Category Archives: Investment firms

traditional pension plans in the US: trouble (ii)

December 16, 2016 By in CalPERS, pension funding, pension plans, Uncategorized Tags: , , , Leave a comment

CalPERS

The California Public Employees’ Retirement System (CalPERS) is a bellwether for government employee pension plans around the US.

not fully funded

By its own calculations, CalPERS is not fully funded, meaning that it does not have enough money on hand today to meet the future pension obligations of its members.  That’s even assuming, as it officially does at the moment, that it can earn on average 7.5% on its investments yearly.

assuming a 7.5% annual return

How reasonable is it, though, to think that CalPERS–or anyone else in a similar situation–can earn 7.5% on a diversified portfolio of stocks and bonds?

reasonable?

Let’s assume an asset allocation of 50% stocks and 50% bonds, just to make the arithmetic simple.

—bonds first.  Let’s say that the yield on Treasure bonds rises to 4% over the next several years and stays steady at that level from that point on.  When we’re there, CalPERS can earn the coupon each year by holding them, or 4%.  A 4% return on half the portfolio is a contribution of 2% to the entire portfolio   Note:  we already know that the return will be less than that over the time it takes for interest rates rise back to normal.

—stocks.  To achieve a 7.5% return on the entire portfolio, assuming bonds deliver 2%, stocks will have to chip in 5.5% per year to the total.  This means achieving an average 11% annual return on the stock half.  How reasonable is this?  Well, over the past ten years the S&P has risen by 58%, or on average by a little less than 5% per year.  If we assume that inflation will remain contained at around 2%, an 11% return would be a whopping 9% real annual return.  Over long periods of time, stock markets around the world have averaged at best a 6% real annual return.

change the asset allocation?

Yes, we could up the overall return by shifting the asset allocation away from bonds and toward stocks.  But the stock portion would have to be above 90%–making calPERS’ assets vulnerable to wide business cycle swings in their value–before it could achieve a 7.5% annual return, assuming a 6% real return on stocks.

In short, the numbers don’t add up.  The biggest issue isn’t CalPERS’ ability, or lack of it, to manage money well.  It’s that the actuarial assumption of future returns is too high.

Over the recent decade or more, pension plans like CalPERS have tried the “magic” solution of alternative investments–hedge funds and private equity–to try to square the circle.  But most hedge funds continually produce returns to clients that are below the S&P 500.  And, again, the allocation to such dubious, and illiquid, vehicles has got to be very large to move the total return needle, even if one believed the promoters’ marketing claims.

changing the actuarial assumption

Interestingly, California has just announced that it is going to accelerate the process of lowering the assumed return on CalPERS investments to what sounds like a target of 6.5%.  To me, this is clearly the right thing to do, and the sooner the better.  But it will also show that CalPERS is more deeply underfunded than today’s official figures suggest.  It will likely mean that state and local governments will have to up their contributions to the fund.

That’s doable for California.  But what about the country’s government pension fund basket cases, like Illinois and New Jersey?  Following suit will show voters for the first timethe reality of how bad the situation is there.

 

traditional pension plans in the US: trouble ahead

December 15, 2016 By in pension plans, Uncategorized Tags: , , , , Leave a comment

the basics

Corporate pension plans of one type or another have been around in the US since the late nineteenth century.  In their simplest form, they offer specified payments in retirement to company workers who meet criteria spelled out in advance.  Since 1974, these plans have been subject to federal regulation under the Employee Retirement Income Security Act (ERISA) which sets out standards companies must comply with.

Although pension plans are an obligation of the firm, companies don’t ordinarily keep on hand in the plan today enough money to meet all future obligations.  Instead, they (or outside actuarial firms they hire) make intricate calculations of what future payments are likely to be and when they are likely to occur.  Then, using the investment returns that on average they believe their investment managers can achieve, they figure out how much must be in the plan right now to fund expected obligations.

open secrets, sort of

–We know professional analysts have a hard time forecasting what will happen even one year ahead.  What does this say about forecasts that claim to look decades into the future?

–Most traditional pension plans have less in the till today than actuarial calculations say they need.

–The return assumptions used are typically, let’s say, heroic.

public sector workers

The uncertainty inherent in what I’ve just written is why most publicly traded US companies have long since switched from traditional pension plans, where the corporation has responsibility for the risk of miscalculation, to 401ks, where the employee bears it.

There still are significant numbers of traditional pension plans, however.  They’re in the public sector.

dealing with underfunding

To my mind, a substantial reason for the popularity of hedge funds over the past fifteen years or so has been their claim of superior performance as far as the eye can see.  The director of an underfunded pension plan knows that his story is not going to end well as things stand now.  He has two choices:  ask his boss, the governor/legislature, for instance, to fix the problem by allocating (a ton of) more money to the plan; or he can find managers who can consistently exceed the returns the actuaries assume and gradually close the funding gap that way.  Not wanting to be the bearers of bad news, directors have by and large chosen door #2.

the actuarial assumptions

Adding to the woes of pension plan directors, the California Public Employees Retirement System (CalPERS), a leader in the public pension plan sphere, has begun to call into question the assumption that it can churn out average annual gains of +7.5%.

The surprise here, if any, is that CalPERS has finally decided to deal with this chronic problem.

More tomorrow.

 

 

 

active managers’ assets shrank last year

November 7, 2016 By in Investment firms, Uncategorized Tags: , , , , Leave a comment

The Financial Times reported on Halloween the results of a study by Willis Towers Watson done for Pensions and Investments (how’s that for complicated?) showing that the assets under management of the top 500 fund management firms shrank in 2015 for the first time since the Great Recession ended.  The decline was greatest for Europe-based managers.

Several factors appear to be at work:

–sovereign wealth funds, especially those sponsored by Middle Eastern oil exporters, have been cashing out to fund expanding budget deficits

–large traditional pension providers are taking assets away from third-party money managers to handle them in-house (this could turn out to be just as disastrous as do-it-yourself dentistry or knee surgery, if the pension administrators try any form of active management)

–flattish markets and a strong dollar, reduced the d0llar value of non-US assets, resulting in slight investment losses.

 

In addition, within the industry market share is shifting:

–the top 50 firms increased assets; the other 450 lost enough to more than negate those gains

–assets shifted from high-fee active management to low-fee passive alternatives.

 

My thoughts:

–not a good time to be a small or mid-sized asset manager, since operating profits are contracting both from lower assets under management and from lower fees on those assets.  This implies to me that greater numbers of minnows will sell out to whales.

–although I can’t see into the inner workings of asset managers any more, my experience is that firms cut their younger, lower-cost (but considerably greater upside) professional employees in order to preserve the income of their higher-paid longer-tenured colleagues.  This is, I think, a recipe for disaster    …and will worsen the position of smaller firms.  More reason to expect consolidation.

–I have little conviction on how this development might affect active management.  My inclination is to think that markets will become less efficient, meaning a better change for you and me to outperform.  Another possibility, though, is that the door will merely open wider for computer-driven investment strategies.  I don’t think this necessarily lessens the chances for you and me.  But it may mean that we will have to key off market indicators that we reckon will have appeal to algorithmic investors, rather than those that will motivate humans.

“The Dying Business of Picking Stocks”

October 18, 2016 By in Investment firms, Uncategorized Tags: , , , 1 Comment

That’s the title of an interesting article in today’s Wall Street Journal on the accelerating replacement of active investing with indexing in portfolios of all stripes in the US.

One important factor in the lagging performance of most active investment groups is being left out, however.  It’s the one no active investment organization wants to talk about.

Beginning in the 1980s and increasing in momentum in the 1990s, active investment groups began to dismantle their in-house investment research departments.

Why do this?

In my view it’s because,

–research departments are expensive.  They’re hard to run well.  Evaluating securities analysts over short periods of time, like a year, is as much an art as a science.  Because of its pain-in-the-neck character, a less tha nstellar research effort is very easy to regard as an unneeded expense rather than a valuable asset

–most money management organizations are run by the chief marketing person, with the head portfolio manager being the Chief Investment Officer.  So the ultimate decision maker on firm-wide administrative matters is typically not an expert on what it takes to have sustainably good investment performance

–in the 1980s and 1990s brokerage firms built and maintained strong research departments, whose output they offered to money management clients in return for charging a higher commission rate for trades.  So reliable–although not proprietary–third party research was available to money managers without their having to pay for it from management fees.  This added to the view that good in-house research was unnecessary

–eliminating in-house research would mean salaries “saved” that could be used to boost compensation for the professionals who remained (including the CEO and CIO, of course).

 

Not every firm used all the reasons on this list, but many found some combination of them persuasive enough that they decided to substantially reduce, or eliminate their independent research entirely.

This, of course, made these firms radically dependent on brokerage research…

…which has proved a disaster when, in their dark days immediately after the stock market collapse of 2008-09, most brokerage houses laid off virtually all their experienced researchers and pared back their for-commission research efforts to the bone.

This left money managers who had eliminate their own research high and dry.  It also meant the affected firms were faced with the prospect of rebuilding their own in-house research.  Because this would involve a substantial expansion of the professional staff, the resulting expense would pressure income for–I think–at least a couple of years.

 

I haven’t followed this issue carefully.  My experience, though, is that this is the kind of decision CEOs really don’t want to make–to admit they were wrong, and badly enough that fixing their mistake will retard or eliminate future profit growth.  As a result, a kind of paralysis sets in and the process of fixing the error never begins.

 

 

hedge funds and uncorrelated returns

August 24, 2016 By in financial planning, Getting financial advice, mutual fund holders and financial advisors, Uncategorized Tags: , , , , , , , , 1 Comment

beta     

One of the initial topics in my first investment course in graduate school was beta, a measure of the relationship ( generated from a regression analysis) between the price changes of an individual stock and those of the market.  A stock with a beta of 1.1, for example, tends to move in the same direction as the market but 10% more strongly.  One with a beta of 0.9 tends to move in the same direction as the market but 10% less strongly.  The beta of a stock portfolio is the weighted average of the betas of its constituents.

the beta of gold stocks

At the end of the class, the teacher posed a question that would be the first item for discussion the following week.  Gold stocks have a beta of 0.  What does that mean?

The mechanical, but wrong answer, is that gold stocks lower the beta, and therefore the riskiness, of the entire portfolio.  If I have two tech stocks, their combined beta may be 1.2.  For two utility stocks, the beta might be 0.8.  For all four in equal amounts, then, the beta is 1.0, the beta of the market.  Take two tech stocks and add two gold stocks and the beta for the group is 0.6. But this doesn’t mean the result is a super-defensive portfolio.

A beta of 0 doesn’t mean the stock is riskless.  It means that the stock returns are uncorrelated with those of the stock market.  So adding one of these doesn’t lower the risk of the portfolio.  Instead, it introduces a new dimension of risk, one that may be hard to assess.

a painful lesson   

Portfolio managers who embraced beta in its infancy didn’t get this. They assumed uncorrelated= riskless, learned the hard way that this isn’t true when their supposedly defensive portfolios imploded due to sharply underperforming gold issues.

uncorrelated redux      

I’ve been looking at marketing materials for financial planning firms recently.  Allocations to hedge funds are being touted with the idea that their returns are uncorrelated to those of stocks or bonds. This is substantially different from the original claims for this investment form. Over the past fifteen years or so, the hedge fund pitch has gone from being one of higher-than-market returns, to low-but-always-positive returns, to the present uncorrelated.

The reason is that in the aggregate hedge fund returns have consistently been lower than those for index funds for many years and that they do have years where their returns are negative.  What’s left?   …uncorrelated, just like zero-beta gold stocks.  I guess it has been revived because the last “uncorrelated” investment disaster is so far in the past that few remember it.

why hedge funds?

Why have hedge funds at all in a managed portfolio?  They must have some marketing appeal, sort of like tax shelter partnerships or huge fins on the back of a car, that are aimed at the ego–not the wallet–of the client.  A darker reason is that the sponsoring organization may also run the funds, and would miss the huge fees they generate for their managers.