Easy Money, Hard Truths?

Leo Kolivakis's picture

Via Pension Pulse.

I want
to share with you comments on my last entry on
a pension chief's exit
. A senior pension fund manager emailed me
with some important observations which I will share with you (some
comments are edited out):

Here are some things you may want
to consider in shaping your argument:

I believe that economies
of scale are important in asset management so having public sector
related funds operate at arm's length on competitive terms is a good

Moving from a fund to a supplier is a bit much, but what
drove the guy out is problematic as well.

The public seems more worked up about paying
internal managers for performance than paying external managers double
or triple regardless of performance

This year, my
internal team added 600 million over public market benchmarks and may
get 10 million (in addition to about 10 in wages and benefits);
external managers lost 500 million relative to market and their fees are
related to assets and amount to 120 million. Want to guess what the
headlines will be?

On benchmarks
my landing spot is that the simplest way to implement a policy is with
index funds. Return will be index - implementation costs.

you run an active program, incremental return on incremental risk has
to be attractive.

Most of the time incremental risk is actually
insignificant or negative. A good active manager tries to improve on
market return/risk and cap weighted markets are not quite risk
efficient. Consequently, active risk tends to be negatively correlated
with the market.

Benchmarks for unlisted assets are tough. Has
nothing to do with fraud in most cases.

In any case the principle has to be that it
will do better that the listed assets it displaces.
Private equity should improve on listed
equity adjusted for leverage.

For infrastructure and timber
we know that the unlevered return is typically between stocks and bonds
once the market becomes reasonably efficient. I think it should do
better than some combination of stocks and RRBs.

Hedge funds are a hodge podge. Few can
deliver uncorrelated return on risk. The HFRX usually tracks global
equities except for 2000-2003

Annual value added does not tell you much. Good active programs can easily be negative 1
year out of 4.
My experience
is that longer periods are better.

The 4 year rule was
chosen by most funds because that is all CRA allowed. I proposed a
perpetual inventory method over ten years ago. It now appears that this
may fly as long as the balance is at risk.

I feel that
something like 5 cents per dollar of net value added over net index
return is fair to clients and managers if incremental risk is

Typically, if you can do something for x
internally, you pay 3x or 5x externally.

If the public really
prefers to pay more for what it cannot see, vs less for what it can
see, more power too them.

goal is to squeeze margin out of total asset management and increase
net return to my clients.

No one care who gets paid what as
a percent of a reasonable price of toothpaste. All we consider is
whether the toothpaste does the job. Why should we care in pension

If I can deliver an extra 1 or 2 % over market with an all in
total pension asset management cost of 30 bps my clients should be well
served, and that is the only criterion that should matter.

it seems that doing so will get you vilified by all sides: you make
more than the Prime Minister (so the public thinks you are overpaid),
and you cut into the external manager industry income.

he added :

We have been arguing over comp since Plato.

As I recall
he thought philosopher kings were the most deserving. I am not sure
what the right answer is.

However, there is a market for
talent out there, and it works reasonably well. I have to compete with
what external managers pay as well as what the public plans pay.

Like it or not, comp systems have to hold on
to people in bad times and good. There will always be some optionality

The comparisons at any point in time are not
always very easy.

Benchmarks are one issue.

Maturity of
portfolios (J-curve effects) can be important.

Legacy portfolios
when you have a new manager coming in.

All these things average
out over longer periods.

smell test is net investment cost in bps. For a 60-100 billion fund
that should be in the 30-40 bps range. Bonuses usually are a very small
part of that.

I have financed all the corporate remedial
investment in operations and investment out of a 40 million cut in fees
so far.

Yet the argument has not been over fees or net costs
but over whether I should be paid more or less than a mediocre hockey
player. If I sound cynical it is because I have become so.

We need more focus on the forest, less on
individual trees.

The comments above come
from one of the wisest people in the pension industry. He is absolutely
right to say that too much focus goes on internal compensation and not
on external fees.

At the end of the day, what counts is returns net of all fees. If you can
bring assets internally, deliver alpha and cut a huge chunk of external
manager fees, then all power to you. Moreover, if you're adding value
over a long period using appropriate benchmarks in all asset classes,
then you deserve to be paid for this added value.

What gets under
my skin is when I see pension fund managers getting paid big bonuses
for what is essentially leveraged beta. The leverage can come internally
through alpha strategies using derivatives or externally through hedge
fund or private equity funds taking huge leveraged bets on markets. It
doesn't matter where it comes from - at the end of the day leveraged
beta is beta, not alpha, and we shouldn't pay big bonuses for it. Quite
simply, benchmarks must reflect the risks taken in each investment

As far as costs are concerned, the senior pension fund
manager is right, the smell test is investment cost in basis points. All
public funds should report these costs clearly in their annual reports.

take the time to read David Einhorn's op-ed article in the NYT, Easy
Money, Hard Truths
. Some have criticized Mr. Einhorn for "blatant
gold book talking
", but he makes several important observations and
asks a very simple question:

At what level of
government debt and future commitments does government default go from
being unthinkable to inevitable, and how does our government think
about that risk?

As Congress
weighs a pension bailout
, I fear that they're past the point of
thinking about that risk. In my mind, it's crystal clear. Financial
oligarchs and their political puppets are doing everything in their
power to reflate risk assets hoping that it will translate into moderate
(or severe) inflation for the economic system. Their biggest fear is
debt deflation, and if their gambles don't work, they're going to get
get it sooner than they think.

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Miles Kendig's picture

Keep at it Leo.  Sooner or later folks are going to have to actually listen to the actuaries, especially those that work the health care side of the house here in the US.  Fact remains that the oligarchs see these pension and health care funds as a great leverable, depletable via government guarantee resource.  An invaluable resource to stabilize their balance sheets and pump compensation.  Soon folks will wake up to the realization that all pensions will be milked dry in the pursuit of these so called predators to afford the oligarchs the lifestyle they believe themselves entitled to.  What a bunch of friggin' welfare queens.  Calling these folks predators is simply unbearable, calling them punks would be a disservice to all of the honest, hard working punks in penitentiaries all over the world.

exportbank's picture

Leo, you're bringing part of the overall pension problem to light. I fall into the category that asks "why do we even need these guys?" There isn't a fund anywhere that if it had to cash out would show a true life-time return better than if the money had been put into a Certificate of Deposit. This chasing for yield when you're trying with billions, is a fools game and only works in a ponzi system. The Canadian plans have liabilities in Canadian dollars yet they chase around the world buying crap real estate while getting whipsawed in various currencies. I'm all for guys making big bucks but only if it's their own money they're bringing to the crap table. 

Sudden Debt's picture

It looks like the GOM is really turning into one big chocolat factory!

Can't wait to buy into the IPO when they launch it!


Sudden Debt's picture

And for all you fuckers trying to cash in on my Idea, I just trademarketed the name "GOM CHOCOLAT"!



Dirtt's picture

These union leader treasons should be dealt with accordingly.  The power grab by them is astonishing.  The USA better be drawing the line in the sand right now.

RockyRacoon's picture

Complex systems will crash.  This is all about fine tuning a broken radio -- it does not work!

Matto's picture


The demographics just arent in favour of the continuation of a system built up during the babyboomers highest earnings and productivity periods.

Mercury's picture

We need more focus on the forest, less on individual trees.

Yeah, like why the hell are taxpayer obligations being gambled on anything but the lowest risk assets in the first place?  When the gamble doesn't work out the government pensioners don't take the hit to the wallet...the taxpayers do.  This isn't a replay of the Harvard endowment fee dispute - take your fancy compensation formula and stick it. This is my money we're talking about here. You're fired! If public employees can't retire on savings socked away in Treasuries than we can't afford the public employees or there are too many of them or both.

It's too late and it's all going to collapse anyway - Einhorn isn't really posing a "what-if" question.  And the first phase will be state and muni pension defaults which the Feds will "bailout" in return for de facto control over state and local government itself (no it won't be free).

Matto's picture

"Their biggest fear is debt deflation, and if their gambles don't work, they're going to get get it sooner than they think."


it is inevitable. Inflation in the sense of orderly price increases are not possible from here as printing money only impacts one small part of the overall equation, and they do not control the whole equation. The only thing they'll succeed in is eventual and total debasement of their currency which, i believe, is different to inflation.

Crime of the Century's picture

total debasement of their currency which, i believe, is different to inflation.

Indeed - hyperinflation is to inflation as the Super Bowl is to bowling. Different animal...