Roane of Fortune reports, Calpers
and risk: Together forever? (HT: Bill Tufts, click on link for full article):
clocking a $100 billion loss in early 2009, the California Public
Employees' Retirement System, known as Calpers, had the swagger of a
hedge fund and the certainty of a saint. Other pension funds followed
its lead, loading up on leverage, investing in unrated CDOs, shoving
money into high-priced private equity deals and barreling into
commodities and real estate.
now is whether a loss of nearly 40% of its market value -- the worst
loss in the system's 77-year history -- has brought Calpers
sufficiently back down to earth to avoid another such debacle, and
whether other chastened pension systems have followed suit. In truth,
not all of the evidence of a rebirth at Calpers is comforting. And in
the case of some other underfunded pension funds, their latest
financial bets look downright scary.
"Some pension plans are
evidently hoping to make up losses by taking more risk," says Olivia
Mitchell, executive director of The Pension Research Council at the
University of Pennsylvania's Wharton School, whose research has shown
many pension funds to be poor asset pickers. But, "pension plans that
take a risky position to try to 'earn their way out of underfunding'
are quite likely to bear big downside risk when the market tanks."
is not to say that Calpers, the nation's largest pension fund, hasn't
made some strides in the right direction. Facing billions in unfunded
liabilities and increasing anger from California taxpayers who are
ultimately stuck with the bill, it would be tempting for Calpers to
double down. But Clark McKinley, a Calpers spokesman, says the pension
system "took some bitter medicine" and has learned important lessons
from the recent financial crisis.
is preparing a new asset allocation strategy after finding that its
diversification efforts failed to cushion much of the stock market's
fall. Calpers is also reining in its exposure to equity derivatives,
moving to reduce leverage in its real estate portfolio, terminating
under-performing partnerships, tightening the review process for real
estate investments and bringing together its diverse investment groups
to poll their knowledge about investment risks and opportunities.
McKinley says, information tended to be stove-piped, meaning the
retirement system's fixed income department was selling off mortgages
even as the real estate department was shoveling money into the sector.
of bad bets catch up
Most of Calpers investment losses came
from its largely passive investments in baskets of equities, which
still account for about half of the system's assets. But the retirement
system also got into trouble by adding leverage, reducing oversight
and by chasing other hot markets.
After maintaining a low-risk
real estate strategy for decades, studies commissioned by Calpers show that it switched
gears in 2002, embracing higher levels of risk even as the real estate
market began to top out in 2005. By mid-2009, Calpers had a one-year
loss of 48.8% in its real estate portfolio and was reporting among the
lowest returns of any large pension fund in the country.
In early 2006, it said it would invest $6 billion in commodities,
particularly through index futures, news that caused Grants' Interest
Rate Observer to respond: "On the timing of this demarche, we hand
Calpers the gold medal for Being Late."
Calpers showed even worse timing in the
mortgage market. Just before the market tanked, it invested
approximately $140 million in unrated collateralized debt obligations
(CDOs) and $1.3 billion in complex buckets of loans and debts called
structured investment vehicles (SIV). A Calpers lawsuit puts the SIV
losses at "perhaps more than $1 billion."
If the investment losses
weren't enough, questions have also been raised about why certain
asset managers were chosen by Calpers during this period. The state
brought fraud charges against the pension system's former chief
executive, Fred Buenrostro, and a former board member named Alfred
Villalobos, who later became a money-manager placement agent trying to
steer pension system business. Both men have denied the allegations.
Calpers is clearly a better managed pension
system these days, and has gained with the market rebound over the
last year -- although its $202 billion market capitalization still
falls roughly $60 billion short of its 2007 high and the plan remains
under-funded by many measures.
But Calpers isn't alone in facing
funding difficulties. In one influential study last year, researchers Robert
Novy-Marx and Joshua Rauh, of the National Bureau of Economic Research,
found that pensions are undercapitalized by $3.12 trillion if one
assumes the states have to make good on all of their obligations.
with such possible shortfalls, some pension funds have begun to swing
for the fences again. Last year, North Carolina passed legislation
allowing its state pension to invest in assets such as junk bonds,
commodities and real estate. Wisconsin recently decided to increase its
pension's bond exposure by levering the portfolio, with one proposal to
add leverage up to 120% within two years (in theory this could reduce
the portfolio's stock risk and slightly increase overall returns, but
only if interest rates stay low). The San Diego County Employees
Retirement Association -- which lost about $150 million when Amaranth
Advisors went bust -- is among other public pensions ramping up similar
schemes; it plans to borrow up to 35 percent of its assets and invest
the money in treasury futures, and sock other funds in emerging market
And a recent review of the Illinois Teachers Retirement
System by Alexandra Harris of the Medill Journalism school at
Northwestern University found that more than 80% of the system's funds
were now seen as risky and that it had added leverage by taking the
predominantly risky side of over the counter derivative contracts, such
as credit default swaps.
Although Calpers has remained active in
many potentially risky markets, so far it has refrained from turning to
the sort of concentrated bets undertaken in Illinois or Wisconsin.
That said, economists say Calpers could still do more to safeguard its
Will Calpers follow
Wisconsin and other pension funds leveraging
up their portfolios? In a world where pension funds will be lucky
to obtain 5% annual return, there is simply no way they will attain that magic 8%
investment return without taking on more risk.
But one thing 2008
taught pension fund managers was that asset class correlations are
notoriously unstable, especially in a liquidity crisis, and that you
have to have safety measures in place to protect against downside risk.
and foremost, pension funds need to do a better job at managing their
liquidity risk. In fact, I think 2008 was a watershed year because
people will look back and say that was the year where illiquid,
complex, structured strategies died and liquid, easier to understand
strategies took off.
But be careful with liquid leveraged
strategies. I know the smart folks at Bridgewater know what they're
doing, and that a lot of the thought process comes from their work on engineering
targeted returns and risk, but I get very nervous when the pension
herd moves into replicating a strategy/process without
thinking of the consequences of their collective actions, adding more
leverage to the entire financial system (bond bubbles can go on longer
than you think!).
Large pension funds like Calpers, CalSTRS, the
Caisse and CPPIB need to rethink their entire approach to mitigating
downside risk. The focus should primarily be on strategic asset
allocation, with enough wiggle room to make opportunistic tactical
decisions when markets shift abruptly.
These large funds
should also be intelligently multiplying their sources of alpha, both
internally and externally. My bias remains with liquid strategies.
Reuters recently reported that Macro hedge
funds best despite May dip - Lombard Odier:
funds taking directional bets on markets will be among the best
performers in 2010 as concerns over the health of major economies
continue to dominate markets, said Lombard Odier's head of hedge funds
Cedric Kohler said on
the sidelines of the GAIM hedge funds conference that strong trends in
currencies, equities, debt and commodities could help the strategy known
global macro to prosper into 2011 despite a disappointing May.
"The overall environment has been driven
by macro events in 2010, and I believe it will continue to be the case
because of economic imbalances in the largest markets," said Kohler,
whose team at the Geneva-based private bank oversees a fund of hedge
funds and advises clients on hedge fund investments.
markets highly volatile, he said macro managers benefited from their
ability to take long or short positions in most markets, trade in very
liquid products and change positioning nimbly if their view of the
economic outlook changes.
"That's not the same for all asset classes; there has been a
significant drop in liquidity in areas like credit, making it difficult
to turn around portfolios when the market moves against you," he said.
CS/Tremont data show global macro
strategies lost 0.63 percent in May, which Kohler said was
disappointing, because such strategies should have performed well in a
month when pressure on euro zone economies triggered heavy market
declines and sent the euro into tailspin.
"The losses were caused because
people were worrying about liquidity and simplifying their trades, with
many ending up in the same trade for different reasons," he said.
For example, he said, managers who had
been short the euro and long the Australian dollar switched into a
euro-dollar trade, which they thought mirrored their original trade and
offered better liquidity, while managers playing the Greece theme
avoided credit default swaps on worries about a regulatory ban, and used
euro-dollar trade as a proxy.
"So people were using same instruments for
different reasons, exacerbating volatility in those instruments."
While Kohler said funds of hedge funds
should thrive after a difficult two years, he expected their numbers to
"There's going to be
industry consolidation. Those funds of funds which are too small or do
not have a clear strategy will either close or be bought," said Kohler.
"But prices won't be high. People won't
be buying their strategy or their distribution, just their assets under
management," he said.
Kohler is too nice. I
think the majority of funds of hedge funds will shut down their operations in the next three years. In a
deflationary world, fees matter even more, and they'd better be really good at picking
alpha managers if they're going to be charging 1 & 10 on top of the 2 & 20. Even
if they are good at picking winners, most investors will balk at paying
an extra layer of fees.
Finally, I leave you with some
excellent Bloomberg interviews that appeared in the last 24 hours. You
will have to click on the links to watch, and trust me, they're all
worth watching, especially the first one with Lakshman Achutan,
managing director of the Economic Cycle Research Institute (click on
links to watch and hit play to load video):
Treasuries Offer Insurance Against Crises: Video
And this last interview with Bill Fleckenstein, which I
am able to embed here, is for all you perma-bears who think we're
heading into another depression. You'll enjoy it, but I don't subscribe
to his gloomy scenario.
To be fair to Bill, I agree
with some things he says on how the stock market lost its discounting
mechanism. He rightly blames this on speculative momentum type traders
and computer powered quant traders who have developed algorithms to
exploit market inefficiencies. I call this "algos running amok". It
works fine when things are fairly stable, but when volatility spikes,
watch out below!