Monday, October 24, 2016

Canada's New Masters of the Universe?

Theresa Tedesco and Barbara Shecter of the National Post report, Inside the risky strategy that made Canada’s biggest pension plans the new ‘masters of the universe’:
They are among the world’s most famous landlords with stakes in major airports in Europe, luxury retailers in New York and transportation hubs in South America. They rank as five of the top 30 global real estate investors, seven of the world’s biggest international infrastructure investors, and were at the table during six of the top 100 leveraged buyouts in corporate history. And they are Canadian.

The country’s eight largest public pension funds, which collectively manage net assets worth more than $1 trillion, have acquired so much heft in the past decade that they are being lauded in international financial circles as the new “masters of the universe.” Their clout has caught the attention of major Wall Street investment firms angling for their business, as well as institutional investors around the world that are emulating their investing model (click on image).

“Canada’s public-sector pension plans are high profile, widely admired and they’re certainly bigger than they used to be,” said Malcolm Hamilton, a pension expert and senior fellow at the C.D. Howe Institute in Toronto.

A veteran Bay Street denizen, who asked not to be named because his firm has business dealings with many of the funds, added: “Asset by asset, around the world by virtue of their investments through ownership or partnership, they are as much economic ambassadors for Canada as anybody.”

But the vaunted positions these pension-plan behemoths have on the world stage is attracting closer scrutiny — and some skepticism — from industry experts at home, including the Bank of Canada, because of the increased levels of risk they are taking and the potential “future vulnerability” many of them have assumed in the pursuit of growth.

“You’re seeing more and more pension funds taking on greater risk in the past 15 years,” said Peter Forsyth, a professor of computational finance specializing in risk at the University of Waterloo in Ontario.

The eight funds, which account for two-thirds of the country’s pension fund assets or 15 per cent of all assets in the Canadian financial system, are acting more like merchant banks in going after — and financing — blockbuster deals in increasingly riskier locations and asset types.

A major reason behind the pension plans’ thirst for less liquid assets, namely real estate, private equity and infrastructure — much of it in foreign places — is the low-interest-environment that has made traditional assets less desirable. Between 2007 and 2015, the big eight public pension funds’ collective allocation to these types of investments grew to 29 per cent from 21 per cent. And foreign assets jumped to account for 81.5 per cent of assets in 2015 from 25 per cent in 2007 (click on images below).

That strategy collides with their traditional image as conservative, risk-averse guardians of retirement nest eggs. Should investments go wrong, benefits would likely be slashed, contributions could be sharply increased and it is anyone’s guess who would be on the hook if there were major losses.

“On the world stage, they are the cream of the crop, but I think they are taking significant risks and they aren’t acknowledging it,” Hamilton said.

Perhaps more importantly, the pension sector in Canada lacks the same stringent cohesive regulatory oversight as banks and insurers, meaning there are less checks and balances governing a big chunk of everyone’s retirement plans. As a result, some industry participants are questioning whether public pension funds should be more closely examined.

“The pension funds are largely unregulated — what’s regulated is the payments to the beneficiaries. The investments of the pensions are not regulated,” said a veteran Bay Street risk expert who asked not to be named. “And so this is the conundrum they’re in as they move further afield … And it’s a big debate going on right now.”

With net assets ranging from $64 billion to $265 billion, the top eight pension funds — Canadian Pension Plan Investment Board (CPPIB), Caisse de depot et placement du Quebec, Ontario Teachers’ Pension Plan, British Columbia Investment Management Corp., Public Sector Pension Investment Board, Alberta Investment Management Corp., OMERS (Ontario Municipal Employees Retirement System and Healthcare of Ontario Pension Plan (HOOPP) — all rank among the 100 largest such funds in the world, and three are among the top 20, according to a study by the Boston Consulting Group released last February. Only the United States has more public pension funds on the global list.

The country’s giant public pension plans, flush with billions in retirement savings, began flexing their investment muscle on the heels of tougher banking laws following the financial crisis of 2008-2009.

Although Canada emerged as the darling in international financial circles for its resilience during the crisis and resulting recession — and the major banks basked in the glory — their global counterparts did not fare so well, which prompted policymakers to layer on additional regulation for all banks.

These new rules, many of which are contained in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, are supposed to protect the financial sector in times of stress by limiting risk-taking strategies. Canadian pension funds, unencumbered from those onerous banking rules, have been all too eager to rush in.

During the past 10 years, they have accumulated an eclectic mix of prime assets in unprecedented fashion. Among them: a 27-per-cent stake in the Port of Brisbane in Australia; interests in Porterbrook Rail, the second-largest owner and lessor of trains in the United Kingdom; luxury retailer Neiman Marcus Group in New York; Transelec, Chile’s largest electricity transmission company; Heathrow Airport; and Camelot Group, the U.K.’s national lottery operator.

In all, they’ve done 20 deals worth more than US$10 billion during that time, according to the Boston Consulting report.

It’s a deal binge that has created a “new world order” in which “Canada’s pension funds have barged Wall Street to stake a claim to be the new masters of the universe,” a British financial columnist noted last year.

Notably, the Canadian public pensions have invested in less conventional businesses and asset classes, where risks are generally higher than more conservative investments such as stocks and bonds. At the same time, there is potentially even more risk looming because the funds are pushing into asset classes and geographies where they have less experience.

For example, CPPIB in June 2015 paid $12 billion for General Electric Capital Corp.’s GE Antares Capital, a middle-market private-equity sponsor. The pension giant has also made a pair of recent investments in the insurance business.

Earlier this month, the Caisse announced plans to invest US$600 million to US$700 million over four years in stressed assets and specialized corporate credit in India. The Quebec-based pension group forged a long-term partnership with Edelweiss Asset Reconstruction Company, India’s leading specialist in stressed assets, which included taking a 20-per-cent equity stake in Edelweiss.

At the same time, the pension funds are increasingly barging in on the conventional bank business. The CPPIB, which invests on behalf of 19 million Canadians as the investment arm of the Canada Pension Plan, has started tapping public markets by issuing bonds to fund their large-scale deals rather than seek debt financing through the banks.

In June 2015, Canada’s largest public pension fund, with $287.3 billion in assets under management — and the eighth largest in the world — raised $1 billion by issuing five-year bonds. A follow-up offering of three-year notes raised an additional $1.25 billion.

“Pension funds used to stick with a balanced portfolio of public-traded debt and equities and a little real estate,” said Richard Nesbitt, chief executive of the Toronto-based Global Risk Institute in Financial Services. “The Canadian model of pension investment management invests into many more asset classes including infrastructure assets around the globe. Banks are still there providing support in the form of advice and corporate loans. But the banks tend to be more regionally focused whereas the pensions are definitely global.”

Meanwhile, Canada’s large pension funds are also borrowing more money to fund their investments. Since they have long time horizons relative to other investors — decades in some cases — they argue that gives them a competitive advantage in both the deal arena and the ability to tolerate more short-term volatility.

“The pressure has just been getting worse and worse, especially as interest rates continue to decline for public funds to get the returns they used to get,” said Hamilton, a 40-year veteran of the industry and former partner at Mercer (Canada).

Low interest rates have a double-whammy effect: they tend to boost the prices of assets and lower expected returns while at the same time reducing borrowing costs, making it cheaper to borrow money and increasing the incentive to use leverage.

But rather than cutting back their risk exposure, Hamilton said the funds, especially those pension plans that are maturing, are behaving the same way they did during the gravy days of high interest rates years 20 years ago. The reason they are behaving this way is because they can’t afford to suffer lower returns, he said, because either benefits would have to be cut or contributions to the plan raised to keep payouts the same.

“They are levering up and hoping for the best instead of making the tough choices,” Hamilton said. “There are alternatives, but they are not so pleasant.”

Forsyth said a main reason Canadian pension funds have avoided making tough choices is partly because of this country’s stellar record. Unlike the Netherlands, where the central bank forces public pension funds to cut benefits when there’s too much risk on the books, Canada has never really faced a systemic financial meltdown that would induce the government to enact such tough measures.

“There isn’t the same amount of pressure in Canada, because we didn’t have the financial blow-ups they had in other countries,” he said.

The Netherlands is one of only two countries whose pension system achieved the top grade in the prestigious annual Melbourne Mercer pension index in 2015 (the other is Denmark). Canada tied for fourth with Sweden, Finland, Switzerland, the U.K. and Chile, all of which are considered to have a “sound system” with room for improvement.

Nevertheless, Canada’s public pension system has pioneered new approaches to institutional investing and governance, and rates among the best in the world in terms of funding its public-sector pension liabilities.

The key characteristic of the Canadian model is cost savings. Canadian fund managers, unlike other public pension managers, prefer to actively manage their portfolios with teams — employing about 5,500 people (and about 11,000 when including those in the financial and real estate sectors) — an organizational style that allows them to direct about 80 per cent of their total assets in-house.

Cutting out the middleman creates considerable economies of scale by lowering average costs, especially through fees to expensive third parties such as Blackrock Inc. and KKR & Co. LP.

In private equity, for example, managers can charge a fee equal to two per cent of assets and 20 per cent of profits. Hiring internal staff and building up internal capabilities is far less expensive. So much so that the total management cost for most Canadian public funds is 0.3 per cent versus 0.4 per cent for a typical fund that relies on external managers.
[Note: I think this is a mistake, the total management cost for a typical fund that relies on external managers is much higher than 0.4%.]

The management style was pioneered by Claude Lamoureux, former head of Ontario Teachers’ Pension Plan, who was the first to adopt many of the core principles espoused by the late Peter Drucker in the early 1990s on creating better “value for money outcomes.” Now all large Canadians funds operate with these key principles.

“That’s the innovation. It’s a simple story of scale allowing you to disintermediate a distributor,” said a senior Canadian pension executive who asked not to be named.

The strategy may be simple, but it has had a significant impact on the bottom line. The cost savings have added up to hundreds of millions of dollars that have been invested rather than outsourced.

Since 2013, total assets under management for the top 10 major public pension funds have tripled, with investment returns driving 80 per cent of the increase.

Even so, the Bank of Canada issued a cautionary note about the challenges in its 2016 Financial System Review. In a recent study of the country’s large public pension funds, the central bank stated that “trends toward more illiquid assets, combined with the greater use of short-term leverage through repo and derivatives markets may, if not properly managed, lead to a future vulnerability that could be tested during periods of financial market stress.”

In its June 2016 paper, “Large Canadian Public Pension Funds: A Financial System Perspective,” the central bank noted the big eight funds have increased their use of leverage, but the amounts on the balance sheet are not considered high.

However, the BoC cautioned that although balance-sheet leverage — defined as the ratio of a fund’s gross assets to net asset value — varies greatly across the funds and appears “modest as a group,” it is still “not possible to precisely assess aggregate leverage using public sources” because it can take on many forms in addition to what is shown on the balance sheet.

“If not properly managed, these trends my lead in the future to a vulnerability that could create challenges on a severely stressed financial market,” the central bank paper warned.

Oversight for most public pension funds, not including the CPPIB, which is federally chartered, falls to the provinces and their regulators are non-arms’ length organizations created by, and report to, the provinces, which also directly and indirectly sponsor many of the same plans being supervised. In other words, pension regulators are not truly independent the way the Office of the Superintendent of Financial Institutions is to the financial sector.

“Can a regulator staffed by members of public-sector pension plans effectively regulate public-sector pension plans?” said C.D. Howe’s Hamilton. “In particular, can such a regulator protect the public interest if the public interest conflicts with the interests of the government and/or the interests of plan members? I think not.”

Furthermore, he said, most pension fund managers would characterize their behaviour as “prudent and creatively adapting to an unforgiving and challenging environment.”

Over at Ontario Teachers’, chief investment officer Bjarne Graven Larsen, welcomed the central bank’s scrutiny and acknowledged that risk is an integral part of any investment strategy. The trick as the pension plan evolves, he said, is to make sure there is adequate compensation for the amount of uncertainty.

“You have to have risk, that’s the way you can earn a return,” Graven Larsen said. Not every transaction will work out according to plan, of course, but he said the strategy is to ensure that losses will not be too great when assets or market conditions fail to meet expectations, even if that means taking a lower return at the outset.

Ontario Teachers’, the largest single-profession plan in Canada, recently moved its risk functions into an independent department and is also tweaking its portfolio construction in an attempt to account for the largest risks it takes and calibrate other positions to balance the potential downside.

“But you will, over time, be able to harness a risk premium and get the kind of return you need with diversified risk — that’s the approach, what we’ve been working on,” Graven Larsen said.

CPPIB, meanwhile, doesn’t have a designated chief risk officer, a key executive who plays a critical role balancing operations and risk. That absence sets it apart from other major government pension plans and other major Canadian financial institutions such as banks and insurers, according to Jason Mercer, a Moody’s analyst.

“A chief risk officer plays devil’s advocate to other members of management who take risks to achieve business objectives,” Mercer said. “The role provides comfort to the board of directors and other stakeholders that risks facing the organization are being overseen independently.”

For its part, CPPIB officials said they have created a framework that doesn’t rely on a single executive to monitor risk. Michel Leduc, head of global public affairs at CPPIB, said the pension organization has an enterprise risk management system that runs from the board of directors, through senior management, to professionals in each of the pension’s investment departments.

“This decentralized model ensures that individuals closest to the risks and best equipped to exercise judgment have local ownership over management of those risks,” Leduc said.

The risks some critics find worrisome, CPPIB officials see as a strength, courtesy of the funds’ unique characteristics, namely a steady and predictable flow of contributions — about $4 billion to $5 billion a year.

CPPIB in 2014 began shifting the investment portfolio to recognize that the fund could tolerate more risk while still carrying out the pension management’s mandate of maximizing returns without undue risk of loss.

The plan is to gradually move from a mix reflecting the “risk equivalent” of 70-per-cent equity and 30-per-cent fixed income to a risk equivalent of 85-per-cent equity and 15-per-cent fixed income by 2018.

With unprecedented amounts of money pouring into public pensions — fuelled by heightened assumptions from governments about what Canadians should expect to receive — the chorus for closer examination of the sector will likely reverberate.

After all, for all the bouquets tossed at them on the world stage, Canada’s public pension funds still have to prove whether their high-profile investments are worth the risk to those at home.
This article was written last Saturday. I stumbled across it yesterday when I read Andrew Coyne's article on keeping tax dollars and public pension plans away from infrastructure spending.

I might address Coyne's latest ignorant drivel in a follow-up comment (he keeps writing misleading and foolish articles on pensions), but for now I want to focus on the article above on Canada's new masters of the universe.

First, let me commend Theresa Tedesco and Barbara Shecter for writing this article. Unlike Coyne, they actually took the time to research their material, talk to industry experts, including some that actually work at Canada's large public pension funds (something Coyne never bothers doing).

Their article raises several interesting points, especially on governance lapses, which I will discuss below. But the article is far from perfect and the main problem is it leaves the impression that Canada's large pension funds are taking increasingly dumb risks investing in illiquid asset classes all over the world.

I believe this was done purposely in keeping with the National Post's blatantly right-wing tradition of fighting against anything that seems like big government intruding in the lives of Canadians. The problem is that the governance model at Canada's large pensions was set up precisely to keep all levels of government at arms-length from the actual investment decisions, something which is mentioned casually in this article.

[Note to National Post reporters: Next time you want to write an in-depth article on Canada's large pension funds, go out to talk to experts who work at these funds like Jim Keohane, Ron Mock and Mark Machin or people who retired from these funds like Claude Lamoureux, Jim Leech, Neil Petroff, Leo de Bever. You can also contact me at and I'll be glad to assist you as to where you should focus your attention if you want to be constructively critical.]

In a nutshell, the article above leaves the (wrong) impression that Canada's large pensions are not regulated or supervised properly, oversight is fast and loose, and they're taking huge risks on their balance sheets to invest in assets all over the world, mostly in "risky" illiquid asset classes.

Why are they doing this? Because interest rates are at historic lows so investing in traditional stocks and bonds will make it impossible for them to attain their actuarial return target, forcing them to slash benefits and raise contributions, tough choices they prefer to avoid.

The problem with this article is it ignores the "raison d'être" for Canada's large pensions and why they all adopted a governance model which allows them to attract and retain investment professionals to precisely take risks in global public and private markets others aren't able to take in order to achieve superior returns over a very long period --  returns that far surpass Canadian balanced funds which invest 60/40 or 70/30 in a stock-bond portfolio.

The key point, something the article doesn't emphasize, is Canada's well-known balanced funds charge outrageous fees and deliver far inferior results relative to Canada's large public pension funds over a long period precisely because they are only able to invest in public markets which offer lousy returns given interest rates are at historic lows. Even the alpha masters, who charge absurd fees, are not delivering the results of Canada's large pensions over a long period.

And it's not just fees, even if all Canadians did was invest directly in low-cost exchange-traded funds (ETFs) or through robo-advsiors, they still won't be as well off in the long run compared to investing their retirement savings in one of Canada's large, well-governed defined-benefit plans.

Why? Because Canada's large defined-benefit pensions use their structural advantages to invest across public and private markets all over the world, and they're global trendsetters in this regard.

[Note: This is why last week I argued that Norway's pension behemoth should not crank up equity risk and is better off adopting the asset allocation that Canada's large pensions have adopted, provided it gets the governance right.]

The brutal truth on defined-contribution plans is they are leaving millions at risk of pension poverty which is why unlike the Andrew Coynes of this world, I kept harping on enhancing the CPP knowing full well Canadians are getting a great bang for their CPP buck.

And when I read about what is happening to Nortel's pensioners, it infuriates me and reminds me that there is still a lot of work left to do in terms of pension policy in this country, like creating a new large, well-governed public pension here in Montreal in charge of managing the assets of all Canadian DB and DC corporate pensions (Montreal is home to the country's best corporate DB pensions like CN's Investment Division and Air Canada Pensions).

Having said all this, I don't want to leave the impression that everything at Canada's large public pensions is just peachy and there is no room to improve their world-class governance.

In particular, I agree with some passages in the article above. Most of the financial industry is subject to extreme regulations, regulations which do not impact Canada's large pensions in the same way.

This isn't a bad thing. Some of them are using their AAA balance sheet to intelligently take on more leverage or emit their own bonds to fund big investments in private markets.

A lot of this is discussed in the report the Bank of Canada put out this summer on large Canadian public pension funds. And while the report highlights some concerns, it concludes by stating:
No pension fund can achieve a 4 per cent average real return in the long run without assuming a certain amount of properly calibrated and well-diversified risk. This group of large Canadian pension managers seem generally well equipped to understand and manage that risk. The ability of the Big Eight to withstand acute stress is important for the financial system, as well as for their beneficiaries. They can rely on both the structural advantages of a long-term investment horizon and stable contributions. Moreover, they have reinforced their risk-management functions since the height of the 2007–09 global financial crisis.
No doubt, they have reinforced their risk-management functions since the global financial crisis and some of the more mature and sophisticated funds are monitoring liquidity risks a lot more closely (OTPP for example), but all the risk management in the world won't prevent a large drawdown if another global financial crisis erupts.

And it is important to understand there are big differences at the way Canada's large pensions manage risk. As mentioned in the article, CPPIB doesn't have a chief risk officer, instead they opted to take a more holistic view on risk and have ongoing discussions on risk between department heads (this wasn't always the case as they used to have a chief risk officer).

Is that a good thing or bad thing? Do you want to have a Barbara Zvan in charge of overseeing risk at your pension fund or not? There is no right or wrong answer here as each organization is different and has a different risk profile. CPPIB is not a mature pension plan like OTPP which manages pensions and liabilities tightly, so it can focus more on taking long-term risks in private markets and less on tight risk management which it already does in a more holistic and individual investment way.

I personally prefer having a chief risk officer that reports directly to the Board, not the CEO, but I also recognize serious structural deficiencies at some of Canada's large pensions where different department units work in a vacuum, don't share information and don't talk to each other (this is why I like CPPIB's approach and think PSP Investments is also moving in the right direction with PSP One).

Are there risks investing in private markets? Of course there are, I talk about them all the time on my blog, like why these are treacherous times for private equity and why there are misalignment of interests in the industry. Moreover, there are big cracks in commercial real estate and ongoing concerns of pensions inflating an infrastructure bubble.

That is all a product of historic low interest rates forcing everyone to chase yield in unconventional places. We can have a constructive debate on pensions taking on more risk in private markets, but at the end of the day, if it is done properly, there is no question that everyone wins including Canada's pension leaders which get compensated extremely well to deliver stellar long-term results but more importantly, pension beneficiaries who can rely on their pension no matter what happens in these crazy schizoid public markets.

But I am going to leave you with something to mull over, something the Bank of Canada's report doesn't discuss for obvious political reasons.

In 2007, I produced an in-depth report on the governance of the federal public service pension plan for the Treasury Board of Canada going over governance weaknesses in five key areas: legislative compliance, plan funding, asset management, benefits administration, and communication.

If I had to do it all over again, I would not have written that report (too many headaches for too little money!), but I learned a lot and the number one thing I learned is this: there is always room for improvement on pension governance.

In particular, as Canada's large pensions engage in increasingly more sophisticated strategies across public and private markets, levering up their balance sheets or whatever else, we need to rethink whether there are structural deficiencies in the governance of these large pensions that need to be addressed.

For example, I've long argued that the Office of the Auditor General of Canada is grossly understaffed and lacking resources with specialized financial expertise to conduct a proper independent, comprehensive operational, investment and risk management audit of PSP Investments (or CPPIB) and think that maybe such audits should be conducted by the Office of the Superintendent of Financial Institutions or better yet, the Bank of Canada.

In fact, I think the Bank of Canada is best placed to be the central independent government organization to aggregate and interpret all risks taken by Canada's large pensions (maybe if they did this in the past, we wouldn't have had the ABCP train wreck at the Caisse).

Just some food for thought. One thing I can tell you is that we definitely need more thorough operational, investment and risk management audits covering all of Canada's large pensions by independent and qualified experts and what is offered right now (by the auditor generals and other government departments) is woefully inadequate.

But let me repeat, while there is always scope for improving governance and oversight at Canada's large pensions, there is no question they are doing a great job investing across public and private markets all around the world and their beneficiaries are very lucky to have qualified and experienced investment professionals managing their pensions at a fraction of the cost in would cost them to outsource these assets to external managers (the figures cited in the article above are off).

That is a critical point that unfortunately doesn't come out clearly in the article above which leaves the impression that all Canada's large pensions are doing is taking undue risks all over the world. That is clearly not the case and it spreads a lot of misinformation on Canada's large, well-governed defined-benefit pensions which quite frankly are the envy of the world and deservedly so.

Below,  on OECD-based infrastructure have become competitive, making Asia a new opportunity, says the Ontario Teachers' Pension Plan's Andrew Claerhout.

Smart man, listen to his comments and you will understand why infrastructure is gaining increasing interest from institutional investors with huge assets to invest and a very long investment horizon.

Friday, October 21, 2016

The Elusive Search For Alpha?

Svea Herbst-Bayliss and Lawrence Delevingne of Reuters report, Some hedge funds post mega-gains, brighten industry gloom:
Hedge funds have suffered a steady drumbeat of bad news this year: poor performance, withdrawals, prominent closures, bribery and insider trading charges, and accusations from a state regulator that the whole sector is a "rip-off."

Yet amid the gloom there are still a few managers posting the double-digit percentage gains that turned hedge funds into an elite asset class more than a decade ago, according to performance data provided by fund investors.

For instance, Eric Knight's activist-oriented Knight Vinke Institutional Partners is up nearly 50 percent before fees this year, while the Russian Prosperity Fund, which picks stocks in the former Soviet Union and is led by Alexander Branis, has climbed 43 percent (click on image below).

Then there are Jason Mudrick's Mudrick Distressed Opportunity Fund and Phoenix Investment Adviser's JLP Credit Opportunity Fund, which are both up 38 percent. Energy-oriented Zimmer Partners' ZP Energy Fund is up 27 percent, while Gates Capital Management's ECF Value Fund has risen 26 percent and Michael Hintze's CQS Directional Opportunities Fund has climbed 20 percent.

By contrast, the average hedge fund returned a little more than 4 percent over the first nine months of the year, according to data from Hedge Fund Research. That is about half of what the S&P 500 Index has returned over the same period, including dividends, and compares to a 7 percent increase for the Barclays Capital U.S. Government/Credit Bond Index, a common measure of the credit markets.

"In general there is no doubt this has been a tough year in terms of performance, but there are still winners out there," said Mark Doherty, a managing principal at PivotalPath, an investment consultant.


The winners are harder to find. They tend not to be multi-billion-dollar household names whose managers appear on television and at industry conferences, attracting money to invest from the largest pension funds.

Although they pursue a variety of strategies, they are united in their relatively small size, investors said.

Gates Capital manages $1.8 billion, while Mudrick Capital oversees $1.5 billion and Phoenix's JLP Credit Opportunity and Zimmer Partner's ZP Energy Fund are smaller, with about $1 billion in assets, investors in the funds said. Representatives for the firms declined to comment.

There are a number of even smaller firms delivering blockbuster returns. Former Paulson & Co partner Dan Kamensky's $125 million Marble Ridge, which started trading in January, is up 23 percent. Svetlana Lee's Varna Capital, which invests less than $100 million, is up 20 percent. Halcyon Capital's $200 million Halcyon Solutions Fund, managed by Jason Dillow, is up 22 percent.

"These funds may be able to capitalize on smaller and more inefficient securities that are too small for the larger funds," said Michael Weinberg, chief investment strategist at New York-based Protégé Partners, which invests in smaller funds.


Knight Vinke's gains were largely driven by the merger of French electronics company Fnac with electrical retailer Darty, which the hedge fund pushed for, its most recent letter said.

Bets on steelmaker Evraz, Russian airline Aeroflot and Federal Grid Company, which manages Russia's unified electricity transmission grid system, helped the Russian Prosperity fund, its investment chief Branis said.

Some of the winners, including Dallas-based Brenham Capital, which manages $1.3 billion and is up 19 percent this year, also scored big by betting on the beaten-down energy sector as it recovers. Mudrick Capital won with bets on Alpha Natural Resources as the coal miner exits bankruptcy and closely held driller Fieldwood Energy, a fund investor said.

To be sure, this year's strong returns were preceded by big losses in 2015 and early in 2016 at some firms. Mudrick Capital, which made early bets on distressed energy and commodity companies, lost 26 percent last year, and Gates' ECF Value Fund lost 19 percent.

Some clients have not had the patience to stick around. Last month Rhode Island's pension fund voted to cut its hedge fund allocation in half following in the footsteps of New Jersey, which voted for a similar reduction in August. This week New York's financial regulator called hedge funds a "rip-off" in a report that said the state pension fund lost $3.8 billion on them in the last eight years.

Investors pulled an estimated $23.3 billion from hedge funds over the first half of the year, according to Hedge Fund Research, less than 1 percent of the industry's $2.9 trillion overall assets.
While a handful of less well-known hedge funds are delivering great returns, the majority are struggling to master their miserable new world where their compensation is getting sliced as big investors pull out, fed up of paying hefty fees for mediocre returns.

A couple of weeks ago, I discussed why Rhode Island met Warren Buffett, stating that while I don't buy Buffett and Munger's biased views on hedge funds, I agree with them that most US public pensions have no business whatsoever investing in hedge funds or even private equity funds which are raking them on fees and delivering paltry returns.

[Note: Interestingly, Business Insider ran an article on how private equity giants are emulating Warren Buffett, trying to lock up more assets for a longer period, which is something I discussed last year. The problem is that these are treacherous times for private equity and many experts are openly questioning the industry's alignment of interests.]

This week I went over why CalSTRS cut $20 billion from external managers and why New York's Department of Financial Services (DFS) issued a report finding that the New York State Common Retirement Fund (CRF) for years has invested pension system funds in high-cost underperforming hedge funds, costing the system $3.8 billion over the last eight years.

I ended that comment by stating the following:
Is this the beginning of something far more widespread, a mass exodus out of external managers? I don't know but clearly there are some big pensions and sovereign wealth funds that are tired of paying hefty fees to external managers for lousy absolute and risk-adjusted returns.

The diversification argument can only take them so far, at one point funds need to deliver the goods or they will face the wrath of angry investors who will move assets internally and never look back.
This week we find out that hedge fund investors withdrew $28.2 billion in third quarter but I take these figures with a grain of salt. Matthias Knab of Opalesque sent this out in an email this morning (click on image):

Clearly there is no mass exodus out of hedge funds (or private equity funds) and the reason is simple, many US public pensions cannot manage assets internally because they lack the size or don't have the governance and compensation system to attract talented investment officers to manage assets across public and private markets internally.

Instead, they hire useless investment consultants which shove them in large brand name hedge funds they typically should be avoiding (because many have become large asset gatherers who focus more on the 2% management fee and less on delivering stellar performance).

If you don't believe me, ask Mark Rzepczynski, Founding Partner, Chief Investment Officer AMPHI Research and Trading, who wrote this on Harvest Exchange:
Investment consultants are a force to the reckoned with in the pension world. They advise and drive many pension decisions around the globe. Consultants literally control trillions of dollars of allocations to managers through their recommendations, yet there have been no studies on the effectiveness of their choices. There may be limited argument that they provide useful information and education for pension managers, but they also give specific advice on managers, so an analysis of their picks is extremely valuable. The result may surprise you. Their investment manager picks do not outperform some simple benchmarks.

The recently published study in the Journal of Finance, "Picking Winners? Investment Consultants’ Recommendations of Fund Managers", makes a carefully researched assertion that consultant recommendations have little value. Worthless may be too strong, but that is close to what most would conclude when they read the paper. Given all of the work on trader skill and market efficiency, this should not be surprising. But, given that consultants supply their work to leading pensions, it is should be surprising that no one has called them on their recommendations.

The authors do a very careful job of researching this topic through analyzing what drives recommendations. Recommendations are driven by more than past performance but by soft factors such as philosophy, service, fees, and size. Consultants are not return chasers but are slaves to size which is a key driver for this results. The soft factors also seem to be key drivers for recommendations. The due diligence process identifies managers that have a well-defined process and can explain well. Given their client base and job, consultants have to be size sensitive. Perhaps in an imperfect world, the best they can do is conduct due diligence and make the best recommendations given size constraints.

Nevertheless, it may be too easy to let them off the hook based on the size argument. First, there is no evidence of outperformance and equal weighted portfolios of recommendations underperform. Second, these performance results hold for a number of different factor models. Third, the size or scale effect can explain the underperformance, but it cannot explain why the recommendations do not outperform alternatives.

Use your consultants carefully. If you want them to sift through managers and find those that meet size criteria and have well-defined processes, you are in safe ground. If you are asking them to pick future winners, beware.
You can read the full article with all charts and tables on Harvest Exchange here.

I agree with Mark Rzepczynski, use your consultants carefully and you should spend a lot more time understanding and vetting your consultants, their business model and any potential conflicts of interest.

In my experience, most consultant are backward looking and they definitely have a size bias. It's not their fault, of course, as their clients are big pension or sovereign wealth funds that are looking to write huge cheques to a few brand name funds but in many cases, there are gross conflicts of interest where consultants recommend funds they themselves invest in or trade with.

I discussed some of this when I went over the Montreal emerging managers conference a few weeks ago and was perplexed as to why some LPs think there are conflicts of interest in bfinance's approach where they put out the RFP, the LPs choose the managers that best suits their needs, and then the GPs have to pay a one time fee to bfinance based on the assets they receive if they are selected by the LP for the mandate.

[Note: I am not just plugging bfinance, on my blog you will find links to a list of advisors and consultants on the right-hand side, many of which are well known but others that are less well-known, small, excellent, independent and conflict-free, like my buddies over at Phocion Investment Services (and I have no monetary arrangement with them).]

Anyways, I am rambling on a bit too much and want to get to the article above. Be very careful when you read articles like this, extremely careful not too get overly excited about any hedge fund manager shooting the lights out on any given year.

Four years ago, I wrote a very popular comment on the rise and fall of hedge fund titans. Investors get so enamored when some hedge fund "superstar" (or no-name) hits a home run in any given year but I'm speaking from experience, one or even two years of stellar results guarantees nothing in terms of future performance and if you chase hot hedge funds, no matter how big or small they are, you will more than likely get your head handed to you.

Does anyone remember Vega Asset Management which was based in Madrid, Spain? I visited them with Mario Therrien of the Caisse back in 2003. Vega was a global macro fund run by Ravi and Jesus, two very experienced traders formerly of Santander. Great macro fund, tight risk management, a marketing machine, assets mushroomed from $2 billion to well over $12 billion in a few short years and after doing well, it sustained heavy losses in 2005-2006 and eventually closed.

In 2003, before all this happened, I recommended an allocation to this fund but also recommended to cut the initial allocation in half. My biggest concern was that I totally disagreed with their main thesis, which was to short US bonds, but I also had issues with how the fund was aggressively marketing to prospective clients.

Still, they had a great operational setup, knew their stuff, were seasoned traders and who was I to question their thesis? And to be fair, they were making excellent risk-adjusted returns even after I left the Caisse later that year (2003) to join PSP.

Sometimes you pick managers who have it all, experience, skills, a great team, great operational setup, tight and first rate risk management, and they still can run into big problems.

Can this even happen to Citadel or Bridgewater? Absolutely, it can happen to any fund and that's why I agree with Jacques Lussier, President and CEO of Ipsol Capital, Return = Alpha + Beta + Luck!!!!!!

[Note: Jacques's second book which he co-authored with Hugues Langlois, Rational Investing: The Subtleties of Asset Management, will be out in March 2017 and you can pre-order and read about it here.]

A lot of novice hedge fund investors need to read When Genius Failed just to get a reality check. I've said this before and I will repeat it, stop pandering to glorified hedge fund gurus and treat everyone the same and start grilling them hard no matter how poorly or well their fund is performing.

"But Leo, I'm very intimidated when sitting in front of a Ray Dalio, his top lieutenants or any other hedge fund guru. I just can't grill them like you used to do." Then investing in hedge funds is not for you, it's that simple.

When you sit in front of a Dalio, a Tepper, or anyone else and start asking them tough questions, you need to be very well prepared and be ready to get jabbed a couple of times (comes with the territory, you're dealing with egos the size of Trump's or worse in some cases).

[Note: Nowadays, even if you're a big investor, you have a better chance of winning the lottery than getting to sit in front of any hedge fund guru to ask them tough questions. Instead, you will deal with some investor relations person which is far from optimal.]

And that brings me to the point I want to make about why you need to be careful reading too much into the performance of any hedge fund manager. Do you understand the process? The sources of returns? The risks of the strategy? Are they benchmarking their performance properly or trying to pull wool over your eyes? Are their operations solid? Is their risk management rigorous or all smoke and mirrors? Are the managers simply lucky, riding a big beta wave up?

That last question might seem easy to answer, after all, if you get the beta benchmark right, it should be easy to determine whether there is any real alpha there, but there is an element of luck that is very underappreciated in all investment strategies.

I mention this because while there is a crisis in active management, we are living in extraordinary times where the alpha bubble has shifted to a giant beta bubble spurred by record low rates, a buyback bubble which is reaching its limits, robo-advisors shoving billions into "low volatility" and other ETFs, etc.

All this to say while it's tough finding elusive alpha, especially for the big giant funds, everyone needs to take a step back and really understand the market environment and what is driving returns in various long-only, hedge fund and private equity strategies.

And yes, on any given year, you will find exceptional outperforming hedge funds and long-only mutual funds, but try to understand their process and source of returns before chasing them (actually, you should never chase after any fund, period).

Hope you enjoyed this comment, if you have anything to add, feel free to email me at As always, please remember to subscribe or donate to the blog via PayPal on the top right-hand side under my picture (need to view web version on your cell phone).

Below, hedge fund billionaire David Tepper is pretty cautious on the market. Remember what I keep telling you, "beware of gurus with dire warnings!", and read my comment on bracing for a violent shift in markets.

More interestingly, Barry Rosenstein, JANA Partners founder, shares his take on why stock picking isn't dead (once the ETF bubble bursts). Richard Pzena, Pzena Investment Management, also weighed in on active vs. passive fund management, as well as market volatility.

Lastly, I embedded the full Al Smith dinner from Thursday night where Donald Trump and Hillary Clinton were supposed to be relaxed and look at the lighter side of things, all in the name of charity.

Trump started off well but then he really "trumped up" and you could feel the tension in the room (thought the good cardinal was going to fall off his chair but apparently they played nice behind the scenes). Have a great weekend and enjoy watching the elusive search for political humor.

Thursday, October 20, 2016

What's Worrying the Bank of Canada?

Barrie McKenna of the Globe and Mail reports, Bank of Canada weighs further interest-rate cut amid sluggish exports:
The Bank of Canada flirted with the possibility of another interest-rate cut this month in the face of a gloomier forecast for the country’s export-led economy.

Governor Stephen Poloz and his top deputies “actively discussed” the merits of what would have been a third cut since the beginning of last year in the lead-up to Wednesday’s rate decision, he acknowledged to reporters in Ottawa.

In the end, the central bank opted to leave its benchmark rate at a still-low 0.5 per cent, because of the “significant uncertainties” clouding the bank’s economic outlook, including the tumultuous U.S. election and new mortgage insurance rules in Canada.

The central bank said it is closely monitoring the effect of the federal government’s move this month to tighten lending standards and limit access to mortgage insurance for riskier borrowers. The new rules should cool resale activity in the housing market and push developers to focus on building smaller units, the bank said.

The housing measures will slice as much as 0.3 per cent a year off economic growth by 2018 as resale activity and home construction take a hit, but they’ll also lead to “higher quality” borrowing patterns over the longer term, according to Mr. Poloz.

“While household debt levels have continued to increase, these measures should, over time, help ease the growth of economic vulnerabilities related to household debt and housing,” he later told members of the Senate banking, trade and commerce committee.

Earlier Wednesday, Mr. Poloz told reporters he wants to be “dead certain” that the bank’s downgraded projection for exports is permanent. He suggested that many businesses in the all-important U.S. market may be holding off on making investments until after the election, and that affects the U.S. appetite for Canadian goods and services.

“It’s worth having a little more time to examine some of these things,” Mr. Poloz explained.

Not cutting rates was the right thing to do, Toronto-Dominion Bank economist Brian DePratto said.

“An interest rate cut would likely do little to spur exports, while potentially undoing much of the impact of recent housing market rule changes,” he argued.

The central bank now expects the economy to grow 1.1 per cent this year and 2 per cent in 2017, down from its July projection of 1.3 per cent and 2.2 per cent respectively, according to its latest monetary policy report, released Wednesday. As well, the bank said the economy won’t get back to full capacity until “around mid-2018” – at least half a year later than it predicted just three months ago.

This expected delay suggests it could be another two years before the bank starts trying to push up interest rates – a timetable that now puts it well behind the U.S. Federal Reserve and could keep a lid on the value of the Canadian dollar, now trading at about 76 cents (U.S.) for the foreseeable future.

“This is a bank that has precisely zero appetite for rate hikes, and seems to be keeping a flame alive for the possibility of rate cuts, should the need arise,” Bank of Montreal chief economist Douglas Porter said in a research note.

On the positive side, the bank said the worst may be over for the resource sector, where economic activity appears to be “bottoming out.” And the bank expects the global economy will “regain momentum” over the next two years.

Still, the bleaker forecast is the latest in a series of disappointments for Mr. Poloz, who has repeatedly predicted that a rebound in non-resource exports would lift the country out of its economic funk. The bank’s latest forecast slashes expected export growth by a full percentage-point in 2017 and 2018, shaving roughly 0.5 per cent off economic growth – and some of the loss may be permanent, rather than cyclical, according to Mr. Poloz.

“The level of exports is well below where we thought it would be by now,” Mr. Poloz told reporters. He suggested that rising protectionism, the unknown status of various free-trade deals, high electricity costs and poor infrastructure may be inhibiting investment and exports.

Wednesday’s report from the bank provides an extensive explanation for why Canada’s exports haven’t hitched themselves to the recovery in the U.S. – the destination for nearly three-quarters of Canadian goods exports. The main culprits are weaker-than-expected U.S. business investment and more pronounced competitive challenges for Canadian exporters. While a cheaper Canadian dollar has made exports more affordable to foreign buyers, the currencies of major trading rivals have declined even more against the U.S. dollar, giving them an edge in the U.S. market, the bank pointed out in its report. The Mexican peso, for example, has fallen by more than 30 per cent since mid-2014, compared with a 20-per-cent drop for the loonie.

The central bank now expects U.S. business investment to grow just 3 per cent over the next two years, down from a previous estimate of 4 per cent, due to greater uncertainty.
Greg Quinn and Maciej Onoszko of Bloomberg also report, Poloz’s Deepest Thoughts on Rates Now Saved for Press Conference:
Investors seeking insight into Bank of Canada Governor Stephen Poloz’s thinking on monetary policy need to look beyond the main rates statement for clues.

For the second time in seven months, Poloz whipsawed markets with prepared comments to reporters after the rate decision was released Wednesday, saying that the central bank “actively” considered adding stimulus to prop up a sluggish economy.

The Canadian dollar, which had rallied on the rates announcement at 10 a.m., erased gains after Poloz read from a separate statement 75 minutes later. Canada’s 2- and 10-year bond yields reacted in the same way, rising and then falling.
“It was interesting that he waited until the press conference to deliver the real message, which in the end was a pretty dovish one,” Alvise Marino, a foreign-exchange strategist at Credit Suisse in New York, said by phone Wednesday. “He just conveyed in a more strong way that easing is still on the table, which was something the market isn’t pricing at all.”

The moves reflect a shift under Poloz, who said in 2014 he was starting to offer more color on the bank’s deliberations in his preamble to the press conference after each quarterly release of the bank’s Monetary Policy Report. Other changes under Poloz include abandoning so-called forward guidance that gives a direct hint on the next move in borrowing costs, and adding new language to forecasts about inflation risks.

The opening statement at the press conference “fills the gap between the MPR and the press release, offering insight into which issues were really on the table during the deliberations and how those issues influenced the decision,” Bank of Canada spokeswoman Jill Vardy said in an e-mailed message. “We think this helps people understand better the thinking behind the decision and provides useful information to market participants about our risk management approach to monetary policy.”
Loonie Declines

The currency initially gained and bonds dropped after the central bank held its benchmark interest rate at 0.5 percent and the policy statement dropped a reference to downside inflation risks that featured in its previous stance from September. The markets then did an abrupt u-turn after Poloz said policy makers discussed monetary easing “in order to speed up the return of the economy to full capacity.”

The currency weakened 0.1 percent to C$1.3128 against the U.S. dollar as of 4 p.m. in Toronto, reversing a rally of as much as 0.8 percent. The rate on Canada’s bond due in November 2018 fell two basis points to 0.57 percent, after an earlier gain of two basis points (click on image).

“I was a little bit surprised how the statement and Poloz didn’t seem to line up too cleanly,” Tom Nakamura, Toronto-based vice president and portfolio manager at AGF Investments Inc. that has C$34 billion ($26 billion) under management. Some of the market reaction to the statement may have gone too far since it wasn’t out of line with Poloz’s overall worldview, he said. “What I think happens is that the market doesn’t think through the big picture sometimes.”
April Move

Investors went through a similar ride in April. Poloz held borrowing costs unchanged in the official rate decision, adding in his opening statement to reporters that the bank “entered deliberations” about easing monetary policy further. The dollar initially reversed losses after the rate announcement, only to resume declines during that press conference.

For a central bank that doesn’t offer minutes of their meetings, the context is helpful, said Marino at Credit Suisse.

“It was totally appropriate for them to say that in the press conference and not the statement,” he said. “It’s not different from what everybody else is doing.”

Investors will hear from Poloz again Wednesday, as he testifies at the Senate Banking Committee beginning at about 4:15 p.m. Another opening statement is expected.
You can view the Bank of Canada's latest Monetary Policy Report here and I embedded the press conference below (it is also available here).

Let me give you my quick thoughts on the latest decision, the press conference, the loonie and other currencies:
  • There was no surprise that the Bank of Canada decided to leave rates unchanged since oil prices have been hovering near $50 a barrel, bolstering the loonie and tightening financial conditions (remember, the loonie is a petro currency, as oil rises, it follows, lifting the pressure on the BoC to raise rates as financial conditions tighten).
  • The big surprise came after during the press release when Steve Poloz said he and his top deputies "actively discussed" the merits of another rate cut. Why were they actively discussing this? No doubt, the Bank is worried about weakness in real estate and exports but I also think there was an active discussion on whether global deflation risks are really fading and more importantly, whether Janet Yellen's speech last Friday was a real game changer
  • By all accounts, the Fed is set to raise rates by 25 basis points in December but during her speech last Friday, Fed ChairYellen dropped a bomb stating the Fed might need to stay accommodative for longer and risk overshooting its 2% inflation target. 
  • I interpreted these remarks as the Fed is still worried about global deflation and might even fear it's behind the deflation curve, so there is no rush to raise rates and it might be smarter to stay accommodative for longer, even if that means risking inflation down the road (they won't publicly admit this but they'd much prefer inflation than deflation even if it will take a miracle to achieve this outcome by inflating risks assets which only exacerbates rising inequality and the retirement crisis which ironically exacerbates deflation!!).
  • What signal is the Fed sending to the Bank of Canada and other central banks? Basically, have no fear, the Fed is in no hurry to raise rates and even if it does raise in December, it will be a one and done deal. 
  • On Thursday, the US dollar hit seven-month high after ECB meeting, pressuring oil and US stocks. I had warned my readers to ignore Morgan Stanley's call at the beginning of August on the greenback being set to tumble, and turned out to be right. The US Dollar Index (DXY) has rallied sharply since then and is now closing in on 100. 
  • I spoke to my buddy in Toronto this morning. He runs a one-man currency hedge fund machine and he was telling me that he thinks now is the the time to take profits on the long USD position and if the DXY goes over 99, start shorting the greenback. He also told me to he's long the British pound (especially versus the euro) but thinks the Canadian dollar could fall as low as 73 cents (oil prices between $50 and $60 will help Alberta and bolster the loonie but slowdown in real estate and exports and divergence in monetary policy will weigh on the Canadian currency).
  • Obviously my buddy who has been trading currencies for over 25 years knows what he's doing and I agree with him on a cyclical basis, especially after Yellen's speech, but structurally, I remain short currencies in regions where deflation is wreaking havoc on the economy and if a financial crisis erupts anywhere, King Dollar will surge much higher. 
  • My buddy also told me that the pickup in China's PPI last week was all due to the devaluation in the Chinese currency, allowing them to import inflation but he too doesn't see this as a sustainable strategy. 
That brings me back to the Bank of Canada's decision and press conference. Steve Poloz was the head of Export Development Canada prior to being nominated Governor of the Bank of Canada. I worked with him in the late nineties at BCA Research when he was a Managing Editor covering G7 economies. He's extremely smart, knows his stuff and is very nice. I have nothing but praise for him even if he pisses off market participants at times (who cares, maybe they aren't reading him right or listening carefully to his message).

I trust Steve's judgment but I also worry that Canadian exports will lag in an environment where US protectionism is on the rise (regardless if Trump loses) and other countries like Mexico keep devaluing their currency to gain US market share.

In other words, if oil keeps rising or hovering above $50 but Canadian exports don't pick up, or worse still, the housing market craters, don't be surprised if the Bank of Canada cuts rates or even starts engaging in QE. We are far from there but I'm very worried that Canada's days are numbered and have been short the loonie since December 2013 (and remain short).
    Speaking of BCA Research, I see Gerard MacDonell is back from vacation and posting all sorts of comments on his blog. I ignore his political rants/ jibberish but love reading his market insights like his latest on the core PCE deflator looking firm in September. I will let you read it.

    Below, the press conference where Bank of Canada Governor Stephen S. Poloz and Senior Deputy Governor Carolyn Wilkins discuss the October Monetary Policy Report. I also embedded the press conference where ECB President Mario Draghi explains the decision to keep rates on hold and once again reaffirmed plans to maintain the quantitative easing program at €80 billion to March 2017 or beyond if needed. The ECB left the door open to more stimulus, pointing to the December meeting.

    Part of me misses those Friday afternoon sessions at BCA Research back in the day when Steve Poloz and other smart Managing Editors like Gerard, Francis Scotland, Chen Zhao, Warren Smith, Martin Barnes and Dave Abramson would all get into it and "actively discuss" their market views (sometimes it was warfare!).

    I got to hand it to Tony Boeckh, he knew how to recruit them and pit them against each other, which made for a lousy work environment but great for his bottom line. Tony's business model was simple, recruit a few top guns from industry and the government, hire a bunch of hungry and smart university students and pay them in Canadian dollars, and deliver great investment research which is sold to clients all over the world charging them US dollars (pure genius which is why he made a fortune when he sold BCA several years ago to manage his money and write his investment letter).

    Unfortunately, I don't have Tony Boeckh's business savvy so I will remind all of you to kindly subscribe and/ or donate to this blog on the top right-hand side under my picture. I thank those of you who support my efforts, I truly appreciate it.

    Wednesday, October 19, 2016

    Norway's GPFG to Crank Up Equity Risk?

    Richard Milne and Thomas Hale of the Financial Times report, Norway’s oil fund urged to invest billions more in equities (h/t, Denis Parisien):
    Norway’s $880bn oil fund is being urged to invest billions of dollars more in equities and take on more risk in what would be a big shift in its asset allocation away from bonds.

    The world’s largest sovereign wealth fund should invest 70 per cent of its assets in shares, up from today’s 60 per cent, at the expense of bonds, according to a government-commissioned report on Tuesday.

    The move is highly significant for global markets as the oil fund owns on average 1.3 per cent of every single listed company in the world and 2.5 per cent in Europe.

    The report is the latest salvo in a debate on how much risk the long-term investor should take and comes amid growing warnings of dwindling returns for government bonds in particular. The allocation to equities was increased from 40 per cent to 60 per cent in 2007.

    “With a higher share of equities the expected return will increase as will the income to the government budget. Yes, it comes with higher risk but we think we are well equipped to handle this risk,” Hilde Bjornland, an economics professor behind the recommendation, told the Financial Times.

    The centre-right government will evaluate the recommendations before setting out its own position in the spring. Senior insiders said they expected the allocation change to go through as the report was co-authored by two former finance ministers.

    Siv Jensen, the finance minister, told the Financial Times: “We are always thoroughly evaluating how we are running the fund … We know now that we have a very low interest rate regime globally. We have 40 per cent in bonds, and that will affect the return over time.”

    Saker Nusseibeh, chief executive of Hermes Investment Management, a UK asset manager, said there was a broader trend of investors looking to increase their equity exposure. “This is about the realisation that you cannot make returns of the same amount that you used to make in the past,” he said.

    He added: “If you are a sovereign wealth fund … you will question why you would have so much in fixed income at all.”

    The latest survey of fund managers from Bank of America Merrill Lynch shows a rise in cash holdings, which in part reflects “scepticism or outright fear of bond markets”, according to Jared Woodard, an investment strategist at the bank.

    In a sign of how the Norwegian debate might unfold, the chairman of the report, Knut Mork, voted against the other eight members and argued the allocation to equities should be cut to 50 per cent. This would give the government a more predictable income stream from the fund, he said.

    The Norwegian government is permitted to take out up to 4 per cent of the value of the fund each year to use in the budget. But it is using only about 3 per cent this year.

    The report estimated that the fund’s real rate of return was expected to be 2.3 per cent over the next 30 years. A majority of the commission suggested “one potential margin of safety” could be to restrict the government’s ability to take money out of the fund to the level of the expected real return.
    Mikael Holter and Jonas Cho Walsgard of Bloomberg also report, Norway Sovereign Wealth Fund Urged to Add $87 Billion in Stocks:
    Norway’s $874 billion wealth fund needs to add more stocks as record low interest rates and a weak global economy will otherwise lower returns to just above 2 percent a year over the next three decades, a government-appointed commission recommended.

    The Finance Ministry should raise the fund’s stock mandate to 70 percent from 60 percent, the committee, comprised of academics, investors and two former finance ministers, urged on Tuesday. A decision on increasing its stock investments will be made by the ministry, which hasn’t always agreed with the conclusions of similar reviews on the fund’s holdings.

    “A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the Fund and a higher risk of a decline in its long-run value,” the group said. “The majority is of the view that the this risk is acceptable, provided that there is political will and ability to adapt economic policy to the accompanying increase in risk, in both the short and long run.”

    Norway is looking for ways to boost returns that have missed a real return goal of 4 percent as interest rates have plunged globally in the aftermath of the financial crisis. The government is this year withdrawing money from the fund for the first time to make up for lost oil income after crude prices collapsed over the past two years.

    “The 60 percent equity share has over time been very good for us because it has given us considerable income from the fund,” Finance Minister Siv Jensen said in an interview after a press conference. “But we have also experienced that there can be swings from one year to another because the stock market moves over time.”

    ‘Considerably Less’

    After getting its first capital infusion 20 years ago, the fund has steadily added risk, expanding into stocks in 1998, emerging markets in 2000 and real estate in 2011 to safeguard the wealth of western Europe’s largest oil exporter.

    It’s currently mandated to hold 60 percent in stocks, 35 percent in bonds and 5 percent in real estate. After inflation and management costs, it has returned 3.43 percent over the past 10 years.

    The committee said that the expected returns from the fund are now “considerably less” than 4 percent. With the current equity share, the commission predicts an annual real return of just 2.3 percent over the next 30 years.

    Still, that didn’t stop the chairman of the commission, Knut Anton Mork, from disagreeing with the majority’s conclusion. The former chief economist at Svenska Handelsbanken in Oslo instead recommended cutting the stock holdings to 50 percent.

    “The minority recognizes that the reduction in the oil and gas remaining in the ground over the last decade is an argument in favor of a higher equity share, but considers this less important than the predictability of budget contributions from the fund,” he said.
    Lastly, Will Martin of the UK Business Insider reports, The world's biggest sovereign wealth fund is about to start taking more risks:
    Norway's Global Government Pension Fund, the biggest sovereign wealth fund in the world by assets under management, could be about to start taking a lot more risks if it follows the advice of a government-commissioned report into the way it allocates its assets.

    The new report, released on Tuesday, argues that the £716 billion ($880 billion) fund should increase its holdings of shares, and move around £71 billion ($87 billion) of its assets into riskier equity holdings.

    This would mean that roughly 70% of the fund's assets are held in stocks, up from just less than 60% right now. As a result, the fund's government bond portfolio would shrink substantially

    "A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the Fund and a higher risk of a decline in its long-run value," the report noted.

    "The majority is of the view that this risk is acceptable, provided that there is political will and ability to adapt economic policy to the accompanying increase in risk, in both the short and long run."

    Previously, the fund held around 40% in equities before increasing its allocation to 60% in 2007, just before the global financial crisis hit.

    Norway's sovereign wealth fund is looking for new ways to make money given the rock-bottom yields most developed-market government debt has right now, and following the crash in oil that has seen prices for the world's most important commodity crash from more than $100 per barrel to just more than $50 now, having briefly dropped below $30 early in the year.

    The crash has impacted Norway's economy so much that in 2016 — for the first time in nearly two decades — the fund is expected to  see net outflows, with the Bloomberg reporting February that the government will withdraw as much as 80 billion kroner (£7.99 billion; $9.8 billion) this year to support the economy.

    Rock-bottom global bond yields are making things even more tricky, as interest rates close to zero all around the world continue to bite. The eurozone, Switzerland, Sweden, Denmark, and Japan all already have negative interest rates, and rates in most other developed markets are pretty close to zero. In the UK, the rate is 0.25%, while in the USA it is 0.5%.

    Low interest rates mean low yields on bonds, meaning that the fixed-income market is not one where there is much money to be made right now, and that has helped drive the recommendation to move more money into stocks.

    "With a higher share of equities the expected return will increase as will the income to the government budget. Yes, it comes with higher risk but we think we are well equipped to handle this risk," Hilde Bjornland, an economist who was part of the team that compiled the report, told the Financial Times.

    Should the fund take up the report's recommendations, it could have a substantial impact on European, and even global markets. The fund's stock holdings are already so large that if averaged out, it would hold 2.5% of every single listed company in Europe. In the UK for example, the fund has invested almost £50 billion in stocks, spread across 457 different companies.
    There are two huge global whales that everyone looks at, Japan's Government Pension Investment Fund (GPIF) and Norway's Government Pension Fund Global (GPFG). The latter was created for the following reason:
    The Government Pension Fund Global is saving for future generations in Norway. One day the oil will run out, but the return on the fund will continue to benefit the Norwegian population
    As you can imagine, it's a big deal for Norwegians and global markets what decisions are taken in regards to the Fund's asset allocation and its investments which are managed by Norges Bank Investment Management.

    I am very well aware of Norway's Government Pension Fund Global because when I wrote my report on the governance of the federal public service pension plan for the Government of Canada (Treasury Board) back in 2007, I used the governance of Norway's pension as an example on how to improve transparency and oversight.

    What I like about Norway's pension fund is that it's clear about its investments, takes responsible investing very seriously and is extremely transparent, providing great insights in its reports, discussion notes, asset manager perspectives and of course, in its submissions to the Ministry of Finance.

    For example, in its latest publicly available submission to the Ministry on October 14, there is an excellent discussion on how the Fund can properly benchmark unlisted real estate investments, going over three methods:
    The first uses data from IPD for unlisted real estate investments, adjusted for autocorrelation. The return series from IPD can be broken down into the countries and sectors in which the fund is invested. The greatest challenge when using IPD data for calculating tracking error is that the time series are updated only quarterly or annually. The relative volatility of equities and bonds is currently calculated using weekly data, equally weighted, over a three-year period. Even an extension of the estimation period to ten years, for example, will yield relatively few observations if the calculations have to be performed on quarterly or annual data.

    The second method uses data for shares in listed REITs, adjusted for leverage. The main benefit of using REITs over IPD data is the availability of observable daily prices. To be able to represent the fund’s unlisted real estate investments meaningfully, we need to select individual funds in the markets in which the fund is invested. Their leverage must also be adjusted to the same level as the “equivalent” investment in the fund. This selection process and adjustments to take account of differences in risk profile will to some extent need to be based on criteria that will be difficult for experts outside the bank to verify.

    The third method is based on an external risk model developed by MSCI. The Bank has commissioned MSCI to compute a return series for an unlisted real estate portfolio that resembles the GPFG’s portfolio of unlisted real estate investments. An external risk model gives the Bank less insight into, and less control over, the parameters that influence the return series, but has the advantage of being calculated by an independent party.
    I will let you read the entire submission to the Ministry of Finance as it is extremely interesting and well worth considering for large pensions that invest in global unlisted real estate and are not properly benchmarking these investments (and I include some of Canada's large venerable pensions with "stellar governance" in this group).

    Now, the latest submission recommending to increase the allocation of global public equities to 70% from 60% and reducing the allocation of global fixed income to 25% from 35% is not yet available on its website in the news section.

    It will be posted on the website but I am not very interested in reading their arguments as I don't agree with this recommendation at all and side with Knut Anton Mork who thinks the allocation should be cut to 50%.

    But I also think the allocation to global fixed income should be cut by 10% so that the Fund can invest more in unlisted real estate and infrastructure all over the world (see below). 

    My reasoning is that over the short, intermediate and even long run, the return on stocks and bonds will be very low and very volatile so now is definitely not the time to crank up the risk in global equities.

    Look, Norway's pension fund can put out all the academic discussion notes it wants on the equity risk premium but when making big shifts in asset allocation, the folks at NBIM really need to think things through a lot more carefully because cranking up the allocation in stocks at this point exposes the Fund to a serious drawdown, one that might take years to recover from, especially if the world falls into a long deflationary cycle (my biggest fear).

    Bill Gross rightly noted last month now is not the time to worry about return on capital but return of capital. In his latest comment, he notes that the doubling down strategy of central bankers significantly increases the risk in risk assets.

    All this to say that I am surprised Norway's mammoth pension fund is seriously considering increasing risk by increasing its allocation to global equities at this time.

    True, global bonds have entered the Twilight Zone and there are cracks in the bond market, which is why delivering alpha gurus are pounding the table that bonds are dead meat, as are other bond bubble clowns.

    But unless someone convinces me that the fading risks of global deflation are credible and sustainable, I still see bonds as the ultimate diversifier in a deflationary world.

    One thing is for sure, Fed Chair Janet Yellen isn't convinced that global deflation is dead which is why her speech last Friday on staying accommodative for longer, overshooting the Fed's 2% inflation target, was a real game changer for me.

    More worrisome, Yellen's speech was a stark admission the Fed may be behind the deflation curve (or unable to mitigate the coming deflation tsunami) and investors may need to brace for a violent shift in markets, one which could spell doom for equities for a very long time.

    And if that is the case, you have to wonder why in the world would Norway risk its savings from oil revenues and flush them down the global stock toilet?

    I'm not being cynical doomsayer here, more of a realist. I've actually recommended selectively plunging into stocks right now, but that advice carries huge risks and it won't help a mega fund like Norway's GPFG.

    Admittedly, it's a mathematical certainty that global bonds are not going deliver great returns over the next ten years, but it might be a lot worse in global stocks, especially when you adjust returns for risk.

    So what advice do I have for Norway's GPFG? Take the time to read my conversation with HOOPP's Jim Keohane where he admitted HOOPP will never invest in negative yielding bonds, preferring real estate instead.

    I personally recommend GPFG follows Canada's large pensions and ramp up its infrastructure investments which it just introduced into its asset allocation. Generally speaking, there is a growing appetite for infrastructure as large institutional investors are looking for scalable investments that can deliver steady cash flows over a long period.

    [Note: Norway’s sovereign wealth fund has bemoaned the smaller scale of infrastructure projects in developing nations after a report to the government called for it be allowed to invest in the asset class, but in my opinion it should exclusively focus on developed nations initially.]

    Still, I'm not going to lie to you, infrastructure investments are frothy and they carry their own set of unique risks (illiquidity, regulatory, political and currency risks like what happened to British infrastructure investments post Brexit).

    But Norway's pension has to stop being so excessively reliant on global public markets and start considering the benefits of global private markets. There is a reason why the Canada Pension Plan Investment Board and other large Canadian pensions are scouring the globe for opportunities across public and private markets, delivering excellent long-term results, and I think Norway's GPFG and Japan's GPIF need to follow suit, provided they get the governance right (not worried about Norway's governance even if it's not perfect, it is excellent).

    To be sure, Norway's GPFG is an excellent fund that is run very well but it's essentially at the mercy of public markets and far more vulnerable to abrupt shifts in global stocks than large Canadian pensions.

    No matter how much risk management it has implemented, at the end of the day, Norway's GPFG is a giant beta fund and that means it will outperform Canada's large pensions during bull markets but grossly underperform them during bear markets.

    On that note, let me remind all of you once again that it takes a lot of time and effort to research and write these comments. Please kindly show your appreciation by donating or subscribing on the right-hand side under my picture (you need to view web version on your cell to view the PayPal options on the right-hand side under my picture).

    Below, a CNBC clip which discussed why Norway tapped its oil fund for the first time back in March. I hope this doesn't become a regular occurrence in the future which is why I'm openly questioning the recommendation to crank up the risk in global equities at this time.

    There is a much better option, like following the asset allocation of Canada's large pensions which invest proportionally more in private markets and are delivering stellar long-term returns.