Tuesday, July 29, 2014

A Revolt Against Hedge Funds?

Dan Fitzpatrick of the Wall Street Journal reports, Calpers Pulls Back From Hedge Funds:
Public pensions from California to Ohio are backing away from hedge funds because of concerns about high fees and lackluster returns.

Those having second thoughts include officials at the largest public pension fund in the U.S., the California Public Employees' Retirement System, or Calpers. Its hedge-fund investment is expected to drop this year by 40%, to $3 billion, amid a review of that part of the portfolio, said a person familiar with the changes. A spokesman declined to comment on the size of the reduction but said the fund is taking more of a "back-to-basics approach" with its holdings.

The retreat comes after many pension funds poured money into hedge funds in recent years in hopes of making up huge shortfalls.

The officials overseeing pensions for Los Angeles's fire and police employees decided last year to get out of hedge funds altogether after an investment of $500 million produced a return of less than 2% over seven years, according to Los Angeles Fire and Police Pensions General Manager Ray Ciranna. The hedge-fund investment was just 4% of the pension's total portfolio and yet $15 million a year in fees went to hedge-fund managers, 17% of all fees paid by the fund.

"We were ready to move on," Mr. Ciranna said.

Before 2004, public pensions favored plain-vanilla investments and avoided hedge funds almost entirely, according to data compiled by consultant Wilshire Trust Universe Comparison Service. Public pensions began wading into hedge funds roughly a decade ago as they sought to boost long-term returns and close the gap between assets and future obligations to retirees.

Hedge funds typically bet on and against stocks, bonds or other securities, often using borrowed money. Hedge funds also charge higher fees, usually 2% of assets under management and 20% of profits.

Many hedge funds dropped less than the overall market during the financial crisis, and some even posted outsize gains by anticipating the collapse. That performance accelerated the flow of pension money into hedge funds.

The move was part of a wider embrace of alternative investments, including private equity and real estate, as pension officials looked to diversify holdings in case more conventional investments faltered. They also hoped bigger investment gains would help them avoid extracting larger contributions from employees or reducing benefits for current or future retirees.

With many hedge funds, that sort of outperformance hasn't materialized in recent years: Average public-pension gains from hedge funds were 3.6% for the three years ended March 31 as compared with a 10.9% return from private-equity investments, a 10.6% return from stocks and 5.7% from fixed-income investments, according to a Wilshire review of public pensions with more than $1 billion in assets.

After peaking at 1.81% in 2011, pension allocations to hedge funds dipped to 1.21% of total portfolios as of March 31, according to Wilshire's review.

The average amount committed to private equity, by comparison, still is climbing. Those investments jumped to a decadelong high of 10.5% as of March 31, according to Wilshire. Stocks and bonds are still the dominant investments for all public pensions.

The reconsideration of hedge funds as an investment option hasn't produced significant shifts inside all funds. Some big public pensions said they are holding firm on commitments or increasing allocations as they worry about how stocks will perform in any future downturn. About half of the U.S. public pensions still have some sort of hedge-fund investment, according to data tracker Preqin.

"We are seeing a little moving away from hedge funds," but so far it's "just on the margin," said Verne Sedlacek, the chief executive of Commonfund, a nonprofit that manages money for pension funds, endowments and other nonprofit groups.

How far Calpers goes with its hedge-fund review may influence decisions at other public pensions because of its size in the industry. The current value of its assets is roughly $301 billion. The examination began in March as officials inside the fund began raising questions about whether hedge funds are too complicated or can effectively balance out poor-performing stocks during a market crash, said a person familiar with the situation.

A Calpers spokesman said the investment staff will make a formal recommendation to the board in the fall. But some cuts already have been made, said the person familiar with the situation. Hedge funds represented 1.5% of Calpers's total assets, or $4.5 billion, as of June 30.

Other states have made reductions as well. The School Employees Retirement System of Ohio decided to lower its hedge-fund allocation to 10% by fiscal 2015 as compared with roughly 15% in fiscal 2013 after investment gains were lower than expected, according to a spokesman. New Jersey's State Investment Council lowered its planned allocation to hedge funds to 12% from 12.25% as part of its fiscal 2014 plan, according to a spokesman.

The debate in San Francisco is indicative of those under way nationwide.

Board members of the San Francisco Employees' Retirement System are considering whether to invest 15% of assets into hedge funds for the first time. A debate about that strategy dominated a June meeting, in which board member Herb Meiberger argued hedge funds have blown up in the past and aren't the only investment alternative. The fund's executive director couldn't be reached for comment Wednesday.

Mr. Meiberger said at the meeting that he had sought out Warren Buffett's advice on the matter. The billionaire investor's handwritten response: "I would not go with hedge funds—would prefer index funds."
A handwritten note from Buffett may cause a hedge fund exodus but the truth is many institutions have been reflecting on their allocation to all alternatives, not just hedge funds.

But this could be the beginning of a revolt against hedge funds and CalPERS' interim CIO, Ted Eliopoulos, didn't bother discussing the hedge fund portfolio when he went over their fiscal year results:
The California Public Employees’ Retirement System’s (CalPERS) interim CIO lauded its performance for the recent fiscal year in public equities (24.8%), private equity (20%), and even fixed income (8.3%). All together, CalPERS’ assets returned 18.4% in 2013-14.

One asset class notably did not get a shout-out from Ted Eliopoulos in his discussion of the results: hedge funds, or—as CalPERS refers to the bucket—absolute return strategies.

The $4 billion allocation made up only a small portion of CalPERS’ $302 billion portfolio, but that slice may get even smaller.

Citing an unnamed source, the Wall Street Journal reported July 23 that the pension fund planned to cut hedge fund allocation by 40%, to $3 billion. Given CalPERS’ July 23 valuation of its hedge fund portfolio, a 40% cut would in fact leave a $2.4 billion bucket.

CalPERS spokesperson Joe DeAnda also disputed that a decision had been reached about its hedge fund program, but confirmed to CIO that changes may be afoot: “The program is under review and has been discussed by the board several times in open session. No decisions have been made about the program at this time. During the review, the ARS portfolio may change in size and structure but conclusion of the review, and formal decisions about the program, likely will not occur until end of Q3 2014 at the earliest.”

In the fiscal year ending June 30, CalPERS’ hedge fund portfolio returned 7.1%, according to preliminary results, which was the weakest of any asset class except cash.

Eliopoulos, who has led the US’ largest public pension fund during its CIO search  remarked that the last year had been “so far, so good.” He noted that CalPERS had posted double-digit returns for four out of the last five years, but cautioned that 2013-14 was “unusual” on two counts.
“One: This sheer magnitude”—25%—“of the public equity performance… That’s a big number. And that’s unusual,” he said.

Secondly, “What you’d expect in a year like that when our equity portfolio is doing so well is that the other asset classes—and in particular, fixed income—would have a less robust or even a negative return,” Eliopoulos explained. CalPERS’ fixed income program in fact beat its hedge fund investments and returned 8%.

“Having all of the major asset classes return positive numbers is somewhat unusual.”
Indeed, having all the major asset classes post positive numbers is very unusual and it actually argues for increasing, not decreasing, their allocation to hedge funds.

But the problem is most hedge funds stink and many high profile hedge funds are nothing more than glorified asset gatherers being managed by overpaid gurus collecting fat fees no matter how well or poorly they perform.

This is one reason why institutions are embracing private equity because unlike hedge funds, PE funds have to recoup expenses and cross a hurdle rate before they can charge a performance fee (they still charge a management fee no matter what). But private equity is more illiquid than hedge funds and its trillion dollar hole is yet another fresh sign of a PE bubble.

In his Bloomberg column, Barry Ritholz writes, Getting Over Hedge Funds:
During the past few months, we have posted a few words here on the quandary that is hedge funds. The first such effort was titled “The Hedge-Fund Manager Dilemma,” and it explored the public’s fascination with the hedge-fund crowd. The second, “Why Investors Love Hedge Funds,” looked at why, despite stunning underperformance during the past decade, so much money was still flowing to the hedge funds.

Now, we are seeing early signs that some institutional investors are losing patience. Case in point: California Public Employees' Retirement System. The Wall Street Journal noted that the pension fund is looking to reduce hedge-fund holdings by as much as 40 percent. “Public pensions from California to Ohio are backing away from hedge funds because of concerns about high fees and lackluster returns.” 
Although this might be a rational response to issues of costs and performance, I would hasten to add that this is only anecdotal evidence. When we look at data such as money flows, it suggests hedge funds are continuing to pull in cash at an astounding pace. The hedge-fund-industrial complex now commands more than $3 trillion in assets. That is up from $2.04 trillion in 2012, and a mere $118 billion in 1997.
Calpers has a reputation for being a thought leader in the institutional-investment world. I have spoken with various pension funds and foundations over the past few years, and while the issue of hedge funds is under discussion, there is no consensus. Based on what various folks in the U.S. and Europe say, there still is great interest in hedge funds. Many investors are more than willing to forsake beta (returns that match the market) in the mad pursuit of alpha (above-market returns).

Still, this looks like it might be the start of something interesting. Given hedge-fund performance relative to the costs, I assumed a shift would have happened years ago. That it hasn’t likely reflects some combination of institutional inertia at big institutional and pension funds and perhaps the impact of consultants.

The Wall Street Journal noted that before 2004, “public pensions favored plain-vanilla investments and avoided hedge funds almost entirely.” The attempt to “boost long-term returns” was driven by the funding gap between assets and future obligations.

This is the crux of the issue: Expected returns. For reasons that remain unexplained, anticipated returns for hedge funds are always far higher than those of bonds and equities. There is no evidence for this erroneous assumption. Unless you are one of the lucky few in a top-performing hedge fund -- that means a small fraction of that $3 trillion in assets -- there is simply no logical or statistical basis for this expectation. It is false, a demonstrably wrong perception, yet one that has become widely accepted.

If anyone has an explanation for how these unfounded expectations came about, or why they persist, please let me know. I am well aware that politicians have embraced these false numbers, as it reduces the amount of contributions they need to make each year to public-pension funds. But it also kicks the can down the road, creating an even bigger hole in future budgets. At this stage, I shouldn't be surprised at irrational policies from innumerate politicians -- but I am.

Regardless, this is a trend that bears watching. The top funds in each category of alternative investment -- venture capital, private equity and hedge funds -- likely have little to fear. The remaining 90 percent of the players in this space should pay close attention. Some changes might be coming.
Go back to read my last comment on Leo de Bever discussing the next frontier of investing. In his excellent presentation, Leo discusses how by definition expected returns have a 50% chance of being wrong and how important it is to be a first-mover in any asset class or investment activity (provided you get the governance right).

There are so many misconceptions on hedge funds and like Ritholz, I blame useless investment consultants who have effectively hijacked the entire investment process in the United States and elsewhere. Also, faced with a looming disaster, many U.S. pension funds are increasingly gambling on alternatives to get them out of their pension hole (instead of fixing their lousy governance).

I know what you're all thinking. There are excellent hedge funds worth investing in and wait till the next crisis, you'll see hedge funds outperform. I'm not convinced and think most hedge funds taking leveraged beta bets in equity and credit markets will get clobbered when the next crisis hits.

As always, please remember to contribute to my blog via Paypal at the top right-hand side. If you have any comments, email me (LKolivakis@gmail.com) or post them at the end of this comment.

Below, David Harding, founder and president of Winton Capital Management, says the market is rigged against his hedge fund. Harding is one of the sharpest managers I ever met, listen to him carefully.

And on “Charlie Rose,” a conversation with Jim Chanos, president and founder of Kynikos Associates. Chanos is one of the best short sellers of all-time (he exposed the fraud at Enron) and is still short China. I don't agree with everything he says but take the time to listen to this conversation (full interview is available here).

Monday, July 28, 2014

De Bever on The Next Frontier of Investing

Rick Baert of Pensions & Investments reports, AIMCO’s de Bever points to ‘next frontier’ of investing:
Leo de Bever, CEO of the C$70 billion (US$65.2 billion) Alberta Investment Management Corp., Edmonton, told participants at a financial analysts conference Thursday that pension funds and other institutional investors need to get out of their comfort zones to take advantage of “the next frontier” of long-term investing — finding return “between the cracks” of asset silos.

Speaking at the CFA Institute conference in Chicago, Mr. de Bever talked about AIMCO’s “big themes” in long-term investments — energy, food, materials and robotic technologies — saying those industries are in a similar position to where infrastructure, timberland and commodities were to pension funds in the 1990s.

“What was new in the 1990s is conventional today,” Mr. de Bever said. “Extraordinary results are not possible using ordinary means.”

He pointed to the C$17.5 billion Alberta Heritage Savings Trust Fund, a sovereign wealth fund from provincial oil and gas revenue managed by AIMCO, that’s investing C$500 million in Alberta-based technology with a 10- to 15-year time horizon.

“There’s no nice, neat recipe” for finding such investments, Mr. de Bever said. “These things often come out of thin air, where people are looking to solve problems before they happen. For example, it’s less expensive to find a solution for potential gas line leaks than it is to clean up a gas leak.”

He pointed to the difficulty in getting pension trustees on board with such investments. “Is it easy to find these? No. Internal resistance is pretty strong. People have a tendency to work in silos.” But, he added, “if a strategy makes your board comfortable, it needs updating.”

AIMCO has 20% to 25% of its assets in what Mr. de Bever called “non-traditional asset classes,” which he said provides 30% of the overall portfolio’s risk. “But if these innovative themes pan out, a small investment now could earn AIMCO more in 10 years than we’ve returned overall in six years.

“Unusual investments can never be the dominant part of your portfolio,” he said. “They have higher risks, but it’s a smart way to make risk because the expected return should be much higher than other investments. If it’s not, you shouldn’t be doing it.”

Mr. de Bever called on pension fund investors to avoid the mainstream economic expectations that point toward trouble ahead. “The idea of a mediocre future is unwarranted,” he said. “If you don’t like that future, imagine a better one and try to make it happen.”

Among more traditional investments, Mr. de Bever said the future risk/return of stocks will be better than bonds over the next 10 years, and he warned against loading up on fixed income. His clients “are coming around to the notion that maybe we’re right on this,” he said. “Here on in (for bonds), I think it’s going to be worse ... There are two ways to go, terrible or really terrible.”

That also won’t bode well for plans looking to employ liability-driven investment strategies, Mr. de Bever added. “Derisking strategies like LDI are OK with high rates. It’s much harder to do now,” he said. “LDI has probably seen better days.”
As Leo prepares to leave AIMCo, he is once again touting unconventional investments and why they have worked well for them. And he is right, there are bubbles forming in credit markets, but I'm far from convinced that higher rates will hurt pensions or that rates will rise anytime soon, especially if global deflation takes hold.

Below, Leo de Bever discusses taking the long view on pensions. Take the time to listen to this presentation, it's excellent.

Sunday, July 27, 2014

Is Israel Losing a War It's Winning?

Jeffrey Goldberg wrote an op-ed in The Atlantic, Why Is Israel Losing a War It's Winning?:
Things change, of course—the only constant in the Middle East is sudden and dramatic change—but as I write it seems as if Israel is losing the war in Gaza, even as it wins the battle against Hamas’s rocket arsenal, and even as it destroys the tunnels meant to convey terrorists underground to Israel (and to carry Israeli hostages back to Gaza).

This is not the first time Israel has found itself losing on the battlefield of perception. Why is it happening again? Here are five possible reasons:

1. In a fight between a state actor and a non-state actor, the non-state actor can win merely by surviving. The party with tanks and planes is expected to win; the non-state group merely has to stay alive in order to declare victory. In a completely decontextualized, emotion-driven environment, Hamas can portray itself as the besieged upstart, even when it is the party that rejects ceasefires, and in particular because it is skilled at preventing journalists from documenting the activities of its armed wing. (I am differentiating here between Hamas's leadership and Gaza's civilians, who are genuinely besieged, from all directions.)

2. Hamas’s strategy is to bait Israel into killing Palestinian civilians, and Israel usually takes the bait. This time, because of the cautious nature of its prime minister, Israel waited longer than usual before succumbing to the temptation of bait-taking, but it took it all the same. (As I’ve written, the seemingly miraculous Iron Dome anti-rocket system could have provided Israel with the space to be more patient than it was.) Hamas’s principal goal is killing Jews, and it is very good at this (for those who have forgotten about Hamas's achievements in this area, here is a reminder, and also here and here), but it knows that it advances its own (perverse) narrative even more when it induces Israel to kill Palestinian civilians. This tactic would not work if the world understood this, and rejected it. But in the main, it doesn’t. Why people don’t see the cynicism at the heart of terrorist groups like Hamas is a bit of a mystery. Here is The Washington Post on the subject:
The depravity of Hamas’s strategy seems lost on much of the outside world, which — following the terrorists’ script — blames Israel for the civilian casualties it inflicts while attempting to destroy the tunnels. While children die in strikes against the military infrastructure that Hamas’s leaders deliberately placed in and among homes, those leaders remain safe in their own tunnels. There they continue to reject cease-fire proposals, instead outlining a long list of unacceptable demands.
2. People talk a lot about the Jewish lobby. But the worldwide Muslim lobby is bigger, comprising, among other components, 54 Muslim-majority states in the United Nations. Many Muslims naturally sympathize with the Palestinian cause. They make their voices heard, and they help shape a global anti-Israel narrative, in particular by focusing relentlessly on Gaza to the exclusion of conflicts in which Muslims are being killed in even greater numbers, but by Muslims (I wrote about this phenomenon here).

3. If you've spent any time these past few weeks on Twitter, or in Paris, you know that anti-Semitism is another source of Israel’s international isolation. One of the notable features of this war, brought to light by the ubiquity and accessibility of social media, is the open, unabashed expression of vitriolic Jew-hatred. Anti-Semitism has been with us for more than 2,000 years; it is an ineradicable and shape-shifting virus. The reaction to the Gaza war—from the Turkish prime minister, who compared Israel's behavior unfavorably to that of Hitler's, to the Lebanese journalist who demanded the nuclear eradication of Israel, to, of course, the anti-Jewish riots in France—is a reminder that much of the world is not opposed to Israel because of its settlement policy, but because it is a Jewish country.

4. Israel’s political leadership has done little in recent years to make their cause seem appealing. It is impossible to convince a Judeophobe that Israel can do anything good or useful, short of collective suicide. But there are millions of people of good will across the world who look at the decision-making of Israel’s government and ask themselves if this is a country doing all it can do to bring about peace and tranquility in its region. Hamas is a theocratic fascist cult committed to the obliteration of Israel. But it doesn’t represent all Palestinians. Polls suggest that it may very well not represent all of the Palestinians in Gaza. There is a spectrum of Palestinian opinion, just as there is a spectrum of Jewish opinion.

I don’t know if the majority of Palestinians would ultimately agree to a two-state solution. But I do know that Israel, while combating the extremists, could do a great deal more to buttress the moderates. This would mean, in practical terms, working as hard as possible to build wealth and hope on the West Bank. A moderate-minded Palestinian who watches Israel expand its settlements on lands that most of the world believes should fall within the borders of a future Palestinian state might legitimately come to doubt Israel’s intentions. Reversing the settlement project, and moving the West Bank toward eventual independence, would not only give Palestinians hope, but it would convince Israel’s sometimes-ambivalent friends that it truly seeks peace, and that it treats extremists differently than it treats moderates. And yes, I know that in the chaos of the Middle East, which is currently a vast swamp of extremism, the thought of a West Bank susceptible to the predations of Islamist extremists is a frightening one. But independence—in particular security independence—can be negotiated in stages. The Palestinians must go free, because there is no other way. A few months ago, President Obama told me how he views Israel's future absent some sort of arrangement with moderate Palestinians:
[M]y assessment, which is shared by a number of Israeli observers ... is there comes a point where you can’t manage this anymore, and then you start having to make very difficult choices. Do you resign yourself to what amounts to a permanent occupation of the West Bank? Is that the character of Israel as a state for a long period of time? Do you perpetuate, over the course of a decade or two decades, more and more restrictive policies in terms of Palestinian movement? Do you place restrictions on Arab-Israelis in ways that run counter to Israel’s traditions?
Obama raised a series of prescient questions. Of course, the Israeli government's primary job at the moment is to keep its citizens from being killed or kidnapped by Hamas. But it should work to find an enduring solution to the problem posed by Muslim extremism. Part of that fix is military, but another part isn't.

5. Speaking of the Obama administration, the cause of a two-state solution would be helped, and Israel's standing would be raised, if the secretary of state, John Kerry, realized that such a solution will be impossible to achieve so long as an aggressive and armed Hamas remains in place in Gaza. Kerry's recent efforts to negotiate a ceasefire have come to nothing in part because his proposals treat Hamas as a legitimate organization with legitimate security needs, as opposed to a group listed by Kerry's State Department as a terror organization devoted to the physical elimination of one of America's closest allies. Here is David Horovitz's understanding of Kerry's proposals:
It seemed inconceivable that the secretary’s initiative would specify the need to address Hamas’s demands for a lifting of the siege of Gaza, as though Hamas were a legitimate injured party acting in the interests of the people of Gaza — rather than the terror group that violently seized control of the Strip in 2007, diverted Gaza’s resources to its war effort against Israel, and could be relied upon to exploit any lifting of the “siege” in order to import yet more devastating weaponry with which to kill Israelis.
I'm not sure why Kerry's proposals for a ceasefire seem to indulge the organization that initiated this current war. Perhaps because Kerry may be listening more to Qatar, which is Hamas's primary funder, than he is listening to the Jordanians, Emiratis, Saudis, and Egyptians, all of whom oppose Hamas to an equivalent or greater degree than does their ostensible Israeli adversary. In any case, more on this later, as more details emerge about Kerry's efforts. For purposes of this discussion, I'll just say that Israel won't have a chance of winning the current struggle against Hamas's tunnel-diggers and rocket squads if its principal ally doesn't appear to fully and publicly understand Hamas's nihilistic war aims, even as it works to shape more constructive Israeli policies in other, related areas.
Jonathan Freedland of the Guardian also opines, Israel’s fears are real, but this Gaza war is utterly self-defeating:
An old foreign correspondent friend of mine, once based in Jerusalem, has turned to blogging. As the story he used to cover flared up once more, he wrote: “This conflict is the political equivalent of LSD – distorting the senses of all those who come into contact with it, and sending them crazy.” He was speaking chiefly of those who debate the issue from afar: the passions that are stirred, the bitterness and loathing that spew forth, especially online, of a kind rarely glimpsed when faraway wars are discussed. While an acid trip usually comes in lurid colours, here it induces a tendency to monochrome: one side is pure good, the other pure evil – with not a shade of grey in sight.

But the LSD effect also seems to afflict the participants in the conflict. They too can act crazy, taking steps that harm not only their enemy but themselves. Again and again, their actions are self-defeating.

Start with Israel – and not with the politicians and generals, but ordinary Israelis. Right now they are filled with the burning sense that the world does not understand them, and even hates them. They know Israel is being projected on the world’s TV screens and front pages as a callous, brutal monster, pounding the Gaza strip with artillery fire that hits schools, hospitals and civilian homes. They know what it looks like – but they desperately want the world to see what they see.

In their eyes, they are only doing what any country – or person, for that matter – would do in the same position. They ask what exactly would Britain do if enemy rockets were landing on our towns and villages. Would we shrug our shoulders, keep calm and carry on – or would we hit back?

But it’s not the rockets that frighten them most. Israelis focus more on the hidden tunnels dug under the Gaza border, apparently designed to allow Hamas militants to emerge above ground and mount raids on Israeli border villages and kibbutzim, killing or snatching as many civilians as they can. Israel’s Iron Dome technology can zap incoming rockets from the sky, but what protection is there against a man emerging from a tunnel in the dark determined to kill you? The fact that tranquillisers and handcuffs were reportedly found in those tunnels, ready to subdue Israeli captives, only leaves Israelis more terrified.

This is why they wanted their government to hit back hard: remember, it was the discovery of the tunnels that prompted the ground offensive. Some Israelis see the terrible images of Palestinian suffering – children losing their limbs, their lives or their parents – and they want the world to see it as they do: that Hamas shares in the blame for those cruel deaths, because it does so little to protect its civilians.

You might discount the argument that Hamas fights its war from civilian areas (replying that it’s hardly going to locate itself in open ground, wearing a target on its back). But the UN itself has condemned Hamas for stashing rockets in a UN school. And in the quiet years, when Hamas finally got hold of long-demanded concrete, it used it not to build bomb shelters for ordinary Gazans, but those tunnels to attack Israel, and bunkers for the organisation’s top brass.

I know that every one of those points can be challenged. The point is not that they represent unarguable truth but that they come close to how many – not all – Israelis feel. They believe they face in Hamas an enemy that is both explicitly committed – by charter – to Israel’s eradication, and cavalier about the safety of the Palestinian people it rules. They fear Hamas, its tunnels and its rockets, and they want security.

But here is where the madness kicks in. Israelis want security, yet their government’s actions will give it no security. On the contrary, they are utterly self-defeating.

That’s true on the baldest possible measure. More Israelis have died in the operation to tackle the Hamas threat than have died from the Hamas threat, at least over the past five years. Put another way, to address the risk that hypothetical Israeli soldiers might be kidnapped, 33 actual Israeli soldiers have died. Never before have international airlines suspended flights into Israel’s national airport. But they did this week, a move that struck a neuralgic spot in the Israeli psyche: if disaster struck, there’d be no escape. (That’s long been true of Gaza, of course.)

Before the current round of violence, the West Bank had been relatively quiet for years. Friday saw a “day of rage,” with several Palestinians killed and talk of a third intifada. An operation designed to make Israel more secure has made it much less.

If that is true now – with the prospect of an uprising encompassing not just the West Bank but some of the 1.7 million Palestinian citizens of Israel as well – it’s truer still in the future. For every one of those Gazan children – their lives broken by pain and bloodshed three times in the past six years – will surely grow up with a heart hardened against Israel, some of them bent on revenge. In trying to crush today’s enemy, Israel has reared the enemy of tomorrow.

Security requires more than walls and tanks. It requires alliances and support. Yet every day Israel is seen to be battering Gaza, its reservoir of world sympathy drops a little lower. And that is to reckon without the impact of this violence on Israel’s own moral fibre. After 47 years of occupation and even more years of conflict, the constant demonisation of the enemy is having a corrosive effect: witness the “Sderot cinema”, the Israelis gathering in lawn chairs on a border hilltop to munch popcorn and watch missiles rain down on Gaza. No nation can regard itself as secure when its ethical moorings come loose.

The only real security is political, not military. It comes through negotiation, not artillery fire. In the years of quiet this should have been the Israeli goal. Instead, every opening was obstructed, every opportunity spurned.

And the tendency to self-harm is not confined to Israel. Hamas may have reasserted itself by this conflict, renewing its image as the champion of Palestinian resistance. But it’s come at a terrible price. After an escalation that was as much Hamas’s choice as Israel’s, 800 Palestinians are now dead, 5,400 are injured and tens of thousands have been displaced. For those Palestinians yearning for a state that will include the West Bank, that goal has been rendered even more remote: what, Israelis ask, if the West Bank becomes another Gaza, within even closer firing range of Ben Gurion airport?

This is the perverse landscape in which both Israelis and Palestinians find themselves. They are led by men who hear their fear and fury – and whose every action digs both peoples deeper into despair.
Finally, Gabor Maté, a Vancouver-based doctor, author, speaker and Holocaust survivor, wrote a courageous opinion piece for the Toronto Star, Beautiful dream of Israel has become a nightmare:
As a Jewish youngster growing up in Budapest, an infant survivor of the Nazi genocide, I was for years haunted by a question resounding in my brain with such force that sometimes my head would spin: “How was it possible? How could the world have let such horrors happen?”

It was a naïve question, that of a child. I know better now: such is reality. Whether in Vietnam or Rwanda or Syria, humanity stands by either complicitly or unconsciously or helplessly, as it always does. In Gaza today we find ways of justifying the bombing of hospitals, the annihilation of families at dinner, the killing of pre-adolescents playing soccer on a beach.

In Israel-Palestine the powerful party has succeeded in painting itself as the victim, while the ones being killed and maimed become the perpetrators. “They don’t care about life,” Israeli Prime Minister Benjamin Netanyahu says, abetted by the Obamas and Harpers of this world, “we do.” Netanyahu, you who with surgical precision slaughter innocents, the young and the old, you who have cruelly blockaded Gaza for years, starving it of necessities, you who deprive Palestinians of more and more of their land, their water, their crops, their trees — you care about life?

There is no understanding Gaza out of context — Hamas rockets or unjustifiable terrorist attacks on civilians — and that context is the longest ongoing ethnic cleansing operation in the recent and present centuries, the ongoing attempt to destroy Palestinian nationhood.

The Palestinians use tunnels? So did my heroes, the poorly armed fighters of the Warsaw Ghetto. Unlike Israel, Palestinians lack Apache helicopters, guided drones, jet fighters with bombs, laser-guided artillery. Out of impotent defiance, they fire inept rockets, causing terror for innocent Israelis but rarely physical harm. With such a gross imbalance of power, there is no equivalence of culpability.

Israel wants peace? Perhaps, but as the veteran Israeli journalist Gideon Levy has pointed out, it does not want a just peace. Occupation and creeping annexation, an inhumane blockade, the destruction of olive groves, the arbitrary imprisonment of thousands, torture, daily humiliation of civilians, house demolitions: these are not policies compatible with any desire for a just peace. In Tel Aviv Gideon Levy now moves around with a bodyguard, the price of speaking the truth.

I have visited Gaza and the West Bank. I saw multi-generational Palestinian families weeping in hospitals around the bedsides of their wounded, at the graves of their dead. These are not people who do not care about life. They are like us — Canadians, Jews, like anyone: they celebrate life, family, work, education, food, peace, joy. And they are capable of hatred, they can harbour vengeance in the hearts, just like we can.

One could debate details, historical and current, back and forth. Since my days as a young Zionist and, later, as a member of Jews for a Just Peace, I have often done so. I used to believe that if people knew the facts, they would open to the truth. That, too, was naïve. This issue is far too charged with emotion. As the spiritual teacher Eckhart Tolle has pointed out, the accumulated mutual pain in the Middle East is so acute, “a significant part of the population finds itself forced to act it out in an endless cycle of perpetration and retribution.”

“People’s leaders have been misleaders, so they that are led have been confused,” in the words of the prophet Jeremiah. The voices of justice and sanity are not heeded. Netanyahu has his reasons. Harper and Obama have theirs.

And what shall we do, we ordinary people? I pray we can listen to our hearts. My heart tells me that “never again” is not a tribal slogan, that the murder of my grandparents in Auschwitz does not justify the ongoing dispossession of Palestinians, that justice, truth, peace are not tribal prerogatives. That Israel’s “right to defend itself,” unarguable in principle, does not validate mass killing.

A few days ago I met with one of my dearest friends, a comrade from Zionist days and now professor emeritus at an Israeli university. We spoke of everything but the daily savagery depicted on our TV screens. We both feared the rancour that would arise.

But, I want to say to my friend, can we not be sad together at what that beautiful old dream of Jewish redemption has come to? Can we not grieve the death of innocents? I am sad these days. Can we not at least mourn together?
That op-ed article elicited many comments from people taking sides on the Mideast crisis. It struck a chord with me personally because he's right, the world can't just sit back and watch children, women and elderly being slaughtered in Gaza and pretend they're just innocent casualties of an endless conflict. We should all mourn this tragedy.

But the reality is Hamas is using humans as shields to keep rocketing Israel, knowing full well they will win the propaganda war as gruesome images of dismembered dead children are portrayed in the global and social media. Hamas couldn't care less about the children and women being killed, they are fully committed to the destruction of Israel, and will stop at nothing to achieve this.

Nonetheless, another reality is that Israel is a military superpower which can literally crush anyone in the region. The problem with the Israeli Defense Forces (IDF) leveling Gaza is that it looks like a massive disproportionate response to the murder of three Israeli teenagers, which were not killed by Hamas according to the latest analysis.

And there is no reason to believe that all this bloodshed will secure Israel. In fact, previous military campaigns in Gaza only emboldened the radicals and made them stronger. This is my worst fear. We've seen this play out over and over and the strategies of hard liners on both sides have failed miserably to secure long-lasting peace in the region (see Haaretz article, It isn't easy being an Israeli leftist during wartime).

As far as the Americans, they too have "blood on their hands." At one point, they have got to lead and bring long-lasting peace to the region. Below, CNN's Paula Hancoks reports on the ongoing Israel and Hamas conflict, evaluating whether the two can peacefully co-exist. I have my doubts and fear that things are only getting worse, not better.

Friday, July 25, 2014

Detroit's Latest Pension Disgrace?

David Sirota of Salon reports, Detroit’s latest pension disgrace: A gaudy new arena at retirees’ expense (h/t, Suzanne Bishopric):
As states and cities grapple with budget shortfalls, many are betting big on an unproven formula: Slash public employee pension benefits and public services while diverting the savings into lucrative subsidies for professional sports teams.

Detroit this week became the most prominent example of this trend. Officials in the financially devastated city announced that their plan to slash public workers’ pension benefits will move forward. On the same day, the billionaire owners of the Detroit Red Wings, the Ilitch family, unveiled details of an already approved taxpayer-financed stadium for the professional hockey team.

Many Detroit retirees now face big cuts to their previously negotiated retirement benefits. At the same time, the public is on the hook for $283 million toward the new stadium.

The budget maneuvers in Michigan are part of a larger trend across the country. As Pacific Standard reports, “Over the past 20 years, 101 new sports facilities have opened in the United States — a 90 percent replacement rate — and almost all of them have received direct public funding.” Now, many of those subsidies are being effectively financed by the savings accrued from pension benefit reductions and cuts to public services.

In Chicago, for instance, Mayor Rahm Emanuel recently passed a $55 million cut to municipal workers’ pensions. At the same time, he has promoted a plan to spend $55 million of taxpayer money on a hotel project that is part of a stadium development plan.

In Miami, Bloomberg News reports that the city “approved a $19 million subsidy for (a) professional basketball arena” and then, six weeks later, “began considering a plan to cut as many as 700 (librarian) positions, including a fifth of the library staff and more than 300 police.”

In Arizona, the Phoenix Business Journal reports that regional governments in that state have spent $1.5 billion “on sports stadiums, arenas and pro teams” since the mid-1990s. Meanwhile, legislators are considering proposals to cut public pension benefits.

In New Jersey, Gov. Chris Christie is blocking a planned $2.4 billion payment to the pension system, at the same time his administration has spent a record $4 billion on subsidies and tax breaks to corporations. That includes an $82 million subsidy for a practice facility for the Philadelphia 76ers.

The officials promoting these twin policies argue that boosting stadium development effectively promotes economic growth. But many calculations rely on questionable assumptions.

In a 2008 data review by University of Maryland and University of Alberta, researchers found that “sports subsidies cannot be justified on the grounds of local economic development.” In addition, a 2012 Bloomberg News analysis found that taxpayers have lost $4 billion on such subsidies since the mid-1980s.

“Sports stadiums typically aren’t a good tool for economic development,” said Holy Cross economist Victor Matheson in an interview with The Atlantic. “Take whatever number the sports promoter says, take it and move the decimal one place to the left. Divide it by ten, and that’s a pretty good estimate of the actual economic impact.”

Of course, while stadium subsidies are promoted in the name of economic development, pension benefits are rarely described in such terms – even though the data suggests they should be. Indeed, an analysis by the Washington, D.C.-based National Institute on Retirement Security notes that spending resulting from pension payments had “a total economic impact of more than $941.2 billion” and “supported more than 6.1 million American jobs” in 2012.

Despite that, retirement benefits are often the first item on politicians’ chopping blocks. Pensions, after all, may support local economies, but they don’t result in shiny new stadiums.

In a sports-obsessed country, that makes those pensions a much bigger political target than any taxpayer handout to a billionaire team owner.
Leave it up to America to get its priorities right. After all, sports stadiums are so much sexier than pensions! But Sirota is right, when it comes to economic activity, the benefits of defined-benefit plans are greatly under-appreciated or completely ignored.

It doesn't take a genius to figure out why defined-benefit plans boost economic activity. As the demographic shift continues, more and more people are retiring with little or no savings. But those retiring with a known pension payout are able to plan better, spend more and contribute to economic activity and state sales taxes.

Unfortunately, Detroit's pension nightmare is only getting worse. Earlier this week, the city's pension holders endorsed a debt-cutting bankruptcy plan:
Detroit's bankruptcy plan approached a new stage Monday after city pension holders endorsed a debt-cutting plan that would dent, but not decimate, their future benefits.

General retirees, who comprise the bulk of those affected, would get a 4.5% pension cut and lose cost-of-living increases. Retired police officers and firefighters would surrender part of their annual cost-of-living increases.

Contingent on the vote was an agreement by the state and private funders to make $816 million available to shore up pensions. That amount represents the present value of the city's world-class collection of the Detroit Institute of Arts, which the city said would be placed in a separate trust.

The official count, filed late Monday night, showed 82% of those eligible for a police or fire pension who voted supported the plan. Roughly 73% of other retirees and employees with pension benefits who voted favored the plan. Voting lasted through early July.

The voting margins from pension holders were seen as an endorsement for the city's plan to confront an estimated $18 billion in long-term obligations.

"The voting shows strong support for the City's plan to adjust its debts and for the investment necessary to provide essential services and put Detroit on secure financial footing," Detroit Emergency Manager Kevyn Orr said

Despite the critical nature of the vote, a sizable chunk of those eligible sat out. About 59% of police and firefighter pension holders and 42% of other pension holders cast ballots, according to the city's legal filing.

Some 32,000 current and retired city employees faced a stark choice: Vote for the plan to cut most pensions and eliminate a future cost-of-living increase, or reject the plan and risk more severe cuts.

"It is not what my heart wanted to do and it still isn't. But I have to support what's best for our retirees," Shirley Lightsey, president of Detroit Retired City Employees Association, said in an interview Monday before the vote filing in bankruptcy court.

The vote, after weeks of tense campaigning, also sets up a confirmation trial scheduled for next month on the city's restructuring plan, the final phase of the bankruptcy case.

Federal bankruptcy Judge Steven Rhodes will have the final say, and will hold a trial on whether the city's reorganization plan, which also includes about $1.5 billion in reinvestment in services and blight removal, is viable.

On Monday, a court-appointed, independent financial expert came to that conclusion in a report. It found the city would likely be able to provide basic municipal services, meet revised obligations to creditors and avoid future default under the plan's terms and using its assumptions.

But Detroit's efforts to fix its ailing municipal services have also met resistance. A crackdown on delinquent water customers since March bubbled over with a public protest last week following concerns voiced by Judge Rhodes. On Monday, the city announced it would stop shutoffs for 15 days while it tries to promote its payment options and financial assistance available for customers.

Opposition has been building in Detroit for months after officials at the city's Water and Sewerage Department in March said they would shut off water service to delinquent customers.

Mr. Orr has said the water-shutoff approach—which affected more than 15,000 people, at least temporarily—wasn't misguided. Rather it was a sign of the city's effort to provide basic city services in a fiscally responsible fashion.
I've said it before and I'll say it again, Detroit is a shit hole. Only third-world countries cut off water to their residents and even they do a better job than Detroit in managing their public services. The public outrage spawned the Detroit Water Project, a platform to help donors pay the delinquent water bills of people in Detroit.

Pay close attention to what's going on in Detroit because it's coming to a city near you. And while Americans for Tax Reform founder Grover Norquist goes on CNBC to blast Obama and Democrats on tax reform, he conveniently fails to mention how America's plutocrats, which now include overpaid hedge fund managers, are skirting their fair share of taxes using questionable practices.

But hey, as long as America has nice sports stadiums, who cares about public pensions? Oh well, at least King James is going back home to Cleveland to give that proud city a fighting chance at an NBA championship. Go Cavs go! :)

Thursday, July 24, 2014

Will Higher or Lower Rates Hurt Pensions?

Randall W. Forsyth of Barron's reports, Pension Funds Should Take Care What They Wish for:
U.S. corporate pension funds are in the best shape they've been in since before the 2008 financial crisis as their shortfalls were cut nearly in half in 2013. Credit surely goes to the rising stock market, but last year's improvement in the funds' positions also owed much to the rise in bond yields.

Indeed, fully closing the gap between pension funds' assets and their future liabilities may depend more on higher interest rates than continued gains in the stock market.

Corporate pension plans among the Standard & Poor's 500 companies were last fully funded in 2007, before the financial near-meltdown of the following year. From 2009 to 2012, the plans' underfunding ranged between 16% and 23% -- with the worst shortfall in 2012, when S&P 500 index already had made a huge recovery from its recession lows.

These data cover the traditional, defined-benefit plans that were the norm for Corporate America a generation ago. As S&P Credit Week observes, U.S. companies have dealt with the burden of pension costs by shifting it to employees with defined-contribution plans such as 401(k) plans. The result: 46% of workers had saved $10,000 or less for retirement while an additional 20% had socked away between $10,000 and $49,900, according to a 2013 study by the Employee Benefit Research Institute. Only half of all workers receive any retirement benefits from their employers.

For those lucky enough to look forward to a monthly check in retirement, their employers have to set aside and invest funds to meet those obligations. Among the S&P 500 companies, 51 were fully funded at the end of 2013, up from just 18 in 2012.

The list of the most under-funded defined-benefit plans were dominated by old-line manufacturing companies, notes Tobias Levkovich, Citi Research's chief investment strategist. Leading that less-august list were General Motors (ticker: GM ), ExxonMobil ( XOM ), Boeing ( BA ), Ford Motor (F), DuPont ( DD ), Pfizer ( PFE ) and Caterpillar ( CAT. ) And that was after the 30% surge in the S&P 500 last year.

There was another, less obvious boost to corporate pension plans in 2013: higher bond yields. Given that the jump in yields, which took the benchmark 10-year Treasury to 3% from a low of about 1.65%, resulted in bond price declines and negative returns from investment-grade debt last year, that might seem counterintuitive.

But the higher yields lowered the present value of future pension fund liabilities. (A higher discount rate for a stream of future payments lowers that stream's discounted present value. At a higher interest rate, it's possible to set aside a smaller sum to meet a future savings goal, and vice versa.) The discount rate on pension funds' liabilities, which is based on the yield from investment-grade corporate bonds, rose in 2013 to 4.69% from 3.93% in 2012.

The impact on interest rates is apparent from the experience of the two preceding years. According to S&P, despite 2012's 13.4% equity return, pension underfunding among the S&P 500 companies actually increased over 27%, to an aggregate $451.7 billion from $354.7 billion, owing to the decline in interest rate and the resulting increase in the present value of future liabilities. And while the 29.6% gain in the S&P 500 index in 2013 helped reduce underfunding by over 50%, to $224.5 billion, the increase in the discount rate on future liabilities "assisted considerably," S&P observed.

While 2014 is only a bit more than half over, the trends are less positive than last year's. The S&P 500 is up 7.5%, setting another record Wednesday. But contrary to expectations of virtually every forecaster, bond yields have fallen markedly this year, to 2.47% on the Treasury 10-year note as of Wednesday, a hair above the 2014 low of 2.44%.

The gain in the S&P 500 and the fall in bond yields suggest a rerun of 2012's experience, when pension fund underfunding increased despite positive equity and debt market returns.

To be sure, writes Citi's Levkovich, "the stock market is crucial to the asset side of pension story." But given the likelihood of "modest single-digit gains through mid-2015, it will not close the gap entirely."

"The most significant impact on pensions will come when interest rates move higher, thus reducing the present value of future pension obligations, which will accelerate the time line of fully funded status," he concludes.

S&P agrees, but it also avers while higher interest rates would drastically improve the funding of corporate pensions, they would also be potentially damaging to parts of the economy.

Indeed, it is difficult to reconcile pension plans' hope for higher stocks and higher bond yields. Low interest rates without a doubt have increased price-earnings multiples as low yields have lured investors into equities. Low interest rates also have provided an important lift to corporate profits as well by sharply reducing interest costs, while stock buybacks have boosted earnings per share for public corporations. The bottom lines of financial companies such as banks also have benefitted from the reduction in loan-loss reserves, which have flowed directly to the bottom line of the S&P 500.

Thus, Corporate America -- or at least the portion that still offer pension plans -- would like higher interest rates to reduce their future liabilities to retirees. But the impact on the economy and the stock market likely would be negative.

Another reason to heed the admonition to be careful what you wish for.
Take the time to read my recent comment on when interest rates rise where I wrote:
A rise in interest rates will benefit pension plans (discount rate rises, lowering the net present value of liabilities) and savers but it will crush many debt-laden consumers and businesses struggling to stay afloat and will lead to a full-blown emerging markets crisis, which is very deflationary.
So should pensions be careful for what they wish for? It all depends on how dramatic the rise in interest rates will be. If interest rates spike up, it will hurt pensions on the asset front real hard but it will significantly lower the liabilities those pensions pay out.

Here we have to introduce the concept of duration. It's important to understand the duration of liabilities are a lot longer than the duration of assets. This means that when interests rates are low, a fall in rates will disproportionately impact liabilities a lot more than it impacts assets. In other words, in a low rate environment, when rates fall, liabilities go up more dramatically than the rise in the value of assets.

This is why many corporations are scrapping defined-benefit plans and replacing them with 401 (k) (RRSP) type plans which effectively places the onus entirely on individuals to make wise investment decisions to retire in dignity. If a bear market strikes them, too bad, they're left fending for themselves.

The problem nowadays is rates keep falling. My former colleague, Brian Romanchuk notes the bond bear market of 2014 has been delayed:
Strategists went into 2014 with a consensus bearish view on bonds (as was also the case in 2010-2013...). The market action so far has not been kind to that view, with yields plunging in the developed markets. It may be that I have fallen into a too mellow summertime mood, but my guess is that this is largely a squeeze of the bond bears during quiet markets (although there are obvious geopolitical concerns).

The JGB market has not been cooperating with those who have been calling for collapse and hyperinflation; rather yields have marched from stupidly expensive to insanely expensive levels. At a 0.54% yield, the 10-year JGB is at a very interesting position. As I have pointed out before (when yield levels were slightly higher...), the payoff on an outright short position which can be held for a considerable period looks attractively asymmetric (click on image above).

It's A Forward Story

What is interesting about the rally in the U.S. Treasury market is that it a story about the forwards. My crude proxy of the 5-year rate, 5-years forward has been marching steadily lower since peaking around New Year's. Meanwhile, the spot 5-year rate has been tracking sideways (click on image above). Therefore, the rally has not been about revising the timing of rate hikes, rather it is a downward revision of "steady state" interest rates. This could be explained by a number of factors:
  • Quantitative Easing (why now?);
  • belief in Fed jawboning future rates;
  • forward rate expectations slowly adapting to lower realised rates;
  • demand for duration by liability-matching investors.
Although I believe that long-term rate expectations needed to be revised lower from the 5% average that held before 2012 as a result of the demand for duration, 3¼% may be too far. In any event, there is unlikely to be clarity until market liquidity comes back in September.
What else explains this move in the yield curve? In a recent comment, I discuss how Japan's private pensions are eying more risk, snapping up corporate bonds, REITs, leveraged loans and U.S. bonds. And they're not the only ones. Other countries facing low yields are also looking at U.S. bonds because of the spread (see Hoisington's second quarter economic letter).

By far, the largest purchaser of U.S. Treasuries after the Fed is China (click on image below):
Investors wrestling with the mysterious U.S. bond rally of 2014 got a clue about where to look: China.
The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago, data released Wednesday show. The purchases help explain Treasurys' unexpectedly strong rally this year. The yield on the 10-year U.S. Treasury note has fallen to 2.54%, from 3% at the end of 2013. Yields fall as prices rise.

The world's most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014, according to the U.S. government data. The buying has been fueled by China's efforts to lift its export-driven economy by weakening its currency, the yuan, against the dollar, market analysts said, a strategy that encompasses hefty purchases of U.S. assets.

China officially holds roughly $1.27 trillion of U.S. debt, about 10.6% of the $12 trillion U.S. Treasury market.

The country's purchases have salutary effects on both sides of the Pacific. In addition to the weaker yuan in China, they hold down U.S. interest rates, making houses more affordable and generally easing financial conditions in the U.S. economy.

On the other hand, lower yields mean lower income for bond investors. They have spurred investors to chase assets globally for returns, fueling asset-price increases and investor fears that some market valuations are stretched.

Also, investors fear any reduction in Chinese purchases, along with other macroeconomic events, could destabilize the U.S. bond market and send rates higher, slowing the housing industry, widely viewed as a key driver of economic growth. Some analysts contend that low rates also can allow capital to be misallocated, fueling the risk of future economic disruption.

In a bid to boost returns, China has sought to diversify its foreign-exchange holdings away from U.S. government bonds in recent years. But it finds itself having to keep purchasing the U.S. debt due to a lack of investment choices elsewhere. "There is no other market that is as liquid and deep as the U.S. Treasury market," an official at China's central bank said in a recent interview.

China's aggressive purchases of dollar assets also present the authorities with problems at home. That is because the purchases cause the money supply to expand and can fuel inflation within China unless the central bank soaks up the excess liquidity injected into the system.

The bond rally has left many traders on Wall Street scratching their heads. Most investors had forecast that interest rates would rise this year as the U.S. economy picked up steam and the Federal Reserve slowly pared its stimulus measures, in a shift that was widely expected to push rates higher.

But yields remain far below 2013 highs even as U.S. job creation has gained pace in recent months. The disclosure of China's holdings underscores the frayed nerves in the bond market as the Fed prepares to raise interest rates as early as next year, for the first time since the financial crisis. Many investors fear that reduced Fed support and unpredictable buying by foreign governments could spell bond-market tumult.

"The big picture is that China buying may be helping to keep bond yields lower than they should be ahead of the Fed moving closer to raising rates," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ. "The market could wake up and get quite a shock…if China changes course." The risk for the U.S. economy, said Mr. Rupkey, is that any slowdown in Chinese purchases could push U.S. bond and mortgage rates higher, which would put "the fragile housing recovery in jeopardy."

At the same time, many investors over the past decade have warned of the risks of reduced purchases from China precipitating a U.S. interest-rate spike—predictions that haven't been borne out.

The rise in China's Treasury holdings disclosed Wednesday marks the biggest first-five-month increase since record keeping began in 1977 and surpasses the $81 billion of Treasury debt bought by China for all of 2013, according to Ian Lyngen, senior government-bond strategist at CRT Capital Group LLC.

China has increased its U.S. Treasury holdings every year since the 2008 financial crisis except for 2011. China continued to log a trade surplus with the U.S., thanks to its aggressive efforts to boost exports over the past decade. That has led to a huge accumulation of foreign-exchange reserves, and the Treasury market is the most liquid bond market for China to invest reserves, analysts said.

China held $1.2633 trillion in notes and bonds at the end of May, compared with $1.156 trillion at the end of 2013, according to Jeffrey Young, U.S. rates strategist at Nomura Securities International in New York.

The gain reflects in part China's decision to shift its U.S. investments to longer-term securities from short-term debt known as bills. Including bills, which mature in a year or less, China held $1.2709 trillion of Treasury debt at the end of May, compared with $1.2700 trillion at the end of December 2013, according to the latest data from the Treasury Department.

Analysts have long cautioned that the Treasury report isn't a complete picture because it doesn't account for China's holdings at third-party custody institutions in other nations, such as the U.K. and Belgium.

China's foreign-exchange regulator, the State Administration of Foreign Exchange, didn't immediately respond to a faxed request for comment.

China's purchases come as U.S. issuance slows, amid higher tax receipts from an improving economy. Mr. Young at Nomura Securities International estimated that net supply of Treasury notes and bonds this year would be $650 billion to $690 billion, down from $836 billion last year and $1.565 trillion in 2010.

The Fed has been dialing back its monthly purchases as well. Mr. Young said the central bank's buying this year would account for about 38.5% of net Treasury issuance, down from 65% last year.

China hasn't been the only big buyer this year. Japan, the second-largest foreign owner of Treasury bonds, increased its note and bondholdings by $9.56 billion during the first five months of the year. Including bills, Japan's holdings of Treasury debt was $1.2201 trillion.

China's foreign-exchange reserves currently approach $4 trillion, the world's biggest in size. China doesn't disclose the composition of the reserves, but analysts say most are denominated in U.S. dollars. This year, China has taken actions to weaken its local currency to make its exports cheaper. When China sold the yuan, it bought the U.S. dollar, and analysts said China likely often used the proceeds to purchase more Treasury debt.

"China will continue to buy Treasury bonds as long as they want to keep the yuan's value lower to support exports," said Peter Morici, professor at the Robert H. Smith School of Business at the University of Maryland. "I don't think China will pull away from the Treasury bond market even if the Fed raises interest rates."

Christopher Sullivan, who oversees $2.35 billion as chief investment officer at the United Nations Federal Credit Union in New York, added that "China's investment in Treasury bonds is mostly trade driven and not opportunistic," like hedge funds or other bond traders.

U.S. bonds yield more than Germany's, which are at 1.2%, and Japan's, at 0.54%. Strategists at Goldman Sachs Group Inc., J.P. Morgan Chase& Co. and Morgan Stanley expect the 10-year Treasury yield to rise to 3% by the end of 2014. Goldman recently cut its year-end forecast from 3.25%.

Some investors caution that higher-yield forecasts may not pan out. China's buying will be "a restraint on yields,'' said Mr. Sullivan. "I think 3% is highly suspect for 2014."
No doubt about it, when it comes to interest rates and currencies, the China factor is huge. One currency trader put it this way to me: "Even if Bridgewater, Brevan Howard, Moore Capital and other big global macro shops are short the euro, the Chinese will squash them like bugs. They have huge F/X reserves and they're not marked to market."

At the end of the day, China will do what's in China's best interest. If they want the USD and euro to hover around a certain level, they can easily manipulate currency markets to boost their exports. How long will this go on? Until they create sufficient internal demand so they don't need to rely on the export driven growth model.

And there is something else driving rates lower, the ominous threat of global deflation, which is now threatening Europe. But not everyone buys the deflation story. Ted Carmichael recently revisited his inflation or deflation scenarios and concluded:
If one believes that US growth will accelerate, that current high level of geopolitical risk will diminish, and that the Rising Inflation scenario will prevail, my preference at mid-year would still be the conservative 45% Equity, 25% Bond, 30% Cash portfolio. The evolving, highly uncertain environment still argues for a cautious and flexible approach.
True but I agree with CNBC's Ron Insana who wrote an interesting comment on why inflation is about to fall -- and fall hard. Watch the clip below and read my comment on when interest rates rise. If I'm right and deflation is the ultimate end game, pensions will get clobbered on both assets and liabilities.

Wednesday, July 23, 2014

Co-investments Entering Hedge Fund Arena?

Christine Williamson of Pensions & Investments reports, Co-investing entering new arena: Hedge funds:
Institutional investors increasingly are translating co-investment experience in private equity, real estate, infrastructure and energy funds to their hedge fund portfolios.

Co-investment with hedge fund managers is growing, if a bit slowly, especially with credit and activist equity managers as institutions become more comfortable with an even more direct type of hedge fund investing.

Appetite is growing: 52% overall of investors surveyed by J.P. Morgan Capital Introduction Group for its 2014 Institutional Investors Survey said they were willing to participate in hedge fund co-investments.

A breakdown of respondents showed 74% of endowments and foundations would co-invest with hedge funds, followed by 68% of consultants; pension funds, 60%; family offices, 59%; and insurance companies and hedge funds of funds, both 46%.

Despite this professed interest, the overall pace of pension funds, endowments, foundations and sovereign wealth funds in hedge fund co-investments has been a tad slow, sources said.

“This is a good investment space, but there are a significant percentage of institutional investors that are too boxy to be comfortable with co-investing,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

“You have to be flexible to take advantage of co-investing because it does fall into the cracks between asset classes,” Mr. Nesbitt added.

“The interest level in co-investments is about the same as a year ago, but the difference is that institutional investors had a desire to see co-investment ideas but not to invest,” said Richard d'Albert, principal, co-chief investment officer and portfolio manager at credit specialist hedge fund manager Seer Capital Management LP, New York.

“The credibility factor has risen and now the conversations are turning more often to investment,” Mr. d'Albert said.

Seer Capital has set up co-investment vehicles with a handful of larger clients, Mr. d'Albert said, noting the firm's hedge funds “get first dibs on any of our investment ideas, but sometimes we do run across an outsized opportunity that has great potential, but is too big to accommodate in our funds.”

Seer Capital managed $2.2 billion in structured credit hedge fund approaches as of June 30.

Hedge fund managers offering occasional one-off co-investment opportunities or permanent, dedicated co-investment funds are grouped within event-driven equity and fixed-income approaches, as well as specialists who invest in structured products, lending, mortgage- and asset-backed securities and more esoteric credit investments, such as Iceland bank debt.

In addition to Seer Capital, among those managers attracting institutional investor interest in their co-investment funds are JANA Partners LP, Pine River Capital Management LP, Solus Alternative Asset Management LP, Starboard Value LP and Taconic Capital Advisors LP.

New niche

One reason for the slow buildup in hedge fund co-investment is the relative newness of the niche. Institutions have been co-investing with private equity and real estate managers for more than two decades. But hedge fund managers, for the most part, only shifted to co-investment since the 2008 financial crisis.

Before the crisis, hedge fund managers routinely segregated less liquid assets in separate “side-pocket” funds they ran alongside their flagship commingled funds. The crisis made it extremely difficult to divest those illiquid investments and, rather than sell assets at fire sale prices, hedge fund managers shut redemption gates, locking up investor assets for years.

Mr. Nesbitt said hedge fund managers have begun to recapture the institutional market by repackaging their best, most concentrated investment ideas into vehicles with “much better terms,” including lower fees, lower carry, fees charged only on invested capital and “very attractive performance.”

“Performance comparison of the hedge fund co-investment niche is impossible,” said Jon Hansen, managing director-hedge funds for C/A Capital Management, Boston, the investment outsourcing money management subsidiary of consultant Cambridge Associates LLC.

“There's no way to give a range of returns for hedge fund co-investments because performance is so dependent on unique, individual underlying deals,” Mr. Hansen said.

But the returns of individual co-investments, rarely revealed publicly by hedge fund managers or their large investors, will propel more institutions to seek a place in the investment queue, sources predicted.

“Hedge fund co-investment will evolve from the minority sport that it is today into a defining feature of risk capital markets in the future,” wrote Simon Ruddick, CEO and managing director of alternative investment consultant Albourne Partners Ltd., London, in an e-mail.

"Nimbleness and flexibility'

“Hedge fund co-investments embody the nimbleness and flexibility required to give hedge fund managers, and their investors, an essential edge in the ever more competitive quest for alpha. We see hedge fund co-investment as a core component of a larger phenomenon: customized investments,” Mr. Ruddick wrote.

One early example of the type of customization institutional investors are doing with their hedge fund managers is the New Jersey Division of Investment's $300 million investment in February with credit hedge fund manager Solus Alternative Asset Management.

The investment division, based in Trenton, manages investments for the $78.6 billion New Jersey Pension Fund.

Solus' credit mandate specifies flexibility, allowing the firm to invest up to two-thirds of the allocation in its flagship opportunistic event-driven and special situations credit strategy and up to two-thirds in “recovery-like opportunities, including ... high-conviction co-investment opportunities,” according to a report from Christopher McDonough, director of investments, at the Feb. 3 State Investment Council meeting. The council advises the investment division on pension fund management.

Mr. McDonough was unavailable to comment about the division's rationale behind the Solus investment, said Christopher J. Santarelli, a spokesman for the New Jersey Treasury Department, which oversees the Division of Investment.

The Solus investment was not New Jersey's first to a hedge fund co-investment. In May 2013, JANA Partners was awarded $100 million for investment in its flagship Strategic Investments Fund, which invests about 30% of its assets in shareholder activist opportunities. New Jersey also committed $200 million to co-investing with JANA in activist shareholder deals.
It was only a matter of time before co-investments made it into the hedge fund arena. But I share some concerns. First, hedge funds have first dibs on their top ideas and then feed them to pensions co-investing alongside them. And what happens when they exit these positions? Do the pension funds co-investing get an advance warning? How will that impact investors in the co-mingled fund?

Pension funds love complicating things. This push to co-invest with hedge funds is all because they don't have the requisite staff to manage absolute return strategies internally and they want to lower fees hedge funds are charging them.

But if you ask me, U.S. pensions need to improve their governance, improve compensation, hire experts to manage portfolios internally and make better use of publicly available information on what major hedge funds are doing. They can track moves on marketfolly.com, insidermonkey.com, or through my quarterly updates on top funds' activity.

For example, when you see Seth Klarman's Baupost Group owning a 35% stake in Idenix Pharmaceuticals (IDIX), chances are something is up (click on image).



And what happened was Merck bought them out for their Hepatitis C drug, sending shares soaring from $7 to close to $25 (click on image):


This morning, I was checking out shares of Puma Biotechnology (PBYI) soaring 270% in pre-market trading because the company said a clinical trial of its experimental drug blocked the return of breast cancer in women with a type of early-stage disease.

Shares of Puma Biotech took a big hit in Q1with the big unwind and have been falling ever since. But that didn't stop one hedge fund I track closely, Adage Capital Partners, from amassing a 19% stake in the company (click on image):


As you can see, Citadel Advisors, another well known hedge fund I track, also bought positions in Puma Biotechnology. But Adage was the one that made big bucks today, a cool $950 million.

Now, admittedly, these are not the type of co-investments pension funds are looking for (biotech shares are too small and risky for them), but I can show you other examples of well known large cap names too. I just showed you biotech because it's a space I track closely and believe in.

If you have any comments on pensions co-investing with hedge funds, let me know or post them below. Don't get too excited about this "new form" of investing with hedge funds. At the end of the day, overpaid hedge fund managers are looking to gather more assets to manage so they can charge institutions with outrageous fees. That's pretty much it.

Below, Bill Ackman tried to convince investors in a presentation Tuesday that the seller of weight-loss shakes is guilty of fraud. I embedded Bloomberg highlights of his remarks.

Unfortunately for Ackman, he got clobbered yesterday as Herbalife (HLF) shares soared 25% following his "bombshell revelations." He might turn out to be right but some pretty big hedge funds are betting against him, including Soros, Icahn and Perry Capital.

Below, Robert Chapman, Chapman Capital, says he is adding aggressively to Herbalife despite Bill Ackman's criticism of the company. Chapman also  explains why he thinks the stock could hit $150 per share within a year (I would steer clear of Herbalife and let the big boys battle it out).