Thursday, January 31, 2013

Pensions Taking On Too Much Illiquidity Risk?

My last comment on the Caisse focusing on illiquid asset classes generated a few excellent responses, so I decided to follow-up on this topic. Let me begin with what a former pension fund manager shared with me after reading my comment:
Excellent article. I am always impressed to see that some investors still think that illiquid assets are less volatile. Most investors know that illiquid assets have their traditional risk measures (standard deviation, covariance, correlation and beta) underestimated due to stale pricing and infrequent “third-party” valuations. Of course, one can use relatively simple statistical adjustments to estimate the true underlying risk but many investors still prefer to stick with the underestimated risk measures.

Private equities generally use more leverage than the average public market investment. It is therefore not surprising to observe a statistically adjusted Beta higher than one. A leading edge Canadian investment organization assumes an average beta of 1.3 for its Private Equity portfolio.

If you don’t risk-adjust your returns, investing in levered strategies, high beta strategies, and private equities may look like a winning strategy. This will outperform when the public market goes up, and it will underperform in down markets. In the long run, assuming the markets go up, the strategy will work but with much more real volatility than its benchmark.

I have done some statistical analysis of a large investment organization using such approach and conclude that its departure from its benchmark in investing into levered strategies, high beta strategies, and private equities is statistically significant. I also find that its residual alpha is significant too but negative. Thus, if one has a negative investment skill (in the sense of stock picking, bond picking, etc), one can try to hide it by leveraging its Beta…

At the end of 2011, the Caisse’s benchmark had 24.4% exposure to private equity, infrastructure and Real Estate. The actual portfolio was slightly overexposed at 25.0% (down from 25.4% in 2010). The planned increases from 25% to 30% will significantly increase the active risk of the portfolio. The unadjusted (apparent) total risk may go down but the true (adjusted) total risk will significantly go up. The Caisse with the largest risk department in Canada (and one of the largest in the world) should know better.

As you mentioned, benchmarking is a major issue in private equities. And one should always be skeptical of changes in those benchmarks. Many such benchmarks are non-public and many suffer from survivorship bias. I have observed one major investor outperforming its benchmark by more than 20% in the first half of the year, then matching its new benchmark in the second half. Was the benchmark changed to lock-in an outperformance obtained by improper risk taking?

I also agree with your observation that the herd behavior of investors out of public equities, into private equities is changing the supply/demand relationship of these assets and therefore affecting their future return potential – something to keep in mind. If too many investors are chasing the same private equity deals, the higher pricing of these investments can only make future returns lower.
There are many excellent points in this comment. First, if you don't adjust returns for risk, private equity (and other illiquid asset classes like real estate and infrastructure) always outperform traditional stocks and bonds. This is why left unconstrained, asset allocation "optimization" models will allocate as much as possible into these illiquid asset classes because they underestimate the true risk of these investments (pension risk managers know this and adjust accordingly).

Moreover, academic studies have shown that there is substantial heterogeneity across private equity funds and that median returns underperform the S&P500. And unlike mutual funds, there is performance persistence among top funds, although lately there seems to be a changing of the old private equity guard.

Other studies using a select sample of funds have found private equity outperforms public markets net of fees but is highly correlated with public market conditions:
On average, our sample funds have outperformed the S&P 500 on a net-of-fee basis by about 15%, or about 1.5% per year. Performance and cash flows over time are highly correlated with public market conditions. Consequently, funds raised in hot markets underperform in absolute terms (IRR) but not relative to the S&P 500 (PME). Both capital calls and distributions are  more likely and larger when public equity valuations rise, but distributions are more sensitive  than calls, implying that net cash flows are procyclical and private equity funds are liquidity providers (sinks) when valuations are high (low). Controlling for public equity valuations, there is little evidence for the common view that private equity is a liquidity sink, except during the financial crisis and ensuing recession of 2007-2009, when unexplained calls spiked and distributions plummeted.
I won't get into the pros and cons of academic studies on private equity and hedge funds. Suffice to note that most of these studies are fraught with pitfalls, survivorship bias being one of the biggest (lots of hedge funds and PE funds don't survive, biasing performance data).

But the comment above from the former pension fund manager also elicited this detailed response from a private equity expert defending the asset class:
Lots of strongly felt assumptions going on here, many reflect familiar biases and presumptions that have plenty room for debate.

For example, valuations of companies do not in fact fluctuate as widely as values of minority bits and pieces of stocks in listed companies (why would they?). The only public company value that is comparable is a takeover bid, which is always at a premium, often significant (30 to 50 %) to the trading value implied market cap. The public market bias in those who evaluate private equity presume the way public markets are evaluated is sacrosanct. Stale pricing, or perhaps correct but simply necessarily subjective and therefore impossible to truly validate? Try unloading 100 % of the a listed company stock on the public market at the end of the trading day, and then you can mark to market.

Many private equity strategies are structured with much more downside protection than a trading common stock, and can mute valuation changes quite legitimately. Sure some firms have higher than public leverage, but the presumption is the public leverage is optimal in the first instance, it rarely is. In private equity, a company is worth what one can finance, a pretty good capitalistic indicator of value, not indicative of "excessive" leverage other than in hindsight.

Most mainstream private equity returns come from acquisition add-ons, or transformative mergers, which are challenging for staff and industries but otherwise have proven productivity enhancing outcomes, or stretch out the life of otherwise dying or fading businesses. Many also use growth capital, debt and equity to enhance existing businesses, and all employ management incentive structures that are far more focused than in most public companies.

To say alpha is negative is fine but presumes alpha makes any sense, that beta is always a rational known, and the time horizons for measuring (a quarter, a year? 10 years?) lead one to rethinking this and regress to old ideas, like seeking absolute returns (used to be called profits) like any other commercial enterprise, which simply makes more intellectual sense. Why should asset managers allocate capital so differently than commercial enterprise allocate their capital, ie. old style payback, hurdle rates and other types of project finance time tested ideas - that's what privately equity is actually structured around as an industry business model, for good reason. The whole alpha beta split is responsible for epic misallocation of capital. Parsing return attribution over short periods is a fools game, really one of compensation, and one that management's at institutions and their comp consultants exploit well.

The fact is that many private equity investment programs don't deliver, but a small but significant number do. All the analysis shows you is being median is a waste of time, while in the public markets median might still be ok. Rather than homogenize the whole industry and force an asset class definition, the portfolio objective is to diversify away from the public market culture and ecosystem, which is quite arguably very polluted, maybe even broken or at least has moved too far away from serving its business aims.

Private equity at its best goes back to old time business rather than investment values, and rewards risks in a way that is much more clearly aligned with investors ie. most comp is paid when cash is returned to investors - why do institutions not require this for hedge funds? Why do institutions say infrastructure is not really equity, because bond and risk guys say so, when it actually is (equity means massive ownership responsibility, not just a different stream of the cash flow), and is often even more levered than private equity? And traders get libor cost of funds, yet that cost of capital is not made available to other traditional investments when evaluating alpha? Why not?

Too many issues and biases for me to even address here. The point is, the reference point the commenter makes assume all other areas of investment and risk have been perfected, and private equity is driving a truck through the framework. Good to think through the potential dysfunctions, but it is far from uniquely in private equity.

You know I am a major sceptic of private equity and those that mislead their audiences and institutions, and I am far from being a shill for the industry. But the challenge is to do the task well, and keep the public market and asset management pollution out of the picture.
I think the Caisse is in its own way trying to escape the dysfunctions of our times, and trying to find a better way. Private equity and illiquids may not be the solution, but what is? They should be applauded for taking a view, however flawed or simplistic it may be.
I don't know if the Caisse is trying to "escape the dysfunctions of our times," but they have taken a clear view that bonds and stocks won't suffice to meet the target rate of returns set by their depositors and are thus allocating more into illiquid private markets.

And they're not alone. Following my last comment, another pension fund manager sent me a Bloomberg article discussing how Norway's plan to cut tariffs to ship gas through its pipelines by 90 percent will deal a blow to funds that have spent more than $5 billion since 2010 buying stakes in the infrastructure of western Europe’s largest gas producer.

The article specifically mentions the Canada Pension Plan Investment Board (CPPIB) and the Public Sector Pension Investment Board (PSPIB) as two of the major investors in these pipelines:
Statoil ASA (STL), which is 67 percent owned by the Norwegian state, sold a 24 percent stake in Gassled in 2011 for 17.35 billion kroner, bringing its holding down to 5 percent. The stake was bought by Solveig, a company owned by Canada Pension Plan Investment Board, Allianz Capital Partners, a subsidiary of Allianz, and Infinity Investments SA, a unit of the Abu Dhabi Investment Authority.

Total AS and Royal Dutch Shell Plc (RDSA) also sold stakes in Gassled in 2011.

Shell in September 2011 agreed to sell its 5 percent stake for 3.9 billion kroner to Infragas Norge AS, a unit of Canada’s Public Sector Pension Investment Board. Total in June 2011 agreed to sell its 6.4 percent stake for 4.6 billion kroner to Silex Gas Norway AS, owned by Allianz.

The pension fund manager who sent me the article noted "how do you model this risk?". And he's right, there are many regulatory risks and other risks in infrastructure that are difficult if not impossible to model.

One of the best comments on the risks of illiquid asset classes I received yesterday came from Jim Keohane, president and CEO of the Healthcare of Ontario Pension Plan (HOOPP). Jim notes the following after reading my last comment:
I find this whole discussion quite interesting. I agree with the commentary of the former pension fund manager. Private assets are just as volatile as public assets. When private assets are sold the main valuation methodology for determining the appropriate price is public market comparables, so you would be kidding yourself if you thought that private market valuations are materially different than their public market comparables. Just because you don’t mark private assets to market every day doesn’t make them less volatile, it just gives you the illusion of lack of volatility.

Another important element which seems to get missed in these discussions is the value of liquidity. At different points in time having liquidity in your portfolio can be extremely valuable. One only needs to look back to 2008 to see the benefits of having liquidity. If you had the liquidity to position yourself on the buy side of some of the distressed selling which happened in 2008 and early 2009, you were able to pick up some unbelievable bargains.
Moving into illiquid assets increases the risk of the portfolio and causes you to forgo opportunities that arise from time to time when distressed selling occurs - in fact it may cause you to be the distressed seller! Liquidity is a very valuable part of your portfolio both from a risk management point of view and from a return seeking point of view. You should not give up liquidity unless you are being well compensated to do so. Current private market valuations do not compensate you for accepting illiquidity, so in my view there is not a very compelling case to move out of public markets and into private markets at this time.
Got that folks? Current private market valuations do not compensate you for accepting illiquididty risk. Lots of pensions learned the value of liquidity the hard way during the 2008 crisis. When they needed it the most, they didn't have it and were forced to sell public market assets at distressed levels to shore up their liquidity.

Jim Keohane also shared his thoughts on Norway's proposed cut in tariffs:
The pipeline example illustrates the point. By investing in private assets you assume all the same risks that you assume when investing in public companies. In the case of infrastructure assets, you also face regulatory risks such as this. Generally speaking, local governments will take actions that favor their stakeholders – the voters in their country and don’t care whether it disadvantages a foreign pension plan. You would be naïve to think otherwise. Canadian governments and regulators act the same way.

I am sure that CPPIB and PSP are well aware that these types of political risks exist within these types of investments. Valuations are the critical factor. As long as you receive a high enough risk premium to compensate you for taking on these risks then it is an appropriate investment. I think that the point that this brings out is that investing in infrastructure is not a free ride. It has all of the risks contained in any other equity investment, so you need to go in with your eyes wide open!
Finally, a pension policy expert from British Columbia sent me this note:
Leo, I’m always impressed by the quality of the comments by the folks who comment on your postings. Shows you are becoming the most prominent commentator on pensions in Canada – and I suspect broader as well.

I’ve always been nervous about this whole private equity thing – not to mention real estate, as I’m not sure how accurate the valuation is. My suspicion has been that changes in value would generally lag the market, especially on the down side – that is just human nature – to think your assets are worth more than they really are, and I suspect the trend to upgrade valuations is most likely when the tide is rising.

Learning more about how the benchmarks are set for private equity and real estate make me even more cautious – especially when bonuses are related to benchmark outperformance. I suspect most boards do not have the expertise to assess the validity of the benchmarks their investment people are recommending them to approve. It seems a whole industry has build up around benchmarks.
The entire pension industry is indeed built around benchmarks which is why I've spent a lot of time in the past demystifying pension fund benchmarks. It's not an easy topic and it doesn't win me support from many senior pension fund managers in Canada who think they're being properly compensated for the risks they're taking.

But this blog is unique and has done more to increase the dialogue on tricky issues in pensions than most other financial news outlets, including specialized pension magazines and sites. The contributions you read here are simply not found anywhere else.

This is why I will ask all of you -- friends and foes -- to show your support by donating any amount or better yet, subscribing on a monthly basis to this blog by clicking on the PayPal button on the right hand side just above my profile picture. I realize that the blog comments are free but I put a lot of  time and effort in these comments. I thank those of you who have donated or have subscribed to a monthly donation.

Below, Mark Weisdorf, chief executive officer of infrastructure investing for JPMorgan Asset Management (formerly head of private markets at CPPIB), talks about strategy for private investment in infrastructure. He speaks with Deirdre Bolton on Bloomberg Television's "Money Moves."

Wednesday, January 30, 2013

Caisse to Focus on ‘Less Liquid’ Assets?

Frederic Tomesco and Doug Alexander of Bloomberg report, Caisse to Focus on ‘Less Liquid’ Assets, CEO Sabia Says:
Caisse de Depot et Placement du Quebec, Canada’s second-largest pension-fund manager, will increase investments in assets such as real estate, infrastructure and private equity to reduce volatility in its returns, Chief Executive Officer Michael Sabia said.

“The markets are no longer a good gauge of value,” Sabia told reporters today during a briefing in Montreal. “Markets are a source of volatility. We think this volatility will last quite some time.”

The Caisse plans to add C$10 billion ($9.97 billion) to C$12 billion in what it calls less-liquid investments in the next two years, Sabia, 59, said. The Montreal-based fund manager seeks to have about 30 percent of its assets in private equity, real estate and infrastructure by the end of 2014, up from 25 percent.

“We have to find a replacement for the performance in fixed-income that will no longer be there,” Sabia said. “We want to stabilize the performance of the organization.”

The Caisse oversees pensions for retirees in the French- speaking province of Quebec, with a dual mandate to maximize returns and foster economic growth in the province. It had net assets of C$165.7 billion as of June 30, including about 37 percent each invested in publicly traded stocks and fixed income.

“Our objective is not to be spectacular,” said Sabia, who has been running the Caisse since 2009. “We are a long-term investor and what matters is the performance over three, five or 10 years.”
Alternative Assets

Canada’s pension funds have been looking to invest more in alternative assets such as infrastructure and real estate, said Scott MacDonald, head of pensions, insurance and sovereign- wealth strategy for RBC Investor Services. (RY)

“Elite-sized plans in Canada have been investing a disproportionate amount of their assets in real estate and infrastructure,” MacDonald said in an interview. “Those returns have been very high and that trend towards investing in those asset classes will continue.”

The country’s defined benefit pensions returned a median 9.4 percent in 2012, according to a survey by RBC Investor Services, a unit of Royal Bank of Canada.
Global Leaders

The Caisse also wants to build up a fund it started in January to buy stakes in companies it considers global leaders. It will add its holdings in Nestle SA (NESN), HJ Heinz Co. (HNZ) and Qualcomm Inc. (QCOM) into the fund, said Roland Lescure, chief investment officer, also speaking at today’s event.

The fund, which will account for about 10 percent of the fund manager’s assets, will hold onto its investments for the long term, he said.

The shift will come as the Caisse pares investments in traditional index investing. “In two to three years we will have fewer traditional equity investments,” Lescure said.

The Caisse plans to also increase investments in emerging markets, Lescure said. Emerging economies such as India and Brazil accounted for 5 percent of total assets at the end of 2011, according to the Caisse’s most recent annual report.

About C$41.2 billion of the Caisse’s assets are located in Quebec, according to the pension-fund manager’s 2011 annual report. The Caisse has invested in more than 530 Quebec companies.
SNC-Lavalin

Sabia said the Caisse plans to stand behind its investment in SNC-Lavalin Group Inc. (SNC), the Montreal-based company embroiled in corruption and fraud probes in Canada and abroad.

“SNC-Lavalin is tarnished because of what happened, but it’s a company worth building,” Sabia said. “They face some challenges but we will be there because we’re convinced of the potential.”

Canada’s largest engineering and construction company has been grappling with $56 million in incorrectly booked expenses and a former executive’s arrest in Switzerland amid a probe of corruption in North Africa. Former chief executive officer Pierre Duhaime faces fraud charges related to a Quebec hospital contract.

“This is a time when a long-term investor like the Caisse needs to help the company build a bridge to a different future,” Sabia said. “If we weren’t convinced of that we would have already exited.”

Canada Pension Plan Investment Board is the country’s biggest public pension manager, with net assets of C$170.1 billion as of Sept. 30.
I read this article last night and fired off an email to Michael Sabia: "Congratulations. You're now converted to a full-fledged pension fund manager! -;)" and added "Be careful with alternatives, they're no panacea." He replied "Thanks!!".

Of course, I was kidding around about being converted to a full-fledged pension fund manager, but dead serious about alternatives not being a panacea. These days it seems like all pensions are betting big with private equity, real estate and infrastructure.

And remember, whenever the pension herd moves into any asset class in such size, its collective action impacts the risk premium in this asset class, bringing down future returns.

But Michael Sabia thinks the bond party is over and he's right, faced with historic low bond yields and volatile equity markets, more and more pensions are looking at illiquid asset classes to achieve their actuarial rate of return. Let me sum up the reasons why pensions are taking this route into illiquid asset classes:
  1. Volatile public markets: Historic low bond yields, sovereign bond concerns, volatile equity markets, massive quantitative easing by central banks, high-frequency trading, naked short-selling, hedge fund Darwinism and cannibalism. Even the world's biggest and best hedge fund is having trouble posting the returns it once did and other well known quant funds are chopping fees in half to stay competitive. In such an environment, how are large pension funds suppose to compete? One way is to take a long-term approach in both private and public markets. Also, illiquid investments aren't marked-to-market, so stale pricing due to infrequent valuations provides much needed return diversification for these large pensions.
  2. Stable cash flows, more control: Pensions like the stable cash flows that come with illiquid asset classes like real estate and infrastructure. It makes it easier for them to plan for liquidity needs of paying out pensions. Also, Canadian pensions do a lot of direct investments in private equity, and co-invest with top funds, giving them more control over these private investments.
  3. Leverage: Another reason pensions like illiquid asset classes is because they can use leverage to juice up their returns. Some pensions have internal limits on how much leverage they can use but this doesn't apply to their external private equity managers.
  4. Managing reputation risk:  Pension funds have become so scared facing their depositors every time they lose money that they're working hard to develop a framework to insulate themselves from negative press articles and manage reputation risk. Notice how the focus shifts on absolute returns when they underperform public market benchmarks. The problem is that many pensions, including the Caisse, are not taking enough risks in public markets. It's less risky to do so in private markets where they can play around with fair value and benchmarks.
  5. Much easier to fudge private market benchmarks: The fifth and equally important reason large Canadian pension funds love illiquid asset classes that it's easier to "fudge" these benchmarks, increasing the probability of beating their overall policy portfolio (beta) benchmark. This translates into big fat bonuses for senior managers at large Canadian pension funds. In other words, potential compensation influences their behavior and choice of asset classes. Without fail, if you take any annual report of all these large funds since the crisis, you'll see their president stating "significant value added was achieved in real estate, private equity and infrastructure." Duh! Because in most cases, private market benchmarks don't reflect the risks they're taking in these illiquid asset classes (ie. do not take into account illiquidity, leverage, and beta of the asset class).
On the issue of benchmarks in illiquid asset classes, in my last comment on pensions betting big with private equity, I wrote that even though it isn't perfect, I prefer using a spread over public markets to gauge the value added of these private investments. An astute investor in private equity sent me this comment:
Public benchmarks make no sense for private equity, and create huge perverse incentives. Might work when one looks back over ten years, but there is no actionable perspective that a public benchmark provides over any useful timetable. I can tell you many dysfunctions of public benchmarks, the whole fund secondaries businesses with discounts to NAV creates huge incentive to transact in this fashion as an obvious example.
And if private equity is supposed to be a diversifier, then in any give year why would aligning with public markets be expected? You will end up paying people for expected diversification effects. If it was so darn simple, do private equity and beat the public markets, and get diversification, holy grail!
Funny how it doesn't work out that way. CPPIB, net of costs and currencies has LOST money on private equity. Someday this will become a major problem for them. And OTPP doubled down with huge commitments at peak cycle too. Their returns on private equity are fading with time, and will not beat public markets long term. Inconvenient truths...too bad allocations continue to be made on the basis of "facts" that don't hold up to due diligence.
He also shared this with me:
I think the strategy around illiquids is very superficial, and the risk of actually owning a company, rather just some shares, carries immensely more responsibilities and the skills and wisdom is beyond that of a "portfolio manager" with numerous other investments to attend to.. Few organizations have really been tested as owners, the institutional business model just does not lend itself to long term accountability landing on a specific individual.
Whoa! Talk about exposing the bullshit in private equity! Before I get bombarded with emails from CPPIB and Ontario Teachers' telling me these assertions are wrong, would like to highlight many other large funds, including CalPERS and PSP, made huge commitments at peak cycle too. Funds learned the hard way all about vintage year diversification. This is what allowed the secondary market to flourish after the crisis.

I still believe that private equity is inextricably tied to public equities. The same can be said about real estate and infrastructure. It's obviously not the same as there should always be opportunities to exploit in these private markets that are not as readily available in public markets But at the end of the day, the opportunity cost of investing in private should be some spread over public markets. The perverse incentives this may create, however, must be taken into account by board of directors.

Finally, while I understand why the Caissse and others are betting big with private, illiquid asset classes, I question the timing as they risk missing the Mother-of-all bull markets. Also worry about them underestimating the risks of these investments. I don't think private markets are the panacea pension fund managers make them out to be and there have been some huge losses and mishaps in these assets too at the Caisse and other large pension funds (need I remind you of the Holy Halabi incident?).

Also, I think the Caisse and other large pension funds can do a hell of a lot more to bolster their internal public market and absolute return groups which focus on taking timely, opportunistic risks in public markets.

The focus on large, global companies is fine but there is a lot more juice to exploit in the small and mid cap space. Even in large global companies, there are tremendous opportunities in companies that are undervalued (eg. Nokia!). As far as emerging markets, can play them directly or through American companies like Caterpillar or through sectors like coal, copper and steel. In my opinion, the Caisse did a huge mistake in indexing their global equities after the crisis.

Another wise investor and former pension fund manager shared these excellent insights with me after reading this comment:
Excellent article. I am always impressed to see that some investors still think that illiquid assets are less volatile. Most investors know that illiquid assets have their traditional risk measures (standard deviation, covariance, correlation and beta) underestimated due to stale pricing and infrequent “third-party” valuations. Of course, one can use relatively simple statistical adjustments to estimate the true underlying risk but many investors still prefer to stick with the underestimated risk measures.

Private equities generally use more leverage than the average public market investment. It is therefore not surprising to observe a statistically adjusted Beta higher than one. A leading edge Canadian investment organization assumes an average beta of 1.3 for its Private Equity portfolio.

If you don’t risk-adjust your returns, investing in levered strategies, high beta strategies, and private equities may look like a winning strategy. This will outperform when the public market goes up, and it will underperform in down markets. In the long run, assuming the markets go up, the strategy will work but with much more real volatility than its benchmark.

I have done some statistical analysis of a large investment organization using such approach and conclude that its departure from its benchmark in investing into levered strategies, high beta strategies, and private equities is statistically significant. I also find that its residual alpha is significant too but negative. Thus, if one has a negative investment skill (in the sense of stock picking, bond picking, etc), one can try to hide it by leveraging its Beta…

At the end of 2011, the Caisse’s benchmark had 24.4% exposure to private equity, infrastructure and Real Estate. The actual portfolio was slightly overexposed at 25.0% (down from 25.4% in 2010). The planned increases from 25% to 30% will significantly increase the active risk of the portfolio. The unadjusted (apparent) total risk may go down but the true (adjusted) total risk will significantly go up. The Caisse with the largest risk department in Canada (and one of the largest in the world) should know better.

As you mentioned, benchmarking is a major issue in private equities. And one should always be skeptical of changes in those benchmarks. Many such benchmarks are non-public and many suffer from survivorship bias. I have observed one major investor outperforming its benchmark by more than 20% in the first half of the year, then matching its new benchmark in the second half. Was the benchmark changed to lock-in an outperformance obtained by improper risk taking?

I also agree with your observation that the herd behavior of investors out of public equities, into private equities is changing the supply/demand relationship of these assets and therefore affecting their future return potential – something to keep in mind. If too many investors are chasing the same private equity deals, the higher pricing of these investments can only make future returns lower.
Finally, while we're on the subject of illiquid asset classes, maybe the Caisse should invest in Quebec's grossly dilapidated infrastructure. Montreal is recovering from major flooding after a water main broke near the intersection of Doctor Penfield Avenue and McTavish Street, sending water gushing into the downtown core. Below, CBC's Joanne Vrakas reports on cleaning up this mess.

Tuesday, January 29, 2013

Five Reasons to Go Slow on C/QPP Expansion?

Fred Vettese, chief actuary of Morneau Shepell, wrote an op-ed for the National Post, Five reasons Canada should go slow on CPP expansion (h/t Suzanne Bishopric):
In December 2010, the federal and provincial finance ministers examined Canada’s retirement system and concluded it was reasonably sound.

At most, the system seemed to be in need of nothing more than minor tinkering. Thoughts of increasing the pensions paid under the Canada/Quebec Pension Plan (C/QPP) were shelved indefinitely and the focus shifted to developing a new, voluntary retirement savings vehicle: Pooled Registered Pension Plans (PRPPs).

Two years later, the federal government stunned many pension observers by announcing it will reconsider expanding the Canada/Quebec Pension Plan after all. Various options for expansion will be discussed by the finance ministers in June. 
So what happened?
In 2010, Alberta and Quebec were both opposed to expanding the C/QPP with only Ontario keen to proceed. The recent election of a pro-labour government in Quebec, however, eliminated Quebec’s opposition and was enough to tip the scales in favour of revisiting “Big C/QPP.” In the meantime, Ontario’s conspicuous lack of enthusiasm for PRPPs seems to have infected the other provinces, which are now dragging their heels after an early show of enthusiasm.

On the surface, Big C/QPP seems a no-brainer. A pension equal to 25% of the average wage – which is what the C/QPP currently provides – is obviously not enough for middle-income households, even if you add in OAS. Surely it would be a good thing for all working Canadians to have bigger pensions, especially given that the coverage ratio within private pension plan is down to only 21% (yes, 21%) in the private sector. 

But when we take a closer look, the case for a bigger C/QPP is questionable at best, and if it is implemented poorly it can be a disaster. Here are five reasons why we should want to take it slow.

1. We don’t have a retirement crisis in spite of perceptions to the contrary, and none will develop for many years to come. The poverty rate among seniors is very low in absolute terms, less than half that of Canadians aged 18-64. An expanded C/QPP therefore starts to resemble a solution looking for a problem. The news is better than most of us realize. Nearly half of recent retirees have enough retirement income to replace more than 115% of their regular pre-retirement consumption.

2. The real looming problem in Canada is the rising cost of health care. We are already paying about $200-billion a year for health care and that is expected to rise by another 50% in real terms over the next 20 years. This is a serious problem because it will crowd out program spending for education and pensions. The rising healthcare bill will inevitably lead to higher taxes or user fees. Before we decide we’re ready to absorb higher C/QPP costs we should look more closely at where health costs are likely to end up.

3. We risk phasing in any improvements to the Canada/Quebec Pension Plan too quickly. This is what we did in 1966 when we provided a full C/QPP benefit after only 10 years of contributing a miniscule 3.6% of covered earnings and we are still paying the price today. The long-term cost of the Canada Pension Plan today is about 9.9% of covered earnings (it is about 11.2% in Quebec) though it should be closer to 6%. We are paying so much more because the previous generation didn’t pay enough into the C/QPP in its early years, leaving an unfunded liability that has to be amortized. 
If labour had its way, we would do the same thing again. The Canadian Labour Congress proposes a “small premium increase” to phase in a doubling of the CPP in just seven years. The fact is, the required contributions — employer and employee combined — would eventually have to climb to at least 16% of pay and possibly to over 20% if this doubling of the CPP is implemented retroactively. The quicker the phase-in the higher the ultimate cost. The situation is worse than it was in 1966-1976 because this time the 55-65 age group is so much larger. Quick phase-in means the next generation will be paying much more for their expanded C/QPP pension than it is worth. As if young people didn’t have enough reasons to resent the older generation!

4. An expanded CPP would enable us to continue to retire fairly early — the current average retirement age is 62 — and maybe even earlier. While this seems like a good thing, the worker to retiree ratio is dropping and will eventually fall from the present 4.4 to 1 to an estimated 2.3 to 1 by 2036. As this happens, we will need the 60-somethings to stay in the workforce longer to slow down this falling ratio. If we expand the C/QPP now so we can continue to retire early, employers and governments down the road will have find ways to reverse the effect in order to entice Canadians to do just the opposite. This is not exactly the most efficient strategy.

5. Fifth, expanding the C/QPP means we will be putting much more emphasis on just one pillar in our 3-pillar retirement system. One of the strengths of our current system (which ranks very highly internationally) is that Canadians get their retirement security from multiple sources. Indeed, we are praised by the OECD for the diversity of our sources of retirement income. An expanded C/QPP would induce us to contribute less to RRSPs and pension plans and increase our reliance on the government to provide for our retirement needs. This reliance is a little precarious. While we weathered the recent financial crisis much better than most countries, who is to say we won’t look more like Greece in 20 years?

If after all this, the consensus is that the C/QPP should be expanded, I would propose changes be phased in very gradually or better still, they should be implemented prospectively only (meaning no retroactive increases in benefits) so that we are paying for the increased pension we get rather than expecting our children to pay for it. Finally, we should use this opportunity to change the range of allowable retirement ages to anticipate when we expect we will be retiring in 20 to 30 years’ time. A quick survey of what is happening in social security systems around the globe suggests that a normal retirement age of 65 is becoming untenable.
Whenever I read op-ed articles by pension experts warning us to "go slow" on C/QPP expansion, I ask myself what's their angle and why are they failing to see that we've dragged our feet on C/QPP expansion for far too long?

Mr Vetesse is the chief actuary of Morneau Shepell, and the author of a book he co-authored with Bill Morneau, "The Real Retirement: Why You Could Be Better Off Than You Think, and How to Make That Happen." The book is advertised on Morneau Shepell's website as a new book that destroys popular myths about retirement in Canada.

The National Post loves publishing one-sided articles on Canada's pension myths. Even though this one is a lot more measured and raises some good points, it's still  misleading and biased, omitting key facts. First, Canadians aren't saving enough, period. Worse still, according to the Canadian Center of Policy Alternatives, income inequality is on the rise, especially in large cities (click on chart above).

The biggest myth of all is that we don't have a retirement crisis. When 20% of the population earns $15,000 a year or less -- basically poverty line -- and most people are struggling to make their rent, mortgage payments and cover their basic expenses, I find it hard to believe that "nearly half of recent retirees have enough retirement income to replace more than 115% of their regular pre-retirement consumption."

Second, no doubt Canada's health care costs are rising fast, especially in Ontario. There are many reasons for this, chief among them is an aging population and the fact that most people are severe hypochondriacs,  overwhelming our health care system every time they get the sniffles (as the son of a physician and someone who grew up with doctors,  I can tell you that there is a lot of waste in health care).

But rising healthcare costs are not as bad as doomsayers make them out to be (much worse in the US). And to say that our taxes will go up and therefore we should go slow on expanding CPP is disingenuous and fails to recognize that pension poverty also looms large and will potentially swamp our social welfare costs and add to rising healthcare costs.

Third, we have dragged our feet on C/QPP expansion for far too long. We can phase it in over years but the reality is the sooner we do it, the better off our citizens will be in their retirement. This is why I wasn't impressed with the grinches who stole CPP's Christmas.

Fourth, an expanded C/QPP will not enable us to retire earlier. This is rubbish. We should raise the retirement age to 67 in accordance with life expectancy. Of course, people need jobs to pay into pensions until they reach 67.

Fifth, and most importantly, expanding C/QPP means we will finally recognize the superiority of having our pensions managed by large, well governed public pension funds. People need to understand that over the long-term, their pension savings are better managed by professional pension fund managers who can invest across public and private markets, investing or co-investing with the best managers in the world. In short, RRSPs, PRPPs, and other defined-contribution solutions just don't cut it  as they leave people vulnerable to the vagaries of the market. When it comes to improving our retirement system, we need to bolster our defined-benefit plans.

That pretty much sums up my thoughts on this flimsy article arguing to go slow on C/QPP expansion. Below, Bernard Dussalt, Canada's former Chief Actuary, shared his insights with me (in red):
Here is in a nutshell my analysis of Fred Vettese’s five stated reasons for Canada to slow down on a CPP expansion;

1. We don’t have a retirement crisis in spite of perceptions to the contrary, and none will develop for many years to come. The poverty rate among seniors is very low in absolute terms, less than half that of Canadians aged 18-64. An expanded C/QPP therefore starts to resemble a solution looking for a problem. The news is better than most of us realize. Nearly half of recent retirees have enough retirement income to replace more than 115% of their regular pre-retirement consumption.

A crisis is an acute temporary condition. In that sense there is a dying retirement crisis that started with the large investment losses incurred by pension funds in 2008. As 35% of Canadian seniors do steadily rely on the GIS and have annual income in the range of $14,000 to $18,000, there is a chronic problem with the Canadian pension system that can be addressed only by compelling Canadian workers to save through the CPP. If close to 50% of recent retirees have more than enough retirement income, what about the other half?

2. The real looming problem in Canada is the rising cost of health care. We are already paying about $200-billion a year for health care and that is expected to rise by another 50% in real terms over the next 20 years. This is a serious problem because it will crowd out program spending for education and pensions. The rising healthcare bill will inevitably lead to higher taxes or user fees. Before we decide we’re ready to absorb higher C/QPP costs we should look more closely at where health costs are likely to end up.

A modest CPP expansion, e.g. increasing the pension rate from 25% to 35% would cost only about 2% of salary. With the resulting higher pension income, Canadian seniors would be in a position to assume themselves a portion of their health costs that the Canadian health care could eventually not be able to absorb.


3. We risk phasing in any improvements to the Canada/Quebec Pension Plan too quickly. This is what we did in 1966 when we provided a full C/QPP benefit after only 10 years of contributing a miniscule 3.6% of covered earnings and we are still paying the price today. The long-term cost of the Canada Pension Plan today is about 9.9% of covered earnings (it is about 11.2% in Quebec) though it should be closer to 6%. We are paying so much more because the previous generation didn’t pay enough into the C/QPP in its early years, leaving an unfunded liability that has to be amortized. 
If labour had its way, we would do the same thing again. The Canadian Labour Congress proposes a “small premium increase” to phase in a doubling of the CPP in just seven years. The fact is, the required contributions — employer and employee combined — would eventually have to climb to at least 16% of pay and possibly to over 20% if this doubling of the CPP is implemented retroactively. The quicker the phase-in the higher the ultimate cost. The situation is worse than it was in 1966-1976 because this time the 55-65 age group is so much larger. Quick phase-in means the next generation will be paying much more for their expanded C/QPP pension than it is worth. As if young people didn’t have enough reasons to resent the older generation!

By virtue of a recent amendment to the CPP, all eventual improvements to the CPP shall be fully funded. And they will. Full funding means no possible phasing-in whatsoever.

4. An expanded CPP would enable us to continue to retire fairly early — the current average retirement age is 62 — and maybe even earlier. While this seems like a good thing, the worker to retiree ratio is dropping and will eventually fall from the present 4.4 to 1 to an estimated 2.3 to 1 by 2036. As this happens, we will need the 60-somethings to stay in the workforce longer to slow down this falling ratio. If we expand the C/QPP now so we can continue to retire early, employers and governments down the road will have find ways to reverse the effect in order to entice Canadians to do just the opposite. This is not exactly the most efficient strategy.

The marginal pension provided by the CPP (about $12,000 a year currently) does not really help retire earlier. One of the main reasons workers retire early is most likely their reduced ability to work of their being forced out of the labour force by their employer. Besides, an early started CPP retirement pension is not synonym of retirement. Indeed, many CPP pensioners actually continue to work and to contribute to the CPP.

5. Fifth, expanding the C/QPP means we will be putting much more emphasis on just one pillar in our 3-pillar retirement system. One of the strengths of our current system (which ranks very highly internationally) is that Canadians get their retirement security from multiple sources. Indeed, we are praised by the OECD for the diversity of our sources of retirement income. An expanded C/QPP would induce us to contribute less to RRSPs and pension plans and increase our reliance on the government to provide for our retirement needs. This reliance is a little precarious. While we weathered the recent financial crisis much better than most countries, who is to say we won’t look more like Greece in 20 years?

The Greece problem is one of too high national debt. The CPP is a distinct standalone program not tied whatsoever to the national budget. Its benefits are paid only to the extent of its available fund. The multiplicity of retirement security sources is a no brainer. Netherlands, who is deemed by the OECD to have the best retirement system i the world, has no such multiplicity as most retirement income is generated by a single private mandatory occupational pension system. In any event, any reduction in the role of RRSPs in the Canadian pension system is not relevant because RRSPs do not essentially generate much retirement income, as a large proportion of RRSP accounts are withdrawn and used before retirement.
I thank Bernard Dussault for sharing this with my readers. Below, David McDonald, economist at the Canadian Centre for Policy Alternatives, on the growing income gap in Canada.

Monday, January 28, 2013

Dangers of Fighting the Last Investment War?

Tadas Viskanta of Abnormal Returns writes on the dangers of fighting the last investment war:
It is often said that generals are always preparing to the fight the last war. The same thing could be said of investors as well. Investors are prone to extrapolate the recent past well into the future. For example, nearly four years into a bull market only now are investors beginning to put money back into equity mutual funds.

This point is well-illustrated in a series of graphics from David Rosenberg, via Business Insider, showing magazine covers from the most important eras finance of the past two decades. These include the Internet bubble, housing boom and the Great Recession. These compilations show how investors become slowly convinced as to the inevitability of the trend at hand.

In terms of trends there are few more well-established than the bond bull market. For over thirty years now bond yields have done little more than go down. Maybe because the trend has been so long-standing there is no cluster of magazine covers to highlight it. However a look at the graph below shows just how far yield have come from the end of the highly inflationary decade of the 1970s.

Some investors are taking notice that this downward trend in interest rates at some point has to end. Josh Brown at the Reformed Broker notes how the big bond mutual fund shops like Pimco and DoubleLine are ratcheting up their equity fund offerings to take advantage of what might very well be expected to be a change in interest rate regimes.

It has also brought out some skeptics of bond heavy, risk parity strategies.* What is a risk parity strategy? Michael Corkery at WSJ provides some background its growing acceptance.

A core tenet of risk parity is that when stocks are falling, bond prices typically rise. By using leverage, bond returns can help make up for losses on stocks. Without leverage, bond returns in a typical pension portfolio of 60% stocks and 40% bonds wouldn’t be large enough to compensate for low stock returns.

Leo Kolivakis at Pension Pulse notes risk parity strategies are more than just leveraging up bonds. However the heavy emphasis on bonds is what is giving some writers pause. Roger Nusbaum at Random Roger thinks the demise of risk parity is likely off a few years. However Stephen Gandel at Fortune is skeptical about the idea that leveraging up an asset at the end of a multi-decade bull market is necessarily a good thing. He writes:

But it’s also just the type of talk – that something like levering up your portfolio is safe as long as you use that leverage to buy bonds – that always pops up, and gets taken as gospel, just as bubbles are about to burst.

The bond bull market has gone on, with the help of the world’s central bankers, longer than most anyone would have believed in 1980, 1990 or even 2000. However at a time of calm bond markets and supportive equity markets, investors have the chance to think ahead to how a sustained rise in interest would affect them and their portfolios.

Things change. Bull markets end. Sometimes quietly, sometimes not so quietly, see the stock market implosions of 2000 and 2008. Investors need be sure they are not fighting the last war but are looking ahead to the next one. The bond bull market will end some day and strategies over reliant on an interest rate tail wind will suffer. The big bond market guys are looking ahead. So should you.

**For a more technical take on the theory underlying risk-parity strategies see: Asness, Pedersen and Frazzini, “Leverage Aversion and Risk Parity,” Financial Analysts Journal, January/February 2012.
I've already covered my thoughts on the so-called bond bubble in my first comment of 2013, Buh Bye Bonds?:
Over the next year,  I remain convinced the US recovery will gain further momentum and China's growth will surprise to the upside, which is why my focus is on coal, copper, and steel ('CCS'). The key thing to watch is inflation expectations. If growth surprises to the upside, there will be a backup in bond yields and surge in risk assets. Sectors tied to global growth will do better than others.

But is the bond party really over? With all due respect to Leo de Bever, Michael Sabia and Jeremy Grantham, nobody really knows where long bond yields will be in five or ten years. True, historic low yields make bonds seem like a poor and risky investment but the world is suffering from an employment crisis and it won't take much to spark a new depression. This scenario will be bullish for bonds, bearish for risk assets. 
 On Monday morning, US durable goods orders jumped 4.6% percent:
A gauge of planned U.S. business spending rose in December, a sign that business worries over tighter fiscal policy may not have held back investment plans as much as feared at the end of 2012.

The Commerce Department said on Monday that non-defense capital goods orders excluding aircraft, a closely watched proxy for investment plans, edged higher 0.2 per cent. The government also revised higher its estimate for November.
One month data on durable goods doesn't mean anything but when you add it to a series of data coming in above expectations, it only proves what I've been warning investors throughout 2012, namely, the US recovery will surprise to the upside (note: my first job was as a fixed income analyst at BCA Research).

The bond market is taking notice. The 10-year Treasury yield now stands at 1.99%, just shy of the 2% mark and well above the 52-week low of 1.39%. Global stock markets are also taking notice as they hover near highs. In fact, both the S&P 500 and the Dow are nearing all-time highs.

Even if the rally in stocks continues to frustrate bears, the truth is this bull market gets no respect. Many investors remain skeptical, dismissing the rally as another bubble. They will regret this stance, just like smart money did in 2012 when it fell off a cliff.

Does this mean the bond bubble is on the cusp of exploding? Not so fast. Some pretty savvy bond investors think the "bond bubble" argument is premature and are picking their sectors and geographies more carefully.

But billionaire financier George Soros recently told CNBC that there will be a dramatic rise in interest rates as soon as there are clear signs the US economy is picking up. Soros also warned of a currency wars, which I dismiss as pure fiction. In another interview, Soros told Bloomberg that hedge funds can't beat market because of fees. Very true, which is why wise hedge funds are chopping fees in half.

Below, George Soros talks about the European sovereign-debt crisis, inflation risk and his Open Society Foundation. He speaks with Francine Lacqua at the World Economic Forum's annual meeting in Davos, Switzerland.

Also embedded an interesting panel discussion moderated by Bloomberg's Francine Lacqua, featuring Bridgewater's Ray Dalio, on the role of central banks in the new normal. Listen to Dalio's comments carefully as he states "normalcy is not like the past," meaning countries will not be able to spend like the past and the "shift of the discussion" will center on productivity, not the debt cycle.


Saturday, January 26, 2013

Hedge Fund Cannibalism?

Sam Forgione of Reuters reports, Rumble in the Wall Street jungle: Ackman, Icahn duke it out on TV:
Two of the most prominent investors in the world, Carl Icahn and Bill Ackman, had Wall Street mesmerized on Friday as years of acrimony exploded into a bruising verbal scrap on live TV.

Initially CNBC was only talking to Ackman, but then the cable TV station put Icahn on as well and all hell broke loose.

The argument centered on nutritional supplements company Herbalife Ltd (HLF), in which Ackman has had a well-publicized short position that Icahn has slammed.

Icahn, 76, who has gone from feared corporate raider to activist investor in more than three decades of dealmaking, called Ackman, 46, a "liar" and "the most sanctimonious guy I ever met in my life."

In a tirade that included expletives, Icahn said he would never invest with Ackman and predicted investors in his Pershing Square hedge fund would lose a lot of money on the Herbalife bet. U.S. news outlets have reported that Icahn has a long position in Herbalife, although he has not confirmed that.

Ackman, who is usually much more restrained than Icahn when speaking publicly, got in a few verbal shots himself. Icahn "does not have a good reputation" and "is not an honest guy," he said.

The altercation quickly became the talk of the financial world, both on trading floors and on Twitter.

"I will never delete today's Ackman vs Icahn CNBC debate from my DVR. Even when DVRs are like Betamaxes, I'll force my grand kids to watch," tweeted Eric Jackson of hedge fund Ironfire Capital LLC.

Business Insider Deputy Editor Joseph Weisenthal tweeted: "It's never going to get any better than what we just saw."

The influential blog ZeroHedge called it the "Ultimate Hedge Fund Deathmatch: Icahn And Ackman As The Real Billionaire Husbands Of CNBC Going Wild."

BusinessInsider held an online poll: "Who Won The Brawl Between Carl Icahn And Bill Ackman?" As of 5 p.m. New York time, 70 percent of the more than 1,800 people who voted declared Ackman the victor.

Neither Ackman nor Icahn could be reached for comment after the CNBC show.

Ackman has called Herbalife a "well managed pyramid scheme" that he predicted will collapse. Herbalife has denied the allegation.

"On CNBC today, Mr. Ackman continued to misrepresent Herbalife," an Herbalife spokeswoman said on Friday.

"Herbalife is a financially strong and successful company, having created meaningful value for shareholders, significant opportunities for distributors and positively impacted the lives and health of our consumers over our 32-year history."

DECADE-OLD DISPUTE

The genesis of their feud stems from a nasty contractual dispute involving a real estate company deal 10 years ago, when Ackman was running his former hedge fund, Gotham Partners, which he co-founded in 1993 with former Harvard Business School classmate David Berkowitz.

After eight years of litigation, a court ruled in Ackman's favor and Icahn was forced to pay Gotham $4.5 million, plus interest.

Indeed, the discussion on CNBC often had little to do with the merits of Ackman's view of Herbalife. At times, Icahn also feuded with CNBC host Scott Wapner, accusing him of "bullying" him when he was pressed on whether he had gone "long" on Herbalife shares.

Icahn may have little to lose from the dustup given that he is simply managing his own money these days. Ackman, on the other hand, manages about $11 billion at Pershing Square, including money from many prominent institutional investors.

Herbalife shares briefly surged over 5 percent when Icahn said during the row that Ackman, by going public with his big short position, would cause the "mother of all short squeezes" in the stock.

A short squeeze is when short sellers are forced to cover their position, a move that pushes a stock higher.

Ackman and Icahn's dislike of each other is well known in financial circles. Some of the tension stems from the fact they both specialize in the same game - taking big positions in companies and agitating for management changes.

Ackman's bet against Herbalife is also being challenged by another big hedge fund player, Third Point manager Daniel Loeb, who has said he holds a big long position on the stock.
You can watch the entire exchange of this billionaire brawl below (also available here). I've already discussed hedge fund Darwinism. Welcome to hedge fund cannibalism.

Several thoughts ran through my mind as I watched this sad display of "my hedge fund penis is bigger than yours." First, I'm glad I didn't touch Herbalife shares when they plummeted after Ackman came out to call the company a "pyramid scheme." Was very tempted to trade it, would have made great money, but when hedge fund titans are involved, best to steer clear from these companies as anything can happen.

Second, Carl Icahn came off looking like an obnoxious prick in this CNBC interview. It's obvious he detests Ackman, and he raised some good points on the suspicious timing of Ackman's announcement and risks of his big short position, but he refused to answer a simple question on whether he's long Herbalife and accused CNBC's Scott Wapner of "bullying" him (pot calling the kettle black) and threatened never to come back on the show.

Third, and most importantly, hedge fund billionaires should never go to war like this on live television. This is especially true of prominent high profile Jewish investors who should know better. My 81 year old father, a psychiatrist, tells it like it is: "Jews can vigorously disagree with each other in private but unlike us Greeks, they have the wisdom not to air their dirty laundry in public."

So my advice to Mr. Ackman and Mr. Icahn is to listen to my father and keep their ongoing feud private. Many people are struggling to make ends meet and the last thing they need is to watch two billionaire hedge fund managers with mega egos squabble on live television like little children. It's great for CNBC's ratings but makes them both look like childish schmucks.

Below, Carl Icahn discusses his outlook on Herbalife and Bill Ackman on Bloomberg Television's "Street Smart." Also embedded the entire exchange on CNBC of the infamous billionaire brawl.

Friday, January 25, 2013

Pensions Bet Big With Private Equity?

Michael Corkery of the WSJ reports, Pensions Bet Big With Private Equity:
On the 13th floor of a sleek downtown office building in Austin, Texas, the trading desks are manned overnight. The chief investment officer favors cowboy boots made of elephant skin. And when a bet pays off, even the secretaries can be entitled to bonuses.
The office's occupant isn't a high-flying hedge fund but the Teacher Retirement System of Texas, a public pension fund with 1.3 million members including schoolteachers, bus drivers and cafeteria workers across the state.

It is a sign of the times. Numerous pension funds are still struggling to make up investment losses from the financial crisis. Rather than reduce risks in the wake of those declines, many are getting aggressive. They are loading up on private equity and other nontraditional investments that promise high, steady returns in the face of low interest rates and a volatile stock market.

The $114bn Texas fund has hit the trend particularly hard. It now boasts some of the splashiest bets in the industry, having committed about $30bn to private equity, real estate and other so-called alternatives since early 2008. That makes it the biggest such investor among the 10 largest U.S. public pensions, according to data provider Preqin. Those funds have an average alternatives allocation of 21%.

Not all pension managers are in on the action. Some funds are wary of the high management fees often charged by private-equity and hedge-fund firms. And while a large fund like Texas' may have access to marquee investors, smaller pensions may have trouble getting an audience with the best performing firms.

Even in Texas, there isn't exactly consensus. Critics worry that the teachers' benefits are leaning too heavily on the esoteric investments, which can be less liquid and less transparent than stocks and bonds. Another sticking point is the fund's generous bonus culture—a contrast against the pensioners, who haven't seen a cost-of-living raise in more than a decade.

"I have problems with these alternatives," says former Texas State Sen. Steve Ogden, who owns an oil and gas company. "It's one of these 'trust me' investments."

And yet the strategy has helped to turbocharge the Texas pension, with returns from private equity averaging 4.8% and 15.6% over the past five-year and three-year periods respectively.

Including all assets, the pension's annual return from Dec. 31, 2007, to Dec. 31, 2012, was 3.1%—better than the median preliminary return of 2.46% among large public funds, according to Wilshire Trust Universe Comparison Service.

Texas pension officials say private equity helped offset declines in its other investments. Britt Harris, the pension's chief investment officer, says he aims to "smash" the stereotype that government pension funds are on the losing end of most investments.

In November 2011, the Texas fund made one of the largest single commitments in the private-equity industry's history, investing $3bn in KKR and another $3bn in Apollo Global Management. Three months later, Texas teachers bought a $250m stake in the world's biggest hedge-fund firm, Bridgewater Associates—a first such equity stake for a US public pension.

For the fiscal year ended Aug. 31, the Texas teachers fund had a 7.6% return, and pension officials say they expect their bet on alternatives can help the fund hit its 8% annual target return over the long term. Over a ten-year period ending Aug. 31, 2012, the fund has had an annual fiscal year return of 7.4%.

Other large pension funds aren't so optimistic. Sticking to a return of 8% or more is "taking a big risk with one's ability to pay for benefits,' says Richard Ravitch, co-chair of the State Budget Crisis Task Force, a nonpartisan research group. Since 2009, one-third of state pension plans have scaled back their return goals, according to the National Association of State Retirement Administrators.

The reason: In some states, like California, failure to hit the target return puts taxpayers on the line to make up the difference.

California's giant public employee pension fund, Calpers, had made an aggressive push into alternative investments such as real estate, representing about one-tenth of its assets. But many of those real-estate holdings, particularly in housing, suffered big losses during the financial crisis.

If Texas misses its mark, state officials could seek to cut benefits or switch newly hired teachers from traditional pensions to less generous 401(k)-type plans. Similar proposals in other states have met with stiff resistance from labour unions.

Retired education workers in Texas, on average, receive an annual pension of $21,730. Most former educators don't receive Social Security, making their total retirement benefits among the lowest of the big public pension systems.

"If new teachers are forced to switch to 401(k)s," says Tim Lee, head of the retired teachers association, "they will end up in poverty."

Unlike many state pensions, the Texas teachers fund is in relatively solid shape. It is 82% funded, meaning there are 82 cents of assets covering $1 of liabilities, up from a low of 68% in February 2009, during the depths of the financial crisis. The average funding level among large public pension systems nationally is about 76%. Contributions from teachers and the state are identical, at 6.4% of employee salaries. The balance comes from investment earnings.

Still, the pension had a $26 billion shortfall, as measured at the end of August, caused in large part by big stock market losses during the financial crisis and increases to benefits for future retirees.

Harris, the pension's CIO since late 2006, says over the long term the fund can keep hitting its target, but "getting to [the 8% target level] over the next five to 10 years is going to be tough," he acknowledges.

With so much riding on returns, Harris has created an investment operation that looks and feels more like a hedge fund than a government agency. The office lobby buzzes with a flat-screen television that hangs next to photos of school children. Two of the fund's traders work into the night from a windowless room, following the markets in Asia and Europe. Staff—including secretaries—can score annual bonuses provided the pension beats its peers by just a small fraction.

Mr. Harris, whose mother is a retired Texas schoolteacher, once managed pension investments for corporations like Verizon and briefly served as CEO of Bridgewater. Last year, he was rewarded by the fund with a bonus totalling $483,753. Harris recused himself from the pension's deal to buy the Bridgewater stake.

Fund officials say the bonuses are necessary to attract an investment staff that can compete with the most accomplished investors around the world.

For decades, the Teacher Retirement System favoured a mild brew of stocks and bonds. But starting in 2000, Gov. Rick Perry, a Republican, put real-estate developers and other investors on the pension system's board. Five of the nine current trustees are investment professionals.

"We had to have a more progressive system of investing if retirees were ever going to get a cost-of-living increase,' says Linus Wright, a former pension board member and former superintendent of the Dallas schools.

Between 2005 and 2007, as Texas and other states were ratcheting up their private-equity investments, state legislatures passed laws preventing certain information about the holdings from being disclosed to the public. Some private-equity firms insisted on these measures before approving investments from pension funds, says William Kelly, a partner at Nixon Peabody LLP, who works with both pensions and private-equity firms on disclosure issues.

"We are not your average investor,' said Steve LeBlanc, the former head of private-equity investments, who left the Texas pension fund in April to return to the private sector.

To help train managers, Harris employed some unusual tactics. He hired former law-enforcement agents to teach his staff how to tell if someone is being less than truthful when touting investments.

One strategy: Always have two members of the pension-fund staff in the room. That way, one person can listen to what the Wall Street salesperson is saying and the other can watch his or her body language.

"We know we are up against the most highly resourced, most sophisticated sales effort probably in the whole world,' says Harris. "But we have brought people in here who are equal to or better than what you find on Wall Street."

During the financial crisis, the Texas teachers fund showed its mettle by making investments that many pension funds couldn't stomach.

As the credit crisis escalated in late 2008, the Texas pension board authorised an investment of up to $5bn in inexpensive, high-yielding debt.

It was a large amount, even for a Texas-size fund. Still, some pension officials had an appetite for more. One pension board trustee said he was comfortable investing up to half of the pension fund's assets in the cheap debt, recalls board chairman David Kelly.

As the recession deepened and fear roiled the debt markets, the pension's investments in residential mortgages, corporate bonds and bank loans, totalling $2.6bn , lost value in the early part of 2009. The pension fund held on to the debt, which eventually gained 15%.

"Everyone, as we like to say down here, cowboyed up," says Kelly, a former Salomon Brothers banker and real-estate executive.

Ogden, the former legislator, had tried to convince lawmakers to reconsider the teachers' investment strategy. Instead, officials opted to extend it to at least 2018 while voting to allow the fund to double its hedge-fund investments.

"They found no smoking gun to convince them to cancel the program,' recalls Ogden.

The pension board also took steps to reduce the red tape in the investment process, giving its senior investment staff "quick-strike authority" to invest up to $1bn without full board approval.

LeBlanc used this authority in the spring of 2010 when he says he got a call from a friend at Paulson & Co., the firm run by hedge-fund star John Paulson. The friend asked: Would the teachers fund join Paulson in providing national mall operator General Growth Properties with new funding to exit bankruptcy?

Paulson lost out on the deal, but the pension fund plowed ahead, joining another group of Wall Street firms that agreed to pay about $10 per share for a large stake in General Growth. The risk was that the shares could fall as the company exited bankruptcy in a difficult retail market. After three weeks of due diligence, the Texas pension made an initial commitment to invest $500m in General Growth.

"No one moved as quickly as they could,' says Adam Metz, General Growth's former CEO.

General Growth turned out to be a big winner. The mall company's shares are worth about $19 today, an 85% gain for the pension fund.

Despite that particular coup, doubters wonder if the strategy is sustainable. "They may think they are the smartest and best investors, but this system cannot work in the long term," says former Rep. Warren Chisum, who in the last legislative session proposed switching new teachers to 401(k) plans.

Pensions officials, such as Harris, say the risks of the alternatives are manageable because the pension fund has ample liquidity to keep paying benefits in the event of big losses.

Texas educators have little choice but to support the pension fund's aggressive investment strategy and Wall Street-style bonuses. But retiree raises can't materialise until the system's funding level improves—to an estimated 90% from its current 82%. One solution, not popular with educators, is to increase the retirement age for teachers to help make up the fund's shortfall.

In the meantime, educators like Vella Pallette, a retired elementary-schoolteacher from the tiny Central Texas town of May, are in limbo. The 78-year-old's $2,000 monthly pension check is her sole source of income. "A little more money," she says, "sure would help."
There is a lot to digest in this article. Think Texas Teachers is doing many interesting things in their investments but I have also questioned previous deals like the equity stake in Bridgewater. As far as their compensation, I've covered this too in a comment on pay and performance at public plans.

Chris Tobe of Stable Value Consultants was a lot harsher, deriding this article as another "WSJ puff piece on TRS." He told me if you want the real story on Texas Teachers, you have to read an article from the Dallas News on how secrecy cloaks placement agents’ role in Texas public pension fund investments.

Leaving placement agent scandals aside, the article is all also about private equity and how plans are shifting more and more assets into alternatives to meet their 8% bogey. In finance, there is no free lunch. If pensions want to achieve their actuarial target return to keep the cost of the plan down for all stakeholders, then they need to invest in both public and private markets. Shifting away from a defined-benefit to defined-contribution is dumb and will only condemn teachers to pension poverty.

However, with interest rates at a historic low, that 8% bogey will be extremely difficult to meet in the next decade. Shifting more assets into private equity might help pensions meet their target return but it also exposes them to other risks such as illiquidity risk, valuation risk, manager selection risk, lack of transparency and potential conflicts of interest.

It's amazing how few US public pension plans understand these risks. CalPERS got creamed in real estate during the last crisis, losing 40% in co-mingled funds that were investing in risky mortgages. In private equity, they were invested in over 350 funds (crazy!!!), paying out enormous fees and getting mediocre benchmark returns.

The task of cleaning up that mess fell onto Réal Desrochers who was appointed as head of PE back in May 2011. There is still a lot of work to do and as I mentioned in a recent comment on CalPERS's 2012 returns, private equity has benchmark issues as they significantly underperformed their benchmark which delivered a whopping 28.5% (12.2% vs 28.5%). There is a problem with that benchmark.

Getting the benchmark right is important for public pension funds because that is how they determine compensation. Unfortunately, private equity benchmarking isn't as easy as it sounds because different pensions have different allocations in sub-asset classes and different approaches to private equity investments.

This morning I received a call from Neil Petroff, CIO at Ontario Teachers' and we had an interesting discussion on intelligent use of leverage at pensions, benchmarks and compensation. Neil told me that their real estate investments returned 18% last year, below the benchmark but far outperforming their peers. Given the circumstances, the board agreed with him that compensation can't solely be based on them underperforming the real estate benchmark.

As far as private equity, Neil agrees with me that the benchmark should be a spread over some public market index (even if this isn't perfect). If a pension fund invests mostly in US buyouts, then it should be a spread over the S&P500, if it's more global, it should be a spread over MSCI World. Even if there is some credit and venture capital in the portfolio, all you have to do is adjust the spread accordingly with the risk of the underlying portfolio.

Interestingly, Neil also told me that after 2008, compensation was adjusted so that long-term comp -- the bulk of the comp --  is based on the Fund's overall performance and short-term comp is based on the group's performance. "This encourages a lot more collaboration among investment departments and reduces blow-up risk from any one department." The senior VPs all get together once a month to discuss big investments they're considering and each have an input before Neil signs off and presents them to the board.

As far as private equity, Ontario Teachers' invests in direct deals, co-invests with private equity funds and does some fund investments when it sells stakes and needs to keep target allocation. He told me unlike 2011, most pensions didn't make money in private equity last year because public market delivered 14-15%, so achieving a spread over public equities was difficult.

He also told me that rumors that Ontario Teachers' ignored 2008 losses in their compensation to retain staff are "totally false." He said his long-term bonus took a "big hit" in 2009 and that so did that of other senior officers. This is why compensation was changed to focus on the Fund's overall results.

Moreover, as far as private equity, they don't collect bonus if they just beat the benchmark. They first have to recoup all the costs -- roughly 7% -- before they can collect bonus (think he's talking about an internal hurdle rate). This makes perfect sense but you'd be shocked to find out how many pension funds do not take costs into account when compensating staff in private investments.

We talked about a news article which came out today which states Ontario Teachers' is interested in pipelines. Neil told me he gets bombarded by calls every time some article comes out but if it makes sense, they look at it regardless of whether it's private or public. "We're interested in everything that makes sense."

Finally, he told me that investment staff logged in millions of  miles traveling last year, meeting GPs, going to board meetings in companies they bought, and cultivating new and old relationships with GPs and LPs."We're not looking to be number one every year but we want to consistently be among the top three. Everyone is trying to copy us but it will take them seven to ten years before they reach the point where we're at now."

I think Neil Petroff is one of sharpest pension fund managers in the world and a very nice guy. Thank him for taking the time to speak with me. Only wish he would write a book on pensions, covering intelligent use of leverage, private equity, real estate, hedge funds, and a whole host of issues, including proper compensation and how to cultivate a great environment at a pension fund.

Below, Stephen Schwarzman, chief executive officer of Blackstone Group LP, and one of the real fiscal cliff deal winners, talks about the private-equity market, the global economy and President Barack Obama's policies. He speaks with Erik Schatzker on Bloomberg Television's "Surveillance" at the sidelines of the World Economic Forum's annual meeting in Davos, Switzerland.

And Jim Leech, president and CEO of Ontario Teachers' Pension Plan, tells CNBC an energy self-sufficient U.S. could cause a "seismic" market shift. Indeed, it will be a global game changer and agree with him, 2013 should be a good year for private equity.