PSP's Annual Public Meeting 2010

PSP Investments' second Annual Public Meeting was held on October 28, 2010. You can consult the website's Annual Public Meetings section to download presentations and listen to audio recordings of the proceedings.

Let's first go over some sections of the speaking notes of Paul Cantor, Chair of the Board of Directors:

As I observed in the 2010 Annual Report, the first 10 years of PSP Investments were challenging times. According to the Wall Street Journal, the first decade of the 21st century turned out to be the worst ever for US stocks based on records going back to the 1830s. Total returns for the period 2000-2009 amounted to negative 0.5%. That compared with a high of 18% in the 1950s and was even lower than the negative 0.2% return for the 1930s Depression era.

In short, it proved to be an inopportune time to launch a new fund. Nevertheless, PSP Investments has grown into a robust, highly diversified fund that will soon rank among the largest pension investment managers in Canada and internationally. Assets under management now exceed $50 billion and the organization has more than 330 employees. PSP Investments has investments on every continent north of Antarctica.

Very true, the timing of this fund couldn't have been worse, but a decision was made to diversify away from non-marketable government bonds and over the long-run, this is the wise thing to do. As Mr. Cantor states further down:

The fundamental premise of the Board is that PSP Investments cannot achieve its desired objective for long-term returns of 4.3% — plus inflation — by investing in bonds. We can only achieve that by investing in other securities as well, such as equities. Of course, as events of the past two years underscored, markets are cyclical.

History has shown us that short-term volatility has always been part of equity investing. History has also shown us, however, that in the very long run markets have gone up more than they have gone down and that stocks have outperformed other asset classes over the long-term.

A note of caution here. Relying too much on history can be problematic given the structural nature of today's market and the unprecedented economic uncertainty that may loom for a prolonged period as developed nations struggle with the burden of debt. Moreover, as was mentioned a few days ago on the retirement disaster that lies ahead, even if you diversify away into stocks and alternative investments, investors will be lucky to achieve a real return of 2.1%.

Mr. Cantor goes on to state:

Thus it is important to not lose courage and sell when the markets decline; because chances are we would not be there in time to catch the wave when they rebound.

On that note, I am pleased to observe today that our patience has been rewarded: during fiscal year 2010, a substantial portion of unrealized losses from the downturn in the previous year was recovered. As at our March 31st year-end, PSP’s consolidated net assets had increased 37% to a new high of $46.3 billion and we earned a total portfolio return of 21.5%. In recent months, we passed the $50-billion mark in assets.

Those results underscore the solid long-term value of PSP Investment’s assets and also reflect initiatives taken to benefit from the market turnaround.

PSP enjoys an enviable liquidity advantage in that it does not have to pay out benefits for several more years. What that means is that unlike other pension funds, they weren't forced to sell stocks at the bottom to shore up liquidity. Deep pockets means you can keep buying the dips and sit tight waiting for markets to eventually turn around.

Mr. Cantor also spoke of reviewing PSP's Policy Portfolio:

Over the past few months we have undertaken a comprehensive review of the Policy Portfolio to ensure that it remains effective in delivering the expected returns. This review was enhanced by a significant strengthening of our ability to review the liability structure of our Funds and to link those with our asset allocation strategy.

The current Policy Portfolio has remained essentially constant since fiscal year 2006, when the last full review was performed. It reflects the diversification strategy initiated in fiscal year 2004 with the introduction of private asset classes — real estate in 2004, followed by private equity in fiscal year 2005 and infrastructure in 2006 — as well as the addition of the small-cap and emerging markets equity asset classes in fiscal year 2005.

The review takes into account the most recent expectations of long-term market conditions developed by PSP’s Economics and Market Strategy group. However, it is not only the market risks and volatility of returns that are being assessed.

The review also looked at another crucial consideration — the funding risk, that is the impact of the volatility of investment returns on the probability that a funding deficit will occur and on the stability of funding requirements.

Simply put, we want to ascertain that any funding deficit or changes in funding requirements as a result of investment returns would remain — under normal circumstances — within an acceptable range, while recognizing that we need to take on risks to achieve the real return objective.

Here too I will caution Mr. Cantor and the board of directors at PSP. Given that PSP is a fully funded plan, funding risks must be taken into account when constructing a Policy Portfolio. But the construction of a Policy Portfolio is tricky, especially nowadays.

My recent discussion with Leo de Bever highlighted some of the concerns that all pension funds are struggling with right now. Mr. de Bever isn't convinced that you can identify top quartile asset managers a priori and he feels that the shift into alternative investments will bring down the expected returns in illiquid asset classes as they become more "efficient".

Importantly, when reviewing your Policy Portfolio in this environment, you need to bear in mind what your peers are also doing. As silly as that sounds, it's crucial or else you risk overestimating the expected returns on an asset class. You also need to understand the long-term structural changes that are going to take place over the next decades. This is anyone's best guess, but a critical qualitative assessment is needed, and don't make the mistake of relying on quantitative analysis based on historical data.

Gordon Fyfe, President & CEO, presented PSP's fiscal 2010 results. The entire presentation and the accompanying audio are worth going over and listening to carefully. Some of the key themes covered were PSP's diversification (see chart above) and the move to bring assets internally. In fact, as shown on the chart below from page 12, more assets are managed internally and a great proportion of active management is internal.

The savings of such a move are significant. According to Mr. Fyfe, external active management is 3.5 to 7 times more expensive and outsourcing all assets to fund managers would cost approximately $140 million more per year.

In terms of returns, it was interesting to note that the top five private investments accounted for a significant portion of value added in fiscal 2010:

Another interesting thing I caught on audio was that 2 deals - Telesat and China Network Systems accounted for the bulk of the gains in private equity. Mr. Fyfe said the PE team reviewed many deals but only chose a select few for direct investments.

Finally, there is a big push to go into emerging markets - both in public and private markets. PSP's performance in the first six months of fiscal 2011 is 5%, but that doesn't include the performance of private markets which are valued once a year at the end of the fiscal year.

All in all, I thought this was a good presentation. Would have liked to have seen a discussion on benchmarks and compensation, but they steered clear of those issues. Also, it was surprising that nobody bothered asking any questions during the Q & A and that once again this year, no media covered PSP's annual meeting (no excuses, the media had ample warning time to do so as the announcement was posted on PSP's site for a few weeks). Once again, PSP is flying under the radar, which suits Mr. Fyfe and his senior management team fine. They prefer delivering the results and staying out of the limelight.

***Feedback***

Here is some feedback from people who attended the meeting:

• The PSP fund was put in place in 2000 with the objective to reduce the government expenditures relating to public sector pensions. Gordon often refers indirectly to this objective by comparing the fund yield to the Chief Actuary's long term investment assumption of 4.3% plus inflation. By limiting his comparison to the period corresponding to the years since when he was appointed is good only to the extent that it assesses the performance of the fund since he joined. What the constituents need (and should want to know) is how is the fund performing since day 1 (2000). It happens that the cumulative yield minus inflation is over 4.3% since 2004 but under 4.3% since day 1 (2000).
• I agree with you that any information regarding performance benchmarks and compensation practices was noticeably absent from the PSP Investments presentation. During the morning session, I raised a concern with CEO Gordon Fyfe regarding the increasing proportion of the PSP Investments portfolio dedicated to foreign asset classes and what corresponding risk management practices had been put in place along with
  this development.

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Irish NPRF Up 1.9% in Q3

A follow-up to my recent post on the luck of the Irish running out. Bloomberg reports, Irish National Pension Fund Posted 1.9% Return in Third Quarter:

Ireland’s National Pensions Reserve Fund earned a return of 1.9 percent to 24.5 billion euros ($34 billion) in the third quarter.

The fund’s so-called directed investments in the country’s two biggest banks, Allied Irish Banks Plc and Bank of Ireland Plc, delivered a return of minus 2.5 percent, the NPRF in Dublin said in an e-mailed statement today.

The return on the fund’s discretionary portfolio was 3.6 percent. That fund amounted to 17.9 billion euros at the end of September, it said.

Donal O'Donavan of the Irish Independent reports, National pension fund loses €400m in AIB and BoI deals:

The National Pensions Reserve Fund (NPRF) has suffered a loss of €400m on the investments it was forced to make in Bank of Ireland and AIB, according to figures released last night.

In 2009 the NPRF invested €3.5bn in preference shares in AIB and the same amount in Bank of Ireland.

However, this €7bn investment was worth €6.6bn by the end of September, according to data released by the NPRF.

Overall the fund showed a return of 4.9pc in the nine months to the end of September. It brings the total value of the fund to €24.5bn.

The NPRF was instructed by Finance Minister Brian Lenihan to make the "directed investments" to meet the banks' capital requirements.

Some of the preference shares have since been converted into ordinary shares, which have fallen in value.

The most recent figures do not take into account the fall in the value of AIB shares since its effective nationalisation was announced on September 30.

News of the losses comes as the NPRF prepares to pump up to €5.4bn in equity into AIB on behalf of the State at a fixed price of 50c per share.

Based on AIB's closing share price of 32.4c yesterday, the NPRF will suffer an immediate loss of €1.9bn if it funds the full amount.

The set price per share for the fundraising makes it highly unlikely that any private investor will buy into the deal.

The fund had €4.14bn of cash on its books at the end of September. It can support the AIB capital raising with a mix of fresh cash and by converting some of its preference shares into ordinary shares.

The NPRF said the return on the directed investments was 1.9pc between January and September, but fell 2.5pc between July 1 and the end of September.

Directed investments account for 27pc of the total wealth managed by the NPRF.

The return on investments not ordered by the Government was 6pc in the nine months to the end of September.

Strong performance by the listed equities that make up over half the investments was the main driver of growth.

As well as quoted shares, the fund also has investments in Eurozone government bonds, corporate bonds and in property and private equity.

While the losses on bank shares are a concern, one debt market source said the multi-billion scale of the NPRF meant it had "an ace up Ireland's sleeve, heading into 2011."

Ireland is the only one of the so called "peripheral euro economies" to have such a large savings account to fall back on.

The NPRF receives an annual investment from the Government and is not due to begin paying out on its investments until 2025.

Its investment objectives include a target of outperforming the cost of five-year government debt over rolling five-year periods.

A copy of the National Pension Reserve Fund's report is available on their website. Not sure if the NFRP has an "ace up Ireland's sleeve", but as shown below, the asset mix is fairly aggressive with almost 70% made up of listed equities and alternative assets (they are thus far not allowed to buy Irish government bonds; that may change):

(click on image to enlarge)

Just like CPPIB and PSPIB, the NFRP is lucky because it is is not due to begin paying out on its investments until much later (2025 for NFRP). That means it can afford to take on more risk in its asset mix and does not have the liquidity constraints of more mature pension plans. Having said this, these so-called "directed investments" will be scrutinized as will further political interference in the investment decisions. If these investments blow up, who will be accountable to Irish pensioners?

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Squeezed and Opting Out of Pensions?

Ellen Kelleher of the FT reports, Squeezed Britons opt out of pensions:

Hundreds of thousands of Britons have taken a holiday from their personal pension contributions, in further proof of the severity with which household budgets have been squeezed by the economic downturn.

The latest data from HM Revenue & Customs show that contributions to personal and stakeholder pensions fell by more than £1bn in the 2009-10 tax year.

As many as 430,000 fewer UK residents put money away for retirement through these vehicles in the last tax period, a fall of 4.5 per cent, according to the Revenue’s estimates.

The decline in pension savings in the UK appears to be turning into a long-term trend. Since the 2007-08 tax year, as many as 730,000 fewer UK residents are putting money into personal and stakeholder pensions, while total pension contributions have dropped by more than £2bn, according to the Revenue’s data.

It showed that £18.2bn was contributed to private pensions, including personal pensions and stakeholders, in the 2009-10 financial year, down from £19.26bn during the previous 12 months.

Tom McPhail, head of pensions research with brokers Hargreaves Lansdown, attributed the shortfall to middle-class Britons’ tendency to favour short-term savings arrangements which have a more immediate impact on households’ bottom lines.

“When people are worried about job security, there’s a tendency to divert savings into shorter-term arrangements such as individual savings accounts, or to reduce mortgage debt,” Mr McPhail said.

Experts believe the losses underline the importance of the auto-enrolment rules, coming into force in 2012, which will see employers forced to pay into a private pension for their employees, or use the government’s new National Employment Savings Trust (Nest) pension scheme.

The minimum employer contribution will be 3 per cent of salary and employees will be enrolled once they earn about £7,500 a year – though they will pay contributions on earnings above roughly £5,700. Staff will put in a minimum of 4 per cent of pay up to a maximum salary of £33,500 in 2006 prices. Tax relief will add 1 per cent.

Nest will have an annual cap on contributions of £3,600 a year, and a ban on transfers in and out – although the independent pensions review says the cap and the ban should go in a few years’ time.

All employers will have to offer a pension at least as good as Nest, or use the scheme. About 750,000 will have to provide a pension for the first time and are likely to take the latter option.

Meanwhile, here in Canada, Janet McFarland of the Globe & mail reports, Ontario report calls for boost to pensions:

Ontario’s recipe for improving Canada’s pension retirement system includes both modest improvements to the Canada Pension Plan and new pension innovations from the private sector, Finance Minister Dwight Duncan says in a new report.

The province issued a consultation paper Friday, asking for public input on proposals to improve pensions for Ontarians as part of a national initiative to find solutions to boost retirement incomes across Canada.

In a letter accompanying the report, Mr. Duncan continued to support a proposal he endorsed at a national finance minister’s meeting in June calling for an expansion of CPP benefits for Canadians. The proposal has faced opposition from Alberta and is expected to be debated again at a finance minister’s meeting in December.

“A modest enhancement to the CPP now would provide a significant benefit to these workers when they retire,” Mr. Duncan said. “I believe such an enhancement is affordable if contribution rates are phased in gradually, particularly in light of the over $8-billion in annual tax relief Ontario will be providing to businesses as part of its tax plan.”

The report does not back any specific model for achieving that goal, however, only outlining different options and asking for comment on the choices.

Currently, CPP benefits are structured to replace 25 per cent of an individual’s career average earnings up to an annual limit currently set at $47,200, although most retirees do not qualify for the maximum amount.

One reform option is to increase the maximum income replacement rate from 25 per cent currently to a higher rate, such as 35 per cent, the report said. Another option is to increase the maximum earnings ceiling, the report said, noting that a 50 per cent or 100 per cent increase would move it from $47,200 a year to $70,800 or $94,400.

The report also asks for comments on potential implementation issues with expanding the CPP, including how to phase in the increases and how extra money in the fund should be managed. It also questions whether an increase would have an impact on other retirement savings by inducing employers to reduce their pension benefits or inducing individuals to save less on their own.

Mr. Duncan also said governments should make regulatory changes that will provide better private-sector pension options.

In his letter accompanying the report, he said current rules only allow pension plans to be offered by an employer to an employee. This limits options for people who are self-employed or who work for small companies that cannot afford to offer a pension plan.

The report asks for input on proposals to allow financial institutions to offer pension plans with participation from multiple employers, allowing more companies to offer retirement benefits to workers and reducing administration costs by creating large pools of funds.

The report said one goal of such plans would be to allow individuals to hold their own accounts in the pension plans, so they could transfer them if they switch jobs. The money would also be portable nationally, the report suggested.

“By changing these laws, we can expand the range of institutions that can set up pension plans, and the range of people who can access them,” Mr. Duncan said.

The report also asked for comments for reforms to make it easier for companies to offer “target” benefit plans, which are similar to traditional defined benefit plans, but allow the employer to reduce payouts if the pension plan does not have sufficient assets to maintain coverage.

Employers and pension experts have argued such plans would be more flexible for sponsors and could be a solution to declining pension coverage in the private sector, where many traditional plans are being abandoned.

You can download Ontario's new report, Securing Our Retirement Future: Consulting with Ontarians on Canada's Retirement Income System. I think it's a step in the right direction, but much more needs to be done. What really worries me is what's going on in Britain, and how long before we see the same trends on this side of the Atlantic (probably already happening).

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Retirement Disaster Ahead?

Brett Arends of the WSJ reports, Warning: Retirement Disaster Ahead:

Don't let the rally in the stock and bond markets fool you. Many Americans are still hurtling towards a retirement disaster. Few realize it. Even many of those running the big pension funds don't know.

That's the conclusion of John West and Rob Arnott at Research Affiliates, an investment management firm, in Newport Beach, Calif. In their latest report, "Hope Is Not A Strategy," they have some numbers to back it up.

"I worry a lot about people reaching their golden years and discovering, 'Oh, I should've saved more,' and 'Oh, I don't qualify for Social Security any more because it's means tested'," says Mr. Arnott, a widely respected market strategist. "We're headed for a retirement train wreck," he adds, "and it's going to get really ugly over the next 15 years."

Alarmist? Perhaps. But follow the math.

The returns you will get from your stock funds can only come from four things, they note: Dividends, earnings growth, inflation and changes in valuation.

Right now the dividend yield on U.S. stocks is about 2.2%, they note. Historically, earnings have only grown by a surprisingly low 1% a year in real, inflation-adjusted terms. Mr. Arnott tells me the average since 1900 is only about 1.2%, and in the last half century just 0.6%. Will we get more in the future? With the U.S. population ageing and heavily in debt? It's hard to imagine.

Throw in a 2% inflation forecast–more on this later–and Research Affiliates forecasts a long-term return of 5.2%.

What about changes in valuation? Some generations are lucky. They invest in the stock market when it's depressed and shares are cheap in relation to earnings. This was the case in the 1930s and the 1970s. Then they retire and cash out when the market is booming and shares are expensive in relation to earnings–such as in the 1960s and 1990s.

People today are not so lucky. The stock market's latest rally has lifted shares already to pretty high levels in relation to average cyclically-adjusted earnings. This so-called "Shiller PE" (named after Yale professor Robert Shiller, who popularized the notion) has been an excellent indicator of market value. Right now it's at about 22–well above its historic average of 16. The only time the market has boomed from these levels, was in the late 1990s bubble–an atypical moment unlikely to be repeated any time soon.

Now look at bonds. Thanks to the recent boom, the picture for investors here looks even worse. And there is less room for ambiguity, because bond coupons and the repayment of principal are fixed.

Based on the yields of prices across all investment grade bonds, Mr. West and Mr. Arnott calculate likely long-term bond returns from here of about 2.5%.

So an investor with 60% of his portfolio in stocks and 40% in bonds, a standard, if conservative, allocation, can expect a weighted average return from here of only about 4.1%.

To put this in context, they notice that the typical big pension fund is still expecting to earn about 7% to 8% a year.

When you strip out 2% inflation, that means pension fund managers are expecting 5-6% percent a year in real, inflation-adjusted terms.

But by Mr. West and Mr. Arnott's numbers, investors can only expect about 2.1%.

Gulp.

Here's what this means for you.

Someone who saves $10,000 a year for 30 years and invests the money at 5.5% a year will end up with $760,000.

Someone who only manages to earn 2.5% on their investments: Just $420,000.

If you're running a pension fund, this kind of shortfall leads to a funding gap that must be made up by the plan sponsor. For a private investor trying to build their own savings, it leads to a dismal retirement.

Is there any hope?

I asked Mr. Arnott about two possible sources of higher returns.

The first: Stock buybacks. Will they help? Many companies are trying to return more money to investors, on top of dividends, by buying back stock. In theory, at least, this ought to boost returns, because it reduces the number of shares, and therefore increases the value of those that remain. But Mr. Arnott cautions against relying on it. We don't know how big these buybacks will be, and we don't know if they're sustainable, he says. Furthermore, the gains are usually offset by the issue of new stock and options to management. "Most buybacks are done to facilitate the exercise of management stock options," he says.

The second possible source of better returns: Emerging markets.

Investors have been throwing money into emerging market funds recently like a hail mary pass–a last, desperate bid to snatch a decent retirement from the jaws of defeat.

But they may be substituting hope for reason. By Mr. Arnott's math, even the most heroic calculations cannot plausibly predict that earnings growth in emerging markets will be more than a couple of percentage points faster than in developed countries. And there are plenty of people who argue it won't be markedly higher, over time, at all. Why? Where economies grow more quickly, new capital flows in. Current investors find their returns diluted by new enterprises and new stockholders.

Meanwhile, look at the valuations. Stock markets in emerging economies have skyrocketed in the past two years. Hot markets like Brazil and India have nearly recovered their 2007 manic peaks. As a result, your dividend income is even worse than in the U.S. The yield on the Indian stock market is down to about 1%, according to FactSet. Brazil has dipped below 2% and China, 1.6%.

Bottom line? Neither pension funds nor private investors seem to have fully absorbed the grim lessons of the past decade. Returns are going to be much lower. People need to save more, much more, for their retirement. If the market rally this year has given them false hope, it will have turned out to be a curse more than a blessing.

I went over West and Arnott's latest report, "Hope Is Not A Strategy," and found it quite interesting. I urge you to read this report carefully, and pay particular to attention to this:

Many investors, keenly aware that returns will be lower than the past 30 years, have turned to alternative categories like hedge funds, private equity, infrastructure, emerging markets, timberland, and so forth, in a quest for equity-like returns and diversification of risk. This eclectic group has a relatively short history, dubious data (i.e. survivorship bias), and a heavy reliance on the most difficult metric of all to forecast—manager alpha. Thus, Polly simply took the 75th percentile 10-year return for the HFRI Hedge Fund of Fund Composite, which equated to 9.4%.9 Even with the boost from survivorship bias, this gets us no better than the top-quartile stock market return. Still, her 8% return assumption does seem within reach.

...

Table 3 illustrates that Polly can “get there” only by assuming top quartile results for stocks, bonds, and alternatives. Furthermore, all three must produce these lofty results simultaneously over the same span! What are the odds of that? Assuming these projections are representative, this works out to 25% × 25% × 25%, or about a 1.6% chance. Yikes!

This is exactly what the overwhelming majority of the U.S. retirement market—pension funds, state budgets, IRAs, 401(k)s, etc.—is not only hoping for but depending upon. That’s $16 trillion of assets expecting a decade of sunshine to achieve the 7–8% targeted returns used for planning and budgeting purposes.

This report highlights the problem pension funds and individuals face when they "hope" their rosy investment forecasts come true. They're setting themselves up for a fall. The only way they can achieve these results is by taking on more risk, but this can backfire if disaster strikes like it did in 2008. Hope isn't a strategy, and even though the Fed keeps pumping tons of liquidity into the financial system, it won't make a difference in averting the major retirement disaster that lies ahead.

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Luck of the Irish Running Out?

John O'Donnell of Reuters reports, Ireland urged to use pension fund to buy bonds:

Ireland's finance minister has been urged by some senior advisers to allow the country's 24 billion euro ($33 billion) state pension fund to buy Irish government bonds to support demand, an Irish official said on Wednesday.

The senior official, who declined to be named but is familiar with financial policy discussions in the Irish government, said no decision to take such action had been made.

A spokesman for Ireland's department of finance, contacted by Reuters, said: "There are no proposals to do this."

Tapping the fund, set aside to pay the state old-age pensions as well as pensions for Irish civil servants, could meet stiff political opposition. Roughly 10 billion euros of it are already earmarked to buy stakes in struggling Irish banks.

But some officials now believe a change in the law covering the fund, which currently prevents it from buying Irish bonds, could help the country as it prepares to return to the debt markets to borrow next year.

"That's an asset that the government has which they can choose to use -- it's there," the official told Reuters, adding that the "firepower" of the 24 billion euro fund could encourage other investors to buy Ireland's debt.

"Under law, the fund is not allowed to invest in Irish government paper. To do that would require a change in legislation," the official said, acknowledging that "raiding the fund" could prove politically difficult.

The suggestion is similar to one made by a prominent economist at Ireland's Economic and Social Research Institute, a think-tank that is influential with the Irish government.

John FitzGerald, a member of a new Central Bank Commission which replaces the old board of the central bank, has recommended selling some of the investments in the pension pot to cut the country's overall debt burden.

But using the fund to shore up Ireland's finances is likely to ignite controversy amid drastic tax hikes and spending cuts.

IRISH HEDGE FUND

Speaking to Reuters, FitzGerald outlined how Ireland could use its cash reserves and the pension fund to reduce its ballooning debt, which is set to match the country's 160 billion euro economic output this year.

"It doesn't make sense to act as a hedge fund," he said, adding, however, that he would be critical were the fund to be tapped to buy Irish bonds. FitzGerald said Ireland "investing in itself ... would lack credibility."

Ireland expects its deficit to blow out to an unprecedented 32 percent of GDP this year due to the one-off inclusion of a bill for purging its banking sector of years after years of runaway lending.

But even excluding the bank burden, which could hit 50 billion euros, the shortfall will be 12 percent of GDP, four times the EU's limit of 3 percent of GDP, as anemic growth and rising unemployment sap tax revenues and weigh on spending.

Once hailed as an economic "Wunderkind," Ireland is battling to prove it is not in need of assistance from Brussels or lender of last resort, the International Monetary Fund.

Olli Rehn, the EU's Economic and Monetary Affairs Commissioner, will meet government members, opposition politicians and trade union officials in Dublin early next week to underline the seriousness of the situation.

Struggling to convince international investors it is not on the verge of a Greek-style debt crisis, Dublin is redoubling efforts to tackle the worst deficit in Europe.

On Tuesday, it said it planned to squeeze 15 billion euros in fiscal savings between 2011 and 2014, double its original target.

Poor Ireland, unlike the US, they can't print dollars to purchase their bonds, so they're resorting to using hard earned savings of pensioners to boost their fledgling debt markets. Needless to say, if they go through with this silly idea, it's a desperate attempt to shore up their public finances and it's not in the best interest of Irish pensioners or taxpayers.

There's an old Irish saying, 'Tis better to spend money like there's no tomorrow than to spend tonight like there's no money!'. But the money has run out. Just like Greece, Ireland is going to go through its share of fiscal austerity and hopefully they'll come away stronger. But I fear that if they start implementing these short-sighted policies, it will only exacerbate their precarious situation, and possibly lead them down the path of another potato famine.

The Irish deserve better. It's high time the Irish government stops using pension monies to implement its policies and starts taking a longer-term view on how to boost Ireland's economy which is way overleveraged to the financial sector.

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Are SWFs The New Endowment Model?

Greg bright of top1000funds.com reports, New endowment model: follow the SWFs:

Some sort of shape is starting to take place, post-global crisis, as to how the biggest, longest-term investors are spending their money. If the endowment model was the one to follow for the past 20 years, the sovereign wealth fund model may be the one to follow for the next.

Endowment-envy swept the world in the early part of this decade, which was probably a decade too late to reap the benefits from following the very clever investment strategies of the likes of Yale and Harvard. By the time of the global financial crisis, the envy had faded.

But investors should think about why the endowment model of investing worked so well for as long as it did. If we can isolate the good things and then transport them to the post-crisis world, a new and better model may emerge. And, as always with investing, if the strategy is right, those in first will be rewarded.

What the big endowments did was invest directly, with their own teams of specialists and professionals, in areas where they had particular expertise, such as private equity and real estate. They then laid off the other parts of their portfolio in much the same way as big pension funds do anywhere, with a mix of growth and defensive allocations.

The problem was that in the crisis, correlations all went to one, and liquidity became a big issue. Endowments usually have to pay some income each year to their associated institution (such as a university), the same as a pension fund does with its retirees. But endowments don’t have a sponsor to top up the pot after one or two negative years. They have to rise and fall on their own merits.

Sovereign wealth funds are also a mixed bag of investors. Some of them have target dates for delivering on returns, some have target returns over various periods. Some are just set up to “make money” for the country by investing resources or foreign exchange reserve build-ups. Some are very transparent, others remain opaque.

What they have in common, though, is a single shareholder – a government – with a legislated genuine long-term aim for the fund’s investments.

Their investments, over the past 10-or-so years when the SWFs around the world have started to attract headlines, have also been a mixed bag. But a common element is the desire to take significantly large stakes in companies or other assets which reflect a long-term theme.

SWFs have, for instance, waded into hostile takeover battles for resource companies. They have invested directly in big infrastructure projects. And they have backed IPOs of established businesses which are targeting future growth areas.

This thematic focus has exacerbated political concerns about some SWFs being too nationalistic. Those from resource-importing countries taking big positions in resource exporters can be perceived as politically inspired. Or not.

But all investors can identify themes and direct their asset allocation accordingly. SWFs have the added advantages of fire-power to get a seat at any table and the inhouse resources to analyse and negotiate their positions.

A classic example of a thematic direct investment by a SWF from a resource-importing country, China, was written up last week in a client newsletter by HSBC, the global bank and fund manager.

In its case study, HSBC focused on a food stock which encompasses the two themes of globalisation and increasing demand for higher-protein food. The stock is Noble Group, based in Hong Kong and listed in Singapore. Last year, the China Investment Corporation, China’s $300 billion SWF, bought 15 per cent of Noble for $850 million.

Noble has operations in a lot of countries, vertically integrating its business and clipping the ticket at various points. It started life as a commodities trader but has grown into a supply chain manager of agricultural and energy products. One of its products is soya beans.

Soya beans, which have East Asian roots through history, are grown now mainly in South America and used for a range of products from animal feed and edible oils to soaps and biodiesel fuel.

Noble sells fertilisers to the South American soya bean farmers, buys the grain from them, stores it in Brazil and Argentina, crushes it, ships via its Noble Chartering subsidiary around the world – including China, which takes 37 per cent of the output – and sells to wholesalers.

Ricardo Leiman, Noble’s Brazilian-born chief executive, was quoted in the HSBC newsletter as saying that Noble and CIC will continue to look together for investment opportunities.

The biggest advantage SWFs have is deep pockets, which allows them to ride out any crisis in the short-term. The biggest problem they have is governance -- too much political interference in their operations and too little transparency. The slide below was taken from a speech David Denison, President & CEO of the Canada Pension Plan Investment Board (CPPIB), made back in June, Fixing the Future: How Canada Reformed Its National Pension Plan.

Despite these shortcomings, SWFs are a power to be reckoned with. They provide huge liquidity to all sorts of markets, both public and private. Mr. Bright wrote another interesting article in early October, GIC signals five emerging markets for future growth:

The Government of Singapore Investment Corporation (GIC) has signalled a further shift towards selected emerging markets and to private markets, in its annual report published last week.

GIC has highlighted five emerging markets in particular for medium-term growth: China, India, Brazil, South Korea and Taiwan.

But Ng Kok Song (pictured), GIC’s chief investment officer, was quoted after a press briefing on the annual report, as saying the sovereign wealth fund would favour private markets over listed equities for its increased emerging markets exposure.

At the end of its March fiscal year, the broad asset allocation for GIC, which invests the country’s foreign exchange reserves, was: 51 per cent listed equities, 20 per cent bonds and 25 per cent alternatives. Geographically, investments were spread: 36 per cent in the US, 30 per cent in Europe and 24 per cent Asia.

Ng said that about 80 per cent of GIC’s emerging markets exposure would be accounted for the three BRICs (excluding Russia) and Korea and Taiwan.

He said the fund would not necessarily be taking the well-trodden path of public markets for its exposures, but rather look at real estate, private equity and infrastructure.

GIC reported a total investment return of 7.1 per cent for the year, against 5.7 per cent the previous year.

The fund, established in 1981, has a 20-year investment horizon mandated by the Singapore Government. It tends to invest more widely than the other Singapore sovereign fund, Temasek Holdings, which has concentrated more on the Asian region.

Tony Tan, GIC’s deputy chairman, said: “GIC started to selectively take on more risk from the second quarter of 2009, amidst growing confidence in the economic recovery. I am pleased that the 20-year return of the portfolio has improved.”

I wonder how many more SWFs "started to selectively take on more risk from the second quarter of 2009". If this is the case, then expect a flurry of activity in private and public markets as the economic recovery takes hold. To ignore these deep pockets of liquidity is foolish.

Finally, Amanda White of top1000funds.com reported in late September, Conservative overweighting hinders world’s largest investor:

An overweight allocation to domestic bonds has not helped the world’s largest investor in the June quarter, with a massive $42 billion shaved off the assets of the ¥116,802 billion ($1.37 trillion), Government Pension Investment Fund of Japan (GPIF).

The fund’s ¥10 trillion exposure to international equities was the main contributor to the negative performance, with that asset class returning -17.43 per cent. Domestic stocks, also underperformed with a -13.93 per cent return for the quarter.

The GPIF has a 72 per cent allocation to domestic bonds, up slightly from the year before, and above its target position of 67 per cent. It also has another 8 per cent in international bonds.

The fund has allocations of 10.87 per cent in domestic equities and 9.11 per cent in international equities, and is most underweight in short-term assets, where its target is 5 per cent, and its allocation is short of 1 per cent.

Last financial year, ending March 31, international equities were the main positive contributor to performance, with a massive 46.11 per cent. The total fund return for the year was 7.9 per cent

Most of the assets are managed passively, and last financial year (ending March 31, it reduced its weighting to actively managed international equities, widening the number of service providers at the same time.

Overall the fund employs more than 80 funds managers.

I get nervous when I see funds massively overweight domestic or international bonds. I reread Niels Jensen's excellent comment, Insolvency Too, and paid particular attention to this passage:

Entire countries may have to (read: will) default on their pension obligations either overtly or covertly. A few countries have already started to adapt to the new reality by delaying the retirement age by a year or two; however, in order to solve a problem of this magnitude, we need a work force that is prepared to work until the age of 75. Expect some hard fought battles in the streets of Paris, Madrid and Athens!

The casino solution Interestingly, there is a solution. Solvency II does not require for insurance companies to hold any capital against EEA5 government bonds. As pointed out by Deutsche Bank in a recent research paper6, this looks an extraordinarily brave decision by the regulator, considering recent developments in peripheral Europe. But rules are rules. If you can see your pension fund sinking like the Titanic, but you know you have a good shot at saving the ship, if only you fill up the portfolio with high yielding government bonds, it must be very tempting to stuff your portfolio with Greek (10-year currently yielding 10.7%), Irish (6.6%), Portuguese (6.4%) and Spanish (4.1%) government bonds. It is one heck of a gamble but, then again, desperate people do desperate things.

At least one Spanish pension fund is already into this game. The €64 billion state pension fund, Fondo de Reserva, recently revealed that they expect to have 90% of their assets tied up in Spanish government bonds by the end of this year, up from about 50% in 2007. Expect this sort of behaviour to spread. It is a gamble many pension providers will be prepared to take, as the alternative is not that exhilarating either. Let’s just hope for the sake of millions of Spanish workers that the pension fund knows what it is doing. Unfortunately, Murphy’s Law has an unpleasant habit of popping up at the most inconvenient of times.

I seriously question why any pension fund would shift 90% of its assets to domestic government bonds. It's beyond stupid, it's actually criminal and violates basic principles of fiduciary duty. When the biggest bond bubble in history pops, these funds are going to get slaughtered. And amazingly, they think they're reducing risk. They're in for a nasty surprise!

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Don't Believe The Rally?

I wanted to follow-up on my previous post where Leo de Bever articulated his fears on what will happen when the music stops. Joe Saluzzi, co-founder of Themis Trading, was interviewed on Yahoo Tech Ticker on Monday (see video below):

Major averages are hovering near their highest levels since September 2008, but retail investors continue to flee the market.

Domestic equity funds have suffered outflows for 24 consecutive weeks through Friday, and over $81 billion has come out of domestic equity mutual funds year to date, according to Morningstar.

At the risk of stating the obvious, several factors explain why investors simply don't trust the rally.

Twice bitten, thrice shy: Having been burned by the bursting of the tech stock bubble in 2000, the housing bubble and the financial crisis of 2008, investors are understandably wary of getting sucked in again. A "lost decade" for index investors hasn't helped either.

It's the Economy Stupid: With the "real" unemployment rate near 17%, millions of Americans simply have no money to put into the market; many are cashing out their 401(k) plans and otherwise raiding their nest eggs in an effort to stay afloat.

Given the economic backdrop, it's no surprise many investors see the rally as being detached from reality and due only to the Fed's easy money policies...and the promise of more!

"We're not seeing any sort of growth other than stimulus," says Joseph Saluzzi, co-founder of Themis Trading. "That is a very disturbing thing -- the constant stimulus that keeps on coming that really does nothing other than barely keep you above [breakeven] on the GDP print."

In addition, Saluzzi says investors are rightfully worried about a market dominated by "high-speed guys just chasing each other up and down the price ladder."

Unsafe at High Speeds

As has been widely reported, high-frequency trading routinely accounts for more than 50% of daily U.S. equity trading volume and regularly approaches 70%.

Saluzzi isn't opposed to high-frequency trading per se, calling it a "byproduct of the market structure," as detailed in the accompanying video. But he believes that structure is broken, thanks to rules promoting computer-driven trading, most notably Reg NMS.

As a result of regulatory changes and new technology, events like the May 6 ‘flash crash' "will happen again," he says. "There's not a doubt in my mind."

Many retail investors feel the same way, another reason for the mistrust of the rally and why about $65 billion of the equity fund outflows this year have occurred in the five months since the "flash crash".

So are high frequency trading (HFT) platforms accounting for 70% of the daily trading volume? I'm not sure if it's that high but I have no doubt that today's stock market is primarily driven by multi-million dollar computers developed by large hedge funds and big banks' prop desks.

And what's the best way to beat high frequency trading? Take a long-run view on a stock, a sector, or an asset class. You're never going to beat the computers day trading but you can make money in these markets by understanding the weakness of these HFT platforms. For example, if you hold shares of a solid company and the price plunges on high volume for no real valid reason, chances are some HFT is going on in that company. My advice is to add to your positions on those dips and just hold on. If you get cute, placing tight stop losses, you're going get burned. Just like anything else, computers have advantages and disadvantages.

[Note: Keep an eye on Citigroup (C), a favorite target of HFTs, and Research in Motion (RIMM). Both stocks are primed to break out from these levels. I prefer RIMM.]

What worries me more is what Saluzzi says on how volatility is impacting the IPO market. But the facts don't back up his claims. In fact, according to Renaissance Capital, $23 billion was raised in the global IPO market last week, making it the biggest week this year and signaling a revival in investor interest for this class of equities:

The Hong Kong offering of AIA, a carveout of AIG's Asia Pacific life-insurance business, raised $17.8 billion, making it the fifth-largest IPO on record. Also Taiwan's TPK Holdings has a $200 million IPO; the firm is the supplier of the touch-screen technology behind Apple's iPad.

In early November, Coal India IPO is set to raise more than $3 billion in what may be the country's largest-ever initial public offering.

In the U.S., handbag-maker Vera Bradley (VRA), Chinese education provider TAL Education (XRS) and Italian restaurant chain Bravo Brio (BBRG) raised a combined $440 million, while in South America, oil and gas provider HRT Participações sold $1.4 billion in new stock on Thursday.

Norway’s Statoil Fuel & Retail raised $800 million after pricing at the top of the range Thursday. Andthe world's largest online betting exchange, London-based Betfair, made its public debut by raising $540 million.

The average 2010 IPO has returned 6.3% from its first day close to date, outpacing the 4.8% year-to-date return of the MSCI World Index (IWRD), says Renaissance.

“Heavy, deal flow, positive returns and a swelling IPO pipeline suggest an active close to an already active year, and an IPO market that has finally returned to more normalized issuance levels,” the company said in an online blog.

As for the economy, don't just focus on the US. CPB Netherlands Bureau for Economic Policy Analysis released its world trade report on Monday, showing world trade up 1.5% month-on-month in August and world industrial production up 0.2%:

Compared to its long run average, production momentum remains high in July, particularly in the United States, the Euro Area, and emerging Asia.

There is a lot of slack in the US economy, but things are slowly shifting. As for the rally, there is plenty of liquidity to propel shares much higher. While I understand asset managers who are skeptical, I fear they will be left in the dust when the markets start going parabolic. And whether or not you believe in the rally, it's irrelevant. What is relevant is how long can you afford to underperform the markets before you lose your job?

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Leo de Bever on When The Music Stops

Late Friday afternoon, I had a chance to speak with Leo de Bever, CEO & CIO of the Alberta Investment Management Corporation (AIMCo). As always, the conversation was fascinating as we delved deep into issues affecting pension funds.

A few weeks ago, AIMCo released its Annual Report 2009/2010. AIMCo's fiscal year ends March 31st, just like that of CPPIB and PSPIB. AIMCo’s total fund return was 12.0% for the year ended March 31, 2010, outperforming the AIMCo Composite Benchmark by 1.2% and the AIMCo Client Composite Benchmark by 1.5% (click on image below to enlarge):

AIMCo’s Balanced Fund Composite return was 17.8% for the year ended March 31, 2010, outperforming the Balanced Fund Client Composite Benchmark of 16.9% by 0.9%.

What I found particularly interesting was the section covering changes to performance benchmarks:

Prior to July 1, 2009, AIMCo measured performance against the asset-weighted composite of client investment policy benchmarks (i.e., the Total AIMCo Client Composite Benchmark). At one point, this measure had as many as 90 separate benchmark components. Some were minor variants of listed market benchmarks. Others reflected long-term inflation-adjusted total return aspirations that already included an expected return from active management. This structure stemmed from a historical focus on filling client demand for standalone investment “products”. It is not well-suited to managing total portfolio risk and return, or for measuring the effectiveness of active management.

A client’s policy benchmark should measure the net return from passively investing policy asset mix in listed bond and stock market indices. Unlisted allocations should be linked to the closest listed return and risk proxy. On July 1, 2009, AIMCo adopted internal performance management benchmarks consistent with this principle.

The 2010 fiscal year Total AIMCo Composite Benchmark reflects the Total AIMCo Client Composite Benchmark prior to July 1, 2009, and the new, market-based measures thereafter. The difference between these two measures will diminish over time. As client investment policies come up for revision, we are making considerable progress towards reducing benchmark complexity and setting separate active return goals.

We made these changes because there is merit in simplicity and conceptual consistency. We would have been better off last year using the AIMCo Client Composite Benchmark, but we believe the new benchmarks are the right benchmarks for the long term. Generally speaking, the absolute targets in the AIMCo Client Composite Benchmark will pose a higher hurdle for active management when markets are declining; whereas the new AIMCo benchmarks are more challenging when markets are rising.

Because this is a transition year, the remainder of the Investment Performance section reports on Balanced Fund actual performance and client composite benchmarks, as we have a longer return history for our Balanced Funds. Future annual reports will report only on the AIMCo Total Fund Composite.

As you can see below (click on image to enlarge), the benchmarks used for AIMCo's policy portfolio are transparent and mostly based on passive listed indexes:

Mr. de Bever was telling me how the benchmark for private equity (PE) used to be CPI + 8%, but this wasn't realistic. "Return on market risk in the 1990s was CPI + 7%. Since 2000, it's CPI + 2%, so you have to adjust your expectations accordingly".

We got into a long discussion on policy portfolios and active management. "My goal is to effectively deal with the end issue -- to deliver the best risk-adjusted returns. Policy determines 80% of the outcome." He referred to work done by Bruce Clark and John Campbell at Arrowstreet Capital (also see their extensive research on-line): "Mean reversion means there are better or worse times to be in equities but the problem is how do you determine that?"

I told him that right now, I see everyone nervously playing the Bernanke put because the fear of underperfomance is overwhelming the fear of another Black Swan event. Here is where the discussion really got interesting. Every senior pension fund manager and asset manager is facing the same concerns, and should pay attention to this part.

"Banks do not mark their commercial real estate to market. Quantitative easing (QE) is all about giving banks enough of a cushion to absorb these losses. For Bernanke, keeping the system afloat takes precedence over everything else. Not sure he's wrong but he's solving one crisis by sowing the seeds of another."

He referred to Carmen Reinhart and Ken Rogoff's book, This Time Is Different: Eight Centuries of Financial Folly and told me that he's worried that something might happen over the next few years. "What am I suppose to do? If I'm too conservative, I risk underperforming. But markets are schizoid right now and not at fair value. Markets are rewarding indiscriminately -- it's a very tough environment to operate."

I told him the problem is that you you can't afford to underperform for too long or else you risk losing your job. That's why everyone is playing up QE even though they're nervous it won't do a thing to bolster the real economy. There he agreed telling me that consumption is holding up because most people are defaulting on their loans.

And on underperforming the markets and your peers, he mentioned the "Brinson effect" referring to Gary Brinson, Chairman and CEO of UBS Brinson (see an interview here). "You might eventually be right but it could cost you your job. Even long-term investors have low tolerance for short-term underperformance. They're long-term investors as long as it makes money in the short-run."

"The problem now is if you're too early, you're worse off. Prince once said as long as the music keeps playing, I'll keep dancing. That's what's happening right now. But when it all comes together, I'm afraid that some catalyst -- like the shooting of the Archduke in Sarajevo -- will blow all this up."

Mr. de Bever's concerns are reflected in the discussion of economic and financial conditions in AIMCo's annual report:

In 2009, massive public intervention restored liquidity to a banking system paralyzed by the crisis of 2008. Credit spreads narrowed, and both bond and stock markets recouped a large part of the previous year’s losses. Output in nearly all countries recovered from recession, but at vastly different speeds. Recovery was, to a large extent, fuelled by expansionary fiscal and monetary policy. The question now is how soon increased private spending will allow public stimulus to take a back seat.

In setting our investment strategy, we have assumed that increased private spending may not happen for some time. High consumption and overinvestment in housing financed by cheap credit were a large part of the problem. Therefore, they are unlikely to be a significant part of the immediate solution. In North America, corporate profits are strong, but investment remains weak because of high excess capacity in many sectors. Many firms used the recession to improve productivity, so labour market recovery will be slow. Currency devaluation is, at best, a stop-gap for more fundamental adjustments.

Overlaying all of this is the longer-term fiscal pressure on health and pension systems from an aging population and the growing realization that some of the policies put in place many decades ago may not be sustainable. One senses a hunger for simple and painless solutions to this complex set of issues. That is probably naïve. Whatever political consensus eventually emerges will take time and involve unpopular changes to taxes and public spending. This is not the greatest recipe for robust focus on economic growth.

Anyone’s ability to predict the three- to five-year return-on-capital with any accuracy is very limited. If markets were predictable, the return-on-equities would be both much lower and more stable. The best a long-term investor like AIMCo can do is to identify superior investments that largely stand on their own, but reflect our best estimate of what the future will bring.

In listed markets, the near-term outlook for stocks is mixed despite strong earnings growth because of doubts about the strength of the economic recovery. That same worry makes the near-term outlook for bonds attractive. However, the longer fiscal stimulus and low regulated interest rates are needed, the higher the medium-term risk is for higher inflation and higher interest rates. Given the inflation sensitivity of our clients’ obligations, we continue to look for assets with long-term inflation sensitive returns.

We would like to find effective ways to participate in the rapid growth of Asia and South America. However, economic growth has a distressingly low correlation with high investment returns. In many cases, it may be more rewarding to invest in sectors that export to regions experiencing rapid growth.

In private equity and debt, we are still seeing good opportunities with the recapitalization of companies that are fundamentally sound but have overextended themselves in the period just prior to the 2008 crisis. The next few years are promising for direct investments in private equity.

Interestingly, the returns on active management in fiscal year 2010 came mostly from internally managed listed equities:

For calendar 2009 and 2010, the Board and management agreed on a stretch target of $500 million for net value-added. This represents about 1% of balanced fund assets. This $500 million is allocated to various asset classes, based on where we expect opportunities to be the most attractive and on AIMCo’s estimated capacity to exploit those opportunities.

For example, the calendar 2009 fixed income target was unusually large because we saw good prospects for capitalizing on 2008 market dislocation. Equities are given a large allocation in calendar 2010 because of improved capacity to focus on incremental return. Managers are given an active risk budget appropriate to their value-added target.

Fiscal 2010 value-added by active management above the Total AIMCo Composite Benchmark was $748 million. Short-term value-added is inherently volatile and active program effectiveness should be judged over longer periods

The positive fiscal 2010 results came mostly from internally managed listed asset classes. Last year was not a good year for unlisted assets. Real estate and infrastructure have done well over longer periods. Our externally managed private equity portfolio suffered from high costs and heavy exposure to vintage year investments obtained near the peak of the last equity boom.

We discussed the cost of external managers, and private markets at length. Here, Mr. de Bever is unflinching: "Go to the discussion on page 24-25 of the annual report. External managers charge management and performance fees. Our internal managers are paid for value added over a listed benchmark. You can literally replace external managers at 1/3 the cost. If you look at how partnerships are structured, a third of the cost goes to paying managers, a third goes to marketing funds, and a third goes to somebody who put up the capital for the fund."

"It really pays to go internal, but when I got interviewed on the results, most reporters didn't focus on the fact that we cut external manager fees down from $175 million in year 1 to $126 million in year 2, but rather on what we paid internal managers."

I then told him that most hedge fund and PE managers will argue that unlike them, pension fund managers do not have skin in the game, no hurdle rate or high-water mark to deal with, and that they don't take stupid risks with other people's money an then fall back on a four-year rolling return when they blow up.

"A lot of hedge funds close shop when they're underwater and reopen under a different name (very true). As far as pension fund officers' compensation, you have to be careful. That four-year rolling return which our long-term compensation is based on is not an absolute return but a relative return to the policy portfolio. It probably should be extended to seven or ten years but Revenue Canada rules made that impossible in the past. And for the most part, pension funds operate under strict risk parameters."

I then brought up 2008 and the blow-ups at large Canadian pension funds revolving non-bank asset-backed commercial paper (ABCP) and credit portfolios. "ABCP was a classic duration mismatch. The extra yield did not justify the underlying risk. As far as credit portfolios blowing up, there was a governance problem between the groups measuring risk and those managing risk. I think 2008 was a wake-up call and a lot of those issues were rectified. You cannot blame risk officers for those credit blow-ups."

I brought up the tyranny of quants and the illusion of normality. "There is a famous dictum: models are to be used but never to be believed. You need a healthy dose of skepticism and you need to separate out risk measurement from risk management. Returns are not normally distributed. We're seeing extreme events more often."

As far as compensation in the investment and pension industry: "It's true that people in the investment industry get paid a lot, but when you consider the tough operating environment and the unstable nature of our industry, then I'm not so sure the compensation is as outrageous as some people think."

And on picking the top external managers, Mr. de Bever had this to share: "I'm not sure you can pick top managers so easily. You can have 1000 Warren Buffett wannabes and at the end of 30 years one of them will have delivered exceptional returns. I operate under two assumptions: (1) try to beat the markets as schizoid as they are and (2) never assume you're better than the market because that's when you're going to fall flat on your face."

The discussion on private markets was particularly interesting. I told him that as more money floods into alternative asset classes like private equity, real estate and infrastructure, returns have been coming down.

"Underfunded plans are shoving money into these asset classes but they fail to appreciate that returns have to be earned. As more money goes into these asset classes, the market becomes more efficient, the opportunity set shrinks and returns come down." To make his point, he pointed out to what's going on in infrastructure right now. In commercial real estate, however, he sees opportunities in some regions where current pricing is "at very low values".

We had an interesting discussion on bonds and underfunded pension plans. I told him it's crazy to see pension funds cutting risk now by going into long-term bonds. The push into liability-driven investing is exacerbating the bond bubble because many pension funds are (erroneously) assuming that they're cutting risk by going into bonds.

"This is the dynamic instability problem. I recently showed our clients what will happen to a 30-year bond if interest rates go up 1% from here. With a duration of 16, you'll suffer a capital loss of 16% and wipe out your gains very quickly. I'm more comfortable with 5-year government bonds." He added: "Most of the money in the bond market was made since 1980. In the last 30 years bonds have made almost as much as stocks, which doesn't make sense."

Finally, Mr. de Bever shared these thoughts with me on the state of global pension funds: "Plan sponsors do not appreciate the difficulty in making money in this environment. Funding ratios in Canada should be increased to 125% to reflect a 60/40 stock/bond split. You can't improve risk-adjusted returns by taking more risk ( In other words: most pension plans do not understand that the price for taking more risk to get higher return is greater volatility of return). The cost of pensions have gone up by a factor of 4 and contributions have not gone up the same. Look at France, people are in denial."

And he left me with this stark warning: "Some time in the next five years, politicians will have to deal with a funding and labour crisis." I guess that's when the music stops playing for good.

[I thank Mr. de Bever for graciously spending so much time with me covering these important issues. Any errors/ omissions in this post are entirely my responsibility and will be corrected if needed.]

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Ego Makes Entrepreneurs?

I spent all morning at the Palais des Congrès here in Montreal attending a conference on entrepreneuship which was sponsored by the Board of Trade of Metropolitan Montreal and financial institutions like the Business Development Bank of Canada as part of Small Business Week 2010:

The Board of Trade of Metropolitan Montreal and its team of experts in entrepreneurship – Info entrepreneurs – today announced the programming for Small Business Week 2010 in Montréal. The program will feature a series of activities that will bring together hundreds of entrepreneurs from the Montréal area. “This prestigious event is a special one for Montréal small businesses,” said Michel Leblanc, President and CEO of the Board of Trade. “It combines helpful training, presentations by experts and the perfect opportunity to establish or develop a professional network.”

The week offers a variety of activities that meet the needs and reflect the interests of all small businesses. On October 19, participants will have a chance to explore the different avenues available to them for financing their business projects. This day devoted to the search for financing will offer invaluable advice on developing business plans and using management tools. The day of October 20 will be devoted to expanding and growing companies, dealing in particular with export and innovation. The day will end with an exclusive evening to celebrate the top performing companies of the year. The week will close on October 22 with a major seminar on entrepreneurship. Panels throughout the day will feature renowned conference speakers who will share their experience and best advice. For details on the program, please visit the www.infoentrepreneurs.org.

At the same time the Board of Trade also unveiled the confidence index for its members for the third quarter of 2010, which has dropped slightly, moving from 5.95 during the second quarter to 5.93 during the third. “Entrepreneurs remain fairly confident about the growth of their businesses, but their confidence in the Montréal economy has flagged somewhat,” said Michel Leblanc. “The results show that Montréal businesses are resilient, in spite of the deteriorating global economic outlook.”

The Business Development Bank of Canada, the presenter for Small Business Week, also presented the conclusions of a survey conducted as part of the Angus Reid Forum. “This survey presents an enlightening picture of the outlook for small business,” said Mr. Leblanc. “It shows us that small businesses have understood the importance of innovation, that they remain prudent in their intentions to invest, but that they are optimistic about their growth objectives.”

This morning's presentations were excellent. There is nothing like listening to entrepreneurs tell their stories and how they succeeded with their companies. I was struck by two things in particular. There were quite a few young women in the audience and as panelists. It seems like women have more of the entrepreneur spirit here in Quebec (maybe elsewhere too).

The second thing that struck me is that while financing remains a big concern, it's not the biggest preoccupation for entrepreneurs. In fact, the bankers and financial experts made it clear that you need to choose your partners well and make sure they bring a lot more to the table than just money.

Jean-René Halde, President & CEO of the Business Development Bank of Canada (BDC) started things off this morning and gave an incredible speech. I've heard Mr. Halde speak a few times while working at the BDC - and was always very impressed - but this speech was amazing. Mr. Halde masters the French and English language and his speeches are both inspiring and thought provoking. Listening to him speak, I almost wish he'd run as the leader of a federal party (we desperately need leaders like him, but he serves us better at the BDC).

Mr. Halde said that the culture of entrepreneurship is lagging in Quebec. He said that the 60s produced some great entrepreneurs and business leaders but in recent years there has been a marked lack of entrepreneurship in Quebec, especially compared with Western provinces. He said that while "we identify, promote and support hockey players with talent starting at a young age, we do little to identify, promote and support our young entrepreneurs."

There was something else that struck me in Mr. Halde's speech. He talked about learning through failure. "In Quebec, we penalize people who fail" but in reality we should not penalize people who take on entrepreneur risk. There is value in failure and some of the best entrepreneurs have failed many times in their lives before succeeding. At one point, he referred to hockey great Wayne Gretzky who once said "You miss 100% of the shots you don't take" (see BDC's latest press releases for more).

Mr. Halde was followed by a panel of young and seasoned entrepreneurs which included:

Daniel Drouet, co-founder, Montreal Start Up
Caroline Saulnier, President, Synetik Ergonomic Solutions
Mary-Eve Ruel, President, Uranium

Élisabeth Deschênes, President, Zoum Armada
Daniel Schneider, Vice-President, Meubles Foliot inc.
André Morissette, President, Campagna Motors


I absolutely loved listening to their presentations. We spend so much time worrying about the stock market, bond market, black swans, etc., but these are the people who are producing and creating real wealth and jobs in our economy. I admire their perseverance, dedication and willingness to chase their dreams. We need more entrepreneurs, less financial engineers.

The ladies really impressed me. Ms. Saulnier spoke of how she developed her business and still has aspirations to pursue other ideas. Ms. Ruel said something very true "If being an entrepreneur was easy, everyone would be doing it". Ms. Deschênes spoke on the importance of branding.

The men were equally impressive. Mr. Drouet spoke on the low barriers to entry of web businesses and how entrepreneurs are using the web to grow their businesses. Mr. Schneider spoke on the importance of succession planning and integrating everyone when important decisions have to be made. He used the term "sociocratie" which is a mode of decision making and governance that enables an organization to behave like a living organism, self-organizing. The primary objective is to develop co-responsibility to the players and put the power of the collective intelligence of the organization's success (pension funds take note!!!). Mr. Morissette spoke of how he started the company at the worst possible time, facing unbelievable odds. "the greatest entrepreneurs are rebels".

A panel discussion then took place with Mr. Halde, Gaétan Morin, First Vice-President, Investments at Fonds de solidarité FTQ, Luc Bernard, Vice-President, Small and Medium Sized Enterprises at Laurentian Bank and Stephen Rosenhek, Associate Director at RSM Richter Chamberland. Michel Leblanc, President of the Board of trade moderated the discussion.

The panelists answered questions from Mr. Leblanc and the audience and gave aspiring entrepreneurs some sound advice: Be transparent, know your clients' clients better than they know them, keep your business plan simple/ realistic and remember you only have one shot to make a first impression. Importantly, choose your financial partners well, and make sure they offer you sound advice and consult you in good times and bad times. And Mr. Gaétan gave some sound advice: "Don't be afraid to surround yourself with people who are better than you."

Finally, Yahoo carried an article on Being Steve Job's Boss and I ran across a 2005 article from Bloomberg BusinessWeek, Ego Makes Entrepreneurs?:

Just how much appetite for risk do entrepreneurs really have? That's the question Wharton doctoral student Brian Wu began asking himself while examining their behavioral patterns. He found the general assumption to be that entrepreneurs are risk seekers -- but the empirical evidence suggests that, surprisingly, they weren't. But if entrepreneurs are more cautious than everyone presumes, then what accounts for their risk-bearing behavior?

That question is at the crux of Entrepreneurial Risk and Market Entry, which received the annual Best Doctoral Paper award from the Small Business Administration's Office of Advocacy this month. Co-written with Professor Anne Marie Knott of the University of Maryland, the paper describes entrepreneurs as inherently overconfident, which helps cancel out their sensitivity to risk.

A native of Shandong province, China, Wu has also studied the influence of the euro on his country's foreign exchange reserve and the staged financing of entrepreneurs. He came to the U.S. three years ago, after earning degrees from Tsinghua University in China and the National University in Singapore. BusinessWeek Online reporter Stacy Perman recently spoke with Wu about uncovering a seemingly inherent contradiction on the nature of entrepreneurs. Edited excerpts of their conversation follow.

Q: The accepted understanding has been that entrepreneurs have a greater tolerance for risk than the rest of the population, and yet your study found the opposite to be true. How so?
A: While conventional wisdom assumes entrepreneurs have great risk tolerance compared to the rest of us, in controlled experiments that tracked attitudes to risk, we consistently found that they aren't really that different. In some cases, they're even more risk averse [than the norm], and yet they continue to bear risk.

Q: So you're debunking the conventional wisdom?
A: I wouldn't say that so much as I wanted to make clear that there are dimensions of uncertainty. This disparity confronts two dimensions of uncertainty: One, the uncontrollable risks or market uncertainty, and two, the uncertainty of ability.

Entrepreneurs, like everybody else, hate uncontrollable risks, but on the other hand, they're overconfident in their own abilities -- they think they can control their abilities in a random drawing of people. It's like the Lake Wobegon effect in assessing their position among peers. They think they're above the average.

Q: That being the case, what then accounts for their willingness to bear risk?
A: It's their overconfidence in their ability. Their confidence is greater than their risk avoidance. It compensates for their aversion to risk.

Q: How does that influence their behavior?
A: Entrepreneurs appear to be risk seeking with respect to their ability. For example, if there are two industries and one has a high cost of ability uncertainty and the other has a low cost of ability uncertainty, the entrepreneur will choose the first case because of his overconfidence.

Even though the second industry has the same mean value, he would be considered just average [there]. While in the first, he thinks he can be Bill Gates. It's that overconfidence in their ability that encourages them to be entrepreneurs.

Q: Is this then the main differentiating factor between what makes an entrepreneur compared to the rest of the population?
A: There are many sources [of difference], like education, culture, social environment, and family tradition, but in the end, it's their overconfidence that drives them to be entrepreneurs.

Q: What's the advantage to this approach?
A: I wouldn't say it's advantageous. These findings help us understand why entrepreneurs take risks. If, in fact, entrepreneurs with low capabilities and high overconfidence enter [ventures], they're likely to fail in the end because they have overestimated their abilities.

For example, look at the airline industry. There's much uncertainty, and it's volatile. Still, we see a lot of entrants into it because they think they understand the industry. They think they have a higher ability then the other guys. They say, "I will be the next Southwest Airlines."

Q: Then is this an inherent disadvantage?
A: Of course, [the venture] is a failure for the entrepreneur, but the average person benefits. Overconfidence encourages [entrepreneurs] to enter an uncertain industry, and their low ability in it may lead to failure. But without that, the average person wouldn't enjoy the creativity of the entrepreneur and their innovations that lead to lower prices due to competition.

Q: What's the broader implication of this research?
A: It helps us to understand the entry-pattern behavior of entrepreneurs across industries. We can see the dynamic of entrepreneurial behavior. When there's a high degree of uncontrollable uncertainty but a low degree of ability uncertainty, we won't see a sufficient level of entry into an industry. But if there's a high degree of ability uncertainty, we will see a sufficient amount of entrants because their overconfidence compensates for the uncontrollable risks.

Q: As a native of China, how do you see the American entrepreneur in comparison to the Chinese entrepreneur?
A: I think mainly the difference is in culture, in terms of confidence and, in particular, overconfidence. I would characterize American entrepreneurs as confident. I wouldn't say they are overconfident, but they're confident, which is good.

Chinese entrepreneurs in some sense used to be constrained by all kinds of social, political, and cultural factors. Now, they're changing, as China enters the World Trade Organization, and they're becoming more and more confident.

The second thing is that, especially in technological startups, many Chinese entrepreneurs in the big cities are trying to learn from the Americans. More and more, there's a flow of information between the two economies. I'm not sure, but I feel there could be a convergence in entrepreneurial behaviors as China and the U.S. are becoming the two most important economies.

I end by telling you that I had a long and fascinating discussion with Leo de Bever, President and CEO at AIMCo on Friday afternoon and will prepare something over the weekend for you to read. It's going to be an absolute must read for senior pension officers, asset managers and all investors.

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