alternative investments, the SEC and Trump

My earliest experience with alternatives was as a rookie analyst in 1979. Among other things, I was covering small oil wildcatters who funded themselves by promoting oil and gas limited partnerships sold through retail brokers. The 1/2″-thick prospectuses laid out terms that were so unfavorable to limited partners that at first I couldn’t understand why anyone would buy them. So I asked the VP Finance of one of my coverage companies. He laughed, and said the offerings were not for people who wanted to make money. They were for people who wanted to tell others at a party that they were wealthy enough to have an income tax problem.

I remember a China-oriented private equity fund whose prospectus touted the promoters’ prowess through their extraordinary history of high returns. The returns were high–but, after fees, they matched almost exactly those of the Hang Seng index. Again, lots of sizzle but…

As part of the financial reform after the financial crisis, and because of widespread improprieties in the alternatives industry–like misstatement of returns, or professional credentials, or size of assets under management …or other stuff I’d call flat-out fraud–many alternatives providers were required to begin filing reports with the SEC, which has since prosecuted a number of high-profile cases of abuse.

Trump is now taking two actions in support of alternatives, both of which seem to me only to be pluses for dubious alternatives promoters. He’s proposing that ordinary investors be allowed to buy alternatives in 401k accounts (they’ve been barred as too opaque and risky). He’s also “solving” the issue of fraudulent reporting by ending the mandate that smaller alternatives firms to file their results with the SEC (removing the threat of Federal prosecution for, say, falsifying returns).

Neither makes any sense to me. Why do this? Maybe the same reason Trump has made no effort to keep his promise to eliminate the carried interest ploy private equity managers use to avoid income tax.

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.




why do pension plans choose hedge fund and private equity managers?

private equity

Mitt Romney’s presidential candidacy has created a new wave of interest in the mechanics of private equity.

The debate has so far primarily been about whether what private equity does–take control of companies that are not making much money, reorganize them and sell them on–is socially useful.  The answer is generally “Yes.”

A secondary question is whether investors in private equity funds, primarily pension plans and university endowments, are getting a good deal. The answer here is generally “No.”  In a recently conducted study for the Financial Times, for example, professors at Yale (whose endowment has been a bastion of such “alternative” investments) and Maastricht University conclude that the vast majority of profits go to the organizers and promoters of private equity schemes, not to the investors who bear almost all the risks.

hedge funds

The same is true of hedge funds, which incidentally are putting the finishing touches on a decade of underperformance versus an S&P 500 index portfolio.  And that conclusion is based on the data the funds themselves voluntarily report.  There’s lots of evidence that some hedge funds routinely overstate their: investment performance, assets under management, and the size and qualifications of their professional staffs.

these are illiquid investments

…oh, and in addition to less-than-stellar profits, these vehicles can be highly illiquid.  In the Great Recession, investors in hedge funds learned to their dismay that the contracts they signed (which they apparently hadn’t read) allowed their managers to refuse requests for redemptions–even for years.  Recently, stories have also been circulating about failed private equity projects that refuse to liquidate, presumably because that would put an end to the management fees the organizers are collecting.

but they’re in high demand

That such a P.T. Barnum-esque situation should have developed with exotic investment vehicles isn’t that strange.  What is, however, is that despite a long period of lackluster performance, institutional investors want to put more of their money into hedge funds and private equity, not less.

Why is this?


The standard answer that institutions will give is that these “alternative” investments aren’t correlated with the movements of stocks and bonds.  Therefore, they’re a diversification.   That lowers the risk of the overall institutional portfolio.

This, of course, is not true.

Generally speaking, the fact that the returns on two assets aren’t correlated doesn’t mean that the risks of one partially offset those of the other.  It just means that you’re exposed to two different sets of risks.  The fact that in bad weather you speed in a racing car and pilot a small plane doesn’t mean you’re safer than if you just did one of the two.

Also, in the case of alternative investments, there’s no public market and holders have no independently verified information about their returns.  So they have no way of determining if risks are correlated or not.

political pressure

A second, less talked-about reason is that hedge and private equity funds hire powerful, politically connected, salesmen who wield influence over the pension plan managers.  There have been scandals about payments to such sales agents in California and New York.

damned if they don’t

To my mind, the main reason institutional investors are attracted to alternative investments is simple arithmetic.  Traditional pension plans don’t have all the money on hand today that will be needed to pay their future obligations to present and potential retirees.  They assume that they can invest the funds they do have to earn a specified return, usually around 7%, so that today’s assets can grow enough to meet future obligations.  If they can’t do this, the plan is underfunded and the employer has to eventually kick in enough to make up the difference.

Is 7% a reasonable annual rate of return in today’s world?  Not if you’re limited to publicly traded stocks and bonds.

Let’s say that you have a 50/50 mix of the two asset categories.

–Stocks can probably have a nominal return of 8% a year (inflation +6%).  History says that in the aggregate the managers you hire will deliver somewhat less than that.

–The 30-year Treasury is yielding about 3%; the 10-year yields about 2%; the return on cash is practically zero.  Interest rates are now at emergency-low levels.  This means chances of a capital gain from holding bonds are slim; chances of a capital loss on your bonds as the economy recovers and rates rise are high.  Let’s be super-optimistic and say you can collect a 3% coupon and make no losses.

With a 50/50 mix of stocks and bonds, then, a pension plan can achieve a return of about 5% annually.  That’s nowhere near enough to meet the 7% goal.  Even if the plan went to an allocation of 100% stocks,  it might not achieve a 7% return.  And doing so would give up all protection against the possibility that another year like 2008 rolls around–as one sooner or later will.

How does the executive in charge of the pension plan deal with this problem?

Does he go to his boss and say he needs an extra $10 billion or so to fund the plan–taking the risk that the boss will shoot the messenger?   …or does he take the chance that, against the testimony of experience, alternative investments will deliver what they promise–big enough returns to get to the 7% goal?

The latter is certainly the path of least resistance.  And this fact also probably makes the political pressure from the hedge fund/private equity salesman that much harder to resist.