Monday, June 30, 2014

Will GASB's New Rules Sink U.S. Pensions?

Darrell Preston of Bloomberg reports, U.S. Public Pension Funding Gaps to Widen Under New Rules:
Some U.S. public pensions, which lack savings for $1.4 trillion of promises to retired government workers, will record wider gaps in fiscal years starting after July 1 because of changes in accounting rules.

Pensions in Illinois, Kentucky, Pennsylvania and other states will see funded levels decline, in some cases by more than half, as they comply with new Governmental Accounting Standards Board rules that for the first time will require future pension costs to be included on balance sheets and change how they must calculate their underfunding.

The new rules won’t affect the amount that states and municipalities actually owe, though they could prompt them to address their underfunding, said Dean Mead, research manager at the Norwalk, Connecticut-based board known as GASB, which makes accounting rules used by most governments. The changes may force some states to cut borrowing or spending.

“It could affect their policy decisions,” Mead said in a telephone interview. “It’s their choice how to react to the new numbers.”

Under the new rules, governments will have to calculate an estimate of how much they owe for future pension liabilities and put that on their balance sheets. Under current rules they put estimates in footnotes on financial statements. Some plans predicted to run out of money will have to lower investment return assumptions used in calculating their future costs, making their liability seem larger.
Funding Adjustments

“They may not want to discuss these numbers,” said Keith Brainard, the Georgetown, Texas-based research director with the National Association of State Retirement Administrators in Washington. “Because of these new numbers, some policy makers will make funding adjustments so they won’t look so bad.”

Teachers Retirement System of the State of Illinois could see its funded level decline to 17.5 percent from 48.4 percent under the changes, according to 2012 estimates from the Center for Retirement Research at Boston College.

Illinois Teachers doesn’t agree with the estimates, said spokesman Dave Urbanek. The only effect of the new GASB rules will be that the fund will have to report a new number. Though the pension has earned 9 percent on average in the past 30 years, the state has never fully funded the plan since it was created in 1939, he said.

“We will have a full range of unfunded liabilities that people can pick from,” said Urbanek. “The bottom line is that we have a problem.”
Fixes Made

Funding for the Kentucky Employee Retirement System would decline to 23.7 percent from 40.3 percent, according to the Boston College estimates.

Executive Director William Thielen said by e-mail that he wasn’t aware that the changes would affect the funding ratio. The rules will require the fund to use new reporting terms and “include significantly more information” in financial reports, he said.

Some municipalities have taken action to try to increase funding ahead of the new rules taking effect: Alaska moved $3 billion from its rainy day fund to shore up pensions. California passed legislation to close a $74 billion gap in the California State Teachers’ Retirement System.

The new numbers may not affect debt costs in the $3.7 trillion municipal bond market because of limited supply and small differences in yields between issuers, said Richard Ciccarone, president of Merritt Research Services in Chicago. Still, borrowers that don’t address shortfalls may eventually be penalized, he said.

“Over time, as the pension crisis continues, you’re going to see spreads widening,” Ciccarone said.
I've already discussed GASB's new rules here. You can read minutes from a March meeting on GASB's new rules for pensions here and download frequently requested material here.

Also, GASB's Exposure Draft, Fair Value Measurement and Application, describes how fair value should be defined and measured, what assets and liabilities should be measured at fair value, and what information about fair value should be disclosed in the notes to the financial statements.

What do I think of the new rules? I welcome anything that increases transparency at public pension funds but at the end of the day, these new rules will only highlight the looming catastrophe that awaits U.S. public pension plans.

Illinois and Kentucky are already bankrupt, never mind these new rules. No matter what they do, they can't invest their way out of their hole. They're pretty much cooked and will need to lower benefits, raise contributions, raise the retirement age or go the way of Detroit and implement the silly hybrid plan.

GASB project manager Michelle Czerkawski outlines statement 67 & 68 implementation guides in a video you can view here. Below, a brief overview of the changes coming to Kentucky's Retirement System (KRS) as a result of GASB 67, and to agency employers as a result of GASB 68.

Friday, June 27, 2014

A Hedge Fund Love Affair?

Halah Touryalai of Forbes reports, Everybody Loves Hedge Funds, Assets Hit Record $3 Trillion:
Love ‘em or hate ‘em, the world of hedge funds is only getting bigger.

The industry saw assets surpass $3 trillion in May for the first time ever.

That’s according to hedge fund database, eVestment, which notes the new record exceeds the asset peak from 2008.

It’s been a particularly strong year for hedge funds. In May alone, $22 billion of new capital was added bringing year-to-date flows to $93.3 billion. That’s the strongest start to a year since 2007.

The industry’s growth is part of a larger trend since the financial crisis that involved hedge funds changing the way they ran their firms.

Before the crisis, many hedge funds left clients in the dark about their strategies and their overall approach to investing. In those days, client simply shelled out a couple million dollars, received performance updates and paid their enormous 2 percent and 20 percent fees.

Since the crisis though, more hedge funds have opened up their doors and taken a more consultative approach with clients. Much of that is the result of stricter rules from regulators, and due diligence requirements by deep-pocketed investors.

Giant institutional investors expect a lot more information these days than hedge funds were open to sharing just a few years ago. Hedge funds are no longer keen on keeping their doors (and books) closed to investors looking to allocate hundreds of millions of dollars.

Not surprisingly, institutional investors have since been the been the main driver of surge in hedge fund assets.

According to a report from Citigroup, institutional clients made up 20% of hedge fund assets in 2002, while family offices and high-net-worth individuals made up the rest. By 2007, institutional investors made up 47% of the industry’s total assets, and today they account for 65% of hedge fund assets.
Further, the report noted that that institutional investors will help boost total hedge fund assets to a whopping $5.8 tillion in 2018.
Steven Russolillo of the Wall Street Journal also reports, Hedge Fund Industry Surpasses $3 Trillion for First Time:
The hedge-fund industry exceeded the $3 trillion barrier in May for the first time ever, according to one research firm, as new allocations and performance gains pushed total assets to a new record.

Some $22 billion flowed into hedge funds last month, bringing the year-to-date inflows to $93 billion, according to data provider eVestment. That’s the largest five-month total to start a year since 2007. Performance gains also added $37.8 billion in assets last month, leaving the total tally just north of $3 trillion.

Cash has flowed into these hedge funds despite relatively muted performances over the past several years. Many hedge-fund managers have underperformed their benchmarks as the stock market has surged to record after record. Hedge funds suffered back-to-back monthly declines in March and April for the first time since April and May of 2012, according to researcher HFR Inc. These funds rebounded in May and posted gains across all main strategies, HFR said earlier this month.

And yet, capital continue to flow toward hedge managers who purport to be better positioned for a potential market downturn.

Much of the cash coming to hedge funds has been allocated to stocks. Some $11.5 billion were added to equity strategies last month, or a little more than half of the monthly inflow, eVestment says. That brings the year-to-date total to equity funds to $59.4 billion, the best start to a year since mid-2007, eVestment said.

EVestment is the first to put total assets in the hedge-fund industry at more than $3 trillion. Other research firms have stuck to more conservative estimates. Data firm HFR pegged the industry at $2.7 trillion in April, the same month that trade publication HedgeFund Intelligence measured it at $2.6 trillion.
And Clayton Browne of ValueWalk gives us some numbers as he reports, Hedge Fund AUM Tops $3 Trillion For First Time:
Hedge funds continue to grow in popularity among global investors. According to a new report from eVestment, strong inflows and returns pushed total hedge fund assets under management above $3 trillion for the first time ever in May 2014. the total of $3,001.77 trillion just edges past the prior all-time high set in the second quarter of 2008.

Hedge funds see strong inflows this month

Hedge funds once again saw strong allocations in May. According to eVestment’s Hedge Fund Asset Flows, May was the fourth consecutive month of to see high hedge fund inflows. The more than $22 billion of new funds takes year-to-date flows to above $93.3 billion, the biggest five month total to begin a year stretching back to 2007(click on image above).

Strong performance gains

The eVestment report also highlighted strong performance gains for hedge funds for the month. “Performance gains added $37.8 billion to total AUM for an estimated asset weighted return of 1.28% in May, well above the 1.00% the industry produced on an equal weighted basis during the month. For the first five months of 2014, equal and asset weighted returns are nearly identical, both just below 2.00%” (click on image above).
Alternative equity exposure continues to grow

Allocations to to equity exposure continued to increase in May, a trend now in place for 11 consecutive months. The new $11.5 billion inflow to equity strategies during the month brings YTD inflows to just above $59.4 billion, the most investor interest in equity hedge fund exposure over a five-month span since mid-2007.
Event-driven strategy funds saw positive inflows

The report also pointed out that allocations to event driven strategy hedge funds grew in May. The $6.4 billion of new money takes total event-driven allocations to $31.1 billion so far in 2014. Of note, activist strategies represent 70% of event driven fund inflows reported in the month, indicating the sector took in somewhat over $4 billion in May.
Managed futures strategies still lagging

Managed futures strategies remain a laggard. This sector has simply not yet seen the return of positive investor interest that most macro strategies have enjoyed. The managed futures strategies sector suffered their ninth consecutive month of outflows in May, and the twentieth month of net redemptions out of the last twenty-one.
So what should investors make from the numbers above? First, it's important to keep in mind that the 500 largest hedge funds control 90% of the assets under management. Bridgewater, the world's largest hedge fund, manages roughly 6% of this total (see my recent comment on the soul of a hedge fund machine).

The big boys are getting bigger for the simple reason that they are able to better address the stringent requirements of large institutional investors who are demanding a lot more from their hedge funds. But the big boys are also good at marketing themselves and spend big bucks coddling their institutional investors as well as useless investment consultants that have effectively become the gatekeepers and herd everyone into the same brand name funds.

Second, while hedge funds have underperformed the stock market since the crisis erupted in 2008, so has everyone else. Institutional investors don't care if hedge funds underperformed stocks. They are diversifying their bond portfolio looking to get extra yield without the volatility of stocks.

But notice how the bulk of the new assets flowing into hedge funds is going to L/S Equity. There is a ton of beta in these equity hedge funds, which makes you wonder why are institutional investors paying overpaid hedge fund gurus 2&20 when they're better off investing in stocks? (you can say the same thing on credit hedge funds, tons of beta betting on direction of interest rates).

The answer is that while stock averages remain close to all-time highs and this bull market keeps repeatedly defying predictions of its demise for five-plus years, people are worried that the worst is yet to come. Nobel Laureate, Robert Shiller, is worried as the cyclically adjusted price-to-earnings ratio (CAPE or the Shiller P/E) he created stands at 26, well above its long-term average of 17 and approaching levels that previously presaged doom for equities.

"It looks to me like a peak," he says in this video. "I would think there are people thinking 'it's gone way up since 2009, it's likely to turn down again.' That's what people might plausibly think."

But one thing I learned in my career is to always remember the wise words of Keynes, namely, "markets can stay irrational longer than you can stay solvent." And even though I am worried of debt-deflation down the road, I know there is plenty of liquidity to drive risk assets much, much higher. That's why I recently came out to urge pension funds to stop loading up on linkers and start loading up on risky stocks and position themselves for a summer or fall melt-up.

As far as the hedge fund love affair, I prefer liquid alternatives over illiquid alternatives but think investors are setting themselves up for disappointment. Like all love affairs, once the initial arousal dissipates and reality sets in, it isn't as sexy or glamorous. Tread carefully with hedge funds and make sure these large funds maintain alignment of interests (most are large asset gatherers).

Once more, please remember to contribute or subscribe to my blog on the top right-hand side. I thank those of you who support my efforts and value my work and ask others to support this blog.

Below, Credit Suisse Private Banking CIO Michael O’Sullivan discusses investor behavior, why they are all over the board and investing in hedge funds with Anna Edwards and Mark Barton on Bloomberg Television’s “Countdown.”

And Agecroft Partners Founder and Managing Partner Donald Steinbrugge and Bloomberg Contributing Editor Fabio Savoldelli discuss hedge fund performance. They speak on “Market Makers”and state investors are happy with hedge funds.

Thursday, June 26, 2014

Detroit's New Hybrid Plan Solution?

Mary Williams Walsh of the New York Times reports, Detroit Rolls Out New Model: A Hybrid Pension Plan:
In the face of Detroit’s tumultuous bankruptcy proceedings, in which multiple parties are quarreling to protect their interests, the city and its unions have quietly negotiated a scaled-back pension plan that could serve as a model for other troubled governments.

One of the most closely watched issues of the case is whether a government pension plan can be legally cut in bankruptcy. Detroit, saddled with a pension system it cannot afford, has introduced a new plan with the cooperation of its unions, which have been among the most vocal opponents of cutbacks.

While both retired and active workers now participate in the same city pension system, the new plan is intended only for Detroit’s active workers, who will shift to it on July 1. Retirees will keep 73 percent to 100 percent of their current base pensions under the city’s proposal to exit bankruptcy.

The new plan is called a hybrid, which means the workers will keep some of their current plan’s most valuable features but will give up others. Trading down to a less generous pension plan is often said to be a legal nonstarter for government workers, so if Detroit succeeds, its hybrid could become a model for other distressed governments from Maine to California. Countless elected officials — from Rahm Emanuel, the Democratic mayor of Chicago, to Chris Christie, the Republican governor of New Jersey — are caught between ballooning pension obligations, angry local taxpayers who don’t want to pay for them and labor lawyers who say it’s impossible to cut back.

“We have a festering sore here,” Christopher M. Klein, the judge in the bankruptcy case of Stockton, Calif., said at a hearing in May, referring to that city’s surging pension costs. “We’ve got to get in there and excise it.”

Detroit’s current pension system simply costs too much relative to its battered tax base, and the watchword for Detroit this summer is feasibility. For the city to emerge from bankruptcy, its emergency manager, Kevyn D. Orr, must convince Steven W. Rhodes, the judge overseeing Detroit’s bankruptcy case, that his long-term financial plan is feasible. The matter is to be decided at a trial to start in August.

There would be little hope of persuading Judge Rhodes if Detroit’s workers were still covered by the existing pension plan and struggling local taxpayers were still liable for the relentlessly mounting obligations. For many years, the current plan allowed city workers to earn benefits that others in Detroit could only dream about — full pensions at 55, longevity bonuses, annual cost-of-living increases, an extra “13th check” in December and bankable sick leave that could be converted to cash, among others. In recent years, the resulting pensions have been greater than the per capita income of the residents who were expected to pay for them.

On June 30, Mr. Orr will freeze that pension plan, meaning that the city’s current workers will not accrue any further benefits on those terms.

Starting the next day, in the new hybrid plan, they will still earn so-called defined-benefit pensions — a specified monthly payment based on tenure, age and earnings history — something their unions consider critical. But they will also start to bear most of the new plan’s investment risk. That means Detroit’s taxpayers — who pay a city income tax in addition to property and sales taxes — will no longer face cash calls every time the plan’s investments drop in value. Officials hope that making the workers backstop the investments will discourage overreliance on high-risk strategies.

This unusual combination of features gives both the city and the unions an opportunity to declare victory and provides Mr. Orr with ammunition for the coming feasibility trial.

But it also flies in the face of a legal principle known as the vested-rights doctrine, which holds that the pension formula in force on the day a public worker goes on the job cannot be reduced for the full duration of employment. No such legal protection exists for workers in the private sector, whose pension plans can be frozen at any time. But in the public sector, the vested-rights doctrine is an article of faith, zealously defended, and it helps explain why a bankrupt city like Stockton is proposing to saddle its other creditors with big losses but not touch the pension plan.

The vested-rights doctrine is especially powerful in California, growing out of court decisions dating back to 1947. Unions in San Jose recently used it to keep the city from making its workers contribute more toward their pensions. Employees of four California counties argued in court last year that they had a vested right to pad their pensions by counting things like unused vacation time in their benefit calculations, despite laws prohibiting the practice. In March, Judge David B. Flinn of Contra Costa County Superior Court ruled that there was no such thing as a vested right to an illegal benefit — but the ruling applies only to current workers. Retirees are still receiving the padded pensions.

California’s state pension system, Calpers, is a powerful proponent of the vested-rights doctrine, and many state and local governments follow its lead.

In Detroit’s bankruptcy, however, the vested-rights doctrine does not appear to be an issue. The Michigan law for distressed cities gives emergency managers like Mr. Orr the power to set the terms of public employment. That means he can legally freeze Detroit’s existing pension plans and establish new ones for city workers, said Bill Nowling, a spokesman for Mr. Orr.

“He is not making any benefit cuts,” Mr. Nowling added.

For Detroit’s retirees, it’s a different matter. They are not being asked to give up benefits they had hoped to earn in the future; they are being told they must give up benefits they have already earned. Michigan’s constitution forbids this, so Mr. Orr is using the Chapter 9 municipal bankruptcy process, in which federal law applies. A bitter battle is already taking shape.

By the time the fate of the retirees has been decided, Detroit’s workers will already be earning hybrid benefits. To shift the investment risk their way, Detroit has set up a series of eight “levers” to pull if the plan’s investments falter. They include setting up a reserve fund that must be used to cover losses, raising the workers’ required contributions, lowering retirees’ cost-of-living increases and making workers build up their benefits more slowly.

Should investments not produce the expected returns — in a protracted bear market, for example — leaving too little money to meet all obligations, officials will be required to pull as many levers as it takes to get the plan back to the 100 percent funded level within five years. Only if all eight levers are pulled and the plan is still not responding adequately can Detroit’s taxpayers be called on to rescue it.

To measure the level of funding, the plan will assume a 6.75 percent rate of return. That still allows for a substantial amount of risk, although it is less than the 7.9 percent assumption the city was using when it declared bankruptcy. Officials of the American Federation of State, County and Municipal Employees, which led the negotiations, did not respond to calls seeking comment. The union is one of 48 that represent Detroit’s municipal workers.

Even as they were negotiating the hybrid pension plan, Detroit’s unions were still appealing a ruling last December by Judge Rhodes that pensions could be cut under federal bankruptcy law, despite protective language in Michigan’s constitution. The unions are required to drop the appeal if they vote for Detroit’s plan of adjustment. From California, Calpers has asked to serve as a “friend of the court” in the appeal, saying Judge Rhodes’s decision “raises issues that are of critical importance to Calpers and its 1.7 million members.”

Calpers’s brief argues that Judge Rhodes ruled improperly and asks the United States Court of Appeals for the Sixth Circuit to vacate his finding that state laws protecting pensions are not binding in bankruptcy cases. Although California’s laws have no force in a federal case in Michigan, Calpers expressed concern that rulings concerning Detroit’s bankruptcy might recast the legal landscape in California.

“Such a precedent can be, and has been, misconstrued for the broad proposition that all pensions are subject to impairment in Chapter 9,” the Calpers brief said.
I know what you're thinking, what a mess! This isn't going to end nicely and sadly, more U.S. public pensions facing a looming catastrophe are headed the way of Detroit.

Sooner or later someone has to pay the pension piper and it ain't going to be the fat cats on Wall Street orchestrating the secret pension swindle, pushing more public pensions to bet big on alternatives, enriching grossly overpaid hedge fund and private equity gurus. They will be collecting huge fees even as Rome burns to the ground, leaving workers, pensioners and taxpayers to foot the pension bill.

And CalPERS is fighting a losing battle. They are worried and rightfully so. If the decision in Detroit goes through, it will have severe repercussions across America and materially impact the large state plans.

But faced with crumbling public finances and overstretched taxpayers, most U.S. cities will have little choice but to implement some sort of risk sharing in their pension plans, forcing workers to share the pain of their plan if it fails to meet its actuarial target.

In a recent comment on why the day of reckoning looms large for pensions, I wrote:
There is nothing that pisses me off more than a bunch of incompetent goofballs in Ottawa and idiots at right-wing think tanks spreading malicious lies on defined-benefit pensions and why we shouldn't enhance the CPP for all Canadians.

But I also got a bone to pick with all these public sector unions who think gold plated pensions are their god given right. Think again. There is nothing written in stone that guarantees you a nice pension for life. Just ask the civil servants in Greece and Detroit what happens when the money runs out.

I worked at various jobs in the public and private sector. There are lazy, incompetent fools in both the private and public sector. It used to drive me nuts when I had some senior civil servant bureaucrat telling me they are counting the days to retire so they can collect their pension.

Let me be clear on something. I am all for defined-benefit pensions across the public and private sector but I am also for major reform including raising the retirement age and risk sharing.

Importantly, if it were up to me, I'd raise the retirement age to 70 because people are living a lot longer and I would pass laws where pension plan benefits are indexed to markets. I would also ensure much more transparency and better governance at all our pension plans, including our much touted large Canadian public pension funds where compensation is running amok.
In another comment on Quebec's declaration of pension war, I wrote:
The government of Quebec and municipalities have no choice but to slay this pension dragon once and for all. I personally think they should amalgamate all these small and medium sized public pensions and create a new pension with world class governance. They could give the money to the Caisse but that organization is big enough and I think we can use another major public pension fund in Quebec with new blood (not the same old Caisse faces which everyone is tired of).
As you can read, Detroit's pension woes are coming to a city near you and this will have huge implications on your public services, especially if unions start striking and wreaking havoc as they did (in vain) in Greece.

The world is awash in debt. Smart economists like Michael Hudson understand the dangerous debt dynamics being played out right now. Creditors (capitalists) are squeezing workers (labor) for every penny they've got and they couldn't care less of laws. When push comes to shove, they will go after your public pension plans with everything they've got.

In a sick twist of irony, the very same creditors fighting for pension money in bankruptcy courts are large, secretive hedge funds being funded by large public pension funds. And they don't just go after city pensions. They go after entire countries, like in the case of Argentina where billionaire Paul Singer’s court victory is turning into a windfall for all the nation's bondholders. (Clinton political adviser James Carville once said that “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.")

And yet, there is a nice easy solution to the U.S. public pension problem. The United States of America should adopt universal pensions for all its citizens and have these pensions managed by well-governed public pension plans that operate at arms-length from the government. (Canada should do the same thing and enhance the Canada Pension Plan for all Canadians).

Nonetheless, as we saw with the adoption of the Affordable Care Act (aka 'Obamacare'), the public solution wasn't even discussed (HMOs funded that bill), so universal public pensions in the U.S. are a pipe dream, for now. But mark my words, as demographics take hold, and more and more people retire in poverty, there will be a public outcry over a broken retirement system. Retirement security will be the hot political issue of the next decade(s) and it's high time politicians realize the benefits of defined-benefit plans and adopt new thinking to tackle the retirement crisis.

Below, Los Angeles City Administrative Officer Miguel Santana discusses pension reform and the city’s deficit. He speaks on “Bottom Line.”

And RT's Abby Martin and Meghan Lopez talk about the recent announcement by Detroit’s Water and Sewerage Department threatening to cut off the water to nearly 50 percent of the city’s population (listen to entire show but Detroit segment is at minute 8). A United Nations team of experts said Wednesday that Detroit officials’ decision to shut off water service to thousands of residents who are late in paying bills is an affront to human rights.

Detroit is a shit hole. RT also reports that cleaning up its dilapidated buildings will cost the city $1.9 billion. And the city thinks hybrid pension plans will save it from Armageddon? Good luck, the ship is sinking and the rats have abandoned ship.

Finally, listen as Abby Martin dissects Obama's appearance on the Daily Show with Jon Stewart and discusses the larger implications of young voters getting their news from the program (October, 2012).  Abby hits the nail on the head and explains why there is no "change you can believe in."



Wednesday, June 25, 2014

AIMCo's Unconventional Investments?

Scott Haggett of Reuters reports, Pension manager AIMCo turns unconventional to boost returns:
Alberta Investment Management Corp (AIMCo), the C$80 billion ($73.7 billion) provincial pension manager, is steering clear of investments tied to existing roads, bridges and transmission lines as their growing popularity squeezes returns.

AIMCo Chief Executive Leo de Bever said on Monday the company is pushing into late-stage venture capital and newly constructed infrastructure as it looks for above-market returns for the pension and provincial government funds it manages.

Investment in land or transmission lines "has become commonplace," de Bever told reporters. "The returns on it have started to diminish."

De Bever was one of the early pioneers of investing pension funds in infrastructure. While a senior vice-president at Ontario Teachers' Pension Plan in the 1990s, de Bever bought a 25 percent stake in AltaLink, which controls half of Alberta's electricity-transmission network. Warren Buffet's Berkshire Hathaway Energy acquired the company from SNC-Lavalin Group Inc last month for C$3.2 billion, a price that kept pension funds out of the bidding.

"The price gives ... about a 5 percent return on equity," de Bever said. "To me, that's a little skinny. These assets are trading at very, very high prices."

Rather than look to existing assets to provide the long-term payouts needed by pension funds, de Bever said AIMCo is looking to play a role in funding new infrastructure construction in fast-growing areas like Fort McMurray, Alberta, a booming city of 77,000 in the heart of Canada's oil sands. As well, it is looking at providing late-stage venture capital for energy-technology companies.

"We have to get more innovative in different areas," he said at a press conference. "We have to stretch ourselves and stretching ... means going for the more difficult assets."

De Bever points to AIMCo's investment in bankrupt Australian timberlands controlled by Great Southern Plantations as an example of the fund manager's search for unconventional assets offering above-market returns.

"It was a huge mess and everybody else looked at it and said it's going to take a long time to sort it out so why would we get involved?" he said. "Us being long-term investors said 'Hey this is a perfect opportunity because if we can straighten this out and we can buy it cheaply then presumably the return is going to come'."

AIMCo is looking to its unconventional investments to replace low-return assets like bonds whose prices are threatened by rising interest rates.

De Bever, 66, plans to retire from the fund manager once an executive search for his replacement is complete.
I recently covered how AIMCo scored huge on timberland and covered AIMCo's 2013 results here. In aggregate, AIMCo earned 12.5% net in 2013 led by a strong performance in public markets but there were significant gains in private markets too.

I also had a chance to chat with Leo de Bever following another comment on why he is stepping down. Leo told me he was somewhat disappointed that I quoted the aiCIO article which was "factually wrong" and he told me that he will be focusing his attention on this new fund looking to help innovative Alberta companies commercialize their technology, which is what he always wanted to do.

AIMCo has indeed turned to unconventional investments. For example, together with OMERS, it bought a stake in Vue Entertainment, one of Europe's  top movie theater chains. This new fund providing late-stage venture capital for energy-technology companies is a miniscule part of AIMCo's total assets but it has huge potential.

I told Leo that I'm highly skeptical of pensions investing in venture capital. My experience at the Business Development Bank of Canada (BDC) cemented my skepticism as the BDC lost a lot of money in their VC investments.

Also, there is another story I forgot to mention when I discussed why Gordon Fyfe is leaving PSP to head bcIMC. When I was helping Derek Murphy set up private equity, I reached out to Sequoia Capital, one of the best VC funds in the world.

I don't know how but I got through to Doug Leone, a senior partner, and told him PSP was interested in meeting them. Initially, he didn't want anything to do with us and warned against investing in VC. "Listen, we don't deal with public pension funds. We're having internal squabbles as to whether to allocate more to Harvard or Yale's endowment fund and our last $500 million fund was oversubscribed by $4.5 billion. My advice to you guys is stay out of venture capital, you will lose pension money."

I called Leone three times that day and practically begged him to meet Gordon Fyfe and Derek Murphy. "I like your persistence kid, so I'll meet your guys for 15 minutes." When Gordon and Derek came back, they were in awe. Derek muttered "fuck did I feel poor" and Gordon said something along those same lines (but more diplomatically). They both loved that meeting and said venture capital is definitely not an area PSP will touch (it changed somewhat as PSP does invest a miniscule portion into clean tech, which is a hot area).

Anyways, Leo de Bever told me that is why he is focusing on late-stage technologies so that he can work to commercialize these technologies without the risks of seeding some new tech company. It's still risky but not as risky as start-ups.

What I like about Leo is he doesn't blindly follow the herd into the infrastructure bubble or the private equity bubble. He prefers to invest between the cracks and use AIMCo's long-term investment horizon to scoop up deals that others are not looking at. They look at the merits of each deal independently of what others are doing and see whether it makes sense. It's not easy but once in a while, you will find gems out there that nobody else is looking at.

I can't help but wonder whether Leo has been approached to take over PSP Investments now that Gordon is leaving to head bcIMC. It's a huge job and I'm not sure he wants to take on such a demanding position at this stage of his career but he's definitely a prime candidate. There are a few others on my list of potential candidates, including Julie Cays over at CAAT which is also delivering exceptional results. We shall see who the board of directors at PSP chooses but for now they appointed John Valentini, PSP's CFO, as the interim CEO.

Speaking of board of directors, CPPIB just appointed Heather Munroe-Blum as chairperson of its board of directors. Ms. Munroe-Blum, who was previously principal and vice-chancellor of McGill university, replaces Robert Astley, who has been chairperson since 2008. She had a controversial style while at McGill and she is tough as nails but she will focus on results and be very vigilant in this important position (hope she read my last comment on CPPIB's struggle with big, bold investments).

Below,  George Whitehead, partner at Octupus Investments, talks with Caroline Hyde about the challenges of venture capital investing in the next generation of robots. He speaks on Bloomberg Television’s “The Pulse.”

Tuesday, June 24, 2014

Big Investors Missed Stock Rally?

Gregory Zuckerman of the Wall Street Journal reports, Big Investors Missed Stock Rally:
Corporate pension funds and university endowments in the U.S. have missed out on much of the rally for stocks since 2009, following a push to diversify into other investments that have had disappointing performances.

The institutions, ranging from large corporations such as General Motors Co. to big universities such as Harvard, have been shifting to hedge funds, private equity and venture capital. But while these alternative investments outpaced stocks during 2008's market meltdown and are seen as potentially less volatile, they have badly lagged behind the S&P 500 since 2009, a period in which U.S. stock indexes have more than doubled.

Diversifying away from stocks could work out since many of these institutions enjoy long investment horizons and won't need to spend the bulk of their assets until years in the future, if ever. At the same time, many alternative investments have topped stocks over the past decade. Investments in private equity, for example, nearly tripled the gains in stocks, according to Cambridge Associates LLC, which invests in these funds for clients.

Missing out on recent stock gains, though, adds to challenges facing pension funds, some of which don't have enough assets to meet future obligations. For universities dependent on endowment income, reducing stockholdings represents a lost opportunity in a time of stretched resources.

The recent poor showing has put a spotlight on pension funds and endowments that have turned away from stocks for more than a decade, including the period after the market's plunge, when stocks became inexpensive relative to their earnings.

"Alternative asset classes are expensive, especially if you have to live with the average fund instead of stellar funds," said Prof. William Goetzmann of the Yale School of Management. Hedge funds and private-equity firms generally charge investors much higher fees than mutual funds and other traditional investments, including management fees of as much as 2% of assets and a take of any returns.

Harvard University, with the world's largest endowment at $32.7 billion, had an average annual return of 10.5% over the past three years through June 2013, according to the school, well below returns of 18.45% for the S&P 500, including dividends, over that same period. Yale University, with an endowment of $20.8 billion, and Stanford University, $21.9 billion, had returns of 12.8% and 11.5%, respectively, over that same period, the schools said.

Over the past 10 years, the schools fared better, generating gains of 9.4%, 11% and 10%, respectively, above the 7.3% return of the S&P 500. Spokesmen for the schools declined to comment.

The U.S. companies with the largest defined-benefit pension plans in 2013 posted an average return of 9.9%, according to a survey of 100 large firms by Milliman, which provides actuarial products and services. The S&P 500 returned 32% in 2013, including dividends.

The average college endowment had 16% of its investment portfolio in U.S. stocks as of the end of June 2013, the most recent academic year, according to a poll of 835 schools conducted by Commonfund, an organization that helps invest money for colleges. That is down from 23% in 2008 and 32% a decade ago. The 18% allocation to foreign stocks didn't change in that period. Schools in the poll, which collectively manage nearly $450 billion, had 53% of their funds in alternative strategies, up from 33% in 2003.

The average allocation of corporate pension funds to stocks was 43% at the end of last year, down from 61% at the end of 2003, according to J.P. Morgan Chase & Co. The average public pension fund had 52% of its portfolio in stocks at the end of 2013, down from 61% at the end of 2003, J.P. Morgan said.

While stockholdings have shrunk, alternative investments made up 25% of the portfolios of public pension funds, up from 10% a decade ago. Corporate funds had 21% of their money in alternative investments, up from 11% at the end of 2003, J.P. Morgan said. Hedge funds and private-equity firms can use a range of strategies, including betting against stocks and buying and selling companies.

The shifts haven't worked out lately. Since the start of 2009, when the market began rallying, the S&P 500 has climbed 137%, including dividends, to record levels. By contrast, the average hedge fund is up 48%, according to research firm HFR Inc., while the average hedge fund that is focused on stocks has risen 57%. Over that same time, private-equity funds have climbed 109% on average, while venture-capital funds rose 81%, according to Cambridge Associates.

Among large U.S. companies with small allocations to stocks in their pensions, shareholdings ranged from 5.2% at NCR Corp. to 14% at Prudential Financial Inc. and TRW Automotive Holdings Corp. to 15% at Ford Motor Co. F to 18% at General Motors to 19% at Citigroup Inc., as of the end of fiscal 2013, according to Milliman and data provided by the companies.

A Prudential spokesman said the company establishes "guidelines that match our obligations with assets in the plan." A Citigroup spokesman said its plan is "largely invested in assets other than equities in part because it has been closed to new participants for several years and has adopted an approach that is consistent with plan closure."

A GM spokesman cited language in the company's annual report that the asset mixes of GM's pension fund aim to improve its funded positions while trying to reduce the plan's risks. Spokesmen for NCR, Ford, and TRW declined to comment.

Some pension funds have elected to have big bondholdings instead of shares or alternative investments. CBS Inc., which had 26% of its pension fund in stock as of last year, largely invests in bonds, according to a CBS spokesman.

Some institutions aim to achieve a certain return above inflation and find steady returns from alternative-investment vehicles make it easier to plan future spending. Alternative investments generally do a better job competing with stocks when the risk of the various investments is taken into consideration.

The long-term results of alternative investments are somewhat better. Over the past 10 years, the S&P 500 has climbed 114%, including dividends. That bests the 75% gain of the average hedge fund, according to HFR, and the 68% return of the average stock-focused fund. But private-equity funds topped stocks, rising 304% on average over that period, while venture-capital funds climbed 153%, according to Cambridge Associates.

"It's in the long term that these strategies hit their stride, particularly private equity," said Andrea Auerbach, head of Cambridge's global private investment research.

Placing money with hedge funds once was viewed as risky; today, a mix of stocks, bonds and cash is seen as more dangerous, industry members said, partly because alternative investments held up better during the financial crisis and are seen as more dependable investments.

Some argue that the shift stems at least partly from an effort to ape the strategy of David Swensen, who has long led the endowment of Yale University and was among the first to shift big chunks of its investments to hedge funds and similar vehicles.

A 2012 paper written by Mr. Goetzmann and another professor at the Yale School of Management, Sharon Oster, argues that university endowments often invest in hedge funds simply to catch up with their closest competitors, rather than to achieve top returns, a shift the professors call "herding behavior" and "trend chasing."

Harvard's endowment had an allocation of 33% to global stocks and stock-focused hedge funds, but just 11% to U.S. shares, as of the fiscal year ended last June. Yale had 15.7% in global stocks and Stanford had a target stock allocation of 25%.

Those shifting to alternative investments more recently could be "too late to the game," said Scott Malpass, chief investment officer at the University of Notre Dame, which has had more than 50% of its $9.2 billion endowment in alternative investments for more than a decade.

Betting on hedge funds and private equity "can be a knee-jerk reaction to the crisis," he said.
I agree with Scott Malpass, the CIO of Notre Dame's mighty endowment fund, institutions shifting into alternative investments, especially illiquid alternatives like private equity and real estate, are late in the game and they're all underestimating illiquidity risk.

Worse still, the big alternatives gamble won't help U.S. public pension funds facing a looming catastrophe. All these pension funds praying for an alternatives miracle are in for a nasty surprise. All they're doing is aiding Wall Street's secret pension swindle, which includes brokers and useless investment consultants recommending the new asset allocation tipping point, and enriching greedy middlemen and overpaid alternative investment gurus who for the most part have become large, lazy asset gatherers focusing more on marketing so they can keep collecting that 2% management fee in good and bad years. The huge shift into alternative investments is stuff worthy of the 1% and Piketty.

And what are the origins of the huge shift? Astute readers of the best blog on pensions and investments will recall a couple of old comments of mine during the crisis, Will Harvard's Horror Decimate Pension Funds and Yale's yardstick Leaves Pensions in Peril.

Everybody followed David Swensen and Jack Meyer into alternatives but they soon realized that these two endowment funds had a big advantage they didn't. They were first-movers and build solid relationships with top alternative investment funds. And even they suffered the wrath of the financial collapse and took a huge hit in their alternatives portfolios.

There is something else that worries me a lot. All these pension funds betting massively on rising rates and loading up on linkers will be decimated if deflation takes hold and they will see the value of their illiquid alternative investments plummet. That is one reason CPPIB is having a tough time beating its reference portfolio with big, bold investments, because the balanced portfolio made up of liquid 65% global stocks and 35% global bonds continues to deliver solid results (this could change if a bear market takes hold).

Every major asset allocator is convinced that going forward, the shift into private markets will pay off over the long-run. I'm not convinced and fear a lot of pension funds are underestimating liquidity risk and will get decimated once the next crisis hits. As Keynes rightly noted, "in the long-run we're all dead."

Going forward, I recommend pension funds focus on liquid alternatives. In particular, L/S Equity, market neutral and L/S credit funds, but that's not enough. Pensions need to start taking smarter risks and by that I mean quickly jumping on opportunities that present themselves in stock and bond markets. For example, how many pension funds bought Greek bonds during the euro crisis? I know of one Greek pension fund that did so. How many pension funds cranked up the risk after each major selloff following the 2008 crisis, including the latest big unwind? Small caps (IWM), technology (QQQ), internet (FDN) and especially biotech (IBB and XBI) have all come roaring back following the Q1 drubbing.

But investment gains alone won't fix the looming catastrophe that awaits U.S. public pension funds. Now more than ever, there needs to be a serious discussion on major pension reforms, which includes reforms on governance. The U.S. public pension problem isn't insurmountable but the longer politicians kick the can down the road, the worse it will get.

Below, Christopher Ailman, chief investment officer of the California State Teachers' Retirement System, talks about the U.S. stock market, private equity and investment strategy. Ailman, speaking with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "Market Makers," also discusses efforts to bring a long-term view and diversity to corporate governance.

Monday, June 23, 2014

Gordon Fyfe Leaves PSP to Head bcIMC

Janet McFarland of the Globe and Mail reports, Victoria native with global network named B.C. pension fund CEO:
British Columbia’s giant pension fund manager has named federal pension executive Gordon Fyfe as its next chief executive officer, saying it wanted a new leader with experience in global investment deals.

Mr. Fyfe, 56, has been CEO of the Public Sector Pension Investment Board in Ottawa for the past 11 years. PSP Investments manages $90-billion in pension assets for employees in the federal public service, and is Canada’s fifth-largest pension fund manager.

He will move to Victoria to become CEO of B.C. Investment Management Corp., which has $114-billion in assets and is Canada’s fourth-largest pension fund manager. BCIMC manages pension assets for public-sector workers in the province, and also oversees public trust funds and public insurance assets.

Mr. Fyfe will replace Doug Pearce, who has led BCIMC for 26 years and announced his plans to retire last August. Mr. Fyfe will take over on July 7.

BCIMC board chair Rick Mahler said Mr. Fyfe was born and raised in Victoria, where BCIMC is based, and most of his extended family is still in B.C. His two sons also are in high school and university in the province.

“We were looking for a Canadian, and not only did we get a Canadian, we got somebody from Victoria,” Mr. Mahler said. “He grew up here, and he went to [the University of British Columbia]. He wanted to finish his career in British Columbia.”

BCIMC has been increasing its focus on global investment opportunities, and announced Thursday it earned a 14.7-per-cent rate of return last year after increasing its weighting in non-Canadian stocks. The fund has announced plans to open offices in London and Singapore to expand its global investment portfolio.

Mr. Fyfe worked for J.P. Morgan in New York and London and also previously worked in France, helping him develop a global network of contacts. Mr. Mahler said asset managers worldwide are seeking out new investment opportunities around the world, and developing strong partnerships with other global fund managers is key to being included in deals.

“Gordon has had a philosophy of developing partnerships in various countries around the world, and he has been very effective in using those partnerships to ferret out transactions,” Mr. Mahler said.

BCIMC said Mr. Fyfe will also carry on the fund’s mandate to invest in a socially responsible manner. The B.C. fund has been a high-profile proponent of responsible investing and Mr. Pearce frequently spoke publicly about policy reforms to improve corporate governance in Canada. He is a former chair of the Canadian Coalition for Good Governance, a powerful lobby group of institutional investors.

Mr. Fyfe has had a lower public profile on policy and governance issues, but Mr. Mahler said the organizations that rely on BCIMC to manage their funds expect BCIMC’s commitment to responsible investing to continue.
Don Curren and Ben Dummet of the Wall Street Journal also report, British Columbia Investment Management Names New CEO:
British Columbia Investment Management Corp., one of several big Canadian pension funds that have become high-impact players in global markets, said Gordon Fyfe is taking over as chief executive and chief investment officer.

Mr. Fyfe comes from another big Canadian fund, the Public Sector Pension Investment Board, where he served as president and CEO.

BC Investment Management, which has $114 billion Canadian dollars ($106 billion) under management, invests on behalf of public-sector pension plans, public trusts and insurance funds.

Mr. Fyfe takes over at BC Investment Management on July 7 from Doug Pearce, who was at the helm for more than 20 years.

"His experience is crucial as (BC Investment Management) seeks to expand its global reach and continues to implement its current business strategy," the fund's chairman, Rick Mahler, said in a release.

PSPB said in a news release that its board will enact a "pre-established CEO succession plan" and that further details will be announced soon.

The new leadership at BC Investment Management is the latest in the changing of the guard this year at some of Canada's biggest pension funds.

Michael Latimer took the helm of Ontario Municipal Employees Retirement System, which oversees C$65.1 billion in pension assets, in April from Michael Nobrega after servicing as chief investment officer. In January, Ron Mock was appointed chief executive of Ontario Teachers' Pension Plan, succeeding Jim Leech. Mr. Mock had previously headed fixed income and alternative investments for the C$140.8 billion fund.

Canada's biggest pension funds have become some of the biggest and most agile investors on the global stage, diversifying their traditional exposure to public equities and bonds into real estate, infrastructure and private equity in a bid to augment long-term returns that match up with their pension liabilities.

The BC pension fund doesn't have as high a profile as some of Canada's biggest funds, led by Canada Pension Plan Investment Board, Quebec's Caisse de Depot et Placement du Quebec and Ontario Teachers'.

Still, the fund is an active investor in alternative investments, including exposure to timber production, water and wastewater production, energy transmission and real estate.

A spokeswoman for the BC pension fund couldn't immediately be reached for comment.
You can read the press release bcIMC's put out here as well as the press release PSP Investments put out here.

So what can I say about Gordon Fyfe? I met Gordon at the Caisse back in 2002 when I was working with Mario Therrien's hedge fund group allocating money to external hedge fund managers. I was overseeing a $400M portfolio of directional hedge funds made up of L/S Equity, CTAs, global macros and a few funds of funds. Every week I would attend a meeting with internal portfolio managers covering global markets and discuss the views of our hedge fund managers.That's where I met Gordon and he left a good impression on me because he was asking tough questions to portfolio managers on their forward looking views.

A month after he left the Caisse to take over the helm at PSP, I joined him (I was he first investment hire). Gordon had me help Derek Murphy on his business plan for private equity and Bruno Guilmette on his business plan for infrastructure.

Once my stints in private equity and infrastructure were over, I was bounced to work with Pierre Malo, who had left the Caisse where he was in charge of currencies to join PSP as Head of Research and Asset Mix. Pierre then hired another analyst, Mihail Garchev who is still working at PSP as the Senior Director for the Office of the CIO.

Together, our small team produced a lot of research and recommended timberland and steered clear from passive commodity indexes. It was research I enjoyed and till this day, that experience helped me make this blog into the success it has become.

Someone from bcIMC emailed me to ask me what to expect of Gordon Fyfe. I told this person that Gordon's focus will be primarily on private markets and he might even bring people from PSP to help him. I also told this person at bcIMC that like any leader, Gordon has his strengths and weaknesses but there is no doubt in my mind that the folks at bcIMC are extremely lucky Gordon is their new leader.

In fact, Gordon Fyfe is an exceptional leader who instills confidence and will fight hard for his employees. And unlike others, he's very approachable and down to earth, which is part of his affable character (just don't share too much with him). He's a hard worker, demands a lot from himself and his employees, but first and foremost, he's a family man and knows the importance of work life balance (he would have breakfast meetings but rarely any lunch meetings because he hit the gym at lunch).

Below, a rare interview with Gordon Fyfe, bcIMC's new CEO and CIO (click here if it doesn't load). Gordon, I wish you much success at bcIMC and hope we touch base again when you're back in town.

Video streaming by Ustream

Friday, June 20, 2014

The Soul of a Hedge Fund Machine?

James Freeman of the Wall Street Journal recently wrote a long article on Bridgewater Associates, The Soul of a Hedge Fund 'Machine':
How do you build the world's largest hedge fund? Bridgewater Associates founder Ray Dalio says he did it by creating a culture of "radical truth and radical transparency." Mr. Dalio's perhaps radical belief is that "everything is a machine"—including organizations and even the individual people within them. At his firm's Westport, Conn., headquarters, we are discussing the human machines at Bridgewater and the equally fascinating machine known as the U.S. economy.

As for the people at his firm, the idea is to encourage everyone to accept unvarnished criticism as a treasured opportunity to learn and to solve problems. This is intended to allow constant refinement of business processes—also known as machines within the firm—from how Bridgewater buys office furniture to how it evaluates the world oil market.

But human machines don't always welcome complete candor. And at Bridgewater they have to get used to internal software that conducts a non-stop evaluation of their performance based on daily entries from colleagues and even rates their credibility on particular issues. This doesn't mean the software makes all decisions. When the system recently reported that the company's head receptionist was underperforming, executives decided that it was a case of the software not being calibrated to effectively measure her work.

If an employee is willing to accept this unique culture, the company promises a rigorous search for the truth with a minimum of politics and subjective decision-making. Mr. Dalio says that anybody in the company can get up in front of a crowd and say that something doesn't make sense. At other firms, he says, "most people keep that to themselves." But at Bridgewater "you have a right and an obligation to say I think this is terrible and explore whether or not that's true." He adds that there's no reason it should not happen at other organizations but that it doesn't happen "because of that emotional ego barrier."

For most new Bridgewater employees, "it's a little bit like entering the Navy SEALs," says Mr. Dalio. "There's a period—usually about 18 months—of sort of adaptation to this. And some make it and some don't make it. And so we call it 'getting to the other side.'" He adds that "the other side looks like: They can't work anywhere else and the reason they can't work anywhere else is they don't know what anybody's thinking anywhere else. They don't have an ability to speak their mind anywhere else. They don't have the guardrails of their weaknesses. Everybody's got weaknesses. They can't candidly address weaknesses.

"We describe it as: there's the upper-level you and the lower-level you. The human brain is part thoughtful man," he explains, "and part animal. And you have to drag yourself. And we see the struggle as between the upper-level them and the lower-level them." In other words the brain wants honest feedback but the emotions aren't always ready to handle it. "It's not a struggle between us and them typically. It's a struggle between what do they want" and "what happens in their emotional reactions to that."

He believes that the Bridgewater culture has been critical to the growth of the firm, because in financial markets "if you can't have independent thinking" and "you can't know what your weaknesses are, and sort those things out, you're not going to be successful."

How does he implement this culture? "I tape everything so everybody can listen to every conversation, except if there's a very personal matter" or "if we're going to execute a trade or something proprietary." Otherwise "everything is taped so everybody can see it and we go through a process of valuing critical feedback to try to together discover what the patterns are" and how improvements can be made.

Created in Mr. Dalio's New York City apartment in 1975, Bridgewater now manages $160 billion in assets. A "global macro" investor that focuses on understanding national economies, the firm has a history of reporting market-beating returns to clients—and even made money during the financial crisis—but posted disappointing results in 2012 and 2013. Bridgewater appears to trade less with some of Wall Street's giant banks than some large funds do, but Mr. Dalio says that it's not a policy of his firm to avoid Wall Street. "We just go wherever the transaction costs are cheapest."

Just as he sees individuals and business processes as machines, Mr. Dalio also sees an economy the same way. And that "means that there are cause-effect relationships" and this allows one to understand that "most things happen over and over and over again." Mr. Dalio says that, "In order to really understand the machine I believe that I have to have timeless and universal rules" across all time and all countries.

The emphasis on transparency within the company doesn't mean that Mr. Dalio is seeking media attention. "No, I hate it," he says. But he has consented to this interview, and has published papers and a video online at EconomicPrinciples.org, because he wants everyone, including Washington policy makers, to look at the economy in a new way—to understand the machine.

"Because I've watched repeatedly so many misunderstandings [that] have bad consequences. And I think that rather than trying to discuss what should be done that we have to start with the basics of saying: how do things work?" He adds, "If we can agree on how it works, then that's a foundation for what should be done and also what will prevent problems. So an example of that would be printing money. Is printing money inflationary? Well let's just go back to basics and look at that question."

While people debate whether the Federal Reserve's money creation will or will not cause inflation, Mr. Dalio says it's first necessary to get a clear view of the monetary machine. Stated simply, he says, all purchases in the economy must come from money or credit. He therefore sees a role for central banks in helping to prevent a steep downturn when the availability of credit plunges during a financial crisis. "The printing of money offsets the contraction in credit," he says, "and relieves the liquidity problem."

The Fed has been creating a lot of money since the crisis. Mr. Dalio says his team at Bridgewater has studied 67 historical periods of deleveraging, when countries or economies had to reduce debts after a credit boom. He pronounces the current U.S phenomenon "a beautiful deleveraging"—with the Fed adding money to the economy to maintain overall spending. And as people in the economy extend more credit, he says, the Fed should in turn reduce its money printing.

Still, he says, "I worry about the effectiveness of monetary policy in the next downturn." That's because the first tool the Fed can use to goose the economy is to lower interest rates. But since rates were already very low during the crisis, the Fed decided to employ a second tool: creating money as it purchased Treasury and mortgage bonds through a program known as quantitative easing. But such purchases are less effective than lowering rates, says Mr. Dalio, because while interest rates directly affect nearly everyone as they buy houses and cars and shop with credit cards, the people who own financial assets and who benefit from QE don't necessarily buy more things as a result. QE works best when not much money is in the system and asset prices are low. With lots of money now in the system and the prices of financial assets having soared since the depths of the crisis, such policies will likely be less effective.

"There will have to be a monetary policy number three," says Mr. Dalio. "This is an issue I haven't yet figured out." He adds that "every cyclical peak and trough in interest rates was lower than the one before it since 1980." One therefore wonders what firepower the Fed will have if it is again called upon to prop up the economy. "We'll probably find a way to manage through that," he says. But for now we are in "neither boom nor bust" and Mr. Dalio doesn't expect much volatility over the next few years.

A lot of readers will no doubt think that we need activity in other parts of the American economic machine, rather than just Fed money printing, to return to robust growth. Mr. Dalio makes it his business to study national economies around the world and of course he has a machine to evaluate them.

Surveying the rise and fall of economies over time, Mr. Dalio and his colleagues have developed a model intended to predict national economic growth rates over 10 years. The model is based 35% on the country's level of indebtedness and 65% on competitiveness and "by that I mean what you get for what you pay," he says. The single "most important factor is what it costs to have an educated person."

For this reason, Mr. Dalio can see significant unrealized potential in Russia because of its very low level of indebtedness, which means "they have the power to buy," and due to its highly educated and cheap labor force. But culture matters, too. Another key to growth "is the notion of self-sufficiency," he says. "Economies in which a greater percentage of the population feels the rewards and penalties of their actions tends to grow faster than those that don't."

In Russia, he notes, "there's no inventiveness, there's no entrepreneurship, there's no small business development." International indexes note high corruption and limited property rights. Mr. Dalio sums up the results for economic growth when few people have ownership opportunities: "Nobody ever washes a rental car."

Such factors are why he still sees a bright future for the U.S., even with lots of debt and moderately expensive educated workers. The U.S. has "a very high rate of innovation," and technology development "in my opinion is going to produce and is in the early stages of producing productivity miracles." He compares America's "connectivity revolution" to Gutenberg's invention of the printing press, and he also notes that the U.S. is becoming energy self-sufficient. "Plus we have rule of law, we have property rights."

One area where the U.S. "could make a lot of progress" is in improving public education. "That's a high-potential area," he adds. It's unclear whether anyone can understand the machine known as the U.S. public-school system, but it's safe to say that it doesn't operate much like Bridgewater.

As for the U.S. economy as a whole—as well as all the people within this great machine—Mr. Dalio offers a simple rule to help avoid the next credit crisis: Don't allow debts to grow faster than income.
It's nice to see Ray coming out again to speak to reporters. Why did he agree to this interview? It's all about Bridgewater's 'marketing machine', and the fact that the world's largest hedge fund is finally performing well after two lackluster years.

According to Bloomberg, Bridgewater’s Pure Alpha II rose 2.1 percent in May and 6.1 percent in 2014, and the fund now manages an astounding $160 billion and Westport Now states the fund now employs 1600 people. It's a far cry from when I invested in Bridgewater over 11 years ago when they had a little over $10 billion in assets and around 120 employees.

I'm not sure how this explosive growth has impacted the firm's culture, but in my experience, the bigger organizations get, the worse the culture becomes. The senior managers become all paranoid, lots of nonsense infighting and internal turf wars where people look out for their interests rather than that of the organization.

But let me give Bridgewater the benefit of the doubt, after all, they are performing well so far this year when most of their peers are getting stung by calm markets:
Some of the biggest investors on Wall Street are losing money with wrong-way bets in markets around the globe, a surprising black eye amid a rise in stock and bond prices.

Hedge-fund managers including Paul Tudor Jones, Louis Bacon and Alan Howard are among those who have misread broad economic and financial trends. Some have lost money as Japanese stocks fell, while others have been upended by the surprising resilience of U.S. bonds.

An unusual period of calm has exacerbated problems for many trading strategies dependent on volatile markets. The losses by these so-called macro investors are contributing to a trading slowdown hurting the largest investment banks.

The flagship fund at $15 billion Moore Capital Management LP, led by star investor Mr. Bacon, was down 5% this year through the end of May, the firm has told clients. Mr. Jones's flagship fund at $13 billion Tudor Investment Corp. is down 4.4% this year, according to a person familiar with the firm.

By comparison, the S&P 500 index is up 5.4% this year, including price gains and dividends, and the Barclays U.S. Aggregate bond index, a standard measure for debt investments, is up 3.4%.

Funds operated by Mr. Howard's Brevan Howard Asset Management LLP, Fortress Investment Group, Caxton Associates LP, Discovery Capital Management LLC and Balestra Capital Ltd. also have posted losses, according to people familiar with their performance.

It is always difficult predicting broad trends, and the losses could quickly reverse. But hedge funds charge high fees with the expectation of impressive performance in any kind of market, and these investors built reputations with prescient market picks. Those running so-called macro funds generally bet on macroeconomic trends in global markets while investing in stocks, bonds, commodities and currencies.

"Macro investors have had a very, very hard time with the fact that bonds have done well and volatility is so limited," said Matt Litwin, director of research at Greycourt & Co., a Pittsburgh-based investment firm that invests $9 billion in hedge funds and other firms but has been reducing some of its investments with macro hedge funds. "There are a lot of losers."

Many funds piled into Japanese shares last year when they began rallying. But the Nikkei Stock Average is down 7.1% since reaching a high in January, amid doubts about the sustainability of Japan's economic recovery. Fortress, a $63 billion firm, has acknowledged to investors in its Fortress Macro fund that it was hurt by both this year's run-up in U.S. Treasury prices and weakness in the Nikkei. The Fortress Macro fund was down more than 3% this year as of June 6.

Brevan Howard Capital Management's roughly $28 billion flagship fund was down 3.8% through June 6, according to an investor in that fund, with interest-rate and bullish Nikkei bets among its losers. Caxton Associates in New York, an $8 billion firm, has lost money every full month this year and was down more than 6% at the end of May, according to the firm's investor updates, partly due to bearish currency positions.

Kyle Bass's $2 billion Hayman Capital Management LP has lost money on wagers against some European countries, as well as a bet on further weakening of the Japanese yen, people familiar with the firm say. The Dallas-based firm's main fund suffered its steepest two-month drop in five years at the start of the year and fell more than 6% in the first quarter, these people say.

Woodbine Capital Advisors LP, a well-known fund run by Joshua Berkowitz, a former senior trader at Soros Fund Management, recently announced plans to stop managing outside money after disappointing returns.

Larger funds have a handicap in slow markets: They can be too big to trade in smaller markets that are seeing more volatility.

"You can't put $1 billion in coffee contracts and expect to get out quickly, so the big funds can't have these smaller plays in their portfolios," said Sam Diedrich of Pacific Alternative Asset Management Co., an Irvine, Calif., firm that invests in hedge funds.

The setbacks for macro investing—a style made famous by George Soros and others who anticipated past market turns—come after a rush of investors embraced this approach to trading, thanks to its impressive performance during the financial crisis.

Macro funds on average gained 4.8% in 2008, even as the S&P 500 fell 37%. Other investors saw how John Paulson, a onetime merger specialist, made $20 billion in profits at his firm, Paulson & Co., anticipating the 2008 meltdown, and they vowed to adopt macro strategies as well.

Today, there are 1,865 hedge funds focusing on macro investing, up from 1,233 in 2008, according to HFR Inc., which tracks the hedge-fund world. That growth is much faster than that of the overall hedge-fund business. Macro funds manage $508 billion, up from $279 billion in late 2008. But macro funds have had three years of disappointing returns.

The poor results are prompting investors to pull money from macro funds and are forcing some funds and other financial groups to scale back their trading. Large banks including Goldman Sachs Group Inc., GS -0.08% J.P. Morgan Chase& Co., Morgan Stanley and Barclays PLC execute many hedge funds' trades. Such banks tend to benefit from rising trading volumes and volatile markets.

Amid the recent quiet, many banks have posted soft results, and some have laid off traders. Goldman Sachs President Gary Cohn said last month that unusually slow markets had made it "difficult" for Wall Street firms. Morgan Stanley said this month it would cut jobs from its currency and rates-trading businesses in response to tepid investor activity.

Some worry that a lack of volatility will continue to haunt various markets, perhaps until the Federal Reserve signals higher interest rates are imminent following a long period with benchmark rates near zero.

"I actually find myself daydreaming about winning 'Dancing With the Stars' on some days in the office," Mr. Jones, of Tudor, joked at an investment conference this spring. "It's gotten to be very difficult, when you depend on price movement to make a living, and there is none."

Average daily bond trading has fallen to about $734 billion, the lowest level in more than a decade, according to the Securities Industry and Financial Markets Association. The CBOE Volatility Index, the most widely cited measure of investor expectations for daily stock-market swings, on June 6 slipped to 10.73, its lowest closing level since 2007, according to FactSet.

"These are very uninteresting times in the market," Jared Dillian, a former trader who now writes a newsletter, recently told his subscribers. "The goal is to not fall asleep."
Lack of volatility and calm markets will continue to haunt these large macro funds. Some are betting on the decline of the euro but the fact is not much has changed since I wrote my comment two years ago on why macro funds aren't bringing home the bacon.

Importantly, central banks have effectively clipped the wings of these large macro funds. Ray Dalio can question the effectiveness of quantitative easing but the reality is the Fed is doing whatever it takes to prop up equity markets in a desperate attempt to stoke inflation expectations, even if QE exacerbates wealth inequality. It will likely fail but in the meantime, enjoy the liquidity party and melt-up in risky stocks.

And the irony is Bridgewater made most of its money this year by going long bonds. I remember my exchange with Ray in front of Gordon Fyfe in 2004 when I was pressing him on why I thought deflation is the end game and he blurted out: "Son, what's your track record?"

Well Ray, since you admire "radical truth and radical transparency," let me be brutally honest with you and all your other superstar hedge fund peers. I honestly think you're a bunch of insanely overpaid gurus who rely more on the marketing machine, collecting that 2% (or 1.5%) management fee in good and bad years. Even 1% on $160 billion translates to $1.6 billion for turning on the lights!

I would love for Bridgewater and other hedge funds to publish their IRRs net of fees and all other costs. In fact, the SEC should demand this from all asset managers. Then we can gauge real alignment of interests.

When I read that for most new Bridgewater employees, "it's a bit like entering the Navy SEALs," I roll my eyes and feel like hurling. Oh yes, once they "get to the other side" they have mastered the machine. Who believes in this self-promoting , self-serving crap?!?

I'm sorry to disappoint you folks but Ray Dalio doesn't walk on water and neither does any other hedge fund or private equity superstar. Many of these gurus were at the right place at the right time and while they performed well, they are also the prime beneficiaries of the big alternatives gamble undertaken by dumb public pension funds desperate for yield as they try to avert a looming catastrophe.

I've challenged the Bridgewaters and Blackstones of this world to do away with management fees altogether (or reduce them to 50 basis points) and rely entirely on their performance fee, which is high enough. So far, nobody has accepted this challenge and why should they? So many dumb pension funds taking advice from useless investment consultants shoving all their clients in the same brand name funds, it's an alternatives orgy out there.

Enjoy it while it lasts because it ain't going to last for long. There will be a radical transformation in the alternatives business in the decade ahead and many pension funds praying for an alternatives miracle will be sorely disappointed. They are all underestimating liquidity risk in private and public markets.

I challenge Ray Dalio and other hedge fund gurus to a few things:
  • Publish your IRRs, net of all fees and costs, for each fund going back monthly to inception.
  • Publish your turnover rate every year with an explanation if it rises.
  • Publish your research and letters for everyone, not only your clients (What ever happened to Bridgewater's research piece "Selling Beta as Alpha'?)
  • Last but not least, diversify your workplace and hire persons with disabilities. Don't worry, it will do wonders in counterbalancing the pervasive arrogance at your shops.
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Below,  Agecroft Partners Founder and Managing Partner Donald Steinbrugge and Bloomberg Contributing Editor Fabio Savoldelli discuss hedge fund performance. They speak on “Market Makers”and state investors are happy with hedge funds. This is an excellent discussion, take the time to listen to it.