Rising interest rates can hurt alternatives as well...

So says Andy Silton.   Alternatives (PE, Hedge funds etc) rely heavily on cheap debt to juice up returns.  So it's not just bonds that get hurt in a rising interest rate environment.

NC Pension Fund bets on Private Equity

An article on Bloomberg.com  (also reprinted in the News and Observer) that talks about NC's move into more PE.

I'm quoted in the article stating that I don't think returns for PE will be that great going forward, simply because "everyone and their grandmother" is in the asset class.

Increasing alternative investments in public pension plans

The NC State legislature is considering increasing the pension fund's allocation to alternatives to 40%. As reported in Pension and Investments magazine, the state is also looking to allow the fund to hold on to assets if they exceed the allocation target.  The idea here is to avoid selling assets whose weights have increased because of high performance.

As Andrew Stilton (in his blog) notes, increasing the allocation to alternatives may not be such a great idea.

The problems are pretty simple:
1. Alternatives are very expensive - they have fees that can easily exceed 2%
2. The fee structure is such that you pay higher fees when performance is good, but you don't get a fee refund when performance is bad.   From the manager's point of view this is "heads I win, tails you lose".
3. Alternatives are very illiquid.
4. There is no free lunch in terms of performance.  To think that you will get higher performance from alternatives without some additional risk is pure folly.
5. Did I mention that these investments are expensive?

I personally think that relying more on alternatives is the wrong approach - a more conservative approach that focuses on traditional assets while paying the lowest fees possible makes more sense.

Underlying this move is a problem that plagues all state pension plans - that the expected return is set too high.   Given that long term bond rates are less than 2%, there is little chance that most funds will achieve their return objectives which are typically in the 7-8% range.   Of course the other options (higher taxes, higher payroll contributions, lower benefits) are all politically unacceptable.  (I've blogged on return assumptions in the past here.)

Incidentally - Stilton's blog "Meditations on Money Management" is excellent - highly recommended.





5/7/13:edited - to note that the legislation hasn't passed the house yet.

Should you add Private Equity to add diversification?

Probably not - from the Economist.

Let's look at a few characteristics of Private Equity.

1. PE has crazy high fees - 2/20.
2. PE underperforms
3. PE has artificially low volatility because its values are assessed by management (not the market).
4. PE is horribly illiquid.

All in all Private Equity sounds awful.  And yet institutional investors line up for it.





HT: Finance II at Tepper.

Private REITs

A fairly new (to me) blog that I've been following is by Josh Brown, aka "the reformed broker".   Josh has a great post on private REITs.   For those who don't know, a REIT is a "Real Estate Investment Trust".  These are basically companies that only invest in commercial real estate and Josh doesn't like them.  He invokes his 4 rules.

1. Brown's Law of Brokerage Product Compensation states that the more money a broker or financial salesperson is paid to sell you something, the worse it is for you.  The commissions on non-traded REITs are in the range of 7% versus the $5 trade you could do to buy a public REIT. 

2. Opacity is always indicative of information assymetry, and information assymetry always benefits The Street, not the clientele.

3. High-fee funds or vehicles will never match the underlying index by definition - the fees act as a drag in bull markets and add insult to injury in bear markets.

4.  The only self-justification brokers ever had in recommending private REITs was that because they don't trade and reprice publicly each day, they somehow served to "smooth the volatility" of a client's portfolio.  Which is Bullshit to the second power (BS²).

It won't come as any surprise that I completely agree with him.   In particular, I think that #4 often gets ignored, even by well informed institutional investors.  For example, it is not at all uncommon to see Private Equity investments in pension funds and college endowments for the alleged purpose of reducing volatility.  Private Equity reduces volatility because it is only valued periodically, and the valuation is done by the manager of the fund.  It's like saying your cholesterol is stable because you only get it checked every 5 years.   Just because something has a low recorded volatility doesn't mean that it is actually reducing the risk of your fund, all that is happening is that the risk is being ignored because it can't be measured.

Pension fund risky bets fail to pay off.

Pension Funds are increasingly chasing risky bets to try to hit return targets.   These investments are frequently highly illiquid, expensive, and as it turns out, not that high returning.

The shocking quote:

The $26.3 billion Pennsylvania State Employees’ Retirement System has more than 46 percent of its assets in riskier alternatives, including nearly 400 private equity, venture capital and real estate funds. The system paid about $1.35 billion in management fees in the last five years and reported a five-year annualized return of 3.6 percent. That is below the 8 percent target needed to meet its financing requirements, and it also lags behind a 4.9 percent median return among public pension systems.  (emphasis added) .

If those numbers are correct, then the State of Penn is paying more than 1% in fees per year.  That is appalling mismanagement.  (I say "if" because I can't believe that they are that bad).

This isn't just a problem for Pennsylvania.  My own state of North Carolina pays close to 0.5% a year in fees on its $75 billion pension fund, which while not as bad, is still a pretty terrible waste of taxpayers money.

Weaning off alternative investments

Apparently South Carolina is trying to reduce the amount of alternative investments it holds.   The State Treasurer cites concerns over fees.  Hmm ... sounds familiar.

Private Equity Fees

There's been much talk about Private Equity recently.   Yesterday, an article in the FT (behind paywall) talked about the fee structure underlying typical PE funds.  The article was based on recent research done by researchers at Yale and Maastricht Universities.

A few findings in the article and my thoughts:
1. Most PE funds are on a 2/20 basis.  2% annual fee plus 20% of any fund gains.   Compared this to your typical Vanguard fund which probably has an annual expense ratio of about 0.21%.

2. The 2% fee is based on committed capital, not invested capital.  This means that if a pension fund commits, say $100 million to a PE fund, but only ponies up $10 in the first year, the first year fee is 2% of the $100 million - or $2 million.  So in the first year, the pension fund could actually be paying a 20% fee on invested capital.  Furthermore, the 2% fee is on the total amount before the manager also takes 20% of the profits.

3. While PE was very profitable in the early years (pre 2000), in the past decade, the average PE fund made 4.5% per year after fees.  This number is also questionable because of the way that most managers compute returns.  If returns are computed on a time-weighted basis, then early returns from a PE fund are likely to be based on smaller investments.  These early returns are also likely to be higher than later returns.  As a result, I'd speculate that the actual dollar weighted returns are lower, not higher than 4.5%.

4. In the past decade, the average pension fund paid 4% a year in PE fees.  According to one of the researchers, about 70% of the investment gains have been paid in fees over the past 10 years.

So who invests in PE?  Well, just about everyone.  Most state pension funds have loads of private equity, as do most university endowments (including the university that I work for).  And these fees are just the beginning.  Frequently private equity is managed as a "Fund of Funds" which charges an additional fee to manage the portfolio of PE funds.  Add to that the overall cost of picking the "Fund of Funds" managers and the result is a huge amount of pension and endowment wealth is being squandered on fees related to PE.

Aside from fees, PE has some other very troubling properties.  First of all it is very illiquid - it is difficult to divest PE.  Second, the risk in PE is chronically understated because there is not market based evidence on how much the portfolio is worth.  The normal practice is for the PE fund manager to assign a value every quarter.  This means that the year to year fluctuation in value in PE is massively understated because of the smoothing effect of the manager's self reporting.  As my students will know, if you have a low volatility asset with a apparently high (overstated) return, a portfolio optimizer will overweight in this asset.  So the smoothing of the volatility gives the false appearance that PE is an attractive asset class.

Most state pension funds and university endowments seem to be so locked into the model that they must have PE and also hedge funds that they seem blind to these fees.  Of course, the fact that the providers of these products frequently contribute to state election campaign funds just makes the issue more troubling.

Here's my suggestion to endowments and pension funds.  Fire all your managers, experts, advisers, fund of fund pickers, tactical allocation experts and consultants and hire maybe one smart person to put together a well diversified portfolio of global index funds.   The administrative costs will be tiny, and the fund management fees will be reduced to a few basis points.  Your portfolio won't be very glamorous, but in the long run it will outperform.

Private equity and job creation

Steve Allen has a great discussion of recent research that show the effect private equity firms have on job creation (and destruction).