CalPERS is exiting its hedge fund investments

the CalPERS decision

The California Public Employees Retirement System (CalPERS), the largest public pension system in the US and an early adopter of hedge funds, has announced that it will terminate its entire $4 billion in hedge fund investments over the coming year.

The decision comes after a review of CalPERS’ hedge fund performance by its investment staff following the death from cancer of the organization’s Chief Investment Officer, Joseph Dear.  Mr. Dear, a strong proponent of alternative investments such as hedge funds, took the reins at CalPERS in early 2009.  His appointment came in the wake of a sharp, recession-induced drop in the value of CalPERS’ assets–and as an alternatives-related “pay to play” scandal involving pension consultants and so-called “placement agents” was unfolding (see my post).

The stated reason for the move is that hedge funds are too complex and too high-cost.  Reading between the lines, this seems to me to mean that the hedge funds CalPERS used didn’t provide either the promised diversification or superior returns.  My guess is that the professional staff, who have the best understanding of the products, wanted to act quickly, before a new political appointee could arrive to muddy the waters.

In one sense, the CalPERS move should come as no surprise.  Although there are a small number of hedge funds run by superb investors, the average offering has pretty steadily underperformed the S&P 500 for over a decade.  In addition, the elevated fee structure results in most of what profits there are going to the fund manager, not the client.  These factors call into question the rationale for having made the investments in the first place–to reduce the underfunding of pension plans through superior investment performance, so that higher contributions to the plans by the corporation or government body that sponsors them can be avoided.  The evidence seems to me to be that hedge funds generally make the underfunding problem worse, not better.

On the other hand, it takes a substantial amount of courage to fire managers who have strong local political connections.

investment significance

CalPERS is a trend-setter.  It may well be in this instance, too.  A lot depends on whether the next CIO supports the investment staff decision to end hedge fund exposure or overrides objections.  In the former case, this could signal the gradual return to less speculative trading-oriented, more fundamentally driven securities markets.




the Scotland referendum

the vote comes on Thursday

On Thursday, Scotland will vote on the Scottish Independence Referendum Bill.  A simple majority of those voting saying Yes will make Scotland (population: 5.3 million) an independent country, no longer part of the United Kingdom.  Recent polls show that likely voters are about evenly split between those who want independence and those who don’t.  (A finer point:  the polls actually tally only what respondents are willing to say to pollsters, which is not necessarily the same as what they intend to do in the voting booth.)

As I see it, the best possible outcome would be for Scotland to become independent and use its small size and new economic vulnerability as the spur for a rush of entrepreneurial creativity.  Maybe the residual UK becomes even a bit more modern, too.  The worst outcome is probably that the referendum fails, but by a small enough margin that the issue remains front and center on the minds of Scottish politicians.  This leaves everyone worrying about what will happen and loathe to invest.

implications of “Yes”

–Scotland will be no longer a part of the UK, and therefore, of the EU.  This means that companies wanting unfettered access to the union must redomicile.  This is already happening, with firms relocating to England.

–Scotland will probably find it very hard to join the EU itself, because existing members–notably, Spain–will not want to give encouragement to their own regional independence movements.

–Negotiations will commence to determine what portion of UK national obligations–government debt, pension/medical insurance…–Scotland will assume.

–Scotland will have to create its own currency, central bank, tax and regulatory regime–all necessary parts of being its own country.  The most stable course, but not necessarily the best, would be for Scotland to mimic the UK; in particular, its currency would track sterling.  Higher tax rates and/or an iffier currency would doubtless have corporate headquarters and national savings headed south.

–Perhaps most important, Scotland has been a big supporter of the Liberal Party.  This suggests that the new UK would be more Conservative than before, implying that Parliament too might vote to distance itself further from the core EU, or leave the union entirely.

investment implications

A Yes vote will probably cause a continuation of recent sterling weakness;  a resounding No vote would likely spark a rebound.  That has implications for stock selection in London (exporters if Yes, domestic firms if No).  Otherwise, we should keep in mind the possibility that Scotland may become a kind of Hong Kong to the EU’s China.  The analogy is a little far-fetched   …but who knows.





analyzing sales rather than earnings (ii)

The answer the Bloomberg Radio reporter gave to the question, “Why sales, not earnings?” was that sales are harder for a less-than-honest company to manipulate.  In some highly abstract and technical way this might be true, but in any practical sense the reply is ridiculous.  Stuffing the channel is a time-honored, easy to do way of inflating sales.

Still, there are instances where an investor will want to look at sales rather than earnings.

1.  Value investors looking for turnaround situations will seek out companies with lots of sales but little in the way of earnings.  They’ll benchmark the poorly performing firm against a healthy rival in the same industry.  They figure that if the two firms have comparable plant, equipment and intellectual property, then a change of management should enable the weaker firm to achieve results that are at least close to what the stronger one is posting now.

As I see it, this mindset is what separates value investors from their growth counterparts.  The latter, myself included, begin to salivate when they see a strong bottom line; the former are magnetically attracted to big sales/no profits firms instead.

2.  Especially in the tech world, companies often go public before they become profitable.  AMZN, which didn’t report black ink for eight years after its IPO, is the poster child for this phenomenon.

Potential investors routinely look at the size of the market a given firm is addressing and the rate of its sales growth as a way of gauging its potential value.  This is a tricky thing to do, since it requires us to decide how much of the money the company is now spending is akin to capital spending–one-time foundation laying that won’t recur–and how much is spending that’s needed to generate each new sale.  Put a different way, it’s a decision on what is SG&A and what is cost of goods.  As AMZN illustrated, there’s huge scope for error here.

(An aside:  I attended an AMZN IPO roadshow presentation.  Management mostly said that during the PC era investors could have bought then-obscure companies like MSFT and CSCO and made a fortune.  The internet age was dawning and AMZN offered a similar chance.  Nothing but concept.)

3.  A simpler variation on #1  + #2, which is currently being worked vigorously by activist investors at the present time, is to find companies that may not break out results by line of business but which in fact operate in two different areas.  In the most favorable case for activists, the target firm will look like nothing special but have one high-growth, high-profit area whose strong performance is being obscured by a low-growth low/no-profit sibling.  The activist forces a separation, after which growth investors bid up the price of one area, value investors the other.


Obviously, no one uses just one metric.  But the way I look at it, the only persuasive case for using sales as the keystone to analysis is the value investor use I outlines in #1.


when to analyze sales rather than earnings

I was listening to Bloomberg News on the radio the other day, when a stock market reporter began a segment of an afternoon show by mentioning a a study he’d received of US stock market valuation based on price to sales rather than PE.

“Why sales and not earnings?” asked the show host.

The reporter had no clue. (An aside: it’s not clear to me whether this host asks probing questions of this particular reporter despite the fact he never can answer them or because he can’t.  I also sometimes wonder how aware each party is of the dynamics of their interaction–showing I must have too much time on my hands.)

Anyway, I decided to write about using sales as an analytic tool.

First, I should be clear that I’m not normally a fan of price to sales.  That’s probably because I’m a growth stock investor and am most often seeking out situations where profits are going to expand faster than sales..

To answer the host’s question as best I can:

Some companies are highly cyclical, like American autos or semiconductor equipment makers.  In bad times, they still have sales but may be posting losses.  Yet nobody pays you to take the shares off their hands; the stock trade at a price greater than zero.  In other words, at market bottoms they trade on something (i.e., sales or assets) other than earnings.  Similarly, as the economy recovers and the profits of deep cyclicals begin to explode to the upside, the PE multiple they sport progressively contracts.  In many cases, profits continue to surge but the stock price stops going up–because investors are anticipating the next dip of the cyclical roller coaster.  Again, they’e not trading on earnings.

So, at market bottoms the losses from cyclicals reduce overall index earnings, making the market look more expensive than it arguably should be.  At market tops, the stingy multiples that investors apply to peak earnings can make the market look misleadingly cheap.

Both distortions are eliminated, or at lest mitigated, by using price/sales.

Also, one might maintain that price/sales allows a better comparison between past decades, when a large portion of the market consisted of deep cyclicals, and the present, when the cyclical content is much smaller.

More tomorrow.

a professional portfolio manager performance check

I subscribe to the S&P Indexology blog.  Like most S&P communications efforts, I find this blog interesting, useful and reliable.

Anyway, two days ago Indexology published a check on the performance of equity managers who offer products to US customers.

In one respect, the findings were unsurprising.  For managers with US stock portfolio mandates, well over half underperformed their benchmarks over the one-year period ending in June.  Over five years, more than three-quarters failed to match or exceed the return of their index.

This is business as usual.  Why this is so isn’t 100% clear to me.

One of my mentors used to say that ” the pain of underperformance lasts long after the glow of outperformance has faded.”   I think that’s right.  In other words, clients will punish a PM severely for underperformance, but reward him/her by a much smaller amount for outperformance.  In a world where risks and rewards aren’t symmetrical, it’s probably better not to take the buck-the-crowd positions necessary to outperform.  Instead, it’s better to accept mild underperformance, keep close to the pack of rival managers and spend a lot of time marketing your like-me/trust-me attributes.

(To be clear, this isn’t a strategy I wholeheartedly embraced.  I generally achieved significant outperformance in up markets, endeavored not to lose my shirt in down markets.  My long-term US results were a lot better than the index, but at the cost of short-term volatility that was greater than the market’s.  Pension consultants, heavily reliant on academic theories of finance, tended to demand a smoother ride, even if that meant consistently less money in the pockets of their clients.  Yes, a constant problem for me.  But it illustrates the systematic pressure put on managers to conform, to look like everyone else.)


The surprising news in the blog post comes in international markets.   Generally speaking, the markets overseas are simpler in structure, information flows much more slowly than in the US, and PMs tend to be ill-trained and poorly paid.  Rather than being the culmination of a long a successful career, being a PM abroad is often only an early stepstone to something better.  So pencil in outperformance.

On a one-year view, however, Indexology reports that the vast majority of managers of global, international and emerging markets portfolios all underperformed their benchmarks.  This is the first time this has happened since S&P has been checking!!

I don’t watch this arena closely enough to have a worthwhile opinion on how this happened.  The fact of underperformance itself is surprising–the fact that more than 75% of managers of international funds underperformed is stunning.  My guess is that no one saw the deceleration of Continential European economies coming.

For anyone with international equity exposure, which is probably just about everyone, current manager performance is well worth monitoring closely.


a Fall stock market swoon?

Over the past thirty years, the US stock market has tended to sell off from late September through mid-October, before recovering in November.  That historical pattern has some brokerage strategists predicting a similar outcome for this fall.

Why the annual selloff?

It has to do with the legal structure of mutual funds/ETFs and the fact that virtually all mutual funds and ETFs end their tax year in October.

1.  Mutual funds are a special type of corporation.  They’re exempt from income tax on any profits they may achieve.  In return for this tax benefit, they are required to limit their activities to portfolio investing and to distribute any investment gains as dividends to shareholders (so the IRS can collect income tax from shareholders on the distributions).

2.  All the mutual funds and ETFs I know of end their fiscal years in October.  This gives their accountants time to get the books in order and to make required distributions before the end of the calendar year.

3.  For some reason that escapes me, shareholders seem to want an annual distribution–even though they have to pay tax on it–and regard the payout as a sign of investment success.  Normally management companies target a distribution level at, say, 3% of assets.  (Just about everyone elects to have the distribution automatically reinvested in the fund/ETF, so this is all about symbolism.)

4.  The result of all this is that:

a.  if realized gains in a given year are very large, the fund manager sells positions with losses to reduce the distribution size.

b.  If realized gains are small, the manager sells winners to make the distribution larger.

c.  Because it’s yearend, managers typically take a hard look at their portfolios and sell clunkers they don’t want to take into the following year.

In sum, the approach of the yearend on Halloween triggers a lot of selling, most of it tax-related.

not so much recently

That’s because large-scale panicky selling at the bottom of the market in early 2009 (of positions built up at much higher prices in 2007-07) created mammoth tax losses for most mutual funds/ETFs continue to carry on the books.  At some point, these losses will either be used up as offsets to realized gains, or they’ll expire.

Until then, their presence will prevent funds/STFs from making distributions.  Therefore, all the usual seasonal selling won’t happen.

how do we stand in 2014?

I’m not sure.  My sense, though, is that the fund industry still has plenty of accumulated losses to work off.  As a general rule, no-load funds have bigger accumulated unrealized losses than load funds;  ETFs have more than mutual funds, because of their shorter history.

This would imply that there won’t be an October selloff in 2014.

Even if I’m wrong, the important tactical point to remember is that the selling dries up by October 15 -20.  Buying begins again in the new fical year in November.






the August 2014 Employment Situation

Last Friday, the Bureau of Labor Statistics released its monthly Employment Situation report at 8:30 am Eastern time.  The figures were at least mildly disappointing.

The country added +142,000 new positions during the month, +134,000 of them in the private sector, +8,000 in government.  That broke the string of extremely positive, over-+200,000 months of job gains.  Revisions to prior months’ data were also negative, subtracting a net of -28,000 positions from the reports for June/July.

Other statistics, like the unemployment rate, the work week, the pace of wage gains…, were basically unchanged.

Although the figures weren’t great, they weren’t horrible, either.  And, of course, they’re subject to possibly large revisions over the coming two months.

For equity investors, the most interesting aspect of the report is that, despite its elevated level, the US stock market shrugged off the so-so news and ended the day higher.  This would have been the perfect excuse for a selloff had short-term traders been feeling bearish.  However, just the opposite happened.


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