February 23, 2007
San Diego County pension fund
I have been developing concerns about the possibility that hedge fund investment flows have become a destabilizing force in world financial markets. Following the maxim "think globally, act locally," I decided to take a look at how the behavior of our local pension funds may be one small part of that phenomenom. And I have some recommendations to make on behalf of San Diego County residents and the world at large.
There are any number of financial instruments that would allow you to construct an investment portfolio that could show high returns with limited variability for many years in a row, even though the investment strategy could actually involve enormous risk or even negative expected returns. An example is MIT Professor Andrew Lo's Capital Decimation Partners. Lo's hypothetical hedge fund simply sells far out-of-the-money puts, earning spectacular returns until the day that it is inevitably wiped out completely.
Such financial instruments could be particularly problematic given a potential conflict between the incentives facing an individual pension fund manager and the best interests of the future retirees whose assets he or she is managing. If the manager can turn in well-above-market returns five years in a row, the manager is likely to be spectacularly rewarded over that period. Whether the beneficiaries are actually paid many years later down the road will be somebody else's problem.
When I heard about the disastrously irresponsible investments made by the Amaranth hedge fund, my first reaction was, who would be so stupid to have put up the margin requirements for such a scheme? The answer turned out to be found in my own backyard-- the San Diego County Employees Retirement Association apparently donated over a hundred million dollars to this worthy cause.
I took a look at the 2006 SDCERA Annual Report to try to find out what was really going on. If you only look at the "summary of retirement portfolio by manager/asset type" on page 54, all appears healthy. Two billion dollars, or 27% of their $7.3 billion portfolio, were reported to have been held in the form of domestic equity, split among a dozen different large, diversified equity funds. There's another 25% in international equity, 26% in fixed income, and 10% for real estate and "alternative equity". There are some other categories such as "commodity swaps" and "overlay" that worry me a little, but these don't amount to that much of the total. So where do you squeeze a couple hundred million for Amaranth in there?
The really interesting stuff is to be found on page 55, which is labeled "summary of derivative financial instruments." Here Amaranth is included as one of a dozen entries in a group of "alpha engine managers." The total market value of these alpha engine managers comes to $1.5 billion, which would amount to 20% of SDCERA's net assets. That's on top of the $1 billion (14%) in "exposure for currency overlay", $350 million for "exposure to policy overlay", and close to another billion in a few other exotic categories.
Obviously these two pages must be counting the same assets twice, or rather, page 54 is not regarding these "derivative financial instruments" as part of SDCERA's "retirement portfolio." Instead the annual report seems to take the position that the fund is still holding the $2 billion in domestic equity, and these other details are some clever little tricks the fund employs to allow it to earn a higher rate of return on those stock holdings than you would if you followed the old-fashioned practice of, you know, hanging on to your assets.
What the fund is actually doing is selling risk. SDCERA is receiving a payment for taking exposure to the risk of what is hopefully a low-probability event, just as you would if you were selling far out-of-the-money puts, and pledging the fund's hard assets as collateral with which to play the game. The result is a far riskier portfolio than would be suggested by a naive reading of the fund's purported asset allocation from page 54.
But as far as I'm aware, there's no place you can go to find an audited statement of the assets and liabilities of these "alpha fund managers", so there's no way to verify exactly what the nature and magnitude of the risk is that's being palmed off on the county. We have only the word of the county fund managers that they're doing something smart. They in turn are likely basing their own confidence primarily on the word of the alpha fund managers. At least in the case of Amaranth, we know how much that word is worth, and it ain't $233,830,268.
And that's just the San Diego County pension fund. The pension fund of the city of San Diego is an even more gruesome story, which perhaps I should take up another time.
Buyer beware, says Dave Altig. Actually, being a man of great erudition, or at least someone who reads Forbes, Dave says it in Latin. But when the buyer is acting on behalf of the government, to me it seems very appropriate for the government to set statutory limits on the extent to which managers' interests can be permitted to deviate from those of the beneficiaries. Specifically, I recommend that California's County Employees Retirement Law be amended to specify that if one calculates the sum of all investments, pledges of collateral, financial liabilities and exposures, and margin deposits and calls made by a county retirement fund in institutions for which there are not publicly available annually audited balance sheets of those institutions' assets and liabilities, the sum of all such commitments across all such institutions can not exceed 10% of the retirement fund's total gross assets.
Maybe Dave can help me to say that in Latin.
Posted by James Hamilton at February 23, 2007 05:40 AMdigg this | reddit
The trouble with these large pension funds, is keeping track of everything, and investing the new money which is coming in all the time, without distorting the markets, how much easier to give it to a fund and say "You manage it for us".
Posted by: Nomial at February 23, 2007 07:21 AM
Well, the big, really big, question is where do the TIAA funds go? We're talking billions upon billions of dollars.
Posted by: arbogast at February 23, 2007 07:53 AM
God, this is a scary post. I just wanted to add that.
Posted by: arbogast at February 23, 2007 08:31 AM
This is an example of the "portable alpha" strategy now in vogue among many institutional investors. The strategy is essentially to get beta exposure via a swap to some underlying index, e.g. the S&P, and then invest in "alpha generating" absolute return funds. The swap only requires collateral for a small portion of the underlying notional exposure, even though the investor is subject to losses on the full notional amount. I've always viewed it as high risk, in that you are leveraging your equity exposure to invest in a group of funds with low transparency/liquidity, and which themselves often use a great deal of leverage. It's popular because Harvard has used it successfully and it got legs when libor was 1%. I think it will be a train wreck for many institutions.
Posted by: peter at February 23, 2007 08:59 AM
Very thought provoking JDH.
This might explain something that's been puzzling me for a little while - why risk seems to have gotten so cheap. Eg, the spread for poor-credit subprime mortgages seemed to me to be ludicrously low until it shot up late last year (ie only after the defaults set in). A friend pointed out to me that there is a similar phenomenon with emerging market debt, which has only a very small spread over eg treasuries.
It seems like the example you explore here could be a general mechanism by which risk could end up underpriced. The holders of the main asset can parcel off the risk via credit swaps, and if large numbers of pension funds are willing to sop up those risks in order to improve their short tem performance numbers because the manager's incentives are different than the fund beneficiaries, that could be ugly. In particular, everything will be great until it all goes bad at once (as seems to be occurring now in the subprime mortgage market).
It would seem to be important to understand how widespread this is.
Posted by: Stuart Staniford at February 23, 2007 09:19 AM
Why do pension funds all think they can earn above market returns? Where does the excess return come from? From consumers, small investors, other pension funds?
Posted by: HZ at February 23, 2007 10:23 AM
So the fundamental problems are two:
1) The pension fund managers' incentives are short-term while the funds' obligations are long-term. And,
2) Some smart guy has invented a new way to "hide the salami" - ie sell non-transparent allocations of risk and return.
Stuart's point about underpriced risk is well made but isn't risk only known in retrospect? Going forward, risk is only a forecast. There is always a meta-risk of changes in risk/return relationships like sudden inversions of yield curves.
As to "everything will be great until it all goes bad at once (as seems to be occurring now in the subprime mortgage market," I understand from a recent WSJ piece that the default rate for subprime mortgages is "only" 10% - higher than usual but offering a social good of increased homeownership.
Posted by: Joseph Somsel at February 23, 2007 10:25 AM
So the other 11 HFs here:
"Here Amaranth is included as one of a dozen entries in a group of "alpha engine managers." The total market value of these alpha engine managers comes to $1.5 billion, which would amount to 20% of SDCERA's net assets."
may have been on the other side of Amaranth's trades or at least offset that loss for SDCERA.
This is what we get with unregulated HFs:
"We have only the word of the county fund managers that they're doing something smart."
I see that commission looking into HFs has decided that no further regulations are needed and I wonder if they, too, were bamboozled by the Latin.
Posted by: calmo at February 23, 2007 10:38 AM
2 points if I could:
The article on the City of San Diego pension fund is a year and a half old. It seems possible that at least some changes have been made, or at least the auditor's report has been completed, thus linking to it seems a tad misleading.
2nd point: The reason risk premia in general are low is because volatility is VERY low. And no, I don't know why vol is low, but vol is the determining factor in many models of risk, thus low vol = low risk.
Posted by: gab at February 23, 2007 10:43 AM
Dr Hamilton - please keep on top of this story. Keep us posted.
That was one of the best presentations of derivative risk I have read anywhere (that a numskull like me can still, sort of, understand).
Posted by: dryfly at February 23, 2007 10:53 AM
It's obvious many of the pension fund managers simply do not understand the risk involved and take the prior returns as an article of faith while performing limited due diligence. The concept of risk seems to have been minimized in today's investment world.
Posted by: Will at February 23, 2007 11:42 AM
Does this have anything to say about how all us small potoatoes guys manage our own retirement portfoils? Does it have anything important to say about investing SS monies in the stock market.
Posted by: DILBERT DOGBERT at February 23, 2007 11:46 AM
Great work, Professor.
When I saw the Amaranth blow up and that San Diego was involved, I was not surprised. What a corrupt pension system that we have, with some folks getting lump sum payouts of $800K and annuities of $100-200K (high powered librarian and Assistant City Attorney):
What a corrupt system, where some firefighters earn over $150K annually:
Given the intransigence of the public employee unions, the only solution is for the system to blow up and to start anew. C'mon pension fund meltdown!
Keep the spotlight on, Professor.
Posted by: jg at February 23, 2007 12:28 PM
Tim's got more on hedge funds today:
Posted by: donna at February 23, 2007 12:29 PM
This piece was quite illuminating about investment bankers and not-as-smart utility rate payers (this means U).
Posted by: calmo at February 23, 2007 03:09 PM
The irony of public sector employees funding the deployment of giant amounts of cash into high-risk investment strategies jumps out and smacks you in the face. Commenter Joseph Somsel summarizes the problem nicely; I would add one more statement that the pension funds' targeted rates of return make the pension fund managers willing to throw cash at just about anything because they "need yield" to meet those return targets.
Posted by: Ravenor at February 23, 2007 03:33 PM
Great post, I think blogs like this should be forced upon all to read and joggle the brain a bit. I think you made an excellent point and you hit the nail on the head when you talk about how alpha managers sacrifice longevity for short term gains. The inherent problem with any investing is if you do not perform, the money will go elsewhere. The investment community is filled with more sharks then the ocean. I agree that pensions should be forced to follow strict investment rules. However the investing community will just come up with some other way of hiding investment risks via "new CDS's, CMO's and now CPDO's" they are nothing more than banks hiding risk packaged in a pretty box to keep the dog sniffing regulators in the dark. Investment banks are now selling insurance for insurance, thats a great concept....seems safe though "it is insurance, I must be protected." I agree that investing public funds should be heavily regulated, the only ones that suffer will be once again the general public. Volatility has been so low not because the world is a safer place, but because there are too many dollars,Yen,Euro chasing too few investments so why not compress spreads a bit more....after all investing is a zero sum game, what does it matter if San Diegos Pensions loses 200mil if Calpers mopped up the other side? Investing isn't the same anymore, buy and hold strategies have given away to alpha mongers and short term sharks collecting the management fee, the only other game in town is to become a CEO of a fortune 500 company, lose money every year in your tenure and walk away with a 200mil golden parachute, thankfully capitalism still exists in this country!!!!!
Posted by: Michael Agne at February 23, 2007 09:02 PM
I guess the SDCERA fund managers forgot to do the mundane, bread and butter stuff involved in fund management.
Like spread their risk.
Are these guys actually county employees? Can't they be fired for losing the county's money on an investment policy which seems to be as ethical as a Ponzi scheme and with as much chance of success as a crapshoot?
Posted by: Martin at February 23, 2007 11:34 PM
The wall of money from pension and institutional funds has provided a platform for housing, equity and commodity bubble inflation. Low volity is an artifact of one way trades by leveraged "alpha engine managers". Like any ponzi scheme, the climb up the pyramid looks fantastic as long as the herd continues to stampede in the same direction.
Low volatility is great if you are long and buyers out number sellers. Low volatility is bad if you are long and sellers out number buyers. See October 1987.
Pension fund trustees have been playing fast and loose with pension assets. Risk is not dead, just asleep. See Orange County bond debacle. Everything was fine until Eve ate the apple.
Posted by: zinc at February 24, 2007 05:29 AM
re: That's on top of the $1 billion (14%) in "exposure for currency overlay", $350 million for "exposure to policy overlay", and close to another billion in a few other exotic categories.
Obviously these two pages must be counting the same assets twice
i don't think they're being counted twice. the overlay means that particular position is "on top of" everything else. so they have their basic positions, like domestic equity, bonds, private equity, etc. that should all add up to 100% or thereabouts. and then, on top of that, they have a 14% currency overlay. i take that to mean they are short the US dollar and long some other currency (or basket of currencies) to the tune of $1 billion notional. that can be accomplished for a relatively small fee and margin requirement via futures or OTC derivatives. so this currency overlay $1 billion is not the same as the $1.5 billion in alpha generators. btw, i think these "alpha generators" will be the subject of jokes in the future, just like "portfolio insurance" is now. 20 years from now, they will have to invent a new catchphrase for an unsustainable financial perpetual motion machine.
btw, Google "alpha always absconds" and read an article on the subject by the inimitable William Bernstein.
Posted by: darffot at February 24, 2007 05:56 AM
Thanks Professor. Another case of giving responsibility to government resulting in lack of oversight. When will we learn that government's job is oversight and when it gets involved in running what it should be watching the result is disastrous collusion and criminal activity that goes unpunished.
Posted by: DickF at February 24, 2007 09:48 AM
A strange response from an Economist...
Isn't the conclusion of Lo's Capital Decimation example that we're all basically just selling out of the money puts... i.e, that's what owning stocks are in on respect, plus of course the possbility that they go up..
Forget whether you call it alpha or duration matching, or liablity matching.. Some body has to own the risk in the economy... and Pension funds are it basically...
You sound as though you've forgotten your Keynes... everyone can't get a better view in the stadium just by standing up...
So surprise.. are you discovering that leverage may be a bad thing? Perhaps...
By the way you probably bear as much responsibility as anyone for this state of affairs..
The confidence people put into econometric data mining and ignoring the higher moments is what drives investors to take these "bets"..
As an exercise take Mr. Low's simulation.. and apply one Filter.. just one. no need for Markov Switching models, clustering, what ever Garch process you imagine..
Just take a vacation every October...plain and simple.. I think you'll find that Captial Deceimation Partners.. never loses money....
So ex ante.. if you were presented with such a program what would you do as the erstwhile investment manager...
The data is before you untainted.. the rule is simple, Out of the money puts seem to be much too highly priced...although we can't understand it... they seem to be clustered at the end of the year..
So.. the real risk.. is of course Barro's survival probablity.. will the United States exist... we're all bearing that risk now.. so why not use an alpha manager.. to take on the risk we all bear in an "optimal manner"..
The same language runs right through your pieces concerning Mortgage rates, FED Funds.. probabilities... forecastablity..
The real question you should ask yourself is this...
if you had discovered the Amaranth investment.. just weeks before.. and had seen that Amaranth had just made over a billion dollars...
Would you have been worried about the risk then???
Posted by: phyron at February 24, 2007 10:30 AM
Phyron, let me address your last question first:
if you had discovered the Amaranth investment.. just weeks before.. and had seen that Amaranth had just made over a billion dollars... Would you have been worried about the risk then?
My answer is unambiguously, absolutely, resoundingly yes. I would dump any fund that is holding more than 40% of the outstanding volume on a given futures or option contract, if that represents over $500 million in obligations, faster than a hot potato, and I have advocated legislative restrictions preventing any entity from exceeding those limits.
And if I were asked to put money into a fund without having any way of knowing whether this is in fact what they were doing, and was only told they've been earning spectacular returns lately, I would say "not with my money you don't!" even faster and louder.
As for your larger point that pension funds are supposed to take risks, surely you would agree that there are limits on how much risk it makes sense for them to absorb. I believe my proposed 10% is a reasonable upper bound for the portion of a county employee pension fund's capital that should be permitted to be at risk from this kind of unverifiable gambling.
Posted by: JDH at February 24, 2007 11:08 AM
AFAIK TIAA/ CREF is pretty transparent. Individuals hold funds, in accordance with their asset allocation.
Some mutual funds are allowed to use derivative strategies, typically one finds these in fixed income funds looking to enhance their yield. One is potentially vulnerable there, depending upon what the strategies permitted are.
But most of the TIAA funds are 'long only' and are not heavy users of derivative strategies to *leverage* the portfolio. As far as I know, that is not permitted.
I am no expert on TIAA, but the core bond/stock index and balanced funds should be pretty safe.
Posted by: Valuethinker at February 25, 2007 11:17 AM
"Overlay" probably just means a bunch of currency swaps aimed at ensuring that San Diego, as a dollar denominated investor, actually realises something close to the local currency performance of its international equity investments. You are on your own with "commodity swaps" though.
In general, if someone is talking about their investment performance as "alpha", then either a) they believe that the CAPM is literally true or b) they are using a technical term to describe a general concept (of good investment performance versus a benchmark) in order to sound clever. To be honest, neither a) nor b) go particularly well for my assessment of a manager's character or ability, apart from very young or recently minted MBAs, who can be cut some slack on b) because they love slang of all kinds.
Posted by: dsquared at February 25, 2007 11:34 PM
I like the table on page 51, "Investment Expenses by Category", which shows a total of $85,542M, including $37,933M paid for "Alpha Engine" and $10,363M paid for "Overlays".
I certainly agree that published reports of what Amaranth was doing makes it seem like a reckless invesment, but also note that (i) of the $233,830,268 mentioned, about one-third appears to be profit [by comparision with book value] (ii) total fund returns [page 49 of the report] seem to be quite satisfactory - with the very important caveat that, as JDH complains, one can't evaluate returns without looking at precisely how they were derived, and I must say that this report seems quite opaque.
Now, not only am I not a specialist in the art of ripping apart the books of pension funds, but I'm not even going to take the time required to try! But it seems to me at first glance that: (a) the fund has a base investment of $2,062MM in domestic equities [page 54], and (b) the overlay manager has shorted $1,397MM in domestic equities (or, at least, the returns thereof) to purchase "Alpha Engine" investments [page 55].
If this is correct, then net domestic equity exposure (before any other swaps!) is only $665MM, less than 10% of fund assets, which seems rather skimpy.
And, finally, I'll reiterate my objections to arbitrary limits on investment allocations. The extracts quoted on page 48 of the report from California Government Code, Section 31450, et.seq. seem perfectly adequate - is JDH claiming that there is reason to question adherence to these standards?
Posted by: James I. Hymas at February 26, 2007 12:37 PM
James Hymas, the general call for diversification in the code to which you refer is sufficiently vague that it does not appear to be limiting SDCERA's strategy at all.
Posted by: JDH at February 26, 2007 01:11 PM
Actually, I was referreing more specifically to the quoted section
The Board, its officers and employees shall discharge their duties with respect to the system: ... (b) With the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.
So my question is: Are their grounds to believe that SDCERA has violated section (b)? And more generally, will a prescriptive law such as the one suggested be better all round than application of section (b)?
Posted by: James I. Hymas at February 26, 2007 02:29 PM
We should ask outselves, "How would have Jimmy Hoffa handled this opportunity?"
Posted by: Joseph Somsel at February 26, 2007 03:57 PM
This is what I remember reading somewhere re Amaranth.
Amaranth was a reasonably sane fund, with an extraordinarily successful energy trader. Amaranth of course had normal risk controls and people trying to prevent a blowup.
Said trader made squillions of dollars, and then threatened to switch to a competitor unless he were given a huge book, and exemption from the risk controls, i.e. a canonical "big swinging dick". Sure enough, the management let him, because he had been so good before. From his point of view, he figured he had a call option on the compensation.
He went all out, naturally (since that was his plan), and then other competing traders who knew his footprint, pinned him and raped the firm.
There was probably no way for an outsider to know any of this.
So, as usual, the risk is in greed and human error, with less in the technical machinations of quants. I think people have a need to blame mathematical and algorithmic complexity when more often (not always!) the cockroaches usually turn out to be old-fashioned fraud and greed.
Posted by: Matthew Kennel at February 26, 2007 07:00 PM
Interesting article, even if it is old news, the battle rages on in San Diego.
My comment is that it seems obvious why pension fund managers for governments take these bad risks, they have all overpromised their employee unions and taxpayers unrealistic returns during union negotiations, and now have to scramble to try to cover it. It is the worse sort of gambling, the kind of thing that in the movies the mob ends up bumping you off.
Posted by: Michael H. at February 27, 2007 01:38 AM
You might be interested in knowing that the way the fiduciary laws are now set up, Pension Board members are held harmless in all instances of pension fund losses - even if the pension fund gets wiped out. Assuming that, 1. they appeared to be awake during official Board meetings, and 2. they did nothing patently illegal – like taking kick-backs.
It’s a great country!
Posted by: c roast at February 28, 2007 05:53 AM
There is more transparency with public sector pension funds, we we know it when it goes wrong.
Private endowments and corporate pension funds take these risks as well. The majority of Amaranth's investors were *not* public sector PFs.
In fact, PSFs have been criticised for being slow to get on the 'alternative assets' bandwagon, especially private equity and hedge funds.
The leading endowments in the country, with the top performance records (Harvard and Yale) are more than 40% alternative asset classes (ie not bonds or stocks).
In terms of pension funds generally, as Defined Benefit schemes in the private sector are now closing, DC schemes don't have the same latitude to invest in alternates (because each individual has his or her own allocation, and requires liquidity which HFs and PE funds can't give).
Companies with DB schemes are closing them, moving to 'cash balance' schemes, or taking Chapter 11 (the Steel Industry) as a way out of those obligations.
So the only DB schemes left, increasingly, are the public ones. Which means they are an increasing fraction of total institutional ownership of HFs etc.
Where you are correct is that, AFAIK US public sector pension plans don't disclose the liability of the Pension Fund properly ie in a consistent manner.
The public sector schemes should be required to report their PF deficit as a debt on the balance sheet of the sponsor, using common (and realistic) actuarial assumptions of future returns, wage growth etc.
It would therefore be impossible to 'give' a retirement benefit away in a wage negotiation, without the ratepayers seeing the impact.
As Warren Buffet observes, a lot of companies do an end run around this on their PF deficit reporting by assuming unrealistic assumptions eg IBM continuing to assume 8.5% real returns even as prospective returns fell.
Posted by: Valuethinker at February 28, 2007 10:22 AM
But ERISA (1974 I think) imposes the 'prudent man' rule on trustees. They must seek outside expertise, and they must seek diversification.
In the old days, trustees just put the pension fund into bonds. When inflation rose after WWII, many funds (and many inheritances) were wiped out.
Making the trustees liable would simply cause them either to resign, or to be excessively conservative in their investment policy, robbing beneficiaries and plan sponsors of the benefits of investing in stocks, private equity, real estate and other asset classes.
Posted by: Valuethinker at February 28, 2007 10:24 AM
Thinking about your proposal.
HFs you have an annual financial statement. It's almost worthless, most of them trade so much.
PE funds you have annual reports. I don't think they are audited *but* the constituent companies are audited. So the quality of information is high.
I guess my concern would be that, in a world where 30-40% asset allocation in 'alternative' assets is not uncommon (see Harvard and Yale's Endowments, the best performing large endowments in the country) your proposed rule would make it difficult for a public pension fund to make such investments, robbing future taxpayers and beneficiaries of those returns and lower correlations.
I don't know what the answer is to this conundrum. Smaller public sector funds are sometimes notorious for their 'me tooism' and the tendency to jump on the investment bandwagon late (I would only be investing, now, in HFs which focused on distressed/turnaround/recovery situations) and for not having the investment expertise to pick HFs and PE funds sensibly.
Yet you want public sector PFs to show good returns.
I don't know if an inflexible 10% rule is a good one or if there is some better risk control rule.
I agree we are headed for some unpleasant collisions between oversold hedge fund instruments, PE funds at the top of the cycle, and greedy pension fund investors.
Posted by: Valuethinker at February 28, 2007 10:30 AM
re 'Currency Overlay'
Normally in an investment portfolio you don't take currency bets.
Most of your assets are in the home currency (US stocks and bonds, real estate).
When you hire managers to invest in say, emerging markets or Japan, you don't pay them to take bets on currency, you pay them to take bets on stocks, and you hedge the foreign currency risk back into dollars.
However currencies is one of those markets where arbitrage is possible. There are managers who sustainably outpeform the index. the reason is hypothesised to be that a lot of players out there in the foreign exchange market (eg the Chinese Central Bank) are not trading to make money, but for other reasons.
So you hire an overlay manager, give him say, 20% of the portfolio gross value, and say 'make bets on currencies'.
Posted by: Valuethinker at February 28, 2007 10:32 AM
Valuethinker : I guess my concern would be that, in a world where 30-40% asset allocation in 'alternative' assets is not uncommon (see Harvard and Yale's Endowments, the best performing large endowments in the country) your proposed rule would make it difficult for a public pension fund to make such investments, robbing future taxpayers and beneficiaries of those returns and lower correlations.
I don't understand this bit. To the extent that those endowments are deemed to represent "prudent men", then application of the prudent man rule makes it more likely that other funds would seek a similar exposure to alternative assets.
valuethinker : I don't know if an inflexible 10% rule is a good one or if there is some better risk control rule.
I'm certainly not going to claim that I know! But I think that principles-based systems are - in general - better than rules-based systems; largely because the reckless find it harder to get around a principle than to pay a lawyer to find a way around a rule.
I've seen an awful lot of stuff sold as fixed income that just plain ain't. Like really wierd double-knock-out currency-based notes that, seemingly, were invented so that that fixed-income managers could do something more interesting than boring old bonds. In Canada (and, I'm sure, in the US) PPNs with equity-market derived returns are sold by banks as deposit notes.
Hey, it doesn't break any rules!
It's extremely difficult to regulate morality & competence - especially in this industry, where by the time you get a statistically valid track record, you're in a different world than the one you started in.
Ultimately, you have to ensure that the people in charge care and are given reason to care by way of feedback from the beneficiaries. No legal system, principle-based or rules-based, in the world can accomplish that as well as knowledgable activist beneficiaries.
Posted by: James I. Hymas at February 28, 2007 07:41 PM
And, oh yeah, I'm averse to too many rules and guidelines of any nature.
I'm certainly willing to support anything that is a Good Thing, principles- or rules-based. Let's never be too doctrinaire! But before I support a new rule, I want to understand what's wrong with the old ones ... and so far I haven't seen any argument at all that "Prudent Man" is no longer effective.
Posted by: James I. Hymas at February 28, 2007 07:50 PM
".....That's on top of the $1 billion (14%) in "exposure for currency overlay", $350 million for "exposure to policy overlay", and close to another billion in a few other exotic categories."
As an economics professor at UCSD I would have hoped you would have a better understanding of such strategies. Or at least have done the research before publicly questionning and critizing.
A large number of plan sponsors types use policy overlay strategies as a rebalancing technique. It is cheaper and more efficient than buying and selling actual securities. For example, if a fund had a strategic 60/40 stock/bond allocation and the allocation moved to 62/38, rather than sell stocks and buy bonds and ring up excessive trading costs, plans utilize futures contracts to rebalance. Thus, they would sell S&P futures and buy derivative fixed income instruments. Its the most efficient method of rebalancing and results in no overall exposures in excess of 100%.
Another reader accurately discussed the currency overlay. It's a strategy used by not just pension plans but corporations as well to hedge currency risks. A variation of currency overlays can also be used to generate returns by matching up currency pairs based on their relative valuations.
These are strategies that have been used by institutions for decades. I am retired now but I encountered many clients using such techniques even in my day. These are not off-the-wall or risky methods here people.
As for the commodity swap, investors have been dumping money into commodities the last few years as you no doubt know. Virtually all of this exposure has been gained by creating a synthetic index fund using swaps. An investor enters into a swap contract on say the GSCI Index. They would receive $100 notional exposure on the index and then invest the $100 of cash in a cash account. The combination of the two components creates an index fund that tracks the benchmark minus the cost of the swap. However, most plans invest the cash in an enhanced cash product in order to gain a little extra return to offset the swap cost.
Whether or not your think a plan should be investing in commodities to begin with is an entirely different discussion. Although they do provide the highest level of diversification to traditional asset classes and a small long-term allocation has proven to be benefical to a well diversfied portfolio.
So as you see, these "other" strategies create no excess exposures or any unknown risks. Keep in mind I am only referring to these "other" overlays you mentioned. The alpha generating strategies with the hedge funds are a whole different ball game. A game that entirely depends on which hedge fund you are invested in. Not all hedge funds are alike and many many funds have demostrated the ability to deliver consistent absolute returns over the last several decades. The recently popular method known as "Portable Alpha" is simpy a snazzy new name for a strategy that has been around for 20+ years. It simply removes the cash investment from the synthetic index example mentioned above and replaces it with a portfolio of hedge funds. The portfolio can be constructed to be as risky or riskess as the designer wants it to be.
As far as I am concerned this is not a strategy or method that will be a "joke" 10 years from now. The strategies have been around for 20+ years and they will be around for decades to come. You are right, it is a zero-game and some investors will lose. Just like many investors will lose on stocks, real estate, and venture capital and others will win.
Nonetheless, buyer beware is a great thing to keep in mind when dealing with hedge funds and all other purchases for that matter.
Posted by: Kyle P. at March 2, 2007 12:40 PM
Dick F: "Another case of giving responsibility to government resulting in lack of oversight. When will we learn that government's job is oversight and when it gets involved in running what it should be watching the result is disastrous collusion and criminal activity that goes unpunished"
This is why the government (i.e. the County) does NOT run the fund. An independent organization called the San Diego County Employees Retirement Association (SDCERA) with an independent Board of Trustees oversees the fund. Get your facts straight kido.
Posted by: Kyle P. at March 2, 2007 12:48 PM
Kyle, yes, an overlay can be used for benign synthetic rebalancing. But what exactly is being "synthesized" with over $2 billion for such purposes here? You can synthesize something with less volatility than the original portfolio and you can synthesize something with more volatility. For example, does the $1 billion in "currency overlay" indicate to you that the fund as a whole has less sensitivity or more sensitivity to fluctuations in currency values than it would have if it did not use these? Is it insuring or speculating? If insuring, is it trying to do so in terms of preserving dollar value (so that the dollar value of the holdings will not change if the dollar depreciates against the euro) or in terms of purchasing power (so the value of the portfolio in terms of dollars would go up if the dollar depreciates against the euro)? What specifically in the report conveys this information to you?
Posted by: JDH at March 2, 2007 01:58 PM
I think I was referring to the suggested transparency rule, which would make it hard for the trustees to invest in the top performing Hedge Funds and Private Equity Funds.
I'm all for prudent man, but in the context of a public pension fund, as much disclosure as possible.
If there had been more disclosure, perhaps Orange County would have avoided the Robert Citron disaster? Our version of this was a local Council (Hammersmith and Fulham) with 300,000 inhabitants (including a large number living in public housing) in inner London lost £500m speculating on interest rate swaps (they ran the Finance Department as a profit centre)-- a court case in the House of Lords saved their bacon (the Lords ruled that they were not competent to enter into those transactions).
I doubt the sophistication of most public pension fund managers with regard to understanding the risks of complex derivative based strategies.
I worry about 'alternative assets' right now. I have a lot of time for timber (but even its advocates admit you can't deal in size). Commercial property looks to me to be overbought on valuation grounds in most world markets-- office buildings in central London are running at 4% yields. Private Equity the problems of excess leverage and high deal multiples are widely known-- a leveraged position in the SP mid cap will outperform, after fees.
Swensen if you read him, demolishes investing in venture capital (all the excess return comes from about 10 partnerships, all of whose investors are 'invitation only'). Hedge Funds have, in many cases, degenerated into 'leveraged long' vehicles. For which one pays 2% + 20%.
Commodities the 'roll' now loses you money-- a function of the amount of institutional money that now goes into commodity indexation strategies. In a world of permanent contango (futures price above cash price), many of the return attractions of commodities are lost. If you are not a natural hedger of commodities (either as a mine or producer or major consumer) I am not sure the rationale holds as it used to.
Even old bonds look sticky. 4.5% on the long bond is hardly going to compensate you for the risks of higher inflation, and will certainly not maintain the real purchasing power of your pensioner's pensions.
Which returns us to garden-variety big cap equities. Which look cheaper, relative to the markets, than they have in 15 years-- Barton Biggs says he cannot find any evidence they have *ever* been any cheaper relative the stock market as a whole. I could name you half a dozen quality institutional managers with expertise in big cap value stocks, who could manage those portfolios for 50-70 basis points.
Yet many institutional funds are 'me tooing' into alternative asset classes.
Posted by: Valuethinker at March 4, 2007 05:27 AM
You've nailed it. We don't know if San Diego is speculating that the dollar will rise/ fall, or whether it is hedging its overseas equity and bond portfolios.
If it is speculating, this *can* be a high Sharpe Ratio strategy-- foreign exchange markets are not efficient, as best we can tell. *however* the question is then what is your potential downside, as a currency manager can, theoretically, lose the lot.
If a public sector pension fund really wants a PPP hedge against the buying power of its pensioners v. movements of the US dollar, it should invest in a portfolio of US companies with overseas operations (like the top 100 cos. of the SP500) or in the equities of international companies. Both are decent long term hedges against movements in currencies.
It's worth remembering that the Yen, which normally never changes by more than 1% against another major currency, appreciated against the dollar by *14 per cent* in 1998, during the LTCM crisis (or just before). that sort of move can wipe out a very clever currency trader.
Perhaps an even more important question, is do the San Diego managers know what the net effect of the currency overlay positions is, of the sub managers?
Posted by: Valuethinker at March 4, 2007 05:32 AM
The dollar value invested in a currency overlay strategy with an objective to add alpha to the fund is meaningless unless one knows the strategy's targeted risk level. For all we know $1 billion may not be enough relative when overlaid on a $7-$8 billion fund. Most public funds that utilize currency overlays for alpha generation purposes tend to maintain tight risk guidelines on the strategies with a goal of adding say 0.25-0.50% in average annual returns over long time periods. I assume this is likely the case here too. The easiest way to answer all of OUR speculation would be to simply attend the next SDCERA Board meeting. I looked on its website and there is one coming in two weeks.
Posted by: Kyle P. at March 5, 2007 02:29 PM
Stories like this make me sick. Formally, no law was broken? Nothing to stop someone pocket other people retirements?
Posted by: theroxylandr at March 30, 2007 10:10 AM
>>Stories like this make me sick. Formally, no law was broken? Nothing to stop someone pocket other people retirements?
The problem is systemic. Instead of seeing a bank or a fund as a business being run for a profit where managers and owners make good money, we have come to believe that we can also be rich/comfortable like them by trusting them with our money.
Such 'schemes' are only possible where trust and the perception of risk is low.
In a low risk universe we are likely to assume that some other person can be trusted to provide for our retirement. Instead of being panic stricken about the thought of old age and being frail and vulnerable and sick and hungry we can relax and look forwards to the best times of our lives.
If you take the blue? pill you will see a world without risk
If you take the red? pill...........
Welcome to reality boys!
Posted by: Anonymous at March 31, 2007 12:09 AM