Friday, June 21, 2013

Great article from the WSJ: Pension Fund Takes Neighborly Advice

Michael Corkery and Kirsten Grind, reporters for The Wall Street Journal, have captured many of the themes of this blog in an article entitled, "Pension Fund Takes Neighborly Advice."  It seems Montgomery, Pennsylvania has adopted the sage advice of John Bogel and indexed their pension assets.  While on my hiatus, I thought this was well worth recommending.

Banff National Park

Tuesday, June 18, 2013

Taking a Break Until July 2 -- Unless There's Major News

Purging: New Jersey Sells Real Estate Partnerships

Purging:  New Jersey Sells Real Estate Partnerships

When public pension plans or endowments sell limited partnerships in their alternative portfolios, they generally don’t want to talk about it because something went wrong.  The most recent example comes from New Jersey where the public employee pension is selling $925 million worth of real estate partnerships to Northstar Realty Financial Group and Goldman Sachs Asset Management.  This transaction would have occurred without any fanfare, except that Northstar has to make public filings with the SEC.
Annuities (1999)
Despite making detailed asset allocation studies and trying to model alternative investments, institutional investors have a habit of overeating when it comes to alternatives.  Whether it’s private equity, real estate, or hedge funds, they often times make excessive commitments and then find themselves with a case of alternative indigestion.  So while one segment of the money management industry is eager to offer rich diets of alternative investments, another segment has sprung up to purge institutional investors of their excesses.

As CIO of North Carolina, I invested in several secondary funds specializing in buying unwanted limited partnerships from pensions, endowments, and banks.   The most successful managers in this area have to have a bit of vulture in their investment DNA.  Typically, the investor is desperate to and embarrassed about unloading a block of alternatives.  The secondary manager is keen to exploit these weaknesses.

According to The Wall Street Journal New Jersey’s CIO, Tim Walsh, is pleased with the bids they received, and noted that the pension will receive the full net asset value of the real estate partnerships.[1]  As far as I am concerned, Mr. Walsh is putting the best light on a bad situation.  It turns out that $925 million is a relatively big mistake, because the pension plan’s total exposure to real estate was about $3.2 billion.  In other words, they are selling 28% of their real estate exposure.[2] 

You have to do a bit of digging to find this out, because the details are only contained in the Treasurer’s Annual Report for 2012.  Moreover, the investment performance of real estate is rolled up into a category called the “alternative investments segments” and the allocation is categorized under something called “real returns.”[3]  The New Jersey Treasurer’s website obscures their asset allocation in categories such as global growth, income, risk mitigation, real return, and liquidity.[4]  These categories are part of trend among institutional investors to provide a level of transparency without making meaningful disclosure.  In any event, New Jersey’s real estate exposure is contained in the real return category.

In looking at Northstar’s SEC filing, we learn that New Jersey isn’t getting $925 million, at least not immediately.  Rather they’ll receive $510 million when the deal closes, and the remainder over the next four years.[5]  However, the structure of the deal allows New Jersey to claim that they got full value.  Even that claim is hollow, because the real estate assets will throw off much more cash flow than $925 million.  Northstar and Goldman Sachs will walk away with a tidy profit.  In fact, the SEC filing reveals that the Northstar/Goldman combination only expects to have to call $60 million from its investors to make this transaction work. 

We don’t know why New Jersey was forced to sell its real estate positions.  My guess is that they needed the cash to fund commitments in other areas.  New Jersey has been busy building up its hedge fund and private equity portfolios, and probably required the proceeds from the real estate partnerships to meet those new obligations.  It’s possible that New Jersey didn’t think the real estate investments were worth holding.  Unfortunately, New Jersey’s annual report doesn’t disclose the names of their real estate managers, so we can’t evaluate the holdings.  However, I suspect most of these partnerships were in descent shape given the level of interest in this transaction.

When institutional investors enter into secondary transactions in order to sell positions, they’re hoping that no one is paying attention.  If the news gets out, they’ll try to put a happy face on a bad situation.  I wish they’d just be honest and admit that they screwed up.

Monday, June 17, 2013

Asset Allocation: The Largest Determinant of Returns, But Don’t Pay for Advice

Asset Allocation: The Largest Determinant of Returns, But Don’t Pay for Advice

The largest determinant of your investment returns comes from asset allocation: how much you put into stocks, bonds, and other assets.  Everything else, such as securities or manager selection, pales in comparison.  And on average, active manager selection actually detracts from returns.  For decades managers have been trying to figure out how to get paid for advising their clients about asset allocation.  As far as I can tell, managers don’t add value in the asset allocation process and most are not held accountable.

The manager’s thinking goes as follows.  If asset allocation is the most important investment decision, and money managers provide the service, then they should be able to earn an extra fee.  Typically, investors have resisted paying extra, and as we shall see, that is a good thing.  However, some managers have managed to bundle asset allocation into their service offering.  For the wealthier investor, asset allocation is thrown in as part of a flat fee, say 1%, that’s meant to include money management services and financial planning.  For the average retail investor, asset allocation can be imbedded in fund-of-mutual fund products (collections of mutual funds), for which the manager can collect an extra fee.
Reserving Capital (2010)
While asset allocation is pivotal to the returns you can expect to generate and the amount of risk you are likely to incur, there’s little evidence that money managers add any value.  Typically, money management firms have committees that ponder the proportion of capital that should be allocated to a wide variety of asset classes and sub-asset classes (e.g., growth or value equities, large or small cap stocks, corporate or high yield bonds).  They also have “proprietary” investment models that provide quantitative rationales for allocating capital.  Wild guesses tend to look predictive when they are carried out to a couple of decimal places in a spreadsheet.  Some of my most fruitful drawings came while listening to an impassioned discussion of the relative merits of allocating 5% or 10% to the emerging markets, or decreasing the weight in mortgage-backed securities.  

Believe it or not, the arguments can become quite heated as portfolio managers marshal a few well-chosen factoids along with strong opinions about the future direction of the various asset classes.  The problem, of course, is no one knows what’s going to happen in the future, so most of the tactical changes in asset allocations are merely guesses.  On some occasions, the changes are merely calculated business decisions because the managers can make more money putting clients into certain products.  There’s nothing better than the rarified air of an asset allocation discussion to hide the real business objective of steering more money into hedge funds or private equity.

So what’s an investor to do?  The balanced approach is the consensus asset allocation consisting of 60% stocks and 40% bonds.  If you are young or aggressive, you want to push your equity allocation toward 80%.  If you are old or conservative, you probably sleep better with 40% or less of your assets tied up in stocks.  Within stocks and bonds, you might divide things up into a few categories.  In equities you need to have most of your exposure to domestic, large cap stocks.  However, international and small company stocks deserve some representation.  In bonds, you want to vary the maturities a bit, and create exposure across different sectors of credit.  Generally speaking, you don’t want to mess with your asset allocation more than once a decade, unless there’s a big change in your life.  If your broker or financial advisor shows you a proposed allocation that is chopped into 15 or 20 small pieces, or advises you to allocate money in 2% or 3% increments (e.g., putting 2% in small cap value stocks), tell him or her to start over with a simpler plan or find someone else to advise you. 

In any event, try not to pay for the advice.  While asset allocation is critical to your future returns, there’s little evidence that complicated asset allocation processes or models do anything, except attempt to justify fees.  As in most matters of money management, simple is best.

Friday, June 14, 2013

Succession at Goldman Sachs: The Wealthy Games

Succession at Goldman Sachs: The Wealthy Games

Gary Cohn, the President and COO of Goldman Sachs, has probably been receiving sympathetic calls ever since The New York Times ran a front page story[1] detailing Mr. Cohn’s increasing frustrations because his rightful role as Chairman and CEO is blocked.  According to the Times, Lloyd Blankenship, age 58, has no plan to retire any time soon, and:

“It is no laughing matter for Mr. Cohn, who as Goldman’s 52-year-old president is the Prince Charles of Wall Street, a man for whom the crown seems just beyond his grasp. Mr. Cohn is growing increasingly restless, according to friends and colleagues.”

This matter is hardly worthy of a front-page story, except that it’s about two incredibly rich guys whose friendship is beginning to fray because of power and greed.  Mr. Cohn followed Mr. Blankfein out of Goldman’s commodities business into broader and broader roles until they ruled Goldman Sachs.  After a few years of coexistence, the story line followed the usual path.   Every decade or so, we get this article about Goldman Sachs. If the number two guy doesn’t get the top job soon, he’s going to leave, putting the firm in jeopardy.  Some people leave, some people stay, and Goldman goes on making money.
Investment Meeting (1996)
I’ve constructed a Tale of the Tape, so you can examine Mr. Cohn’s financial grievances.  I don’t have data before 2006 because Mr. Cohn had not yet assumed his position as COO.  At that point he was merely head of Fixed Income, Currency and Commodities, and making untold tens of million of dollars.  Thus, we don’t have a complete picture of Mr. Cohn’s financial shortfall relative to Mr. Blankfein.  Nonetheless, we can see that Mr. Cohn trails Mr. Blankfein by over $12 million in total compensation over the past seven years, and more significantly, Mr. Cohn only owns about $289 million worth of Goldman stock versus Mr. Blankfein’s $507 million stake.

As senior executives, both gentlemen are entitled to invest in Goldman Sachs PE, real estate, and hedge funds.  Unlike regular clients, the executives enjoy significant breaks on the fees.  While we don’t know how much Mr. Blankfein or Mr. Cohn invested in these offerings, the proxy statements show that they received $126 million and $93 million respectively in distributions from those investments. Again, Mr. Cohn trails.

Perhaps it's the small things that are irking Mr. Cohn.  Since 2006, Mr. Blankfein has received $1 million more in “other compensation.”  As far as I can tell, they’ve received about the same amount of benefits, such as their 401(K)s, medical and dental plans (they have a special plan for the management team), executive life insurance, tax consulting, and car allowances.  Mr. Blankfein receives security protection, which appears to account for much of the difference.  The company also discloses the amount of money it donates to charity on behalf of its senior executives.  In the past three years, Goldman has donated $12.4 million on behalf of Mr. Blankfein and $12.0 million to Mr. Cohn’s causes.  It’s clear that Mr. Cohn deserves the chairmanship so he can finally reap the rewards.

I know it’s hard for mere mortals to comprehend all these figures and the growing tension between these two men.  However, let’s put this story into terms we can all understand.  Over the past seven years, Mr. Blankfein has earned an average of about $9,200 per hour, while Mr. Cohn has brought in $8,600 per hour.[2]  By contrast, the average private sector American receives total compensation of $28.89 per hour according to the US Department of Labor.   It takes Mr. Blankfein just one day to earn what the average American makes in a year, while Mr. Cohn has to put in a bit of overtime.

As the days and months go by, the succession struggle at Goldman Sachs will consume more and more time, and yet the CEO and COO will continue to get their fabulous pay packages.  If you were to spend your time plotting to keep your job or figuring out how to replace your boss, the way executives scheme on Wall Street, you’d probably be fired.  However, Wall Street plays by a different set of rules, and The New York Times seems fascinated by their excesses.

[2] I’m assuming they only take two weeks vacation and work 60 hours per week.  If they take more vacation or leave early for the Hamptons, the hourly rate would be higher.

Thursday, June 13, 2013

The Kind of Insider Trading We Don’t Need to Worry About

The Kind of Insider Trading We Don’t Need to Worry About

Here’s the recipe for the type of insider trading that’s not a concern for the long-term wellbeing of the financial markets.

1                   1.  Set up new account shortly before the event that’s going to make you a lot of money.
2                   2.  Only trade in the stock, options, or futures of the company that you have information on.
3                   3.  Take positions that would put you at enormous risk of losing all your money but for the              fact you have inside information.

The first two steps are self-explanatory.  If out of the blue, you suddenly decide to open a brokerage account days before a merger, product announcement, bad earnings report, or another stock-moving event, that’s got to be taken as a bit unusual.  Then if you don’t buy and sell a bunch of different securities, but only trade in the company that’s got important news pending, that’s even more peculiar.

Incentive Plan (1995)
The third step is the clincher.  It would be one thing just to buy a few shares.  Let’s face it, anyone could have a hunch about a company and decide to make a small wager.  When you’ve got inside information, you’re not acting on a gut feeling.  As result, you’ll likely make a bet that has a big pay-off and appears to be very risky.

For example, you might borrow money, known as a margin loan, so you can buy much more stock than the amount of cash you transfer into the account.  Better yet, you could buy a deeply out-of-the money call option with a short-expiration date.  What does this mean? 

Suppose you had an inkling that a certain pork processor was going to be taken over.  And suppose the stock was trading at about $25 per share.  An option to purchase the stock $30 per share within the next two months would be selling for only cents on the dollar.  The option gives you the right, but not the obligation, to purchase the stock at a set price over a specific period of time.

In the absence of some big event, such as a Chinese company offering to buy the pork producer, the odds of the stock jumping 20% in two months or less are pretty low.  Thus, the price of buying the call option is low.  What happens when the pork produce receives an offer at $34 per share.  Suddenly those options are worth close to $4 per option.  In other words, you bought something for pennies a few days ago. Now it’s worth hundreds of times more.  Of course, if the deal hadn’t occurred, you would have lost all your money when the option expired (the cost of buying the options).

Instead of using options, you might have decided to buy futures.  A futures contract obligates the purchaser to buy stock at a specified price at a date in the future.  The beauty of the futures contract is that you don’t have to plunk your money down right now.  However, you have to put down a deposit of 20%.  Normally this would be a pretty risky trade, but if you know that the pork producer is going to be acquired for $34, you’d be very interested in buying lots of futures contracts to buy stock at $30 per share.  A quick four-dollar profit with only 20% down produces a great return.

The SEC caught Badin Rungruangnavarat, a Thai citizen, using this recipe in the Smithfield Foods takeover by Shuanghui International.  According to the New York Times, he made 3300% for his efforts.[1]  His ill-gotten gains have been frozen.

While Mr. Badin’s case makes great headlines, it is not the kind of insider trading that threatens the integrity of the stock market.  Blatant stupidity is easy to ferret out and prosecute.  Rather, the more damaging form of insider trading is the subtle and sophisticated form practiced by some hedge funds and proprietary traders.  Armed with lawyers, analysts, complicated analytic systems, and complex legal structures, this type of insider trading is much harder to detect and prove.  The whole idea is to obscure all three steps of the recipe, so that the trade looks like it was place in the normal course of business.

There’s no doubt that long-term investors lose when traders act on inside information.  Unfortunately, some of recipes for insider trading don’t readily reveal their ingredients.