Tuesday, October 6, 2015

CalSTRS Pulling a CalPERS on PE Fees?

Back in July, Chris Flood and Chris Newlands of the Financial Times reported on CalSTRS's private equity woes:
The second-largest US public pension fund has admitted it has failed to record total payments made to its private equity managers over a period of 27 years.

The admission by Calstrs, the $191bn California-based pension fund, prompted John Chiang, the state treasurer of California, to declare he will investigate the failure, which poses serious questions as to how pension fund money is being spent.

The news comes a week after FTfm reported that the state treasurer had voiced “great concern” that fellow pension fund Calpers, the US’s largest at $300bn, also has no idea how much it pays its private equity managers.

Mr Chiang said he would demand clear answers from Calpers over why it does not know how much has been paid in “carried interest” or investment profits over a period of 25 years to the private equity managers running its assets.

A spokesman for Calstrs, which helps finance the retirement plans of teachers, said the fund does not record carried interest. “What matters is the overall performance of the portfolio.”

Following questions from FTfm, Mr Chiang said he would demand Calstrs look into payments of carried interest to its private equity managers.

“Disclosure [of carried interest fees] is very important,” said Mr Chiang, who sits on the administration board of both Calstrs and Calpers.

The revelations come just weeks after US regulators issued an explicit warning to the private equity industry to expect more fines for overcharging investors. 
Calpers, which uses more than 100 private equity firms, identified a need to track fees and carried interest better in 2011, but it has taken until now to develop a new reporting system for its $30.5bn private equity portfolio.

But Calstrs, which manages a $19.3bn private equity portfolio and has 880,000 members, said it has no plans to upgrade its systems for tracking and reporting payments to private equity managers.

Margot Wirth, director of private equity at Calstrs, said it used “rigorous checks” to ensure private equity managers took the right amount of carried interest.

All of Calstrs’ partnerships with private equity managers were independently audited, Ms Wirth added. She said the pension fund carried out its own internal audits and employed a specialist “deep dive” team to look at private equity contracts.

Professor Ludovic Phalippou, a finance professor at the University of Oxford Saïd Business School, who specialises in private equity, told FTfm last week: “Calpers’ total bill is likely to be astronomical. People will choke when they see the true number.”

Prof Phalippou said the same would be true of Calstrs, which first invested in private equity in 1998.

Ms Wirth argued it was “wrong to conflate the fees paid to private equity managers with carried interest”.

She said: “Carried interest is a profit split between the investor and the private equity manager. The higher that carried interest is, then the better both the investor and private equity manager have performed.”

The fear is that if sophisticated investors such as Calpers and Calstrs faced difficulties in obtaining accurate information, then it could only be harder for smaller pension funds, endowments and wealth managers that are less well resourced.

David Neal, managing director of the Future Fund, Australia’s A$128bn sovereign wealth fund and one of the world’s largest investors in private equity, said: “There just are not enough decent private equity managers around to justify the fees.”

He added: “We negotiate fee arrangements that transparently reward genuine performance and drive alignment of interest. Where managers cannot meet those expectations, we do not invest. While we work hard at the arrangements with our managers, the industry still has some way to go.”
Fast forward to October where Yves Smith of Naked Capitalism just put out another stinging comment, CalSTRS Board Chairman Harry Keiley, in Op-Ed Rejected by Financial Times, Gave Inconsistent and Inaccurate Information in Carry Fee Scandal (added emphasis is mine):
The staff and board members of California public pension fund CalSTRS continue to embarrass themselves in their efforts to justify their indefensible position on private equity carry fees.

Readers may recall that the biggest public pension fund, CalPERS, had a put-foot-in-mouth-and-chew incident when it said it didn’t track the profits interest more commonly called “carry fees,” which is one of the biggest charges it incurs on its private equity investments. CalPERS added to the damage by falsely claiming that no investors could get that information. After we broke that story and a host of experts and media outlets criticized CalPERS over the lapse and the misrepresentation, CalPERS reversed itself. It asked its general partners for all the carry fee data for the entire history of all of its funds, and obtained it all in a mere two weeks, with only one exception out of the nearly 900 funds in which it has invested.

So what has the second biggest public pension fund, CalSTRS, done? Like CalPERS, it has admitted that it does not track carry fees. But in a remarkable contrast, CalSTRS is attempting to justify inaction by misleading beneficiaries as to how much information it really has and saying that it’s thinking really hard about what (if anything) to do.

The dishonesty of the CalSTRS position is evident in its e-mails with the Financial Times after the pink paper reported that CalSTRS, like CalPERS, did not track carry fees, and California Treasurer John Chiang, who sits on both the CalPERS and CalSTRS boards, said he would press CalSTRS to look into the matter. I became aware of the contretemps when an FT reporter called me to thank me for my work. I asked him how CalSTRS was taking his story. He said they weren’t happy with it and they’d offered CalSTRS the opportunity to publish an op-ed, which was running early the following week. When I failed to see any such article, I contacted the reporter, who said his editor had rejected the article. I then lodged a Public Records Act request (California-speak for FOIA) for the op-ed and all e-mails between CalSTRS and the Financial Times from the date the Financial Times ran the article on CalSTRS’ carry fee tracking.

It’s important to remember that CalSTRS had said, flatly, that it does not know what it pays in carry fees. From the Sacramento Bee on July 2:
Ricardo Duran, a spokesman for the California State Teachers’ Retirement System, said CalSTRS can estimate the fees “within a couple of percentage points” but doesn’t report the figure.

“It’s not a number that we track,” Duran said. “It’s not that important to us as a measure of performance.”
Memo to CalSTRS: if you are estimating, you don’t know for sure.*

After the Financial Times ran its CalSTRS story, Ricardo Duran, CalSTRS’ head of communications, sent a clearly-annoyed e-mail to the Financial Times’ Chris Flood. Duran tried objecting that the so-called carry fee was not a fee because….drumroll..it was not paid directly by CalSTRS to general partners:
The following paragraph talks about [California Treasurer and CalSTRS board member] Mr. Chiang’s demand of CalPERS about how much has been “paid in carried interest.” Carried interest is not a payment but a profit split. I believe [head of private equity] Margot [Wirth] mentioned that distinction as well.

The language throughout the piece conflated carried interest with management/manager fees. That’s fine if that’s the way you want to characterize it. I only ask if you write about CalSTRS and carried interest again, you specifically mention this and attribute it to me or Margot.
So get a load of this: CalSTRS demanding that if the FT ever dare report on CalSTRS’ carry fee reporting again, that it include the staff’s pet position that a carry fee is not a fee, even when that contradicts statements by board members who oversee CalSTRS. Since when do mere employees a California agency have the right to undercut on-the-record statements of top California government officials?

And that’s before you get to the fact that this “carry fee is not a fee” position is bogus. As Eileen Appelbaum, the co-author of Private Equity at Work, wrote:
The email exchange in which CalSTERS argues with the Financial Times over the question of when is a fee not a fee has a certain Alice in Wonderland quality. The CalSTRS representative insists that a fee is not a fee if it takes the form of profit sharing. But profit sharing is clearly a performance fee – a fee paid to the PE investment manager based on the performance of the PE fund.
And as an expert who has been writing about private equity fees for decades said:
Private equity general partners put up around 1% of the money in a fund once you back out management fee waivers. They get 20% of the profits. The part over and above their pro-rata share is clearly a fee. As we lawyers like to say, res ipsa loquitur.
But the best part is Duran’s wounded claim that the FT “conflated” interest with management fees, as if that were inaccurate. This is from the very first limited partnership agreement I looked at from our document trove, KKR’s 2006 fund:
The Partnership will not invest in investment funds sponsored by, and as to which a management fee or carried interest is payable to, any Person….
Gee, KKR says in its own agreement that carried interest is indeed “paid” just like management fees!

But this is all a warm-up to the op-ed that the chairman of CalSTRS’ board, Harry Keiley, submitted to the Financial Times. It’s troubling to see a board chairman defend staff’s delaying tactics after another board member has demanded answers.

Other public pension fund trustees thought the odds were high that the article was either originally drafted by staff or had staff input. If staff did indeed provide text that Keiley assented to have run under his name, that has the effect of committing him to their position, even if he was privately not fully aligned with them.**

Moreover, it is peculiar to have a defense of CalSTRS’ position on carry fees come from someone who is almost certain never to have seen a private equity fund’s financial statements or reviewed the language in limited partnership agreements that describe the distribution “waterfall,” as opposed to the officers who are responsible and who presumably have expertise.

The full text of Keiley’s submission is at the end of this post. Here are the telling parts (emphasis ours):
We at CalSTRS are in favor of more, rather than less, transparency and disclosure as our history and current checks and balances show. We agree that it’s important for the public to know the estimated amount of carried interest investment managers are earning, tracked as net profits, which a majority of public pension plans report. Almost all private equity partnerships split profits, with the investor (e.g. CalSTRS) taking at least 80 percent and, at most, 20 percent taken by investment managers. Typically, a partnership must earn a minimum of 8 percent return for its limited partners (e.g. investors) before an investment manager earns any carried interest. Also, there are several large, publicly-owned private equity investment managers that report their earnings to delineate their carried interest income. I am confident that the CalSTRS board will continue to examine the issue of reporting carried interest in the context of its overall private equity disclosure practices to ensure we are taking all necessary steps to have full awareness and understanding of both fee and profit structures.
The boldfaced section is simply wrong. At best, it’s a laughably inept effort to mislead the audiences CalSTRS is most concerned about: its beneficiaries and California legislators. Net profits to investors like CalSTRS are after carry fees have been taken by the general partner. Tracking net profits tells you absolutely nothing about carry fees. And Keiley effectively admits that in the next paragraph:
Within our private equity program, we have always reported our returns net of all costs and fees.
From Eileen Appelbaum via e-mail (emphasis original):
What strikes me in the CalSTRS op-ed and their correspondence with the Financial Times is the complete lack of consistency in what CalSTRS’ board is saying. Mr. Keiley, Board Chair of CalSTRS, says that the pension fund agrees that it is important for the public to know what the pension fund pays to its investment fund managers. He finishes that sentence, however, by saying that CalSTRS fulfills that obligation by tracking and reporting net profits. I don’t know what subject Mr. Keiley teaches, but is it possible that he doesn’t understand that this is the crux of the matter? Tracking net profits is not the same as tracking all fees, expenses and carried interest the pension fund pays to private equity managers.

After trumpeting CalSTRS commitment to transparency, Mr. Keiley goes on to baldly contradict himself by asserting: “Within our private equity program, we have always reported our returns net of all costs and fees.” If Mr. Keiley is to be believed, the problem is not that private equity firms don’t provide information on the amount of carried interest they collect; indeed, he asserts that they “keep investors [like CalSTERS] fully informed as to the carried interest shared with their investment managers.” Astoundingly, one is left to draw the conclusion that CalSTRS has that information but chooses not to share it with California’s taxpayers and teachers.
Remember, as we stressed with CalPERS, California taxpayers are ultimately on the hook for public pension fund shortfalls. CalSTRS’ double-speak about transparency and its tracking of carry fees reveals that staff and a complaint board are more worried about keeping relations with limited partners friction-free rather than putting the interests of their beneficiaries, Calfornia schoolteachers, first.

I encourage you to send this post to people you know in California, particularly public school teachers. Urge them to e-mail Keiley to give him feedback on the terrible arguments he presented. Tell him that CalSTRS has no excuse for dragging its feet on obtaining carry fee data given that CalPERS has done just that. It would also help to tell him that it does not reflect well on him or the board to mislead the public, as he intended to do had the Financial Times not saved him from himself.

Given the e-mail address, I am highly confident that this contact information (p. 11) is indeed Keiley’s. I request that you NOT call him unless he fails to respond to an e-mail after two attempts.
Harry Keiley
Board Chair, CalSTRS
Mobile Phone: (310) 428 3624
Email: hkcalstrs@aol.com
Thomas Jefferson said, “When government fears the people, there is liberty.” There’s clearly no fear at CalSTRS. I hope you instill some.

* Many private equity funds actually do disclose their carry fee payments in their quarterly distribution notices, so in those cases, CalSTRS would have good data. But CalSTRS uses the same private equity management system that CalPERS does, State Street’s Private Edge. Private Edge does not have a field for recording carry fees. One of CalPERS’ excuses for not capturing carry fees was that it didn’t have a system for doing so, as if it would be too difficult to keep it in a speaadsheet in Excel.
** There is a considerable body of research that shows that people become persuaded of a point of view they advocate, irrespective of whether they originally believed it or not. For instance, trial lawyers who represent clients they strongly suspect are guilty come to believe they may be or even are innocent as they develop arguments supporting a “not guilty’ plea.


By Harry M. Keiley,

Mr. Keiley is the chair of the Teachers’ Retirement Board, the governing body of the California State Teachers’ Retirement System. Mr. Keiley is a high school teacher with the Santa Monica-Malibu Unified School District, and was elected to the Teachers’ Retirement Board in 2007.

With assets of $191.4 billion and nearly 880,000 members, the California State Teachers’ Retirement System (CalSTRS) is the largest public pension plan in the world dedicated solely to serving educators.

In addition to being one of the largest public pension plans, CalSTRS has one of the most comprehensive private equity programs globally. Begun in 1988, the current market value of our private equity portfolio is $19.3 billion. Since inception, our private equity program has generated over $21.8 billion in profits for the benefit of our members.CalSTRS’ highest returning asset class, private equity has returned on average 12.3 percent per year over the last ten years – well above the plan’s overall ten-year average of 6.8 percent and that of broad-based stock indices which averaged approximately 8.2 percent. Given its healthy performance over the past decade, the private equity program has also played an important role in the total CalSTRS portfolio by contributing excess returns above our long-term earnings assumption of 7.5 percent, thereby having a positive impact on the system’s overall funding.

We at CalSTRS are in favor of more, rather than less, transparency and disclosure as our history and current checks and balances show. We agree that it’s important for the public to know the estimated amount of carried interest investment managers are earning, tracked as net profits, which a majority of public pension plans report. Almost all private equity partnerships split profits, with the investor (e.g. CalSTRS) taking at least 80 percent and, at most, 20 percent taken by investment managers. Typically, a partnership must earn a minimum of 8 percent return for its limited partners (e.g. investors) before an investment manager earns any carried interest. Also, there are several large, publicly-owned private equity investment managers that report their earnings to delineate their carried interest income. I am confident that the CalSTRS board will continue to examine the issue of reporting carried interest in the context of its overall private equity disclosure practices to ensure we are taking all necessary steps to have full awareness and understanding of both fee and profit structures.

In addition to a commitment to transparency, CalSTRS also places utmost importance on internal control measures and prudent audit practices and, as such, our private equity program adheres to U.S. Government Accounting Standards Board (GASB) standards and General Accepted Accounting Principles (GAAP). Additionally, all cash flowing into and out of the CalSTRS private equity portfolio is accounted for and certified by annual independent audits. Within our private equity program, we have always reported our returns net of all costs and fees. In all cases, CalSTRS receives and regularly reviews independently audited financial statements of its private equity partnerships. It is important to note that, many times, details of those private equity partnerships are confidential due to the agreements signed by the various investors which are funding the limited partnership. However, as referenced above, capital investors involved in limited partnerships are provided with audited financial statements that disclose carried interest distributions made by the partnerships to the investment managers. As such, there is an established system of strong checks and balances to keep investors fully informed as to the carried interest shared with their investment managers.

CalSTRS has been, and continues to be, a leader in the private equity industry. Bringing innovation and diversity to our overall investment portfolio, the CalSTRS private equity program is a leader in transparency and disclosure, and acts as a fierce defender of investor rights when negotiating partnership agreements. CalSTRS is steadfastly committed to reviewing all of the checks and balances outlined above to see if we can improve upon our long track record of transparency and accountability in our disclosure practices. And, we will continue to apply our high standards, expectations, and drive for results to our ongoing and new investment partnerships in an effort to reach and exceed our private equity performance benchmarks.
Wow, where do I begin? First, let me praise Yves Smith (aka Susan Webber) for lodging a Public Records Act request (California-speak for FOIA) for the op-ed and all e-mails between CalSTRS and the Financial Times and bringing this to our attention.

Second, in sharp contrast to other tirades, I completely agree with Yves Smith, these emails and that editorial are a total embarrassment to CalSTRS and either show gross incompetence on the part of CalSTRS's private equity staff (Keiley didn't write that without their input) or more likely, a pathetic attempt to misinform the public on how much has been doled out in management fees and carried interest ("carry" or performance) fees throughout all these years.

Third, and most importantly, I do not buy for one second that the private equity staff at CalPERS or CalSTRS do not track all fees doled out to each GP (general partner or fund) to the penny. If they don't, they all need to be immediately dismissed for gross incompetence and breach of their fiduciary duties and their respective boards need be replaced for being equally incompetent in their supervision of staff (except keep JJ Jelincic on CalPERS's board as he's the only one doing his job, grilling CalPERS's private equity team and asking tough questions that need to be answered).

I'm not going to mince my words, it's simply indefensible for any large public pension fund investing billions in private equity, real estate and hedge funds not to track all the fees paid out to the GPs as well as track any hidden rebates with third parties which these GPs hide from their clients, effectively stealing from them.

You might be wondering, how hard is it for a CalPERS or a CalSTRS to track fees and other pertinent information from their private equity fund investments? The answer is it's not hard at all. Over the weekend, I was looking at buying a few more books in finance (not that I need to add to my insanely large collection) and was looking at one called Inside Private Equity.

I was attracted to the book because one of the authors is Austin Long of Alignment Capital who I met back in 2004 when I was helping Derek Murphy set up private equity as an asset class at PSP Investments. I liked Austin and their approach to rigorous due diligence before investing in a private equity fund (like on-site visits where they pull records off a deal thy pick at random to analyze it and pick a junior staff member at random to ask them soft and hard questions on the fund's culture).

Anyways, I was reading the foreword of the book which was written by Tom Judge, a former VC investor and inductee to the Private Equity Hall of Fame (1995), and he was writing about how it used to be complicated tracking over 100 partnerships for the AT&T pension fund until he met Jim Kocis, another author of the book, and founder of the Burgiss Group which provides software-based solutions for investors in private equity and other alternative assets (click on image to read passage):

Today the tools Burgiss Group developed support over a thousand clients representing over $2 trillion of committed capital.

Why am I writing this? I'm not plugging Burgiss Group because I simply don't know them well enough and haven't performed a due diligence on them but obviously it's a huge firm with excellent experience in tracking detailed information of PE partnerships on behalf of their clients, providing them with the transparency they need to track their fund investments.

Again, in 2015, it's simply mind-boggling and inexcusable for a CalPERS or a CalSTRS not to be able to track detailed information on all their fund investments going back decades. This includes detailed information on management fees and carry.

What are CalPERS and CalSTRS hiding? I don't know but I think John Chiang, the state treasurer of California, is absolutely right to investigate and inform Califonia's taxpayers on exactly how much has been doled out in private equity, real estate and hedge fund fees over the years at these two giant funds which pride themselves on transparency.

Below, I embedded the three investment committee clips from CalSTRS's September board meeting. In the first clip, Chris Ailman, calSTRS's CIO, discusses their risk mitigation strategies and Mike Moy of Pension consulting Alliance, discusses the performance of private equity.

I know they're excruciatingly long (you can fast-forward boring sections) but take the time to listen to these investment committees as they provide a lot of excellent insights. Not surprisingly, nothing was mentioned on how exactly CalSTRS is going to track and disclose all fees paid to their private equity partnerships (however, in the third clip, Mr. Murphy, a teacher representing the California Federation of Teachers did mention this issue was a huge concern).

If the staff at CalSTRS, CalPERS or anyone else has anything to add, feel free to reach out to me at LKolivakis@gmail.com. I have my views but I don't have a monopoly of wisdom when it comes to pensions and investments and I welcome constructive criticism on all my comments and will openly share your input, good or bad.

Monday, October 5, 2015

The Courage To Act?

Ben Bernanke, the former chairman of the Federal Reserve, wrote a comment for the Wall Street Journal, How the Fed Saved the Economy:
For the first time in nearly a decade, the Federal Reserve is considering raising its target interest rate, which would end a long period of near-zero rates. Like the cessation of large-scale asset purchases in October 2014, that action will be an important milestone in the unwinding of extraordinary monetary policies, adopted during my tenure as Fed chairman, to help the economy recover from a historic financial crisis. As such, it’s a good time to evaluate the results of those measures, and to consider where policy makers should go from here.

To begin, it’s essential to be clear on what monetary policy can and cannot achieve. Fed critics sometimes argue that you can’t “print your way to prosperity,” and I agree, at least on one level. The Fed has little or no control over long-term economic fundamentals—the skills of the workforce, the energy and vision of entrepreneurs, and the pace at which new technologies are developed and adapted for commercial use.

What the Fed can do is two things: First, by mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce. High unemployment is a tragedy for the jobless, but it is also costly for taxpayers, investors and anyone interested in the health of the economy. Second, by keeping inflation low and stable, the Fed can help the market-based system function better and make it easier for people to plan for the future. Considering the economic risks posed by deflation, as well as the probability that interest rates will approach zero when inflation is very low, the Fed sets an inflation target of 2%, similar to that of most other central banks around the world.

How has monetary policy scored on these two criteria? Reasonable people can disagree on whether the economy is at full employment. The 5.1% headline unemployment rate would suggest that the labor market is close to normal. Other indicators—the relatively low labor-force participation rate, the apparent lack of wage pressures, for example—indicate that there is some distance left to go.

But there is no doubt that the jobs situation is today far healthier than it was a few years ago. That improvement (as measured by the unemployment rate) has been quicker than expected by most economists, both inside and outside the Fed.

On the inflation front, various measures suggest that underlying inflation is around 1.5%. That is somewhat below the 2% target, a situation the Fed needs to remedy. But if there is a problem with inflation, it isn’t the one expected by the Fed’s critics, who repeatedly predicted that the Fed’s policies would lead to high inflation (if not hyperinflation), a collapsing dollar and surging commodity prices. None of that has happened.

It is instructive to compare recent U.S. economic performance with that of Europe, a major industrialized economy of similar size. There are many differences between the U.S. and Europe, but a critical one is that Europe’s economic orthodoxy has until recently largely blocked the use of monetary or fiscal policy to aid recovery. Economic philosophy, not feasibility, is the constraint: Greece might have limited options, but Germany and several other countries don’t. And the European Central Bank has broader monetary powers than the Fed does.

Europe’s failure to employ monetary and fiscal policy aggressively after the financial crisis is a big reason that eurozone output is today about 0.8% below its precrisis peak. In contrast, the output of the U.S. economy is 8.9% above the earlier peak—an enormous difference in performance. In November 2010, when the Fed undertook its second round of quantitative easing, German Finance Minister Wolfgang Schäuble reportedly called the action “clueless.” At the time, the unemployment rates in Europe and the U.S. were 10.2% and 9.4%, respectively. Today the U.S. jobless rate is close to 5%, while the European rate has risen to 10.9%.

Six years after the Fed, the ECB has begun an aggressive program of quantitative easing, and European fiscal policy has become less restrictive. Given those policy shifts, it isn’t surprising that the European outlook appears to be improving, though it will take years to recover the growth lost over the past few years. Meanwhile, the United Kingdom is enjoying a solid recovery, in large part because the Bank of England pursued monetary policies similar to the Fed’s in both timing and relative magnitude.

It is encouraging to see that the U.S. economy is approaching full employment with low inflation, the goals for which the Fed has been striving. That certainly doesn’t mean all is well. Jobs are being created, but overall growth is modest, reflecting subpar gains in productivity and slow labor-force growth, among other factors. The benefits of growth aren’t shared equally, and as a result many Americans have seen little improvement in living standards. These, unfortunately, aren’t problems that the Fed has the power to alleviate.

With full employment in sight, further economic growth will have to come from the supply side, primarily from increases in productivity. That means that the Fed will continue to do what it can, but monetary policy can no longer be the only game in town. Fiscal-policy makers in Congress need to step up. As a country, we need to do more to improve worker skills, foster capital investment and support research and development. Monetary policy can accomplish a lot, but, as I often said as Fed chairman, it is no panacea. New efforts both inside and outside government will be essential to sustaining U.S. growth.
Mr. Bernanke is a devastatingly brilliant economist who is promoting his new book, The Courage to Act. I agree with the thrust of his arguments above, given how dysfunctional Washington is, the Fed had to step up to the plate in 2008 to save the U.S. economy from another Great Depression.

But Bernanke ends his comment by stating "monetary policy can no longer be the only game in town" and here is where agree and disagree with him. In a perfect world, those politicians in Washington would all get together and pass laws by compromising on their proposals, ensuring fiscal policy would support long term growth.

Unfortunately, I just don't see this happening any time in the near future. In fact, I see the politics of division and inaction gripping Congress and the Senate becoming worse which is one reason why we're witnessing the extraordinary rise of non mainstream candidates from all sides of the political spectrum.

If someone told you we would be talking about Donald Trump, Ben Carson and Bernie Sanders as serious presidential contenders a year ago, you would have scoffed at them. Even though they don't share the same ideological views, they've been able to capitalize on the growing frustration with politics as usual in Washington.

Why am I bringing this up? Because if fiscal policy doesn't support the economy, then the only game in town by default will be monetary policy which is why Bridgewater's Ray Dalio is increasingly worried about the next downturn, and he's not the only one.

On Friday, DoubleLine Capital co-founder Jeffrey Gundlach, the current bond king, warned of 'another wave down' after the weak jobs number on Friday that the U.S. equity market as well as other risk markets including high-yield "junk" bonds face another round of selling pressure.Gundlach joins Bill Gross, the former bond king, in warning of a rout in stocks and other risk assets.

With all due respect to Ray Dalio, Jeffrey Gundlach, Bill Gross and Carl Icahn who recently warned of a looming catastrophe ahead, it remains to be seen who gets the last laugh on stocks. As I discussed in my weekend comment, with the Fed out of the way for the remainder of the year, the October surprise won't be a market crash but a huge liquidity rally in risk assets that could last well into 2016.

There is something else that happened over the weekend that received little attention as everyone was talking about Ben Bernanke's new book and how he thinks more execs should have gone to jail for causing Great Recession.

Alister Bull and Matthew Boesler of Bloomberg report, Korcherlakota Says Low Inflation Warrants Further Fed Stimulus:
Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the U.S. central bank would have been “totally justified” if it had increased policy stimulus to combat low inflation when it met last month, adding that negative interest rates could be a useful policy tool.

Speaking in an interview Sept. 29 with Arthur Levitt on Bloomberg Radio, the Fed’s most outspoken policy dove declined to say if he had recommended negative interest rates in projections submitted for the Sept. 16-17 meeting of the Federal Open Market Committee. He did say, however, that more aggressive Fed policy was warranted than the current setting of near-zero rates.

“Given the inflation outlook, given how low inflation is expected to be, to ensure the credibility of our inflation target, taking a more accommodative stance in September would have been totally justified,” Kocherlakota said in the interview, broadcast Saturday. He steps down from the Fed on Dec. 31 and is not a voting member of the FOMC this year.

The FOMC decided last month to hold rates near zero, though Chair Janet Yellen said Sept. 24 that she expected that the central bank’s first rate increase since 2006 would be warranted later this year. Kocherlakota has repeatedly argued for a delay in rate liftoff.
Accommodation Time

“My main point -- this is a time to think about adding accommodation, not a time to be thinking about taking it away,” he said.

Policy makers submit quarterly economic forecasts including their projections for the appropriate future path of the federal funds rate, which has been held near zero since December 2008. Displayed as dots on a chart, forecasts on the so-called “dot-plot” released Sept. 17 showed that one official viewed the appropriate rate at the end of this year and next to be slightly less than zero.

Kocherlakota said he was prevented by the Fed’s rules of confidentially from disclosing if this was his dot, though he expressed interest in the decision of central banks in Sweden and Switzerland to drive rates below zero.

“I think it’s another useful tool in our toolkit that we should be surely thinking about,” he said, in response to the question of whether the Fed should consider doing likewise if officials decided there was a need to stimulate the economy more aggressively.

“It’s been very interesting what the European central banks have been able to do in terms of actually provide more stimulus than I would have expected, by driving interest rates below what economists used to call the zero lower bound,” Kocherlakota said.

Yellen was asked about the negative dot in the Fed’s Summary of Economic Projections during a post-FOMC press conference on Sept. 17. She said “negative interest rates was not something that we considered very seriously at all today.”
In my opinion, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota is way ahead of his colleagues in understanding the Fed's deflation problem. He understands the real risks of deflation coming to America and I think he has been instrumental in the sea change at the Fed which impacted its big decision to stay put on rates.

Will the Fed consider negative rates any time soon? I doubt it but if inflation expectations keep sinking to record lows, this option might be considered and so will more quantitative easing (Bridgewater went on record to state more QE will come before a rate hike).

Right now, this isn't something which worries me as I believe global growth will recover in the short run, or at least that's what the stock market is indicating to me as investors bet big on a global recovery (click on image):

Is this just another countertrend rally which will fizzle out or is this part of a meaningful sector rotation back into commodities and energy following Friday's tepid jobs report? I don't know but the huge reversal on Friday may signal a change in risk appetite and you have to pay close attention to emerging markets (EEM), Chinese (FXI), Energy (XLE), Oil Services (OIH), Oil & Gas Exploration (XOP), Metals & Mining (XME) and solar (TAN) shares to see if this is part of a much bigger move.

As far as large (IBB) and small (XBI) biotech ETFs, they are down late Monday morning after popping at the open but this didn't surprise me as I expected both these indexes might retest their 400-day moving average before moving back up (click on image):

A lot of traders are fretting about the "death cross" on biotech but I never took these 'death crosses' too seriously, especially in the volatile biotech sector which unlike energy and commodities is still in a secular bull market and has the potential to surge higher and make new highs.

Below, former chairman of the Federal Reserve Ben Bernanke tells USA Today's Susan Page that more corporate executives should have gone to jail for their misdeeds. Bernanke also appeared on CNBC on Monday where he stated he sees no reason why central bank policymakers should rush to increase interest rates.

I agree with him but historic low rates are fueling inequality and the buyback binge, which is very deflationary. Still, unlike Greenspan who sent out a dire warning on bonds in August, Bernanke is very cautious as he sees many risks to this tepid recovery. No wonder he's now advising Ken Griffin, the reigning king of hedge funds, the man is brilliant and very careful in his analysis.

Friday, October 2, 2015

The October Surprise?

Akin Oyedele of Business Insider reports, Huge Miss on Jobs Report:
The US economy added 142,000 jobs in September, fewer than forecast.

Economists had been expecting the economy to add 200,000 jobs.

The unemployment rate held steady at 5.1%, a seven-year low.

Average hourly earnings were flat month-over-month in September, below expectations for 0.2% growth.

Ahead of this report, economists had noted that August and September nonfarm payrolls prints had been revised higher most of the time over the past decade. The August print, however, was revised lower to 136,000 from 173,000 in Friday's report.

Economists had noted that the broad-based slowdown in the manufacturing sector, partly because of the strong dollar and slower exports, would most likely show up in this report. Manufacturing employment fell 9,000 in September, versus expectations for no change.

Mining employment also fell, as healthcare and information added more jobs, according to the Labor Department.

The labor-force participation rate, which measures the share of Americans over 16 who are working or looking for a job, fell to 62.4%, the lowest since October 1977.

The year-over-year projection for hourly earnings growth, at 2.4%, was the most bullish forecast for wages in this economic cycle. Wages missed, at 2.2%.

In September, the Federal Reserve held off on raising its benchmark rate for the first time in a decade, citing global growth concerns and a labor market that needed further improvement. After the jobs report, Fed fund futures reflected only a 30% chance that the Fed would lift rates in December and a 52% probability for March.

Stock futures nosedived after the report — all three major indexes lost more than 1%, and Dow futures shed as many as 200 points. The yield on the 10-year benchmark Treasury note fell below 2% for the first time since the market sell-off on August 24.

Here's what Wall Street was expecting for the jobs report:
  • Nonfarm payrolls:+200,000
  • Unemployment rate: 5.1%
  • Average hourly earnings, month-over-month: +0.2%
  • Average hourly earnings, year-over-year: +2.4%
  • Average weekly hours worked: 34.6
I don't know why economists are so shocked to see the pace of job growth in the United States is decelerating. The mighty greenback, the rout in commodities and China's big bang are all weighing on the U.S. economy. Moreover, when a record 94.6 million Americans are not in the labor force, it's not a sign of economic prosperity and strength.

Although some think the weak jobs numbers are masking a strong economy, the truth is the jobs picture is even worse than you think. The U.S. economy may be in relatively better shape than the rest of the world but it's far from firing on all cylinders and the risks of another downturn are high which is why Bridgewater's Ray Dalio is worried about what happens next. In my opinion, the Fed's big decision a couple of weeks ago has been vindicated and it's right to fear deflation coming to America even if it will never publicly admit it (I warned you about this possibility a year ago).

As far as stocks, bonds and commodities, the knee-jerk reaction following the September jobs report was swift (click on image):

Stock futures reversed course and got slammed, the yield on the 10-yield Treasury fell below 1.94%, the US dollar declined spurring commodities like oil higher. Gold rallied partly because the US economy isn't doing as well as anticipated and some big investors think the Fed's next big move will be more more quantitative easing (QE), not a rate hike.

What do I think of all this? To be honest, not much. I maintain my views which I clearly outlined in my recent comments on a looming catastrophe ahead and who gets the last laugh on stocks.

If anything, I'm now more convinced than ever that the Fed won't make the monumental mistake of raising rates this year and that now is the time to load up on risk assets, especially biotech which got massacred last month, hitting major indexes and the healthcare sector very hard.

I want you all to stop listening to investment gurus scaring the crap out of you and start paying attention to markets, focusing on the sectors that have been leading us higher because they are in a secular bull market. If you look at the charts of healthcare (XLV) and biotech stocks (IBB and XBI), they got hit very hard in September but are coming back strong (click on images below):

Notice how the large (IBB) and small (XBI) biotech indexes have already crossed above their 400-day moving average and the smaller biotech shares are rallying hard on Friday as they are the ones that got clobbered the most in September. The healthcare index (XLV) is also close to crossing over its 400-day moving average (healthcare is a mix of big pharma, big insurance plans, big biotech and medical equipment stocks).

Again, this to me is very positive and if this momentum continues, it represents a change in market sentiment and risk-taking behavior. Importantly, with the Fed out of the way for the remainder of the year, I would ignore Carl Icahn's dire warning and load up on risk assets right now. Just make sure you pick your spots carefully as some sectors will rally and fizzle quickly or not participate while others will surge higher and make new highs (mostly tech and biotech).

I could be wrong, markets are crazy in October (or so everyone is conditioned to believe) but I think the big October surprise will be a huge rally that continues into the first half of next year. The bears love talking about "bull traps" but if you ask me, September was a huge "bear trap" and all these short sellers shorting this market and sectors like biotech are in for a lot of pain in the months ahead.

In fact, as I'm ending this comment, markets are staging a dramatic reversal on Friday and the small biotech companies I trade are surging higher (click on image):

Admittedly, I got clobbered in September along with many other biotech investors but I didn't panic, added more to my core positions and I'm sitting tight here (I'm better at buying the big dips than selling the big rips!).

But it's not just biotechs taking off on Friday. Check out the big moves in emerging markets (EEM), Chinese (FXI), Energy (XLE), Oil Services (OIH), Oil & Gas Exploration (XOP), Metals & Mining (XME) and solar (TAN). Below, a list of ETFs I track and how they performed on Friday (click on image):

It's clear that with the Fed out of the way, smart money is betting big on a global recovery (click on image below):

All of the stocks above are still in a downtrend but they can bounce big from these levels if market sentiment shifts and risk appetite increases (could be a violent countertrend rally).

Below, Rich Ross of Evercore ISI explains why biotech stocks are on their way back up from a recent plunge. And Len Yaffe, Stoc*Doc Partners, discusses key areas in the biotech industry, and his top stock picks.

Third, Jim McCaughan, Principal Global Investors CEO, says buying on setbacks is a promising strategy in U.S. equities. McCaughan is more cautious on emerging markets in the near term.

Lastly, Scott Minerd, CIO with Guggenheim Partners, discusses the jobs number and the markets and gives his best investing ideas, including investing in Spain (EWP) and Brazil (EWZ). Great comments on global liquidity trends, listen to this discussion.

We shall see what positive or negative surprises October has in store for us but one thing you should all be made aware of is James Bond is ditching his classic, straightforward martini for a dirty martini, combining vodka, dry vermouth, a muddled Sicilian green olive, and a measure of the olive’s brine (great choice!).

Hope you enjoyed this comment and wish you all a great weekend! Please remember to kindly donate and/or subscribe to this blog at the top right-hand side and support my efforts to bringing you the very best insights on pensions and investments. Thank you!!

Thursday, October 1, 2015

Why Is PSP Suing a Hedge Fund?

Ted Ballantine of Pension360 reports, Canada Pension Sues Hedge Fund Over Alleged Pricing Manipulation:
The full story was reported by Saijel Kishan and Katherine Burton of Bloomberg in their article, Boaz Weinstein's Revival of Saba Challenged by Pension's Lawsuit:
For Boaz Weinstein, whose credit fund had hemorrhaged money and investors over the past three years, April seemed like the turnaround moment.

The fund produced the best monthly return in its six-year history, a 10 percent jump that wiped out the pain of March when it suffered its biggest loss ever. From April on, there were no more losses, and he outpaced his rivals as volatility picked up in credit markets. Then on Friday, one of Canada’s largest pension plans and an erstwhile investor, said cheating may have contributed to the big swing -- allegations that Weinstein soon called “utter nonsense.”

In a suit filed by the Public Sector Pension Investment Board, once one of the biggest investors in the $1.6 billion Saba Capital Management, the pension fund accused Weinstein of “shortchanging” it by marking down a “significant” portion of the fund’s assets after the retirement plan asked that all its money be returned at the end of the first quarter. The next month, after the pension’s exit, Saba raised the value of the holdings, according to the lawsuit.

Whatever the outcome of the dispute, the accusations could curtail future money-raising for Weinstein, 42, as he seeks to rebuild his business, which has been hit by a 20 percent loss from the beginning of 2012 through last year. The tumble caused clients to pull billions, and employees, including three long-time executives, to leave the firm that once managed $5.5 billion.

‘Fully Vetted’

“Any suit of any nature against a fund manager will be a negative on a due-diligence checklist even if the suit is dismissed,’’ said Brad Balter, head of Boston-Based Balter Capital Management. “It’s not insurmountable, but it will be a hurdle to getting new investors.”

In a statement Sunday, Weinstein said he takes the allegations very seriously, even though they relate to only a “tiny portion” of the pension fund’s investment. “The valuation process was transparent, it was appropriate, it was fully vetted by auditors, counsel and others, and it was entirely fair,” he said. “The suggestion that I manipulated the valuation of two bonds for my personal gain is utter nonsense.”

The court fight could invite scrutiny from the Securities and Exchange Commission, which has cited valuations as one of its priorities this year and anticipates bringing cases involving pricing of portfolios.

SEC’s Concerns

“The SEC has several key concerns and valuation is one of them,’’ said Ron Geffner, a former SEC lawyer. In investigating cases of potential misvaluation, the SEC will look to see if a firm followed the methodologies disclosed in offering documents, its written policies and procedures and other client communications, said Geffner, now at Sadis & Goldberg LLP. If the investment manager deviated from its usual methods, the SEC will ask why the change occurred, he said.

John Nester, a spokesman at the agency, didn’t respond to a message seeking comment outside business hours.

The C$112 billion ($84 billion) pension fund, which oversees the retirement savings of Canadian federal public servants, said it was the Saba Offshore Feeder Fund’s largest investor, having invested $500 million over the course of 2012 and 2013 and accounting for 55 percent of the fund’s assets. The plan said it had asked Saba for its money back early this year, saying Saba’s 2014 losses appeared to be “unrelated to any market development that could or should have adversely affected the fund’s performance had the fund been properly managed,’’ according to the lawsuit.

McClatchy Bonds

Saba couldn’t adequately explain the losses, the Montreal-based pension fund wrote. The pension said it rejected a request by Saba to return capital in three installments, a move that allegedly would hide the redemption from other clients. By late January, clients accounting for 70 percent of the assets in the offshore fund asked for their money back.

The suit filed in Manhattan state court centers on hard-to-sell McClatchy Co. bonds owned by Saba. Between late January and the end of the quarter, there was only one trade done in the bonds that was for greater than $500,000 in notional value. Weinstein was looking to sell about $54 million in the bonds, according to a person familiar with the firm.

Normally, the hedge fund used independent pricing services or brokers who regularly traded the bonds, and these sources valued them at 50 cents to 60 cents on the dollar at the end of the first quarter, the pension plan said. When the pension asked for its money back, Saba used a different process called “bid wanted in competition,” a sort of auction used to trade a block of securities. That method valued the bonds at 31 cents as of March 31. Saba did not sell the bonds, and within a month, returned to its usual pricing methodology, marking the bonds in the 50s, the pension plan said.

Weinstein’s Response

“They did so to stanch further investor defections from the fund and to directly benefit themselves by boosting the residual value of their investments in the fund and other affiliated hedge funds with exposure to the same bonds,” according to the lawsuit. The pension plan, which is represented by law firm Skadden Arps Slate Meagher & Flom LLP, is asking for unspecified compensatory damages and disgorged profits.

Weinstein denied that he changed his pricing methodology in April. “We continued to use the auction to price those (and other) bonds in the second and third quarters of 2015,” he said in the statement. “PSP could have corrected its mistake with a one-minute phone call to me.”

Weinstein said he used the same auction process to sell 29 other bonds, prices that the pension fund didn’t challenge. “We couldn’t discard two of the prices resulting from the auction simply because PSP was unsatisfied with the outcome; to do so would have been improper and unfair to every other Saba investor,” he said. “I am 100 percent committed to treating all of my investors fairly, and I did exactly that in connection with PSP’s redemption."

‘Price for Liquidation’

Weinstein started Saba -- Hebrew for grandfather -- in 2009, after he stepped down as co-chief of the credit business at Deutsche Bank AG, where in 2008 he lost at least $1 billion. It was his only losing year out of 11 at the bank, a person with knowledge of the matter said at the time. At Saba, where he trades on price discrepancies between loans, bonds and derivatives, he initially produced strong profits, gaining 11 percent in 2010 and 9.3 percent the following year. Then he struggled as as central banks embraced quantitative easing that reduced volatility in credit markets.

Saba returned 7.6 percent this year through Friday.

Uzi Zucker, an early investor in Saba who pulled some of his money in the first quarter, called the suit unprofessional. “It’s just sour grapes,” he said. “He had to price for liquidation. I never questioned his judgment.”

The case is Public Sector Pension Investment Board v. Saba Capital Management LP, 653216/2015, New York State Supreme Court, New York County (Manhattan).
Antoine Gara of Forbes also reports, Canadian Pension Fund Says It Was Cheated By Boaz Weinstein's Saba Capital:
The Public Sector Pension Investment board, a pension fund for the Royal Canadian Mounted Police and the Canadian Forces is accusing Boaz Weinstein’s Saba Capital of incorrectly marking assets this year as it sought to redeem a $500 million investment in the hedge fund. PSP said in a Friday lawsuit filed in the New York State Supreme Court Saba and its founder Weinstein knowingly mis-marked assets during the redemption in order to inflate the value of the hedge fund’s remaining assets for investors, including top executives.

Weinstein, a former Deutsche Bank proprietary trader who lost nearly $2 billion for the German bank during the worst of the financial crisis, created Saba Capital in 2009 and quickly took in billions in assets from investors around the world. At its peak, Saba Capital held over $5 billion in assets under management. One of the firm’s most profitable trades was taking the other side of JPMorgan Chase’s so-called London Whale trading debacle in 2012, which cost the bank over $6 billion, but earned Saba significant profits.

When PSP made its $500 million investment in Saba in early 2012, the hedge fund had nearly $4 billion in assets under management. However, in recent years Saba’s assets quickly dwindled amid the fund’s poor performance. By the summer of 2014 Saba’s assets had fallen to $1.5 billion, PSP said in its lawsuit.

In early 2015, PSP reevaluated its investment in Saba and decided to redeem 100% of its Class A shares. At the time, PSP, a $112 billion fund, was Saba’s largest investor. To mitigate the impact of such a large redemption, Saba asked that PSP take its money back in three installments, however, the public pension fund refused.

Saba eventually agreed to a full redemption. PSP alleges that Saba knowingly manipulated its assets to depress their value during the redemption process, thus minimizing its payout.

According to its complaint, PSP accuses Saba of arbitrarily recorded a markdown on some of its bonds during the March 2015 redemption. A month later, Saba then marked its assets upwards. “As a result of defendants’ self-dealing, the Pension Board incurred a substantial loss on its investment in the Fund, for which defendants are liable,” PSP’s lawyers at Skadden, Arps , Slate, Meagher & Flom said in the complaint.

Specifically, Saba is accused of valuing bonds issued by The McClatchy Company using a bids-wanted-in-competition (BWIC) process that created depressed bidding prices that the hedge fund used to value PSP’s investment assets. Other measures from external pricing sources, which the hedge fund had used previously, put the McLatchy bonds at far higher values. Once the redemption was complete, Saba immediately moved away from BWIC valuations and back to those that could be gleaned from external pricing sources.

“[D]efendants used the BWIC process in a bad faith attempt to justify a drastic and inappropriate one-time markdown of the MNI Bonds held by the Master Fund, thereby depriving the Pension Board of the full amount it was entitled to receive upon redemption of its Class A shares of the Fund as of March 31, 2015. By reason of defendants’ unlawful conduct, the Pension Board has suffered substantial damages,” the fund said in its complaint.

In recent weeks Saba partners including Paul Andiorio, George Pan and Ken Weiller were reported by Bloomberg to have left the hedge fund.

Jonathan Gasthalter, a spokesperson for Saba Capital, relied with this comment:

“Saba Capital is disappointed that the Public Sector Pension Investment Board (“PSP”) has chosen to file a meritless lawsuit over the valuation of two securities out of well over a thousand. The difference in value at issue amounts to merely 2.6% of the total of PSP’s former investment with Saba.

As was explained to PSP in writing earlier this year, these two securities were priced using an industry-standard bid wanted in competition (BWIC) process, soliciting competitive bids from every leading broker and dealer in the relevant securities. The BWIC process was fully consistent with Saba’s valuation policy, and was carefully vetted and approved not only by Saba’s internal valuation committee, but by at least four external advisors: auditors, outside counsel, fund administrator, and Saba’s external members of its board of directors.

Contrary to the allegations in PSP’s complaint, Saba did not use the BWIC prices for a single month and solely for purposes of PSP’s redemption, but rather continued to use BWIC pricing as appropriate in the second and third quarters of 2015. Moreover, the results of the BWIC process were accepted by PSP more than 90% of the time, for dozens of securities. In only two instances–the two at the center of PSP’s lawsuit–did PSP take issue with the prices obtained by the BWIC process. PSP’s cherry-picked objection to these two prices has no legal merit.

Saba Capital took great care in redeeming PSP’s investment on a time-table dictated by PSP, including by finding fair and accurate market prices for extremely illiquid positions. Saba Capital looks forward to vindicating its position in court.”
This is an interesting case on many levels. Let me quickly share some of my thoughts:
  • First, PSP made a sizable investment in Mr. Weinstein's hedge fund, having invested $500 million over the course of 2012 and 2013 and accounting for 55 percent of the fund’s assets when it redeemed. I understand scale is an issue for the PSPs and CPPIBs of this world but whenever you make up over 25% of any fund's assets, you run the risk of significantly influencing the performance of this fund or its ability to garner assets from other investors who aren't going to invest knowing one investor makes up the bulk of the assets.
  • Second, why exactly did PSP invest so much money in this particular hedge fund and what took it so long to exit this fund? Saba Capital Management suffered losses over the past three consecutive years! I would love to know the due diligence PSP's team performed, especially on the operational front, and understand their rationale after reviewing the people, investment process, operational and investment risks at this fund. It looks like PSP was lulled by the fund's decent performance in 2010 and 2011 but investing $500 million with a manager who lost $1 billion back in 2008 is crazy if you ask me. There certainly wasn't a lot of backward or forward analysis on PSP's part in making such a sizable investment to this hedge fund.
  • Third, on the operational front, did PSP perform a due diligence on this fund's administrator (one that has the expertise to rigorously analyze the fund's NAV) and was the way the fund prices bonds clearly spelled out in the investment management agreement (IMA)? This lies at the heart of the issue. When you're investing in a quant/ credit hedge fund that invests in illiquid bonds or derivatives, you need to understand the method it prices these investments and you better be comfortable with it before you sign off on such a sizable allocation. If Mr. Weinstein violated the IMA in any way, then PSP is absolutely right to sue him. If not, PSP will lose this case no matter what it claims. It's that simple.
  • Fourth, this case also highlights why more and more institutional investors are moving to a managed account platform when investing in hedge funds. Go back to read my comments on Ontario Teachers' new leader and on his harsh hedge fund lessons. Following the 2008 debacle, Teachers' moved most of its hedge fund investments onto a managed account platform to mitigate operational risk and more importantly, liquidity risk which is currently a huge concern. But even if you have a managed account platform and have transparency, it's useless unless the underlying investments are liquid. And again, did the manager violate the IMA? That's the key issue here.
  • Fifth, this lawsuit is a black eye for Saba Capital Management which has suffered from redemptions and key departures. As one investor stated in the article, it's a negative for a due diligence checklist and it will be a hurdle to getting new investors. But the lawsuit also reflects badly on PSP Investments and it will make it harder for this organization to approach top hedge funds which can pick and choose their investors in this tough environment. Nobody wants a litigious pension fund as a client and win or lose, this lawsuit is a lose-lose for both parties involved in the case. Mr. Weinstein claims “PSP could have corrected its mistake with a one-minute phone call to me.” If this is true, then why didn't PSP call him to rectify the misunderstanding or why didn't Mr. Weinstein reach out to PSP to make this suit go away?
  • Lastly, I would love to know which other pension funds invested in this hedge fund and how this lawsuit and recent redemptions are impacting their impression of the fund. 
Those are my brief thoughts on this case. One expert I reached out to shared this with me on this case: 
"The situation may have been averted if the proper controls were in place to monitor the fund's pricing and ongoing monitoring of funds redeeming from it. In this case, it's a credit hedge fund investing Level 2 assets. The price was most likely derived from broker prices. However, if the controls were put in place, then PSP may have a point and the manager may be at fault."
There is nothing that pisses off institutional investors more than operational mishaps or fuzzy pricing when they are redeeming from a hedge fund. I remember when I was working at the Caisse investing in hedge funds and we had trouble with a CTA as we wanted to move from a highly levered fund to one of his lower levered funds. It took forever for this manager to execute a simple request and here we are talking about a CTA who invests in highly liquid instruments! I called him a few times and warned him that we weren't pleased at all and he gave me some lame excuse that the funds were tied up with his administrator.

News flash for all you overpaid hedge fund Soros wannabes out there. When an institutional investor wants to redeem, please stop the lame excuses on your pathetic performance and don't get cute on pricing. In fact, you should be bending over backwards to accommodate these investors on the way out just as hard as when you were schmoozing them when you wanted them to invest in your fund.

As always, if you have anything to add on this case, you can email me at LKolivakis@gmail.com. Let me end by plugging a couple of Montreal firms that specialize in operational due diligence for hedge funds, Castle Hall Alternatives run by Chris Addy and Phocion Investments which is run by Ioannis Segounis, his brother Kosta, and David Rowen (Phocion specializes in performance, operational and compliance due diligence. In fact, performance analysis is Phocion's bread and butter which gives them a real edge over their competitors).

As far as a managed account platform, Montreal's Innocap is still around and provides excellent services to institutional investors looking to gain more transparency on their hedge fund investments and significantly mitigate their operational and liquidity risks (for a small fee, of course, and Innocap also makes sure the hedge fund managers are properly pricing all their investments on a daily basis and raise flags if they see discrepancies in the pricing).

Below, an older Senate Banking Committee (1998) where you will hear testimony from Brooskley Born, the former head of the CFTC discussing operational risk at large hedge funds investing in the OTC derivatives market. It's too bad President Clinton, Alan Greenspan and Robert Rubin never heeded her warning and foolishly marginalized her. She would agree with me and tell all investors to beware of large hedge funds, now more than ever.

Wednesday, September 30, 2015

Who Gets The Last Laugh on Stocks?

Myles Udland of Business Insider reports, Bill Gross is literally laughing at the stock market:
Bill Gross is literally laughing at the stock market.

In a tweet on Tuesday morning, Janus Capital's Bill Gross said: "Stock market refrain from a few months ago: "Where else are you gonna put your money?" LOL ... Ever considered cash?"

Put another way, Gross is laughing at people who invested in the stock market because there was nothing else to invest in.

Folks who have been reading Gross' investment updates over the past year or so most likely know that Gross would prefer holding cash to being invested in the stock market — or almost anything else.

Early in September, Gross' monthly missive basically said everything sucked.

Gross wrote:
Global fiscal (and monetary) policy is not now constructive nor growth enhancing, nor is it likely to be. If that be the case, then equity market capital gains and future returns are likely to be limited if not downward sloping. High quality global bond markets offer little reward relative to durational risk. Private equity and hedge related returns cannot long prosper if global growth remains anemic. Cash or better yet "near cash" such as 1-2 year corporate bonds are my best idea of appropriate risks/reward investments. The reward is not much, but as Will Rogers once said during the Great Depression – "I'm not so much concerned about the return on my money as the return of my money."
Early Tuesday, stocks were falling after getting crushed on Monday.
I guess we can add the former bond king to a growing list of investment gurus warning of a looming catastrophe ahead. The only problem is the stock market is laughing right back at Bill Gross and other doomsayers.

In fact, ever notice how every time we get a big pullback in stocks you get all these dire warnings from gurus that the worst is yet to come? Sure, stocks are getting clobbered and some sectors like biotech just experienced a real drubbing in Q3 but if you ask me, it's better to ignore these dire warnings from eminent "investment gurus" and remember the wise words of the late comic genius George Carlin: "It's all bullshit and it's bad for you!".

That's right folks, there is so much nonsense and misinformation being spread out there from informed sources that it's no wonder many retail and institutional investors are having a hard time navigating through these volatile markets. And some of the best and brightest are taking a real beating this year.

Take the time to read my recent comment on the looming catastrophe ahead.  I cleaned up some typos and dates I got wrong but my message remains the same. In fact, I was listening to Jim Cramer on CNBC this morning (cynics call him the king of bullshit but he has spurts of great insights) and he made a few excellent points on how Tuesday was the fiscal year-end for mutual funds and many sold stocks for tax reasons and how these markets are highly illiquid, exacerbating downside moves.

What else? Tim O'Neill, Goldman Sachs' partner and global co-head of the investment management division, has a warning: If passive investing gets too big, then the stock market won't work.

I should know, I trade biotech stocks and have seen huge and unbelievable downside moves which makes me highly suspicious that either Fidelity (the biggest biotech investor in the world) is playing games here to "shake out weak hands" or there was some big hedge funds suffering from redemptions and forced to close out their big leveraged biotech bets. Either way, I'm not panicking here and prefer to sit tight and ride out this storm.

On Wednesday, things are looking much better. Sure, we're heading into the dreaded month of October but I'm confident the worst is behind us, especially in the biotech sector which everyone now loves to hate. Pay close attention to the iShares Nasdaq Biotechnology (IBB) and the SPDR S&P Biotech ETF (XBI) as I think they are going to bounce big from these way oversold levels once these markets stabilize (click on images):

Keep in mind the former is made up of large biotech stocks and leads the latter which is made up of smaller biotech stocks and is thus a lot more volatile. The same goes for the ALPS Medical Breakthroughs ETF (SBIO). It too is made of small cap biotech shares which swing like crazy (all biotech stocks are definitely not for the faint of heart).

Below, I list a few small biotech companies I track and trade. Some are way oversold and look terrible from a technical point of view but I'm confident many will recover from the latest biotech bloodbath (click on image):

There are plenty more but the truth is this sector just experienced a good thrashing and it scared the crap out of many investors. Still, if you think the rout in biotech is awful, check out the carnage in energy (XLE) and metals and mining shares (XME) or even in top hedge fund picks like Sun Edison (SUNE). OUCH!!

Below, CNBC's Brian Sullivan looks at how much market cap has been lost by the big oil companies during the commodities crush. In his latest comment, We’ve Seen This Picture Before—–Global Markets Down $13 Trillion Already, David Stockman warns the worst is yet to come.

I prefer listening to the ageless wisdom of George Carlin than all these so-called investment experts.  He nails it in the clip below and if you need a good laugh to get your mind off markets, watch it.