Wednesday, December 30, 2015

Hedge Funds are More and More like Mutual Funds

Hedge Funds are More and More like Mutual Funds

Some of the best-known hedge funds are going to report dismal numbers in the coming weeks.  According to The New York Times[1], David Einhorn, the founder of Greenlight Capital, and William A. Ackman the founder of Pershing Square Capital Management, are two prominent managers who will face disappointed investors.  Reading The Times coverage and other articles, I am reminded about how much hedge funds have become an ultra-high priced version of mutual funds.  Back in the 80s and 90s a series of value and growth portfolio managers developed stellar track records.  Retail money poured into their funds, and institutions clamored for their services.  After a while, these “great” managers had attracted too much capital, and their performance faltered.  Good luck was replaced by bad luck.

As The Times reports, “Pressure from investors to perform better will be intense for hedge fund managers heading into 2016.”  Setting aside the poor construction of this sentence, Alexandra Stephenson and Matthew Goldstein capture the irrational reaction of investors.    Does anyone think that Einhorn, Ackman, and their respective investment teams weren’t working very hard to find profitable investments in 2015?  Does anyone think that these hedge fund managers will do better in 2016 because their investors are breathing down their backs?  Putting pressure on money managers to perform better may make investors feel better, but it is a waste of time.  If Einhorn and Ackman are luckier in 2016, their returns will improve.  Mutual fund investors have been making the same irrational demands on their portfolio managers for decades.

The article chronicles another common investment problem that has also plagued mutual funds for years:

Hedge funds were hurt, in part, because they piled into many of the same companies — often known as “hedge fund hotels” because of their popularity among hedge fund managers — that suffered sharp declines in shares later in the year. Among them were SunEdison, Williams Companies, Cheniere Energy and Valeant Pharmaceuticals International, which drew negative publicity for steep increases in some drug prices.

When hedge funds began marketing to institutional investors about 15 years ago, they critiqued conventional money managers for piling into the same stocks.   Hedge funds touted their ability to find unique investments that were outside the mainstream.  Today, hedge funds have become too mainstream, and their investment strategies are suffering from the same deficiencies that have plagued mutual funds.  In order to allocate all the money coursing through hedge funds, portfolio managers have to chase the same companies.

In the end hedge funds aren’t much difference from mutual funds.  They promise investors big rewards and deliver disappointment.  However, there’s one big difference: hedge funds charge a lot more for the privilege of being disappointed.


Thursday, December 24, 2015

The Big Short Falls Short

The Big Short Falls Short

After you’ve seen The Force Awakens for the second or third time you might be in the mood to watch The Big Short, the movie adaption of Michael Lewis’s book.  This post is not meant as a movie review, and there’s a very good chance that I’m not going to see The Big Short.  However, I have read the book, and I expect that the movie will tell the story as well as Mr. Lewis constructed it in his book.  Even if the movie is true to the book, the book is not a serious explanation of the financial crisis or the housing bubble. I’m sure you’ll get caught up in the detective work of the hedge fund managers who figured out that Wall Street was manufacturing fraudulent products.  It’s likely you’ll feel a bit of admiration for the hedge fund managers as they put down their bets (selling short) and wait for the housing market to crash.  However, the protagonists in the movie/book aren’t heroes, and they didn’t do anything to prevent the crisis or staunch the losses when the market crashed.  They just cashed in when the housing market collapsed.

Investors who short are selling securities they don’t own in the expectation that they will be able to buy those securities at a lower price.  They aren’t better investors than conventional money managers. Instead of seeking investments that are likely to go up in price, they are looking for securities that are prone to fall in price.  Sometimes short investors get it right and generate handsome profits, and sometimes they get it wrong and lose a lot of money.  And like your average money manager, the difference between those that make money and those that lose money is usually determined by pure chance.

Contrary to the central contention of the movie, the protagonists weren’t the only ones who thought that housing and mortgage securities were vastly overvalued.  Many investors, economists, and regulators believed that a housing bubble had formed.  Unfortunately, the tactics of Wall Street and the insatiable appetite of all too many investors for yield kept the bubble inflated.

The movie will leave you a strong feeling that the protagonists are heroes.  Investors, long or short, aren’t heroes.  They aren’t moral or immoral.  They are just making bets, hopefully informed bets, about the direction of security prices.  As I’ve written many times before, investing is an amoral exercise.  When we turn portfolio managers into heroes, we’re distorting their role and exaggerating their power, whether they buy or sell stocks, bonds, or derivatives.  Hero worship in the financial sector is a dangerous practice as it leads to excess, gross inequality, and severely distorted public policy.

Adam McKay and Charles Randolph, who wrote the screenplay, deserve great credit for turning money management into viewable entertainment.  However, The Big Short tells a story that has little to do with the sources of or resolution of the greatest financial disaster since the Great Depression.

Wednesday, December 23, 2015

Christmas 2015

Christmas 2015 (12" x 18") Watercolor
for my granddaughters

Wednesday, December 16, 2015

3-D Yule Season Installation (2015) watercolor

This 3-D project consists of a church, house, floorscape and landscape

Entire Installation - 2 

Set up with floorscape (12" x 18") - 1 
Landscape 18" 24"  (2015) Watercolor
Entire Installation - 1

Buildings with Floorscape -1 12" x 18" (2015) Watercolor
Front and back of church 5" x 9 1/2" (2015) Watercolor

Buildings with Floorscape -2 12" x 18" (2015) Watercolor
Front and back of church 5" x 9 1/2" (2015) Watercolor

Sides of church 6" x 8" (2015) Watercolor
House 3" x 3" x 5 1/4" (2015) Watercolor

Saturday, December 12, 2015

Reposting an N&O Column on High Yield

Stress is building up in the high yield portion of the bond market.  Third Avenue Focused Credit, a mutual fund, is shutting down as a result of declining prices and investor redemption.  About nine months ago i published a column in the N&O explaining the risks.

Friday, December 11, 2015

A well argued essay on CalPERS's view of risk in Private Equity

A well argued essay on CalPERS on Bloomberg News

Yves Smith of Naked Capitalism makes strong arguments about CalPERS's failure to properly address and measure risk in private equity.

Doing the Work of the Private Equity Industry: The Times Deal Professor

Doing the Work of the Private Equity Industry:  The Times Deal Professor

Yet again, there’s a financial item that requires me to put down my pens and brushes.  Steven Davidoff Solomon, “the Deal Professor” in The New York Times, published a column entitled, “Private Equity Fees Are Sky-High, Yes, but Look at Those Returns.”[1]  Mr. Solomon makes the case that private equity is a worthwhile investment despite the high fees.  He cites the entirely obvious and expected fact that the returns of private equity beat the returns for publicly traded stocks over lengthy periods of time.  Although he concedes that the fees are indeed large and partially obscured, he concludes that the fees are a secondary matter because the overall returns are all that really matter in the end.  While a small investment in private equity can certainly add to an investor’s overall return, the average investor would be best served by ignoring Mr. Solomon’s column.

Unlike public stock or bond funds, private equity funds are not normally distributed.  This means that the average fund doesn’t produce the average return for the asset class.  It turns out that top quartile PE managers pull up the overall average.  Thus investors face two big problems.  As Mr. Solomon points out, they have to gain access (be allowed to invest), and they have to hope that the fund will perform.  Mr. Solomon doesn’t discuss this latter point.  It’s easy to identify top performing funds with the benefit of hindsight.  It’s very difficult to identify top quartile funds before they’ve invested any money.

As evidence for the attractiveness of PE, Mr. Solomon cites Yale’s endowment and CalPERS.  This is like citing Warren Buffet as the reason for investing in common stocks or a big winner at a casino as a reason to gamble.   The average investor isn’t going to achieve Mr. Buffet’s success and is best off following Mr. Buffet’s advice to index his equity investments.  Yale and CalPERS have sound long-term PE records.  However, they began investing in a period when the industry was neither large nor institutionalized, and they enjoyed spectacular returns decades ago.  The average endowment and public fund has not had this degree of success.

Mr. Solomon also cites the long-term record of KKR and Apollo.  Again, he’s correct that both firms have strong long-term track records. However, he fails to point out that these records are based on some huge early successes and very variable results thereafter.  For example, if you invested in Apollo V in 2001, you enjoyed a 44% return, but if you selected Apollo VI in 2006, your return was only 10%.  KKR has a similarly variable record.  Most importantly, the average firm hasn’t come close to these results.  Nonetheless, Mr. Solomon characterizes, PE returns as having “steady return potential.”  Any investor who makes a commitment to PE based on steady returns doesn’t understand the risk and shouldn’t have any exposure whatsoever.

While Mr. Solomon acknowledges that the fees are high and that investors need to pay some attention to them.  However, he doesn’t give the question of fees nearly the attention that it deserves.  Unlike mutual funds, PE fees calculations are complicated and hidden.  Moreover, the GP has control and discretion over the calculation.  Although an accounting firm audits the fund, there’s still plenty of room for the manager to enhance his return at the expense of the investor.  Even with the recent addition of SEC oversight (which mainly concerns proper legal disclosure), there’s still a need for investors to closely monitor fees.

Mr. Solomon surmises that CalPERs has done a pretty good job of negotiating fees because their carried interest is only 12% rather than the customary 20% of profits.  Mr. Solomon forgets that many funds do not pay out carried interest because they fail to earn a sufficiently high return, while some funds charge less than 15%.  Thus, the fact that CalPERS has paid out 12% of profits doesn’t tell us much about their negotiating prowess.

As a whole, private equity can and should beat public stocks, much as emerging market or small cap stocks should return more than large cap stocks in the long run.  Thus, PE can play some role in a diversified investment portfolio.  However when PE or any asset class is seen as a panacea for what ails investors, it tends to be overused and then winds up being a disappointment.  Unfortunately, Mr. Solomon’s column does nothing to enlighten investors and does much to broadcast the talking points of the private equity industry.


Monday, December 7, 2015

From “Leading the Way” to “Losing its Way”: CalPERS

From “Leading the Way” to “Losing its Way”: CalPERS

In recent weeks, I’ve incorporated charts and graphs from money management firms into my paintings.  While creating these works, I’ve been listening to recent committee meetings conducted at CalPERS.  I suppose it’s a way of connecting my former professional life with my art.  I’m listening to these sessions and perusing some of meeting materials because the nation’s largest pension plan is completing a sad transformation from “leading the way” to “losing its way.”  

As I’ve written before, I frequently called upon the senior staff at CalPERS when I ran the North Carolina pension plan in the early 2000s.  They were the leaders in formulating investment policies, hiring capable staff, and exploring new investment opportunities.  As they shared their experience and expertise, more than one investment professional warned me not to go too far in borrowing from the CalPERS’ model.  They cautioned that a portfolio could become too complicated, the range policies and procedures could become too detailed and cumbersome, and the staff and consulting relations could become too numerous.

Thanks to the tireless efforts of Naked Capitalism[1] and those lengthy videos of CalPERS meetings, I’m seeing a troubling picture of a public pension that has lost its way.  Like all too many states and municipalities, California made promises to its employees and retirees without providing adequate funding.  Instead they relied on unrealistic capital market assumptions and unrealistic promises from their money managers and consultants.  CalPERS was supposed to be the public pension plan that was too sophisticated to fall into this trap.  While the staff and board at CalPERS acknowledge the challenges, they’re doing little to address any of their shortcomings.  In fact, they’ve decided to do more of the very things that won’t work.

On the investment front, CalPERS has reaffirmed its commitment to private equity as its main strategy for meeting or exceeding its investment assumption.  As Naked Capitalism has detailed in a series of posts, CalPERS conducted a lengthy private equity workshop for its investment committee.  While the workshop was billed as an effort to better educate the committee, it was really a multifaceted effort to justify CalPERS’ commitment to private equity.

Meanwhile the finance and administration committee has tacitly acknowledged that the pension’s investment assumption is unrealistic by adopting a formula to lower the assumption in years when the capital markets are ebullient.  For example, if the CalPERS portfolio earns 4% more than its 7.5% assumption in any given year, the future assumption would be reduced by .05%.   If the portfolio beats its assumption by 7%, the assumption would drop by 0.10%.[2]  The idea is to use some of the “surplus” to fund a move toward a more realistic investment assumption.  Unfortunately, excess performance in a given year isn’t a surplus; it’s just a random result that will be followed at some point by performance that falls short of the assumption.  CalPERS is adopting this policy because they know that their portfolio (even with its unwavering commitment to private equity) can’t earn 7.5%, and because they know that state and local government are either unwilling or unable to increase the contribution required to meet the obligation to the beneficiaries.

To be clear, CalPERS faces a daunting challenge.  When a pension plan becomes underfunded, the way forward is intimidating.  The current board and professional staff didn’t create the central problem (liabilities significantly greater than assets).  This problem has been building for more than a decade.  However, they’re doing a poor job of confronting and addressing the problem.

Within the hours and hours of committee meeting videos, I’ve seen all sorts of troubling signs.  For example, the governance committee is grappling with potential new policies to limit inquiries by board members and prevent board members from using the public records law to obtain documents when they aren’t furnished in the normal course of business.  When I was CIO I didn’t particularly like pointed questions and public records requests.  No one enjoys having their recommendations questioned or producing reams of documents.  However, I recognized that tough questions and inquiries were a necessary part of the process.  Instead of stifling inquiries, the professional staff at CalPERS needs to grow a thicker skin. 

At the governance committee meeting, the members also considered reducing the number of board meetings.  I think this is a sensible step, except for one big problem:  the professional staff hasn’t earned the trust requisite to reducing the frequency of meetings.  There’s little doubt in my mind that CalPERS’s board and committee meetings are too long and too frequent.  Moreover, many of the presentations are mind-numbing expositions on overly ornate procedures, well-worn platitudes, and unrealistic promises. 

At the most recent governance committee and investment committee meetings, the trustees heard from CalPERS’s outside fiduciary counsel.  Naked Capitalism[3] and others[4] have documented that the pension plan’s fiduciary counsel, Robert Klausner, has a history that does not inspire confidence in his opinions.  I am also troubled by the fact that the fiduciary counsel doesn’t report directly and exclusively to the trustees.  Instead Mr. Klausner’s practice appears to be yet another consultancy constructed on conflicts of interest, spending too much time mediating potential rifts between the staff and board.

When pension plans, or for that matter any organization, face big challenges its board needs to be very active.  At CalPERS, we have a lot of video evidence that only one trustee is asking probing questions and that the staff and governance committee would like to limit his inquiries.    In my view, all of the trustees should be asking tough and probing questions.  The board and committee meetings should be interactive and at times even raucous.    After all they’re facing tough problems.  Moreover, the trustees should have an independent and unbiased fiduciary counsel who exclusively advises them on their role as fiduciaries.

I doubt CalPERS will change because they’ve lost their way.