diversification | Pension360

U.S. Pension Funds Return 6.7 Percent; Sixth Straight Year of Gains

U.S. public pension funds saw median returns of 6.76 percent in 2014, according to Wilshire Associates. It marks the sixth consecutive year of positive investment performance for public funds in the U.S.

The country’s corporate pension plans returned 6.92 percent.

More from Bloomberg, via the Salt Lake Tribune:

U.S. public pensions reported median returns of 6.8 percent last year, the sixth year in a row of gains after the financial crisis, according to Wilshire Associates.

The gains, though, are less than the annual investment returns of 7.5 percent to 8 percent that many state and local governments count on to pay benefits for teachers, police and other employees. In the 10 years through Dec. 31, public pensions had a median return of 6.6 percent.

“A lot of the plans can’t be satisfied with a return of less than 7 percent,” said Bob Waid, a managing director at Santa Monica, California-based Wilshire, adding that a portfolio containing 60 percent U.S. stocks and 40 percent U.S. bonds returned 10 percent. “I’m a huge advocate of diversification, but you have to wonder sometimes when you see that the guy who did 60/40 beat you.”

While the Standard & Poor’s 500 Index of U.S. stocks returned 13.7 percent, public pensions were dragged down by international investments. Stagnation in Europe and a strong dollar led to losses of almost 4 percent on foreign stocks, according to Wilshire.

As Pension360 covered this week, the assets of U.S. public plans also rose to all-time highs.

Photo by Andreas Poike via Flickr CC License

Report: Hedge Funds Expect Pensions To Up Their Allocations in 2015

State Street has published a new report, titled The Alpha Game, which analyzes a survey that quizzed 235 hedge fund managers on what the future holds for pensions investing in hedge funds, and other industry trends.

The majority of managers think pension funds will increase their hedge fund holdings over the next few years.

Some key points, from ValueWalk:

The State Street report points out that hedge fund managers are expecting increased capital flows over the next few years. The survey highlighted that nearly two-thirds (65%) of hedge fund managers anticipate ultra-high-net-worth investors will increase their hedge fund holdings, and almost the same number (63%) expect institutional investors will also up their alternative positions. Furthermore, over half (55%) of managers believe pension funds will increase their allocations to alternatives as they look for improved performance and greater diversification

Hedge fund managers also think the main reason for pension funds reducing exposure to Hedge Funds will be disappointment with returns. Nearly half (47%) noted this as their primary concern. The report noter: “This highlights the sharp focus on hedge funds’ ability to deliver value and align with institutional needs.”

Over half of the hedge fund professionals surveyed (53%) think the main reason why pension funds will invest more in hedge funds is to try and boost portfolio performance. Just over one-third (35%) think pension funds are mostly trying to improve portfolio diversification.

The full report can be read here.

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Study: Pension Funds Flock to ETFs for Diversification

A recent survey of European institutional investors, including almost 70 pension funds, attempted to pin down why institutional investors are driven towards ETFs.

The research, conducted by Greenwich Associates, concluded that most investors are drawn toward ETFs because of the diversification they promise.

More on the results from Investments & Pensions Europe:

Pension fund allocations to exchange-traded fund (ETFs) are driven by diversification and tactics over short-term transition management, research shows.

[…]

The study, sponsored by BlackRock, also found 69% of pension fund investors used ETFs for international diversification.

More than half (53%) used the funds for tactical adjustment in portfolios, as well as part of a core allocation.

Only 9% used ETFs for transitional management, with roughly one in 10 using the strategy for interim beta or overlay management.

The report said: “Despite the widespread use of ETFs for tactical applications, few institutions are employing ETFs as true short-term investments.

“Less than 2% of study participants report average holding periods of a month or shorter. In practice, European pension funds seem to be employing ETFs in the most strategic manner.”

The full report can be accessed here.

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Quebec Pension Buys Manhattan Office Tower for $2.2 Billion; Second Most Expensive Office Sale in U.S. History

Canadian pension fund Caisse de dépôt et placement du Québec said on Friday it had completed the second most expensive office sale in U.S. history by buying a Manhattan office tower for $2.2 billion.

The fund partnered with Callahan Capital Properties to buy the building, located at Three Bryant Park.

Public Pensions Experience First Negative Quarter Since Early 2013 As Investments Decline

The median return of public pension investments was –1 percent in the third quarter, according to a Wilshire Trust Universe Comparison Service report.

It was the first negative quarter in over a year for public plans, collectively.

More on third quarter performance, from Reuters:

Public pensions lost a median 1.00 percent in the third quarter, compared with a median drop of 0.84 percent for all plans over the same period. Wilshire’s benchmark investment performance measure is gleaned from nearly 1,600 plans, including corporate plans, foundations and endowments.

The biggest losers: small public pensions with less than $1 billion of assets. Their returns were down a median 1.07 percent for the quarter.

Larger corporate funds with more than $1 billion of assets had the best showing for the second quarter in a row, losing just 0.54 percent this past quarter.

Overall, the various plans suffered their first negative quarter since the second quarter of 2013, Wilshire said.

The funds’ underperformance was a surprise, said Robert Waid, managing director at Wilshire Associates, in a quarter when the Barclays U.S. Aggregate Index rose 0.17 percent.

“This is a quarter where classic diversification did not pay, with U.S. small-cap, international equity, real estate and commodities all underperforming,” Waid said in a statement. “This explains why the median performance for all plan types underperformed the classic 60/40 portfolio.”

In the second quarter, public pensions’ performance had improved greatly, returning a median 3.71 percent and outperforming peers, Wilshire data showed.

The Wilshire Trust Universe Comparison Service (TUCS) is a widely accepted benchmark for institutional investment performance, representing $3.7 trillion in institutional assets from over 1600 plans and endowments.

Public Pensions Outperformed Endowments in Fiscal Year 2014

For the second year in a row, U.S. public pension investment returns outpaced endowment funds.

Endowment funds on the whole returned 15.8 percent, while public pension portfolios returned 16.86 percent.

From Chief Investment Officer:

US university endowments returned an average 15.8% in the fiscal year ending June 30—more than 100 basis point less than the typical public pension fund, two studies have shown.

Public pensions rode their large equities allocations (averaging 61%) to 16.86% gains, Wilshire Associates reported in August. Funds larger than $1 billion did even better, returning 17.44% for the fiscal year.

Endowment portfolios, in contrast, held an average 30% of the best-in-class performing asset, according to preliminary data from the annual NACUBO-Commonfund study. For the 129 institutions evaluated, domestic equities generated 22.6% returns while international stocks gained 19.6%.

“Smaller endowments, which typically have the largest allocations to traditional asset classes, benefited from the strong performance of liquid domestic and international equities beginning in 2009,” said Commonfund Institute Executive Director John Griswold.

“But,” he added, “the greater diversification practiced by the largest endowments and their emphasis on a variety of sources of return, both public and private, tends to result in higher long-term investment performance.”

[…]

A number of the nation’s most high profile, elite universities have, in recent weeks, revealed FY2014 performances far in excess of the average large endowment’s 16.8% gain.

Yale University earned 20.2%, Princeton 19.6%, MIT 19.2%, and Columbia returned 17.5% on its $9.2 billion portfolio.

But the largest, most-watched endowment of all once again failed to enter the winner’s circle. Harvard University disclosed its sub-par 15.4% returns for FY2014 just hours before announcing the replacement for outgoing CEO Jane Mendillo. Managing Director and Head of Public Markets Stephen Blyth is set take over the $36.4 billion fund on January 1, 2015.

To see a breakdown of endowment funds’ returns by asset class, click here.

Surveys: Institutional Investors Disillusioned With Hedge Funds, But Warming To Real Estate And Infrastructure

Two separate surveys released in recent days suggest institutional investors might be growing weary of hedge funds and the associated fees and lack of transparency.

But the survey results also show that the same investors are becoming more enthused with infrastructure and real estate investments.

The dissatisfaction with hedge funds — and their fee structures — is much more pronounced in the U.S. than anywhere else. From the Boston Globe:

Hedge funds and private equity funds took a hit among US institutions and pension managers in a survey by Fidelity Investments released Monday.

The survey found that only 19 percent of American managers of pensions and other large funds believe the benefits of hedge funds and private equity funds are worth the fees they charge. That contrasted with Europe and Asia, where the vast majority — 72 percent and 91 percent, respectively — said the fees were fair.

The US responses appear to reflect growing dissatisfaction with the fees charged by hedge funds, in particular. Both hedge funds and private equity funds typically charge 2 percent upfront and keep 20 percent of the profits they generate for clients.

Derek Young, vice chairman of Pyramis Global Advisors , the institutional arm of Fidelity that conducted the survey, chalked up the US skepticism to a longer period of having worked with alternative investments.

“There’s an experience level in the US that’s significantly beyond the other regions of the world,’’ Young said.

A separate survey came to a similar conclusion. But it also indicated that, for institutional investors looking to invest in hedge funds, priorities are changing: returns are taking a back seat to lower fees, more transparency and the promise of diversification. From Chief Investment Officer:

Institutional investors are growing unsatisfied with hedge fund performance and are increasingly skeptical of the quality of future returns, according to a survey by UBS Fund Services and PricewaterhouseCoopers (PwC).

The survey of investors overseeing a collective $1.9 trillion found that only 39% were satisfied with the performance of their hedge fund managers, and only a quarter of respondents said they expected a “satisfying level of performance” in the next 12-24 months.

[…]

The report claimed this showed a change in expectations of what hedge funds are chosen to achieve. Investors no longer expect double-digit returns, but instead are content to settle for lower fees, better transparency, and low correlations with other asset classes.

Mark Porter, head of UBS Fund Services, said: “With institutional money now accounting for 80% of the hedge fund industry, they will continue seeking greater transparency over how performance is achieved and how risks are managed, leading to increased due diligence requirements for alternative managers.”

Meanwhile, the USB survey also indicated investors are looking to increase their allocations to infrastructure and real estate investments. From Chief Investment Officer:

“Despite the challenges of devising investment structures that can effectively navigate the dynamic arena of alternative markets, asset managers should remain committed to infrastructure and real assets which could drive up total assets under management in these two asset classes,” the report said.

“This new generation of alternative investments is expected to address the increasing asset and liability constraints of institutional investors and satisfy their preeminent objective of a de-correlation to more traditional asset classes.”

The report noted that despite waning enthusiasm for hedge funds, allocations aren’t likely to change for the next few years.

But alternative investments on the whole, according to the report, are expected to double by 2020.

Pension Funds Need To Stay Out of the “Bargain Bin” When Shopping For Hedge Funds

More than ever, pension funds are negotiating fees with hedge funds in an effort to lower the expenses associated with those investments.

That sounds like a wise course of action. But a new column in the Financial Times argues that pension funds need to stop shopping in the “bargain bin” for hedge funds—because the hedge funds that are willing to negotiate fees are also the ones who deliver lackluster returns.

From the Financial Times:

With many pension funds facing deficits, and needing investments that will generate high returns, the promise of hedge funds has an obvious appeal.

The problem is, like the star chef, the small number of hedge funds that have made staggering amounts of money for their investors over several decades already have too many clients and are closed for business.

Among these are Renaissance Technologies’ Medallion Fund, founded by the mathematician James Simons, which has long been all but shut to new money, and Seth Klarman’s Baupost Group, which last year returned $4bn to clients and has a highly select number of investors.

At the same time investors in hedge funds, such as pension managers, are loath to pay high fees for their services, and must enter into tough negotiations to bring these fees down. This makes sense.

But few of the handful of truly top tier hedge funds have any need to lower their fees for new investors and tend to politely show such requests to the door.

Mediocre hedge fund managers on the other hand cannot afford to be so dismissive, and are more than happy to gather more assets to play with.

The outcome is that many pension funds end up forcing themselves to shop in the hedge fund equivalent of the reduced aisle in a supermarket. They should stop. At the root of this problem is the flawed thinking that a large number of investors have been either seduced into, or institutionally obliged to believe in: the idea that hedge funds constitute an “asset class” all of their own, distinct from other types of active fund management.

[…]

Wholesale shopping for hedge funds is a bad idea. Instead of deciding to bulk invest in hedge funds as a questionable means of diversification (the HFR index shows the majority of hedge funds have underperformed the S&P 500 while being correlated to it), investors should only seek out the select few.

And if the best are closed to new investment they must find something else to do with their money.

The author puts the situation in context by comparing hiring a hedge fund to hiring a caterer. From the column:

You are planning a party and have decided to hire a caterer. A trusted friend has recommended two of the best in the city. One is a famous chef who has won numerous awards for his cooking, and another is a younger caterer who previously worked for one of the best restaurants in the world.

You call them both, only to have second thoughts. The first, the famous chef, is simply too busy with existing work to help you.

The other is unbelievably expensive, costing at least double what a regular caterer would charge. But you need your guests to be fed, so you look for an alternative option. You find a cheaper company on the internet and book them.

Come the party the food arrives late. When you taste it, the hors d’oeuvres are stale and the wine tastes like biro ink. Embarrassed and enraged, you mutter under your breath about the money you have wasted, vowing to never hire a caterer ever again.

This flawed thinking resembles the way too many institutional investors select hedge fund managers.

Pension360 has previously covered studies that suggest problems with the way pension funds select managers.

Photo by Gioia De Antoniis via Flickr CC License

Lessons In Infrastructure Investing From Canada’s Pensions

Canada’s pension plans were among the first in the world to invest in infrastructure, and they remain the most prominent investors in the asset class.

Are there any lessons to be learned from Canada when it comes to infrastructure investing? Georg Inderst, Principal of Inderst Advisory, thinks so.

In a recent paper in the Rotman International Journal of Pension Management, Inderst dives deep into Canada’s infrastructure investing and emerges with some lessons to be considered by pension funds around the world.

The paper, titled Pension Fund Investment in Infrastructure: Lessons from Australia and Canada, starts with a short history of Canadian infrastructure investing:

Some Canadian pension plans, notably the Ontario Teachers’ Pension Plan (OTPP) and the Ontario Municipal Employees Retirement System (OMERS), were early investors in infrastructure in the late 1990s and early 2000s, second only to Australian superannuation funds. Other funds followed, and the average allocation has been growing steadily since, reaching C$57B by the end of 2012 (5% of total assets). Here, too, there is a heavy “size effect” across pension funds: bigger pension plans have made substantial inroads into infrastructure assets in recent years (see Table 2), while small and medium-sized pension funds have little or no private infrastructure allocation.

The main driver for infrastructure investing appears to be the wish to diversify pension funds’ assets beyond the traditional asset classes. While Canadian pension funds have been de- risking at the expense of listed equities, regulators have not forced them into bonds, as was the case in some European countries. Real estate and infrastructure assets are also used in liability-driven investing (LDI) to cover long-term liabilities.

Canada frequently makes direct investments in infrastructure, an approach that is now being tested by pension funds around the world. From the paper:

According to Preqin (2011), 51% of Canadian infrastructure investors make direct investments, the highest figure in the world. This approach (known as the “Canadian Model”) has attracted considerable attention around the world, for several reasons:

• lower cost than external infrastructure funds

• agency issues with fund managers

• direct control over assets (including entry and exit decisions)

• long-term investment horizon to optimize value and liability matching

This direct approach to infrastructure investment must be seen in the context of a more general approach to pension plan governance and investment. Notable characteristics of the “Maple Revolutionaries” include

• Governance: Strong governance models, based on independent and professional boards.

• Internal management: Sophisticated internal investment teams built up over years; the top 10 Canadian pension plans outsource only about 20% of their assets (BCG 2013).

• Scale: Sizable funds, particularly important for large-scale infrastructure projects.

Potential challenges for the direct investing approach include insufficient internal resources, reputational and legal issues when things go wrong, and the need to offer staff market-based compensation in high-compensation labor pools.

Despite these challenges, however, the direct internal investment approach of large Canadian pension funds is now being tried in other countries. Other lessons from the Canadian experience include the existence of a well-functioning PPP model, a robust project bond market, and long-term involvement of the insurance sector.

Finally, the paper points to some lessons that can be learned from Canada:

Lessons learned include the following:

• Substantial infrastructure investments are possible in very different pension systems, with different histories and even different motivations.

• Infrastructure investment vehicles can evolve and adjust according to investors’ needs. In Australia, listed infrastructure funds were most popular initially, but that is longer the case.

• Pension plan size matters when investing in less liquid assets. Private infrastructure investing is driven primarily by large- scale funds, while smaller funds mostly invest little to nothing in infrastructure. In Australia, two-thirds of pension funds do not invest in unlisted infrastructure at all.

• Asset owners need adequate resources when investing in new and difficult asset classes. Some Canadian plans admit that their own estimates of time and other inputs were too optimistic at the outset.

• New investor platforms, clubs, syndicates, or alliances are being developed that should also attract smaller pension funds, such as the Pension Infrastructure Platform (PIP) in the United Kingdom or OMERS’ Global Strategic Investment Alliance (GSIA). However, industry experts stress the difficulties of such alliances with larger numbers of players, often with little experience and few resources. Decision time is also a critical factor.

The full paper offers much more insight into Canada’s approach as well as Australia’s. The entire paper can be read here.

Wall Street Securitizes Pension Liabilities to Create “Longevity Derivatives”

No one ever said Wall Street wasn’t creative.

Several firms are selling securities backed by longevity risk—the risk that retirees receiving benefits will live longer than expected and thus incur a higher cost on their retirement plan. More from Institutional Investor:

Sovereign wealth funds, educational endowments and ultrahigh-net-worth individuals are the target investors for longevity derivatives, which package the risk that retirees drawing annuities will outlive actuarial expectations.

The roots of this nascent market date back to 2006, when small monoline insurance companies such as U.K.-based Lucida (purchased by Legal & General in June 2013) and Paternoster (bought by Goldman Sachs Group in 2011) began taking longevity risk off European pension funds through bulk annuity buyouts.

These buyouts entail a company selling pension assets earmarked for all or some of its plan participants. The assets are converted to annuities that the sponsor can keep on its books or off-load to the insurer.

[…]

Banks build longevity derivatives products using risk models provided by firms like Newark, California–based Risk Management Solutions (RMS). They’ve closed a dozen such deals, but the customized structure can be tough for investors to grasp. Deutsche Bank is focused on creating a path into the capital markets, according to Paul Puleo, global head of pension and insurance risk markets in New York.

In December 2013, Deutsche created longevity experience options, or LEOs, a more standardized product tailored to capital markets participants. Longevity derivatives resemble the older catastrophe bond, or insurance-linked security (ILS), market, which packages insurance against natural disasters. A key difference between longevity insurance derivatives and cat bonds is that there are now a number of hedge funds dedicated to the ILS market.

Who buys these securities? It’s been mostly life insurers so far. But firms anticipate other interested parties will soon be buying up these instruments, as well. From Institutional Investor:

Although it’s been difficult for capital markets participants to compete with such natural buyers, long-term investors like sovereign wealth funds may find the portfolio diversification attractive. Ultrahigh-net-worth investors might also be interested, says Peter Nakada, Hoboken, New Jersey–based head of the life risks and capital markets units at RMS. These products can be viewed as a social good because they provide insurance for people who may not have enough cash in retirement, Nakada posits: A wealthy individual makes good money now by purchasing them; in the unlikely event that retirees exhaust their annuities, the monetary outlay can provide financial relief to the needy elderly.

The firms selling these instruments seem to realize the market is “immature” and it will take investors a while to warm up to them. But several industry sources told Institutional Investor they see longevity derivatives as a diversification tool and a good fit for portfolios of endowment funds and even high-worth individual investors.