brown (click here to view the paper). This is a fact based piece of research which looked at the cost of shifting from DB to DC. Proponents of a shift from DB to DC, such as this article, portray this as a win-win situation, but when Dr. Brown looked into the facts, what he found was that this is in fact a lose-lose situation. The liabilities in the existing plans are very long tailed and putting these plans into windup mode causes the costs and risks to go up, so there are no savings to taxpayers – in fact the costs go up, and the individuals are much worse off having been shifted to DC plans because they end up with much lower pensions.

When I read these articles in the Wall Street Journal, it makes my blood boil. Why? Am I a hopeless liberal who believes in big government? Actually, not at all, I’m probably more conservative than the resident “scholars” at the American Enterprise Institute (read my last comment on Greece’s lose-lose game to understand the effects of a bloated public sector and how it destroys an economy).

But the problem with this article is that it spreads well-known myths on public pensions, and more importantly, it completely ignores the benefits of defined-benefit plans to the overall economy and long-term debt profile of the country. Worse still, Biggs chooses to ignore the brutal truth on defined-contribution plans as well as the 401(k) disaster plaguing the United States of Pension Poverty.

Importantly, pension policy in the United States has failed millions of Americans struggling to save enough money and all these conservative think tanks are spreading dangerous myths telling us that DC plans “offer cost stability for employers, transparency for taxpayers and portability for public employees.”

The only transparency DC plans offer is that they will ensure more pension poverty down the road,  less government revenue (because people with no retirement savings won’t be buying as many goods and services), and higher social welfare costs to society due to higher health and mental illness costs.

And again, I want make something clear here, I’m not arguing for bolstering defined-benefit plans for all Americans from a conservative or liberal standpoint. Good pension policy is good economic policy. This is why I wrote a comment for the New York Times stating that U.S. public pensions need to adopt a Canadian governance model (less the outlandish pay we pay our senior public pension fund managers) in order to make sure they operate at arms-length from the government and have the best interests of all stakeholders in mind.

But the problem in the United States is that politicians keep kicking the can down the road, just like they did in Greece, and when a crisis hits, they all scramble to implement quick nonsensical policies, like shifting public and private employees into defined-contribution plans, which ensures more pension poverty and higher debt down the road.

Finally, while most Americans are struggling to retire in dignity, the top brass at America’s largest corporations are quietly taking care of themselves with lavish pensions. Theo Francis and Andrew Ackerman of the Wall Street Journal report, Executive Pensions Are Swelling at Top Companies:

Top U.S. executives get paid a lot to do their jobs. Now many are also getting a big boost in what they will be paid after they stop working.

Executive pensions are swelling at such companies as General Electric Co., United Technologies Corp. and Coca-Cola Co. While a significant chunk of the increase is the result of arcane pension accounting around issues like low interest rates and longer lifespans, the rest reflects very real improvements in the executives’ retirement prospects.

Pension gains averaged 8% of total compensation for top executives at S&P 500 companies last year, up sharply from 3% the year before, according to data from LogixData, which analyzes SEC filings. But the gains are much larger for some executives, totaling more than $1 million each for 176 executives at 89 large companies that filed proxy statements through mid-March. For those executives, pension gains averaged 30% of total pay.

The gains often don’t represent new pay decisions by corporate boards. Instead, they reflect the sometimes dramatic growth in value of retirement promises made in the past. Nonetheless, they are creating an optics problem for companies at a time when executive-pay levels are under greater scrutiny from investors and the public. Companies now face regular shareholder votes on their pay practices that can be flash points for broader concerns, leaving them sensitive about appearing too generous.

New mortality tables released last fall by the American Society of Actuaries extended life expectancies by about two years. That, as well as low year-end interest rates, helped push pension gains higher than many companies had expected. The result is much higher current values for plans with terms like guaranteed annual payouts, which are no longer offered to most rank-and-file workers.

GE Chief Executive Jeff Immelt’s compensation rose 88% last year to $37.3 million. Meanwhile, excluding $18.4 million in pension gains, his pay actually fell slightly to $18.9 million.

The company says about half of the pension increase came from changes in its assumptions about interest rates and life span. About $8.8 million, however, comes from an increase of nearly $490,000 a year in the pension checks he stands to take home as his pay has risen and he approaches 60 years old, the age at which top GE executives can collect full pension benefits.

In all, Mr. Immelt’s pension is valued at about $4.8 million a year for life. The company puts its current value at about $70 million, up from around $52 million a year ago.

A GE spokesman said that much of the gain reflects accounting considerations and that Mr. Immelt’s recent salary increases reflect balanced-pay practices and board approval of his performance.

The SEC is particular about how companies report pay in their proxy statements. There is a standard table that breaks out salary, bonuses and pension gains, along with totals for the past three years, and other details. GE, encouraging investors to overlook the pension gains, added a final column to the table to show what top executives’ total pay would look like without them. The company says investors find the presentation useful in making proxy voting decisions.

Lockheed Martin is also asking investors to look past pension gains when considering its executives’ total pay.

At Lockheed Martin Corp., CEO Marillyn Hewson’s total pay rose 34% to $33.7 million last year, with $15.8 million of that stemming from pension gains. An extra column in the proxy statement’s compensation table strips out those gains, showing her pay up about 13% to $17.9 million.

Lockheed says that $5 million of the pension gains can be traced to changes in interest rates and mortality assumptions. Most or all of the remaining $10.8 million probably stems from increases in the payments she would receive in retirement: about $2.3 million a year now, up from about $1.6 million a year under last year’s proxy disclosure. Ms. Hewson’s pay rose sharply with her ascent to CEO in 2013 and chairman last year, increasing her pension benefit significantly.

Overall, the company’s obligation for future pension benefits for executives and other highly paid employees totaled $1.1 billion last year, up from $1 billion at the end of 2013.

A Lockheed Martin spokesman said the company broke out a nonpension compensation total in the proxy statement to provide more context for pay.

Executive pensions generally don’t consume the attention that pensions for the rank and file do. For years, as costs of traditional pension plans have risen amid low interest rates and longer lifespans, big companies have been closing them to new employees or even freezing benefits in place, often continuing with only a 401(k) plan for all but the oldest workers.

Last June, Lockheed Martin told its nonunion employees that it would stop reflecting salary increases in their pension benefits starting next year, and that the benefits would stop growing with additional years of work starting in 2020.

“It eliminates a lot of the variability that defined-benefit pension plans can create in our cost structure,” Chief Financial Officer Bruce Tanner told investors during a Dec. 3 conference presentation.

In 2011, GE stopped offering new employees traditional defined-benefit pensions and replaced them with 401(k) plans. At the time, Mr. Immelt cited recent market downturns and lower interest rates as being among the reasons for the shift.

In a cruel twist of irony, America’s top CEOs are now enjoying much higher pension payouts while they cut defined-benefit plans to new employees and increase share buybacks to pad their insanely high compensation. I guess longer life spans are fine when it comes to CEOs’ pensions but not when it comes to their employees’ pensions.

Lastly, my comment on the 401(k) experiment generated a lot of comments on Seeking Alpha. Some people rightly noted that looking at 401(k) balances distorts the true savings because it doesn’t take into account roll overs into Roth IRAs. When you factor in IRAs, savings are much higher.

While this is true, there is still no denying that Americans aren’t saving enough for retirement and that 401(k)s are an abject failure as the de facto pension policy of America. It’s high time Congress stops nuking pensions and starts thinking of bolstering and enhancing Social Security for all Americans, as well as implementing shared risk and serious governance reforms at public pensions.