when quantitative investment strategies “add up to fraud”

Yesterday’s online Financial Times contains an article titled “When use of pseudo-maths adds up to fraud.”  It references an academic paper (which I haven’t read yet–and may never) which concludes that while quantitative management strategies may look impressive to neophytes, many are mathematically bogus.  This could be why they often fail deliver the superior investment performance they appear to promise.  Anyone with mathematical training needed to construct such a statistical stock-picking system should know this.

Quelle surprise!, as they say.

There’s a powerful cognitive urge to simplify and systematize data.  But that’ not why investment management companies typically create the mathematical apparatus they tout to clients.

The reality is that investment management has a large right-brain component to it.  It depends on individual judgment and intuition honed by experience.  This fact makes clients uncomfortable.

Typically the company treasurer, or other person in the finance department who is in charge of supervising the company pension plan, has little or no investment training or experience.  He may know corporate finance, but that’s a lot different from portfolio investing.  Suppose the manager I just hired begins to lose something off his fastball, he thinks.  He tells me he reads 10-Ks, but suppose he just goes into his office, takes an hallucinogen and picks stocks based on the visions he experiences.  How can I explain this to my boss if the pension plan returns go south?

That’s why his first step is to hire a third-party pension consultant.  It’s not necessarily that the consultant knows any more than the treasurer–in my experience, the consultant probably doesn’t.  Hiring an “expert” is a form of insurance.

Selecting a manager with a quantitative stock-picking system is another.  The supposed objectivity of the system itself–safe from emotions or other human foibles–is a second form of defense.

Up until now, the apparent safety net created by hiring the consultant and selecting a recommended manager who relies on “science” instead of intuition has been enough to clinch the deal for many quantitative managers.   Of course, while this decision may make the treasurer feel better–and may be an effective defense as/when the quantitative system in question blows up–it doesn’t eliminate the risk in manager selection.  It simply shifts the risk fulcrum away from the human portfolio manager to the statistician who has constructed the stock selection model.  The paper the FT references, “Pseudo-Mathematics and Financial Charlatanism,” argues that, empirically, this is a terrible idea.

I wonder if anything will come of it.

institutions reacting to poor hedge fund/private equity returns

A couple of days ago, the Dealbook section of the New York Times reported on a recent meeting of the Institutional Investors Roundtable in western Canada.

The purpose of the organization, founded in 2011, is to help large government-linked investment bodies, like sovereign wealth funds and managers of government employee pension plans, cooperate to solve common problems.

According to the NYT, the agenda of the latest meeting was hedge fund and private equity investments.  Although the proceedings are secret, it doesn’t take a genius to figure out what went on.

The institutions’ dilemma:  on the one hand, they want and need the diversification and the high-return investment opportunities that hedge funds and private equity promise.   On the other, despite their colorful brochures and persuasive presentations, many hedge fund/private equity ventures produce pretty awful returns.

There are two main reasons for this:

–some hedge fund/private equity operators are brilliant marketers and well-connected politically, but that’s it.  They’re not great investors.  It doesn’t help matters that academic research shows a significant number of them bend the truth in stating their qualifications, track records, assets under management…

–the hedge fund/private equity fees are so high that there’s little extra return left over for the institutions who supply the investment capital.

The IIR solution?

It’s to try to develop hedge fund/private equity projects among the members themselves, thereby cutting out the fees charged by third parties.  One institution cited in the NYT article says doing so adds 5 percentage points to the annual returns it received from such projects.  On a world where bonds yield next to nothing and where stocks may produce 6%-8% annual returns, a 5 percentage point pickup is enormous.

This movement is in its infancy.  Not every institution will be able to participate, either because of political pressure at home or lack of even minimal expertise.  But even that may change in time.

The most important thing to notice, I think, is the evolution away from traditional Wall Street practices that make the financiers–and no one else–rich.  I think that sovereign wealth funds, bot from China and the Middle East, will take leading roles in this development.

pension consultants and placement agents: the CalPERS report

the situation

Imagine you’re a global equity portfolio manager.  You have a top quartile record over virtually any period during the prior ten years.  In fact, there’s no one in the US, and only one in the EU, who can equal or better your numbers.  You have presentation skills polished by intense preparation by experts both inside and outside your firm, as well as your many hours of practice.

You visit a pension consultant in Connecticut.  You show him your numbers, make your presentation, and await his comments.

He has only two:

–your presentation skills are terrible.  Before he can recommend you to any clients, you must take a remedial course from his firm.  It costs $25,000.

–he’s not sure you know enough about foreign markets.  The only way he can gain the confidence he needs is if you subscribe to his firm’s international information service.  He shows you the latest copy.  It’s a worthless collection of news clippings–superficial, and weeks behind what your own information network provides.  It costs $50,000 a year.

Summary:  despite the fact your record is better than that of anyone he is currently recommending to clients (who are, incidentally, paying him large amounts of money to do manager searches for them), those clients will only hear your name if you agree to make an upfront payment (read: bribe) of $75,000 and agree to continuing payments of $50,000 a year.

We decline.

Welcome to the Realpolitik of pension consulting.

the CalPERS report

The consultant I’ve described lacks finesse.  It would be more common for a pension manager to agree buy analytic services from a consultant, who would examine the manager’s product offerings for their potential attractiveness to customers.  Paying the consultant to come to your offices and spend time digging through your products will not only give the consultant the knowledge of your products that might otherwise take five years of you visiting him to impart.  But it might engender a feeling of obligation as well.

The biggest weapon in the consultant’s arsenal, however, is his control over the types of products he will recommend that his client buy.  They will be all highly specialized, offering the maximum potential for the consultant to “add value” by applying asset allocation services to the individual pieces a given asset manager sells, thereby customizing a portfolio.

CalPERS wouldn’t see the sometimes seamy interaction between manager and pension consultant.  But that’s small potatoes compared with what the consultant earns by selling manager selection and asset allocation services.

None of this is mentioned in the just-released CalPERS investigative report on placement agents and consultant services.  In fact, the part about consultants is much like the amuse bouche in a five-course meal.  What the report says is this:

1.  Somehow, while it continued to pay pension consultants as neutral third-parties to find managers and monitor performance, CalPERS ended up hiring the same organizations as money managers, as well.  Talk about the fox guarding the chicken coop.

CalPERS has finally worked out that, in addition to not being a sound action from a fiduciary standpoint, this is a no-win situation for it.  If the performance is outstanding (and my casual reading suggests it isn’t), there’s still the blatant conflict of interest.  If it’s poor, there isn’t even a pragmatic justification for the breach of prudent behavior.

2.  The big issue in the report, though, is placement agents.  These are well-connected individuals who sold their privileged access to CalPERS management for tens of millions of dollars in fees paid by third-party money managers, some of whom gained CalPERS as a client.  This appears to have happened predominantly in CalPERS alternative investment and real estate areas.

The report of the investigation, lead by law firm Steptoe and Johnson, LLP, is a carefully crafted document.

The authors point out that they received “universal and unlimited cooperation”  only from CalPERS and its current employees, less than that from others.   Some relevant people, notably former CalPERS CEO Fred Vuenrostro and former board member Alfred Villalobos, refused to cooperate entirely (understandably, perhaps, in the case of the named individuals because the report notes both are defending themselves against charges brought by the California Attorney General).

As I read it, the report makes several, not entirely consistent, points about the attempts of several of CalPERS key alternative investment managers to buy influence through Villalobos and Vuenrostro:

a.  CalPERS lost no money (not relevant from an economic point of view, but likely a key point under state securities laws)

b.  the main operational failure was on the part of the board of directors in not reining Villalobos and Vuenrostro in, and in some cases, aiding their influence-peddling efforts; the staff of CalPERS consistently resisted unwarranted pressure from Vuenrostro to select certain managers or not negotiate fees diligently

c.  nevertheless, the report also cites the case of the former head of CalPERS’ alternative asset arm, who appears to have accepted inappropriate favors from Apollo Global Management, while CalPERS was negotiating to buy a stake in Apollo

d.  in addition, many of the third-party managers who paid a total of $180 million to placement agents, Apollo Global Management, in particular, remain among CalPERS’ “most trusted external managers.”

e.  again, despite the contention that the staff of CalPERS acted entirely appropriately, the report also says that four alternative asset managers, Apollo, relational, Ares and CIM, “agreed to a total of $215 million in fee reductions for CalPERS.”

my thoughts

At least this behavior is out in the open.

To me, the conclusions in the placement agent part of the report don’t add up.  It may be, however, that CalPERS is so deeply entwined with the alternative asset managers who paid placement agents all that money and who overcharged the agency by close to a quarter billion dollars that it isn’t able to extricate itself.  So it has decided to make the best of a bad situation.  We’ll probably find out more as pending lawsuits wend their way through the legal system.