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Will Pensions Follow Harvard's Mea Culpa?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
BusinessWeek reports that Harvard Endowment Corrects Course With Return to the Past:
One of the first rules of PR damage control is get control of your message. After being battered by months of bad, really BAD press, Harvard University seems to have had enough of anonymously-sourced, semi-accurate attacks on its investing strategies. Jane Mendillo, who’s run Harvard’s slightly-less-massive endowment fund since July 2008, is on-the-record today in The Wall Street Journal, Bloomberg and probably a few other places I haven’t seen yet (feel free to call them out in the comments, please).
The popular critique of Harvard begins with accusing the endowment of taking too much risk by investing too much with illiquid hedge and private equity funds and usually winds up with sordid tales of egomaniacal leadership gone astray. And it’s not completely off-base. The fund, after decades of amazing returns, fell to earth with a loss of about 30% for the university’s fiscal year which ended in June.
But strangely blameless in these critiques are the members of the Harvard community who spent years complaining that the fund’s managers were paid too much and that the fund wasn’t contributing enough to the university’s annual budget. As a nearly direct result of those criticisms, many of the top managers (and their fearless leader, Jack Meyer) packed up and left the building. And the amount of cash poured into the university’s annual budget quadrupled to $1.6 billion from 1998 to 2008, far outstripping growth of the endowment fund itself which more than doubled from just under $15 billion to over $36 billion (See this recent letter for the data points). The wave of departures also prompted Harvard to rely more on outside managers, giving the university far less say over risk management, far less access to cash and substantially fatter fees for services.
Now Mendillo is reversing course. She tells the Journal she’ll be keeping more money in-house. The fund recently made some big-splash hires, bringing in investment managers from Fortress Investment Group and Caxton Associates. And she’s re-setting expectations for the Harvard community as well, telling Bloomberg that future returns likely won’t be anywhere near the 14% annual gains for the 10 years before the crash and referencing a target of about 8%.
Interestingly, I didn’t see a real “money” quote from Mendillo about the fund’s woes in either story. Bloomberg’s Gillian Wee cast the story as about Harvard increasing its cash position by an unknown amount. The Journal’s Craig Karmin emphasizes the fund’s efforts to sell some of its illiquid investments and bring more money in-house. “That will allow us to be more nimble,” says Mendillo. But neither piece has much of a mea culpa-type statement (you know, “mistakes were made”). Perhaps that’s a subject Mendillo would best like left in the past.
Mendillo doesn't need to publicly apologize but her actions speak louder than words. The WSJ quoted her as saying "We are looking to have a greater portion of our assets managed internally over the next few years...that will allow us to be more nimble...".
Pension parrots are you paying attention? You all suffered the fate of Harvard's horror and Yale's yardstick as you blindly followed them into illiquid asset classes, pumping billions into private equity, real estate and hedge funds. But you pension parrots aren't half as sharp as Jack Meyers, David Swensen or Jane Mendillo, so you will end up getting creamed on those illiquid investments, selling them to into the secondary market for 50 or even 30 cents on the dollar (if you're lucky).
But pension parrots remain undeterred, blinded by the belief that private markets are the way to go no matter what economic cycle we're in. They want more private equity and more real estate. If things go wrong, they can always change the benchmarks and "presto", they manufacture alpha, even if it is based on bogus benchmarks.
Oh baby! What a great gig being part of the private markets at a large Canadian public pension fund. You get to fly first class all over the world, wine and dine with rich managers who are looking to woo you and then you can game your benchmark to claim that you added "significant value added" at the end of the fiscal year, allowing you to collect a big bonus. No wonder his Pension Eminence, Claude "PE" Lamoureux, the former head of Ontario Teachers', loved private equity. It made him stinking rich.
The poor public market guys and gals can't game their benchmarks because hardly anyone can easily beat the S&P500 or EAFE. I don't blame public market managers for feeling duped. If I were working at a large Canadian public pension fund, I'd love to allocate billions into external private funds, taking virtually no risk whatsoever and changing my benchmark at the first sign of trouble.
Speaking of changing benchmarks, I noticed something else going through PSP Investment's FY2009 annual report. When I took a closer look at their pathetic results, I focused more on how real estate significantly underperformed their Policy Portfolio benchmark, but something else caught my attention today. Look at the FY2009 results by asset class below:
(click on image to enlarge)
You notice how private equity underperformed its benchmark by 70 basis points (-32.3% vs. -31.6%)? I went back to PSP Investments' FY2008 annual report to look at the results which were equally pathetic:
(click on image to enlarge)
I noted the following on page 16:
A significant source of value-added in fiscal year 2008 came from the Real Estate and Private Equity asset classes. Real Estate (included in real return assets) generated a rate of return of 21.9%, surpassing the Policy Benchmark rate of return of 7.6% by 14.3% and was the primary driver of value-added in the Real Return asset class.
Private Equity (included in Equities) generated a rate of return of 10.1%, surpassing the Policy Benchmark rate of return of 3.7% by 6.4%. As a result of the PE team’s careful fund and asset selection, the Private Equity Portfolio has not experienced the negative performance (J curve effect) typically experienced during the early years of such a portfolio.
Equities underperformed the benchmark return primarily due to the underperformance of related public market asset classes in fiscal year 2008, partially offset by the aforementioned private equity outperformance.
So the Policy Benchmark for PSP's Private Equity went went from +3.7% in FY2008 to -31.6% in FY2009? It looks like they changed the benchmark but failed to mention this in the FY2009 annual report. How many times will they change benchmarks in private markets without publicly disclosing it?
What a joke. No wonder public market managers at large Canadian pension funds are fuming. One public market portfolio manager recently told me that he refuses to look at the published salaries in their annual report because his "blood pressure goes up" when he sees how much total compensation the private market fund managers are making beating their "bullshit benchmarks".
And wait, it gets better. Private markets get fiscal advantages that public markets don't have. For example, PSP Investments acquired Telesat for $3.25 billion in October 2007 as well as Revera Inc., which was formerly operated through Retirement Residences Real Estate Investment Trust (RRREIT). These investments pay no corporate tax and they were not marked down. That means that on top of bogus benchmarks, PSP's upper management made big bonuses partly owing to the tax status of these investments.
As shown below, despite those terrible results, PSP's senior private market managers and president reaped big bucks in total compensation in FY2009:
(click on image to enlarge)
[Note: My apologies to public market managers with high blood pressure. You're all in the wrong asset class but don't worry, the tide will change.]
Moving on, the FT reports that Dutch pension scheme turns to hedge funds:
These are difficult times for pension plans around the world; market tribulations in 2008 badly hurt their performance record, leaving many teetering and underfunded. Aggravating the trouble caused by plunging asset values, the steep decline in global interest rates has further escalated their liabilities.
Stichting Pensioenfonds ABP, the Netherlands-based pension sponsor servicing 2.7m Dutch education and government workers, did not avoid the rollercoaster. The plan, third largest in the world after the Japanese and Norwegian state pension funds, with €173bn (£149bn, $245bn) of assets, lost 20 per cent in value in 2008, severely denting its funding ratio and asset base. Liabilities, meanwhile, rose to €193bn from €155bn, triggering an ambitious five-year resuscitation plan. As of June, ABP’s recovery was ahead of schedule. Assets have risen to €180.5bn while liabilities have fallen to €185bn. The coverage ratio now stands at 98 per cent, compared with 90 per cent at the end of 2008.
Part of this recovery is due to increased exposure to hedge funds. Earlier this year, ABP raised its allocation to absolute return strategies by one percentage point even as hedge funds in general were reeling from the fallout of their worst ever year in terms of losses and redemptions. The average hedge fund fell 19 per cent last year and industry assets tumbled to $1,300bn from a June 2008 peak of $1,900bn.
The increased allocation to hedge funds looks like small change for the giant plan, but if it is successful the move could help steer ABP toward recovery. The Absolute Return Strategies division now takes up 6 per cent of its balance sheet, about €10bn. It comprise Amsterdam-based Global Tactical Asset Allocation (GTAA), a directional and liquid portfolio that seeks to exploit short-term market inefficiencies around the world; and New Holland Capital of New York, which invests in external alpha, or excess return-seeking hedge funds.
These strategies, and all the plan’s other portfolios, are managed by APG (All Pensions Group), its asset management and administration arm, voluntarily spun off by ABP in March 2008. ABP remains its sole owner.
Gerlof De Vrij, a managing director of Absolute Return Strategies and fund manager of GTAA, is helping oversee it all. Through GTAA, he oversees internal investments in managed futures and global macro strategies that can span anything from a few weeks to years, and also allocates to an array of external managers.
Thanks to its diversity, GTAA delivered gains in 2008 despite widespread losses in most of ABP’s other asset classes – commodities, equities, private equity and real estate. Fixed income, meanwhile, eked out a small gain. That said, the overall absolute return portfolio, including New Holland Capital’s investments, delivered a loss of 5.6 per cent. This year, GTAA’s performance has been “very good,” says Mr De Vrij.
“Hedge funds as an asset class have shown flexibility in the financial turmoil,” he says. APG is upbeat about this investment category.
“Our optimism stems from the fact that they give high returns with relatively low risk,” he says.
“It was last year’s liquidity scare that made hedge funds correlated to all other asset classes, but that’s not how things work fundamentally.”
The APG absolute return division tries to construct a portfolio with no correlation to bonds, currencies, equities or anything else, says Mr De Vrij. “We aim for absolute return and aren’t looking to benchmark our behaviour with other hedge funds or parts of the market.”
The real diversification comes from the fact that its investments can explore not only the liquid parts of the markets but also the more complex and non-traditional ones and can adapt rapidly to change in the marketplace.
Distressed assets still look attractive even though the peak investment period has passed, he argues. But he cautions that only long-term investors can benefit from illiquid strategies and only those who can stomach illiquidity should wade in.
Distressed or not, investors should view all hedge funds as an illiquid asset class, he says. “If you are going to view this asset class as a liquid one, you’ll use it as an ATM and that’s a mistake. If at the first sign of crisis investors take their money back, it won’t allow managers to exploit the complete market cycle,” says Mr De Vrij, who previously led strategy and research at PGGM Investments, another Dutch pension fund, joining ABP in August 2005.
He disagrees with those who hold hedge funds responsible for causing market upheaval. “Yes, speculators can destabilise markets, but if they were to sit on the sidelines, the total market liquidity will just dry up. In many cases, hedge funds have stabilised financial markets.”
However, some sort of regulatory checks-and-balances are warranted in the future. he feels, as self-policing by managers will be inadequate. The events of 2008 jolted investors’ confidence so deeply that it is unclear how quickly it may return. For now, “I feel the industry stress felt late last year is fading. Redemptions are becoming more manageable even though investors have become more risk averse in general.”
Hedge funds are making a range of attempts to regain investors’ trust. Some funds, especially those in distress, are offering better terms, says Mr De Vrij. Still, hedge funds with strong performance will continue to have the power to ask for unchanged fees even though investors these days clearly have an upper hand in negotiations, he adds.
One common misperception, according to Mr De Vrij, is that hedge funds are a risky asset class. “Hedge fund risks aren’t any different than those present in credit, real estate or other strategies as we saw last year when no single asset class was spared by the market turmoil; the fundamental link between hedge funds and other asset classes was the liquidity scare.”
On the performance side, hedge funds are now doing relatively well and will attract fresh capital if they can sustain the momentum, he predicts. The average hedge fund has returned about 7 per cent this year, according to industry estimates.
The question remains: When will investors return? Mr De Vrij reckons that in spite of the recent erosion of confidence, “quality investors” will find their way back into hedge funds. “The better part of hedge funds will survive,” he says. But they will have to resign themselves to more oversight. “We as investors want to see more transparency, risk reporting and proper due diligence processes. We want better checks and balances.”
Commenting on the noise surrounding various regulatory proposals on hedge funds, Mr De Vrij says “active communication” with rule makers is necessary. Being such a large investor in hedge funds, APG constantly engages the Dutch financial regulator in “an active conversation, to explain nuances of absolute return, how it works, why we’re comfortable with it, what risk-adjusted returns mean,” notes Mr De Vrij.
Mr. de Vrij is a smart guy but he conveniently omits a few things. First of all hedge funds are doing well this year because global equities have rallied sharply since March. It's worth repeating this, most hedge funds charge alpha fees (2% management fee and 20% performance fee) for delivering disguised beta. But he says that ABP invests in hedge funds that are not correlated to the markets.
Second, go back to read my comment on demystifying pension fund benchmarks. In that comment, I noted:
Unfortunately, it's not always possible to find the appropriate benchmarks that fits all pension funds in each of this alternative asset classes, but that is why you need a comprehensive performance audit to make sure they are not gaming their benchmarks to easily beat them. Take hedge funds for example. Some strategies are liquid, others are illiquid, some use leverage, others use no leverage, and so on. Using an absolute return benchmark of T-bills + 500 basis points might seem appropriate, but what if your pension fund manager is investing in highly leveraged illiquid strategies? Up until last year, they would have trounced that benchmark, reaping huge bonuses, but then the music stopped and credit markets seized, effectively killing these strategies. As I discussed before, it's all about the benchmarks stupid! Unless the benchmarks reflect the risks, beta and leverage of the underlying investments, then you simply do not know if the value added your pension fund manager is claiming to add is really that or just a free lunch.
Some pension funds got cute with hedge funds, investing in asset-based lending (ABL) funds, but they got creamed in 2008. The attraction there is that these funds are not correlated to the overall markets, but they carry their own set of risks and the benchmarks must reflect this (I doubt ABL funds will come back as strong as before the crisis hit).
My final thoughts are that Jane Mendillo is right and if pension funds are smart, they will follow suit by lightening up on private equity and by bringing assets internally to develop their absolute return strategies. In the environment we are heading into, don't try to copy what ABP is doing. You're going to end up paying tons of fees for mediocre results and you do not have the skill set of ABP's hedge fund team who along with Ontario Teachers' hedge fund team, is one of the best in the pension industry.
Remember, small is beautiful and staying nimble is critical for making money in these markets. But while Harvard regroups and tacitly admits its mea culpa, most pension parrots will keep repeating the same mistakes, losing billions in the process. They will all learn the hard way.
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Relative performance won't pay the rent and shouldn't pay the mortgage either.
You set the expectation bar for non-profit pension performance way too high. The fact that Harvard wasn't a Madoff scam is remarkable. They only (claim to have)lost 30%, which while probably a lie in a liquidation, is admirable. Compared to the joke that is the U.S. Social Security system, these people ought to be held up as a shining example of what quasi-public employees can achieve.
I think the new regime is doing the prudent thing of returning to more liquid assets. In the end, they just need to hit up their rich alumni more heavily to fulfill their liberal/progressive indoctrination mandate. After all, with such shining examples of brilliance like Barry Soetro and Henry Gates, we need to ensure they have the raw material to help them expand their empire globally.
omething monetarists like to forget), but continuing to prop up failed investments will do nothing but delay
You set the expectation bar for non-profit pension performance way too high. The fact that Harvard wasn't a Madoff scam is remarkable. They only (claim to have)lost 30%, which while probably a lie in a liquidation, is admirable. Compared to the joke that is the U.S. Social Security system, these people ought to be held up as a shining example of what quasi-public employees can achieve.
I think the new regime is doing the prudent thing of returning to more liquid assets. In the end, they just need to hit up their rich alumni more heavily to fulfill their liberal/progressive indoctrination mandate. After all, with such shining examples of brilliance like Barry Soetro and Henry Gates, we need to ensure they have the raw material to help them expand their empire globally.
i agree w/ much of this... but i think illiquid investments do have their place. I dont know why pensions or endowments would do anything but passively manage their equity portfolio's, but there are definitely opportunities in private equity and real estate. the problem is that whats true of those asset classes is true for others, being that they are never ALWAYS a good deal or a sure bet. Smart PE managers and RE managers will be very slow to invest during frothy markets, and be selling portfolio companies and properties into those mkts (blackstone shorted itself to the market at arguably the exact pinnacle). and groups that are terrible at buyouts (Apollo) are very good in distressed-for-control situations (look at what they are doing w/ Charter). Its all about being compensated for the risk you take and some managers are better at patience than others. there is a time and a aplace for collecting illiquidity premium (and paying for it).
but generally i agree that the allocations are too big, and the commitment levels have been poorly managed. do maybe 5 to 10 % of total portfolio in illiquids. thats the point, they are very illiquid, so you have to be very careful w/ them and REALLY not need that money for a full 5 years+.
"I believe that's 70 bps rather than 700 bps. 1 bps = 0.01%. Also, I find your unit conversion (i.e. 0.7% --> 700 bps) not only blatantly wrong, but highly misleading in a feeble attempt to extract outrage from your readers with a larger number in a small unit. If you can't do simple multiplication correctly, you have no business writing about finance."
I made a mistake and you caught it. I thank you for catching it and I edited my comment. But the point is that if they changed the benchmark, the results in private equity (relative to the Policy Portfolio), would have been much, much worse and PSP's total underperformance relative to its Policy Portfolio would have been even worse.
This is the key point that needs to be emphasized. I corrected the mistake and yes, I do know the difference between 700 basis point (7%) and 70 basis points (0.7%). -:)
"You notice how private equity underperformed its benchmark by 700 basis points (-32.3 vs. -31.6)? I went back to PSP Investments' FY2008 annual report to look at the results which were equally pathetic"
I believe that's 70 bps rather than 700 bps. 1 bps = 0.01%. Also, I find your unit conversion (i.e. 0.7% --> 700 bps) not only blatantly wrong, but highly misleading in a feeble attempt to extract outrage from your readers with a larger number in a small unit. If you can't do simple multiplication correctly, you have no business writing about finance.
Yves is that you?
LOL, I was thinking the exact same thing when I first read this comment.
i rated this article a 5 because i think it shows the ineptitude of the money/asset management industry in general. but, as the article also points out it makes the managers stinking rich with 2/20.
the major issue as i see it is "Is even the possibility of a 30% drawdown appropriate for a pension fund, endowment, or family trust?" i say hell no. in order to avoid this much loss, you have to have active and effective risk management/loss control methods.
you can't effectively control loss with illiquid or buy/hold assets. no form of real estate is liquid. in my context here, liquid means easily sold within a day or two to control loss. Harvard and others are heavy into commercial real estate e.g. timberland and office space.
hedging principal, when possible, is very expensive in terms of performance. but how do you hedge hemorrhaging real estate equity anyway? there was a time long, long ago when bankers wouldn't touch real estate for this reason. long, long ago.
pensions/endowments/family trusts, in my opinion, are critical enough to require the best proven non-discretionary objective mechanical trading methods. OR short of that they should be kept in the most liquid safest possible vehicles. if you can't consistently trade profitably, then you have no business managing other peoples money.
remember that increased reward equals increased risk. if you insist on gambling with your own pension then good luck. maybe these links will help you throw away your pension.
the most recent Barron's 100 Hedge Fund article ...
http://online.barrons.com/article/SB124182239611202181.html
the performance table ...
http://online.wsj.com/public/resources/documents/BA_HF100_090511.pdf
a personal anecdote:
Years ago on 1st nuke-powerplant job, co-worker nodded upward and remarked "See those 2 [reactor containment] domes".
"Ugh-huh."
"Well, they are filled with money...and our job is to empty them out!"
Appropos the hired CEO: "minding his business" translates to hollowing-out his employer's business. A good CEO has his employer's skin in the game.
[This from Belaqua Jones, when George was prez]
Dear George from his ardent admirer Belacqua Jones
Madmen and idiots are the lifeblood of corporate imperialism. They give life its color and pizzazz with their belief in infinite growth in a finite world, a doctrine they share with a cancer cell.
Corporatists differ from primitives only in that corporatists mistake a blind momentum driven by ego, greed and stupidity for destiny.
Human sacrifice is more popular today than at any time in history. Only now, the priests wear suits instead of robes
The battlefields of the world are littered with the corpses of those who thought they were fighting ignorant savages.
Let’s talk about the mainstay of American ascendancy, Feral Corporatism. I know folks like to talk about a feral capitalism, but they are missing the point. This is why so many of your critics are shooting blanks. Corporatism stomped capitalism into the ground decades ago. Though the public tends to conflate the two, there is a crucial difference between them: In capitalism, the owners call the shots; in Corporatism, overpaid employees call the shots.
Dogma of “free markets” is sanitized by calling the disasters “structural adjustments.” This is like calling Hiroshima a home renovation project.
Feral Corporatism is the harbinger of freedom. The path to freedom leads through the swamp of impoverishment. The best way to teach a man about free enterprise is to starve him. The starving man is motivated to steal bread and sell the surplus to his neighbors for a tidy profit. In this way, he improves his station by screwing his fellows.
All commerce is grounded in crime. A man achieves success when he is powerful enough to legalize the crimes that brought him to power.
One basic rule of world domination: The only way to defeat a rogue state is to become one; the only way to crush the Axis of Evil is to embrace evil.
American liquidity growth is the global economy. The quality of this growth, however, is low
sleazy linking practices; borderline fraud ..http://www..
hat tip: gay porn and deceitful, slimy operators
Well done Leo this is a good article. Love the Obama image. Cheers.
that image was used unironically by obama supporters during the election, now it kinda rings hollow
That's why it actually made me laugh out loud!