Emerging Managers Get Redefined In Chicago

by Lillian C. Jones          March 18, 2013

The annual Opal Emerging Manager Conference took place in Chicago from May 15 – 17, 2013.A lot was different this year. It was held at the Radisson Blu Acqua Hotel. In previous years it was at the Suisse Hotel around the corner. I did not stay at the Rad Blu for even the “negotiated rate” was, in my opinion, too high. So I shopped around and found a hotel where I was able to get two nights for the price of one at the “negotiated rate” and it was right across the street.

The conference was a lot smaller. I would guess the conference room was half the size of events in the past. There were old timers, plenty of newbies, and as always more people with product to sell than people to buy. The speaking panels were mostly white males. What is going on I wondered at a conference where a few years ago I was told from a person on the dais that in Chicago “emerging manager” means minority and woman-owned firms and white men need not apply.

The answer came in the second panel discussion, the Investor Roundtable. The Honorable Stephanie Neely, Treasurer, City of Chicago, a true superstar, told us that the City is severely underfunded and although she likes emerging managers because they add value, the City can no longer be angel investors investing in next generation managers. The term angel investor stunned me for a moment. Did she mean angel investor the way I think of it, as a venture capital type of investor? But then again, when times were flush many public funds were taking ownership in emerging managers. Either way, as a traditional investor committing pension investments by hiring emerging managers or as an angel investor taking an ownership stake, the City is looking at insolvency. And then she said she doesn’t fire managers, she takes the cash. “The more money a manager makes, the more we take away.” What money manager in their right mind would want to work for them?  She said they are going more and more to cash. The writing is on the wall and it spells bankruptcy for the City of Chicago.

Another superstar, Mellody Hobson, President of Ariel Investments, was on a panel called “Redefining Emerging Managers”, and she began by giving us a short history lesson reminding us that in the early 1980s there were three minority firms; Ariel, Brown, and NCM. Then Prop 209 came along and race based selection was illegal. Size was a way to get around the issue since most minority money managers were small in assets. Arbitrarily $2 billion was selected as the definition of an emerging manager. In Illinois it was $10 billion. Mellody said although race and gender was the original intent, now it is about entrepreneurship and size. Some say in Illinois  the emerging manager definition was set at $10 billion so that Ariel could be included in searches. Really? Ariel with $6 billion in assets wants to participate in emerging manager searches? Why? As I listened to her I think what she was saying is that Ariel is having a difficult time scaling up. As most strong-performing managers tend to grow to the sky, think Vanguard or PIMCO or the largest, Blackrock with $3.5 trillion, poor Ariel is stuck at $6 billion. But Ariel should no longer be relying on emerging manager programs to grow assets. They are now competing in the big leagues where consistent and strong performance (which Ariel lacks) plus other qualitative and quantitative factors that consultants must analyze and evaluate determine the outcome, not race or gender.

Mellody said no other profession has the term emerging……..no one would go to an emerging doctor or dentist. She says the term emerging is not helpful. She says the term “diverse firm” should be used and the term “emerging” should be retired.  Whether Ariel is called “emerging” or “diverse” does not change the fact that they can be relied upon to consistently deliver mediocre returns. Fiduciaries (trustees) hire people like me to find the talented, skilled managers (before they get really big) to earn a return on assets in order to pay pension benefits. If “emerging” means “mediocre”, they will be screened out.

Election Year Politics and Retirement Issues

 

 

DEMOCRATS	REPUBLICANS
Workplace retirement accounts   Increased pension portability   Push companies to provide annual disclosures to employees about pension investments   Make pension funding a priority in the event of corporate bankruptcy filings   CEOs can’t dump workers with one hand while lining their pockets with the other   Preserve Social Security and strengthen it	Focus on PBGC ($26B deficit in 2011)   Immediate remedial action to address underfunded public pension liabilities caused by irresponsible promises by politicians at every level of government   Comprehensive reform of Social Security Raise age of retirement Slow the rate of benefit growth for higher income earners Allow younger workers to have personal investment accounts   Annual audit of the Federal Reserve More transparency Less potential for political influence   Study ways to set a fixed value for the dollar

CALPERS AND COMMODITIES

Indexing with an actively managed overlay recommended by banks and investment consultants has proven to be a losing strategy for CALPERS since inception in 2007. John Kemp is a Reuters market analyst who has written a great piece about the issue. I have attached it here as it is worth the read.  

 

The California Public Employees’ Retirement System (CalPERS) lost 11 percent investing in commodity derivatives in the last financial year, according to a performance report published on Monday [Aug. 6], making it the second worst-performing asset class in the portfolio. Only the fund’s investment in forestland proved more disappointing. In the 12 months ending on June 30, the fund’s commodity investment program lost 11 percent on an allocation of just over $3 billion, compared with a long-term expected return of 5 percent a year. Losses in the $2 billion forest program were also 11 percent, which was even more disappointing against a higher expected annual return of 7 percent. Overall, the fund squeezed out a return of just 1.0 percent on its $233 billion portfolio in 2011-2012. Big gains in real estate, infrastructure, inflation-linked bonds and private equity helped offset losses in public equity, commodities, forestland and absolute return strategies, according to reports to be presented to the investment committee on Aug. 13. A small gain in the commodities program during June, rising 1.2 percent, was not enough to offset a horrendous May, when the program shed 12.2 percent in a single month. Reviewing the poor performance of the program in his annual report for 2011-2012, CalPERS Chief Investment Officer Joe Dear wrote: “Commodities had a difficult year due to global economic uncertainty, natural disasters, and a China slowdown in economic activity.” He failed to mention many developments that have boosted commodity prices, including unrest across the Middle East and North Africa, outages in North Sea oil fields, the shutdown of Japan’s nuclear industry and fossil fuel buying, drought, and the continued interest in “real assets” amid a welter of fears about both inflation and deflation. CalPERS’s failure to make money in commodities does not seem to be a short-term problem, and it is not restricted to the last year. Overall, the program has struggled with exceptional levels of volatility since its inception in October 2007. While the program was always expected to deliver variable returns (it has the highest expected standard deviation of any asset class in the CalPERS portfolio) it has failed to achieve consistent underlying performance. The commodity program has lost money heavily since inception. A formal assessment will be published when CalPERS reports performance for the third quarter. But a review of previous investment reports shows the program had a rate of return of negative 6.9 percent a year between October 2007 and June 2011, and has now capped it off by losing another 11 percent in the last 12 months. Indexing Returns Vanish CalPERS is one of the most sophisticated and influential institutional investors. Its early move into commodity derivatives helped win broader acceptance of commodities as a new asset class among traditionally cautious institutional money managers. CalPERS has only a small team researching and implementing the commodity investment program, but it has been able to leverage its size and influence to secure the best advice around from sell-side banks, hedge funds and investment consultants. CalPERS has also followed the currently recommended best practice, allocating roughly 75 percent of its funds to a passive index-based strategy designed to track total returns on the Goldman Sachs Commodity Index with the rest allocated to an actively managed overlay. The actively managed component is designed to enhance index returns, mostly by under-weighting derivatives stuck in a contango structure and over-weighting those more prone to backwardation. Indexing with an actively managed overlay is currently advocated by many banks and investment consultants. But if even CalPERS cannot make money from an enhanced indexing strategy, there must be doubts about whether any other pension funds will be any more successful. The index-based program was set up to capture systemic returns from passively investing in a broad basket of commodity derivatives. Index returns comparable to equities were formally estimated in a paper on “Facts and Fantasies about Commodity Futures” published by Gary Gorton and Geert Rouwenhorst in 2004-2005. But they have since vanished, perhaps because too many investors have chased the same returns, leaving pension funds struggling with losses. CalPERS’ quarter allocation to alpha-generating strategies has helped it outperform the GSCI, but only slightly, and not by enough to avoid the crippling effect of the contango. In effect, the fund has not been able to generate enough alpha to outrun the contango drag on performance, which appears to have doomed the strategy to failure. Time for a New Strategy CalPERS has rejected much of the criticism of last year’s poor overall investment performance, countering that many critics fail to understand that it is a long-term investor. “As a long-term investor we fully expect a range of possible returns every year … we use investment strategy to reach our long-term goals,” according to a response posted on the fund’s web site last month. “The key to have having a strategy is working with it,” CIO Joe Dear warned. “The worst mistake is to abandon the strategy when it appears to have some trouble.” Actually, that is the second-worst mistake. The worst one is to stick with a strategy long after it has proven to fail, persisting with it over and over again and hoping for a different outcome. CalPERS may be right about the correctness of its overall strategy, but in the commodities segment it is time for a serious rethink. First generation “passive” index strategies are now widely understood to have failed. With its active management overlay, CalPERS is already beyond this stage. But there are good reasons to be skeptical about whether second and third-generation “dynamic” and “enhanced” indices will be any more successful. The large amount of institutional money chasing the same sources of systematic return in relatively shallow markets is likely to cause dynamic and enhanced returns to disappear as well. Second-generation indices have already begun to struggle this year, as the Financial Times noted back in April (“New style commodity indices underperform” April 4). CalPERS faces a tough choice. It could axe the commodities program altogether. Or it could switch to a fully active strategy that would see the pension manager behave more like a hedge fund in the commodity sector. Active management would have its own pitfalls. Not least CalPERS would risk being criticized for fueling food and energy price swings, though it would actually remain modest by the size of current commodity hedge funds. But if the giant public pension fund wants to remain in the commodities asset class, while earning positive returns, it may have to take the risk and embrace a far more active approach in future. —John Kemp, Reuters Market Analyst

Tuesday, August 7, 2012

Buying The Government

                It’s happened before and it’s still happening. The talking heads debate whether the Glass Steagall Act (GS) would have made a difference in the 2008 financial collapse. I even saw one prominent writer go through each event of the financial crises measuring whether GS would have made a difference. That exercise misses the whole point. The real issue is, what kind of capitalism allows well capitalized private interests to control the government? Is that free market capitalism or something else? 

                If you review the events leading up to the repeal of GS, it took more than 20 years and $300 million worth of lobbying efforts, but in November of 1999, it was finally repealed. Greed and hubris on the part of large financial institutions to enable them to wheel and deal required the elimination of GS. As they chipped away at it and got cozy with the politicians, although it took a while, they finally got what they wanted. The push and pull between government and enterprise, the struggle between big business that wants to get bigger and the US government who can be bought through strenuous lobbying, does eventually give business want it wants. And then it bails them out when things go in the crapper. Is that free market capitalism? Was it always that way? 

                I am reading a biography of Andrew Carnegie and during his time (Civil War and after) it is pretty amazing how he and his compatriots used the system to build vast empires. They would not do any deals unless they had inside information. The deals they did were usually with friends and family or someone who was known by friends and family. There was no income tax. They paid people off.  

They built the transcontinental railroad, the steel industry, invested in lots of new enterprises, and established foundations that to this day are funding philanthropic endeavors. Andrew Carnegie believed he was simply in the right place at the right time. Sandy Weill, former head of Travelers Insurance who with John Reed of Citigroup, together spearheaded the demise of Glass Steagall, would probably say the same thing. 

                Just after the Clinton administration agreed to support the repeal of GS, the then treasury secretary, Robert Rubin (former Goldman Sachs co-chair), raised eyebrows by accepting a job as Sandy Weill’s chief lieutenant. The previous year when Weill called Rubin to give him notice of the upcoming merger (between Travelers and Citigroup), Rubin was reported to have said: “You’re buying the government?”

Something Every Plan Sponsor/Trustee Should Know

                Everyone talks about the lack of integrity by the big banks but what about large investment consulting firms? In the institutional world of large private and public pension funds, endowments, foundations, Taft Hartley, hospitals, etc., the plan sponsor/trustees hire a professional investment consultant to share their fiduciary liability and do their work for them. Investment consultants/Pension consultants serve as a fiduciary and advise the plan sponsor/trustee how to allocate assets,  hire and fire the investment managers that actually manage the assets, and perform the quarterly performance reporting ritual by meeting with trustees to review how the portfolio performed during the prior quarter. 

                Mercer, a large multi product firm, has an asset management division that includes investment consulting. They work with the largest corporate pension funds. They recently held a Global Investment Forum in Washington DC.  Ted Koppel, former correspondent for ABC News was the keynote speaker.  Mercer invites their pension fund clients, their in-house research staff and investment consultants and outside investment managers who manage money for Mercer’s clients or who want to manage money for Mercer’s clients. Mercer clients and staff do not pay to attend. The Investment managers pay $10,000 (up from $3,000 last year). Why would an investment manager pay that kind of money? One word, ACCESS (to potential or existing clients and to Mercer consultants).  Consultants at Mercer rarely make themselves available to meet with investment managers. Do plan sponsors/trustees know they are there as bait for investment managers to enable Mercer to rake in the dough? Does Mercer owe anything to the investment managers who pay dearly to attend?  And what about conflicts of interest? Mercer’s publicly stated goal this year is to increase profitability so they invited less consultants and more money managers. Getting paid a lot of money by investment managers if you are a consulting firm offering a service where the primary benefit rests on the ability to be independent and objective in the recommendations they provide either is or has the potential to be compromised.  They are hosting the next event in September in London. And let’s not single out Mercer. Rogers Casey/Segal hosted a similar event the day before Mercer’s event. Callan, another large consulting firm, does the same thing. 

                Plan sponsors/trustees need to know that large banks, large asset managers, and even large consulting firms, in their quest to sustain and increase profitability, do things that small to mid size firms would never do because the smaller firms know that to compromise their ability to be independent and objective is to lose their most important competitive advantage. And if it is considered totally  inappropriate for  a plan sponsor/trustee of a pension fund to accept any type of financial benefit from an investment manager (remember pay to play?), why is it appropriate for their investment consultant? And then, for the investment consulting firm to use the plan sponsor/trustees, whether it be a prospect or a client, to attract the investment managers who must pay a large sum of money for the privilege of speaking with the consultants and plan sponsor/trustees seems like prostitution, metaphorically speaking.

Connecting the JP Morgan Chase Dots: Greed, Arrogance, and Brokers

Jamie Dimon, when he testified before Congress a few weeks back, listed the positives and negatives of large banks. He described the downside to large institutions as:

• Greed
• Arrogance
• Hubris
• Lack of Attention to Detail 

The benefits, he stated, were:

• Economies of Scale
• Diversification 

On the Tuesday, July 3rd, the front page of the NY Times had a column about former JP Morgan brokers saying they put the bank’s profits ahead of the needs of investors. JP Morgan, unlike competitors, when advising clients, sells the mutual funds it creates. Since the market crash and new regulations, the banks have turned to retail investors to rake in the profits. The fees are high, the performance in many cases, mediocre or less. 

Mr. Dimon was correct, large banks who have morphed into brokerages are greedy and arrogant and I will also add with an intense sales culture that places a large emphasis on sales over client needs. And JP Morgan is not alone. For as much as brokers say they are a trusted advisor to their clients the reality is the securities laws do not impose fiduciary duty on brokers who give investment advice because if they were a fiduciary, they would be required to act in the best interest of their clients. Brokers recommend what is suitable which gives them the right to pitch investments that make money for themselves and their firm. 

The SEC was trying to impose a fiduciary duty on brokers but of course that never happened. The financial services industry with all of its lobbyists opposed it and, no surprise, there was weak support by Congress.

The Taxes Are Coming, The Taxes Are Coming

 Congress Needs to Act or the Market Will Crash At The End of 2012

Taxable investors will have every reason to dump stocks by the end of the year unless Congress takes action.

The Bush-era tax cuts—enacted in 2001 and 2003—are scheduled to expire at the end of this year. Unless Congress acts, most taxpayers will see rate and other increases

The existing 10% bracket will go away, and the lowest “new” bracket will be 15%. The existing 25% bracket will be replaced by the new 28% bracket; the existing 28% bracket will be replaced by the new 31% bracket; the existing 33% bracket will be replaced by the 36% bracket; and the existing 35% bracket will be replaced by the 39.6% bracket

Right now, the maximum federal rate on long-term capital gains and dividends is 15%. Starting next year, the maximum rate on long-term gains is scheduled to increase to 20% (or 18% on gains from assets acquired after Dec. 31, 2000, and held for over five years). The maximum rate on dividends will skyrocket to 39.6%.

People in the lowest two rate brackets of 10% and 15% currently pay 0% on long-term gains and dividends. Starting next year, they will pay 10% on long-term gains (or 8% on gains from assets acquired after Dec. 31, 2000, and held for over five years) and 15% and 28%, respectively, on dividends.

And let’s not forget the estate tax which will rise to 55%.

Financial Advice, Education or Defaults?

This article by  Jill Cornfield, http://www.planadviser.com raises some points to consider.

June 20, 2012 — Younger, less-educated and lower-paid employees are more likely to choose the investment provider that offers face-to-face financial advice according to a new study. 

The authors of the study “What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?” by the National Bureau of Economic Research point out that defined contribution (DC) retirement plans ask individuals with poor financial literacy to make choices that could have far-ranging effects on their finances and retirement. One way to improve the quality of their financial decisions is to invest in educational programs that target financial literacy. Another approach is to rely on default investments, such as target-date retirement funds. In a third method, financial intermediaries provide access to financial advice.

The actual portfolios of participants in the Oregon University System’s DC retirement plan were examined by the authors, John Chalmers, associate professor of finance at the University of Oregon, and Jonathan Reuter, assistant professor of finance at Boston College. In order to benchmark the participants’ portfolios of these self-directed investors, hypothetical portfolios using target-date funds—a popular default investment—were constructed.

They sought to determine whether financial advice is an effective substitute for financial education or for the use of defaults.

Providing financial advice to investors is a multibillion dollar industry, Chalmers and Reuter said, but the volatility of investment returns can make it difficult for investors—even those who are financially literate—to distinguish good advice from bad.

Citing previous studies, they brought up the point that financial service providers can profit from transforming simple financial products into more complex ones that may offer little additional benefit to investors.

Clients of brokers allocate contributions across a larger number of investments than self-directed investors, and they are less likely to remain fully invested in the default option. However, broker clients’ portfolios are significantly riskier than self-directed investors’ portfolios, and they underperform both benchmarks. Exploiting across-fund variation in broker compensation, when broker fees are higher, so are the broker clients’allocations, the survey found.

Survey responses from plan participants supported the study authors’ contention that the portfolio choices of broker clients reflect their brokers’ recommendations.

The main findings of the study are:

• Significant differences exist between investors who choose to invest through brokers and those who do not. Employees who chose to invest through a broker are younger, less educated and make less money. They are also more likely to state that they chose to meet face to face with a broker, and to state that they relied upon their broker’s recommendations when making investment decisions.
• Portfolio choices show some significant differences. Broker clients pay an average of 0.89% in broker fees each year, which helps explain their underperformance compared with the higher fees paid by self-directed investors, of 1.54%. This corresponds to an annual “tax” of $530. In exchange for these fees, broker clients are moved out of the default fixed annuity and into funds with higher-than-average past returns, higher-than-average exposure to several forms of market risk, and that pay higher-than-average broker fees.
• These findings highlight the agency conflict that can arise when unsophisticated investors seek investment advice from financial intermediaries, the authors stated. They said the findings also highlight the fact that, on average, brokers do not help investors construct portfolios that are “at least as good” as the portfolios constructed by self-directed investors. In this sense, financial literacy dominates financial advice.
• The majority of the broker clients and self-directed investors in the sample would have earned significantly higher annual after-fee returns from being defaulted into target-date funds. The investors most likely to choose to invest through an adviser are also the likeliest to accept the default investment option in the absence of access to financial advice.

The study concludes that the benefit investors receive from face-to-face meetings with financial advisers would need to be substantial to justify the use of agency-conflicted advisers over sensible default investment.

Oregon University introduced its Optional Retirement Plan, a portable DC retirement plan in October 1996 as an alternative to the state’s traditional defined benefit (DB) retirement plan. Participants in Oregon University’s system can choose to invest through a firm that uses brokers to provide personal face-to-face financial services.

Between October 1996 and October 2007, approximately one-third of the university’s participants chose the high-service investment provider. Two-thirds of participants chose to invest through three lower-service investment providers. With assistance from the Oregon University System, the authors matched administrative data on investor characteristics, given the type of investment advice chosen.

Who Needs Long Term Care Insurance?

Barry Gillman, CFA sent me an email about Long Term Care Insurance (LTC). Since I never gave the subject much thought I imagine you haven’t either. It’s worth a look. Here it is:

We’re pleased to announce the publication of our new report analyzing long-term care (“LTC”) insurance.

CLICK TO DOWNLOAD: Long-Term Careless Full Research PDF

About 70 percent of people over age 65 will require some type of LTC services during their lifetime. That’s a scary number. Surely anyone contemplating their senior years should rush out and buy a long-term care policy?

Maybe not. Our research suggests that standard LTC policies are generally not good value for money if you are in average or above average health.

LTC policies are only a good deal for folks who are in significantly below average health, and hence more likely to claim. But insurance companies spend a lot of effort weeding out and rejecting those applications.

Even if LTC is poor value for money, most healthy individuals do need LTC coverage to reduce the risk of financial hardship and potential ruin. While 90% of LTC policies max out their coverage by six years, 10 and 20% of LTC needs can last longer than that; sometimes ten years or more. For most people that level of potential expense likely represents a very large dent is accumulated savings, or even total financial ruin. There’s a real need to insure against that.

But there is a better solution, especially for those who enjoy above average health. Our research paper “Long Term Careless?” takes a detailed look at handling the considerable financial strains of long-term care and answers the questions individuals and their advisors need to ask:

• Who really needs LTC coverage?
• Do all types of LTC coverage still leave you exposed to financial disaster?
• How a simple ratio can help you figure out what’s a good or bad deal (and why insurance companies tend not to advertise this)?
• Which type of LTC coverage represents the best deal for those in average health?
• What is longevity insurance and how can it help solve your LTC problem?
• How assessing the impact of your own health and lifestyle on life expectancy can be your most powerful tool in making the best long-term financial decisions on LTC?

The free report is also available by emailing info@longevityFC.com.

The Pension Hole Gets Deeper

 by Lillian Jones 

And while this may not apply to every public pension fund, many of them are in deep trouble with little hope on the horizon for improvement. The most recent aiCIO (ai-cio.com)  had a piece about how NCPERS put on a brave face after a public pension study saying that public pensions are managing assets efficiently and effectively. The problem is, that’s not enough. 

A survey of 147 American public pensions in April and May has found that average funding status has dipped from 76.1% in 2011 to 74.9%. 

(June 11, 2012)—The funded status of municipal and state pension funds in the United States has dropped from 76.1% in 2011 to 74.9%, a wide-ranging survey by the National Conference on Public Employee Retirement Systems (NCPERS) has determined.

The study comes on the heels of a BNY Mellon report that found that the average funded status of American corporate pension plans had reached their lowest level since 2007. Precipitated by a falling equity market and ever-lower interest rates, the report recorded that the funded status of the typical corporate plan had declined 6.5% to 69.8%.

Most experts, however, concede that public pension accounting should generally be viewed with a jaundiced eye. The Governmental Accounting Standards Board (GASB) permits public pension funds to employ whatever anticipated rate of return they see fit. Consequently, the typical public fund uses an expected rate of return of as much as 7.5% to 8.5%, well above that allowed to their corporate pension peers (around 4.5%).  As such, a less generous metric would yield a rather different funding level for the average public plan.

We need growth, we need interest rates to rise, we need leadership to address these issues that will not improve by themselves.  The problems faced by Scott Walker in Wisconsin and his solution, although widely unpopular, illustrates how difficult it is when there is just not enough money to go around and hard decisions have to be made.  The entitlement culture is over.

The largest debt pension load is carried by CT, Hawaii, IL, KY, MA, Mississippi, NJ, RI, and PR. Let’s not forget NY, CA, and Del who take the honors for their long term liabilities. Add it all up and it’s a recipe for disaster. Take a weak return on investment add in not enough money set aside during good times, plus impending retirements of those born between 1940 – 1960 plus people living longer in an environment with artificially low interest rates and there you have it.

A future with a lot of poor people in the richest country in the world