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
thing.

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.

If
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
insignificant.

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.

My
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
management.

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.

But
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.

And
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
involved.

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.

The
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
activity.

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.

Finally,
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.