Supreme Court Refuses Disabled Workers' Case

Robert Sibley of Postmedia News reports in the Ottawa Citizen, Panel refuses disabled workers' case:

The Supreme Court failed to serve the "national interest" and thereby jeopardized the disability insurance plans of hundreds of thousands of Canadian workers by refusing to hear a case involving a group of disabled former Nortel employees, says a financial expert.

"It was in the national interest to hear the case so that 1.1 million Canadians could be assured their disability insurance plans were protected," said financial analyst Diane Urquhart. "The Supreme Court of Canada has de facto allowed a court precedent to stand that compromises every health and welfare trust in Canada for disabled insured policyholders."

On Thursday, a three-judge panel of the Supreme Court refused the group's request for leave to appeal a lower court's previous decision rejecting the former workers' attempt to challenge a court-approved settlement of Nortel's restructuring. As is customary, the panel did not provide a reason for why the court wouldn't hear the group's appeal.

Last June, a group of about 40 disabled Nortel employees workers lost its bid to extend benefits being terminated at the end of 2010 under a restructuring plan that involved the allocation of funds in Nortel's Health and Welfare Trust. The restructuring plan, approved by Ontario Superior Court Judge Geoffrey Morawetz, called for future pensioner life benefits to be included in distributions of the trust.

The group, a minority among the company's 360 disabled workers and 19,500 others covered by the agreement, objected, saying the plan would dilute existing claims of the disabled by $30 million.

According to court documents, an employee who earned $50,000 a year before becoming disabled would might see their annual income cut to $13,700.

However, the Court of Appeal for Ontario denied the group's request for a hearing on the settlement, upholding Morawetz's plan. The group turned to the Supreme Court, hoping it would hear their appeal of Morawetz's decision.

Urquhart, a Mississaugabased financial analyst who has been working pro bono for the disabled workers, was disappointed, saying the Supreme Court should have taken the opportunity "to issue directions to Canadian employers" for maintaining the financial viability and integrity of the disability insurance plans they sponsor.

Morawetz's decision, Urquhart argued, "has made every employer-sponsored disability insurance plan in the country unsafe" because it allows pensioners the legal right to take assets from the health and welfare trusts for their future life insurance promised by the company. But this, she said, "compromises" every health and welfare trust plan in the country with respect to disability insurance. "You wipe out the insurance for disabled workers."

In this way, by refusing to hear the case, the Supreme Court has effectively opened the door to allowing companies facing bankruptcy to raid trust funds supposedly intended to maintain health and welfare benefit plans, said Urquhart, a former research director with both Scotia Capital Markets and the former investment firm of Burns Fry.

"There are 1.1 million Canadians whose private employer-sponsored disability insurance plans are now unsafe if their employer goes bankrupt. That's why we felt the Supreme Court should have allowed the case -- it's in the national interest."

The court's unwillingness to act makes it incumbent on the government amend bankruptcy legislation to protect employees, she said. "The court could have made a decision to protect these people within the current legal framework. They chose not to. That means we need legislative change because the courts failed to enforce the current protections."

In the meantime, four members of dissenting group disabled former Nortel employees have filed a complaint with the Ontario Consumer Services Bureau under the provincial Consumer Protection Act.

They charge that Nortel Networks, its suppliers, and Sun Life Financial, which administered Nortel's disability insurance plan, engaged in "unfair practices in the form of false, misleading or deceptive representations to Nortel employees about its disability insurance."

I thank Diane Urquhart for sending me this article as it demonstrates more Supreme Injustice. There will be no justice for Nortel's disabled, only more pain as they struggle to cope with the cuts they received following Nortel's bankruptcy. Diane informed me that Peter Burns, a dissenting Nortel disabled employee, died on May 14th of this year. How many more disabled have to die before we start taking disability insurance seriously? The amounts we are talking about are a pittance and yet bondholders made a huge stink about it. This decision has sent Canada back to the Dark Ages, and I fear that this is one more assault on labor as the conservative agenda looks to weaken the rights of workers. We should all be very concerned (watch video below).

***Feedback from Bernard Dussault***

Bernard Dussault, Canada's former Chief Actuary sent me this comment:

I fully agree with you. This is outrageous, immoral and pure nonsense. The Supreme Court decision is exclusively technical. The SC should for the least have made recommendations as to how business money may/shall not be used, e.g. paying bonuses while the company is going bankrupt and owes money to various parties. Please let me know if you have an idea how my voice could be heard in order to avoid further cases like this one.

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Public Pension Problem Shrinking?

Lisa Lambert of Reuters reports, Public pension problem could be shrinking:

As the issue of underfunded public pensions in the United States takes center stage at city council meetings, state budget drafting sessions, congressional hearings and public protests, a report released on Wednesday says the problem may be getting better.

"Public pension funds are experiencing a robust recovery from the historic market downturn of 2008-2009 -- reporting strong investment returns, growing assets and funding levels on track to meet obligations," said the National Conference of Public Employee Retirement Systems.

The group, the largest trade association for public sector pensions, surveyed state and local systems representing 7.6 million people and assets exceeding $900 billion.

It found that over the last year, funds have achieved an annual investment return of 13.5 percent, nearly double the 7.7 percent rate most assume.

On average, said NCPERS, pension systems are 76.1 percent funded, meaning they can cover more than three-quarters of liabilities. Typically, pensions are considered fully funded when they surpass 80 percent.

"In addition, funds have responded to changes in the economic, political and social landscape by adopting substantial organizational and operational changes to ensure their long-term sustainability," NCPERS said.

Pensions are backed by contributions from employees and employers and by earnings from investments, which NCPERS found make up 66 percent of fund revenue. Employer contributions, essentially the taxpayer bill, comprise about 24 percent of revenues, it said.

Typically, when investment returns are low, governments increase contributions. But amid some of the worst budget crises in recent memory, state and local governments cut deposits just as the stock market plunged.

With most states beginning a new fiscal year in less than a month, investors in the $2.9 trillion municipal bond market are worried that they cannot fund pension promises.

The study found the annual investment return for pension funds when averaged over three years, which would include the time of the financial crisis, was 1 percent.

NCPERS found that over the last two years most public pensions have lowered their assumed rates of return, lengthened the period of time to amortize their liabilities, increased employee contributions and raised the retirement age.

The findings are in sync with a recent National Conference of State Legislatures report that 33 states changed their public pension plans from January 2010 through May 2011, with 23 requiring future employees to make higher contributions.

On Wednesday, the Philadelphia City Council took up reforming its Deferred Retirement Option Plan. It allows workers to set a retirement date four years in the future and then deposits pension payments into an interest-bearing account leading up to that date. Retirees are paid a lump-sum amount and a reduced monthly pension when they retire.

Saying the system costs Philadelphia hundreds of millions of dollars, Mayor Michael Nutter has proposed scrapping the plan, known as DROP.

You can read the NCPERS report by clicking here. The strong showing in the stock market over the last two years fueled asset returns but public pension funds are by no means out of the woods. These are choppy, volatile markets that can turn on a dime. If global stock markets start retracing, then pension funding will get worse before it gets better. And pension deals remain elusive in NJ and NY, which means the politics of pensions are heating up, adding more pressure on public pension funds.

***UPDATE***

Bernard Dussault, former Chief Actuary of Canada, sent me a short message on the claim in the above article that "typically, pensions are considered fully funded when they surpass 80 percent." According to Bernard, this is "nonsense as a plan is fully funded only when the funding ratio is at least 100%." Like I stated, public pensions are not out of the woods, not by a long shot.

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Guest Comment: Can India Be Unshackled?

My friend, Mehran Nakhjavani of MRB Partners was kind enough to provide a guest comment, Celebrity Yoga, Tear Gas and Reform: Can India be Unshackled?:

India arguably owes its existence as an independent democracy to a charismatic guru who made the rulers of the day squirm with his uncomfortable questions. It took some 50 years of for the movement led by Mahatma Ghandi to topple the British Raj, but the current anti-corruption protest led by guru Ramdev is asking for something far simpler. While Ramdev and his supporters were greeted this past weekend with a display of force worthy of the colonial masters in their day, his essential demand is merely for the rule of law to be applied equally to India’s feckless and bloated public sector, as well as to the private sector that feeds at the trough of privileged access to bureaucrats and their political masters.

That India’s government feels so deeply threatened by simple demands to crack down on corruption speaks volumes. India’s burgeoning middle class has in recent years taken a huge leap forward in its access to higher standards of living and a better quality of life, but along with more income and more information comes less tolerance of the shenanigans of an incestuous and venal ruling class. For as long as the only route to social and economic advancement lay through the door of dealing with or being employed by the government, this middle class was co-opted into the self-serving game. But for the past decade or so, the path to advancement, and the escape from caste and social limits, has come via education, technology and business savvy (all of which are in plentiful supply in India) and fortunes have be made without needing access to government connections.

The disgust over a telecom scandal that has exploded in recent months is by no means the first in Indian history. However, this episode is shaping up to be a social mutiny because of three factors: the emergence of a large middle class as noted, the rapid dissemination of incendiary details of the scandals via social media, and most importantly, the gathering storm over the immediate cyclical prospects of the economy.

The inflation tiger is out of its cage

Indian policymakers are frozen in the face of an inflation tiger that has already escaped its cage. They are pinning all their hopes on the ability of the central bank to choke off price pressures with monetary policy. But they remain absolutely incapable of supporting monetary policy with the requisite fiscal tightening. Watching this slow-motion train wreck, India’s middle class has every right to fear the consequences: a credit squeeze and a further delay in being able to afford a new home, along with less attractive job prospect to match their hard-won educational qualifications.

India’s inflation is the highest among emerging markets, and it can’t blame food prices for its problems: headline inflation currently outstrips food CPI by 1.5%. The mounting inflationary pressure has come despite a cumulative 200 bp of tightening by the Reserve Bank of India (RBI) since March last year which has had a moderating effect on monetary expansion, but which has not prevented a dramatic expansion of credit growth to the private sector. In addition to the CPI, asset inflation is a mounting problem, with major city home prices rising at a compound annual growth rate of 23% since 2007.

There are, of course, very powerful structural forces driving India’s long-term economic growth, including a dynamic and globally competitive service sector, very positive demographic tailwinds and massive pent-up demand for both capital and consumer goods and financial services. The key constraint is its infrastructure, which, in turn, is a reflection of a creaky public sector. To the extent that investment can debottleneck key chokepoints such as transportation and energy, the inefficiency of the state does no more to sprinkle some sand into the gears of economic growth. But the public sector’s inability to balance its books is a long-term challenge.

In the current circumstances, with policy rates and bond yields both ratcheting up as a result of the inflationary surge, the cost of budget deficits of the order of 10% of GDP generates an appreciable crowding-out effect for the private sector. The RBI’s policy tightening is raising the cost of capital for India’s businesses and will continue to act as a drag on their return on equity (ROE).

Despite significant underperformance relative to other EM equities, Indian valuations are still not compelling. Its trailing P/E ratio is still 40% higher than other emerging markets, and this premium is no longer justified by a substantial ROE premium.

Conclusions for investors

Avoid Indian equities. The RBI tightening cycle is in its very early stages and there is as yet little evidence that overheating pressures are waning. Typically, investors will seek to front-run economic indicators, so timing re-entry is by no means straightforward. Three pieces of evidence will need to be in place or imminent before buying equities: real credit growth to the private sector lower than real GDP growth; real policy rates close to potential GDP growth rates; and attractive valuations within the EM equity universe.

Mehran Nakhjavani

MRB Partners

For additional information about MRB, please see us online at www.mrbpartners.com.

If you would like to receive a copy of our May 17^th Country Report “India: Too Hot to Invest” please contact our Head of Client Relations, Chris Sandfield: chris.sandfield@mrbpartners.com, or +44 (0) 20 7073 2792.

I thank Mehran for sharing his insights on India with my readers. I invite institutional clients to contact MRP Partners at the contact info above and get additional information on their research and services.

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Rearranging the Deck Chairs on the Titanic?

On Monday morning, I had breakfast with Leo de Bever, CEO and CIO at Alberta Investment Management Corporation (AIMCo). We spent almost two hours conversing but time flew by so fast. Leo is one of the smartest pension fund managers I ever met and he grasps the complexities of many issues facing pension funds.

I am not going to delve into details but will share some key points below:

• The biggest problem Leo sees in the US economy is the lack of business confidence which is impacting investment, much like Keynes wrote about years ago.
  
• On bonds, he is worried that the amount of debt issuance in the US will exert upward pressure on bond yields over the next couple of years. He did, however, highlight the possibility that we are heading down some sort of "Japan scenario."
• I told him that the Fed will do whatever it takes to reflate risk assets and introduce inflation into the system. The last thing banks want is a protracted period of debt deflation.
• He agreed but added all the QE in the world is just like "rearranging the deck chairs on the Titantic." He is also worried about income inequality exacerbating the jobs crisis.
• On the Canada bubble, he mentioned an outfit called Demographia, which shows the ratio of housing prices to incomes is exploding especially in cities like Vancouver.
• But he also admitted he thought the music would have stopped in the stock market and was underweight last year. "You are right, I underestimated that they're going to do whatever it takes to drag this out for as long as possible."
• We talked about levered versus unlevered benchmarks for private markets, but he and I are on the same page, the opportunity cost of being in private markets is public markets, adjusted for illiquidity and a spread for leverage. On benchmarks, keep it simple.
  
• He agrees with Jim Keohane, CIO at HOOPP, that too much money flowing into private markets is driving up prices and lowering expected returns.
• On seeding funds, he was a little more cautious telling me that he agrees emerging managers are hungrier than more established managers who tend to be asset gatherers but very few will succeed long-term.
  

I also exchanged emails with Jim Keohane, CIO at HOOPP, on an article I read this morning on Zero Hedge, The Real "Margin" Threat: $600 Trillion In OTC Derivatives. Jim shared these thoughts:

With regard to the article, clearing house practices have been adopted in the OTC derivative market as standard market practice over the past number of years, so there won’t be some giant margin call if and when some of these contracts move to central clearing . Right now, every OTC derivative contract requires the posting of collateral and daily mark-to-market to maintain the counterparty credit risk of the contract within acceptable ranges. The major difference is that in the OTC world, the amount of credit being extended will differ from counterparty to counterparty depending on their creditworthiness. For example, most investment banks will extend a larger threshold level for margin calls to an organization such as HOOPP which has a large balance sheet and is very credit worthy than they would to a hedge fund which may have a very small balance sheet and limited ability to meet the obligations of the contract. In the central clearing world, there is no differentiation made between market participants – if you can meet the margin requirements you can participate.

Also, that $600 trillion number is the gross notional of the outstanding contracts. The actual amount of market risk associated with those contracts is a much smaller number. If this were measured on the same basis as listed contracts, it would be a much smaller number. For example, if I traded a listed contract with you, that would create an open interest of 1 contract. Under the OTC measurement, that would be counted twice – you have and open contract and I have an open contract. In the listed market, if I then traded my position in the market to a third party, there still would be 1 open contract. In the OTC market, if I entered into an identical offsetting trade with a third party, we now would have 4 open contracts. So you can see that the $600 trillion number contains a significant amount of double counting.

You also have to keep in mind that the largest component of that $600 trillion is interest rate swaps. The payments and margin calls on interest rate swaps is based on the difference in the interest rate movements between short term rates (generally measured by 3 month LIBOR) and longer term rates. That differential does not create large payments or large margin calls relative to the notional value of the contract.

I do have some concerns around the rush to move to central clearing. First, the amount of capital backing these contracts will be substantially reduced. In the OTC world, if we enter into a derivative contract with an investment bank, the full capital of that bank backs the contract – and inability to pay is the same as a debt default. Under central clearing, that banks liability on that contract is limited to the capital backing the clearing corp. In effect, we will be moving to a “source and sell” business model, a model that proved disastrous in sub-prime mortgages. If institutions don’t retain the exposure on their balance sheets, they tend to be more lax in their underwriting standards.

Secondly, the move to centralized clearing envisions a move to standardized contracts. As an end user of these contracts, the reason why we frequently employ bespoke contracts is that they are more effective at managing risks. This is particularly true in the interest rate swap market and in the currency forward market where you are trying to hedge specific exposures to which standard contracts are very ineffective. So by moving to standard contracts and central clearing, the ability to hedge risk will be diminished and overall systematic risk may rise.

In my view, the move to central clearing does not address or solve the real problems that lead to the credit crisis. For example the counterparty credit losses resulting from the Lehman bankruptcy are mostly a result of outdated bankruptcy laws with don’t allow for an orderly reorganization of financial institutions the way that Chapter 11 allows for an orderly reorganization of other public companies.

To conclude, people like to throw out these huge notional numbers because they make great headlines, but the amount of exposure associated with these contracts is a small fraction of that number and there is already a daily mark to market and collateral posting taking place in the OTC market which is similar to the clearing house model. I think that there are some issues that will be created by moving to central clearing but not the issues referred to in this article.

Finally, I also received feedback from another sharp pension fund manager who shared these thoughts on the real margin threat:

There’s been a fair amount of commentary about “financial repression” (Carmen Reinhart has been going on about that recently) – governments forcing banks to hold govvies for liquidity management, and as a convenient way to finance their deficits.

It should have the effect of reducing bank profitability ratios, but it should also reduce risk in the system. And it’s great for the conspiracy theorists – they have yet another excuse why their predictions about the impending demise of the Treasury market was again wrong.

There is general agreement that moving to central clearing will increase demands for collateral, but OTC positions already have collateral posted against them. And the collateral does not have to be government bonds, so I would guess this will not be a huge problem. But it should widen bid/offer spreads, as banks will have to embed more capital costs into pricing.

Hope you enjoyed reading this comment and the feedback from senior pension fund managers. Please remember to contribute to this blog through the PayPal button under the pig at the top of the page.

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Is the US Jobs Crisis Here to Stay?

John Talton of the Seatle Times reports, Why the US is in a jobs crisis:

The situation is nicely encapsulated by economist Nouriel Roubini's tweet this morning: "US economy now close to stall speed. From anemic recovery to tipping point to stall speed and growth recession. Is a double dip next?"

The economy only created 54,000 jobs last month. It takes between 125,000 to 150,000 net new jobs a month just to keep up with the organic numbers of people entering the labor force, much less make up for the losses of the Great Recession.

Unemployment "officially" stands at 9.1 percent, the real rate much higher. "To remind us what a healthy unemployment rate looks like, four years ago, in May 2007, the unemployment rate stood at 4.4 percent, and 11 years ago, in May 2000, the unemployment rate was 4.0 percent," according to economist Heidi Shierholz of the Economic Policy Institute. "The U.S. workforce needs the pace of job growth to accelerate dramatically in order to re-establish full employment within any reasonable timeframe, and instead, the recovery is on pause."

Put another way, by the blog Zero Hedge, the U.S. would have to create 250,000 jobs a month for 66 months just to return to where unemployment stood in December 2007 by the end of President Obama's second term. But why is job creation broken?

It's an area where we need urgent research and sober debate. I can think of these reasons:

• The stimulus and the Federal Reserve's QE2 failed. They arguably prevented worse unemployment and deflation, but it's impossible to prove a negative. The stim was particularly ill-suited for job creation — heavy on ineffective tax cuts, light on infrastructure. Too much of the Fed's money was used to save the Wall Street playerz, then let them make a new killing off it.


• Business models have changed. Many companies have found ways to do as much or more with fewer workers. Thus, record corporate profits and cash on hand haven't translated into much hiring. Offshoring, technology, doubling-down on the existing workforce and continuing industry consolidation all play a role.


• The negative feedback loop continues to discourage hiring: The housing collapse (where so many jobs were created in the 2000s); millions struggling with the consequences of losing their homes or being underwater on mortgages; 10-year wage gains worse than during the Great Depression, lowering buying power and hurting business; many small businesses, a key engine of jobs, unable to get loans; government fiscal crises hurting investment and education, as well as causing layoffs in this sector and hurting small private vendors.


• The jobs-skills disconnect. Millions of jobs for the housing bubble required relatively few advanced skills. But manufacturers now complain they can't find the workers who have the training to handle the leading-edge jobs they have. This is even more pronounced in advanced technology sectors.


• The dogma about tax cuts for the wealthy leading to job creation doesn't work. Indeed, job creation during the George W. Bush administration was some of the worst since the Hoover years, but it was cloaked by the housing bubble. Meanwhile, the political climate won't allow for more aggressive job-creating stimulus, such as infrastructure spending.


• The capital markets have disconnected from their traditional role of assembling funding for productive, job-creating enterprises. Much of the big profits come from trading or job-killing mergers. LinkedIn and Groupon are clever and will siphon off billions of dollars in investment. They will create relatively few jobs. Even seemingly traditional large corporations spend time making profits trading on Wall Street rather than using the money to hire. Meanwhile, the finance sector is among the most politically powerful and will protect the status quo.


• The hollowing out of much of the economy is real and it has happened in sectors that once created millions of jobs. Tens of thousands of factories closed during the 2000s, and not just in the auto industry. The textile and apparel sectors in the Carolinas were devastated by NAFTA and China's entry into the WTO. Again, this was cloaked by the housing bubble.


• The recovery has never been broad-based, and businesses have been faced with ongoing uncertainty. President Obama did himself no favors here with the complex health revamp, although it is a huge windfall for the insurance industry. But the uncertainty also includes the price of oil and the future of energy costs.


• The sectors once called "high tech" (but almost everything involves high tech now) are not creating large numbers of American jobs, as retired Intel Chief Executive Andy Grove has pointed out. As companies "scale up" they are no longer doing much hiring of Americans.


• Some will point to immigration, and in the 2000s the U.S. saw its largest wave of immigration in its history, even larger than 1890 to 1920, and much of it illegal. The academic evidence points to immigrants being a net plus in terms of economic output vs. their cost in social services. But it's also true that easy immigration helped drive down wages. Yet this took place as American business as a whole adopted Wal-Mart's low-wage, part-time, minimal-benefit model. "Consumers" got low prices, but unfortunately they also suffered as workers. Who to blame here?
  

For all the political theater, America has a jobs crisis much more than a debt crisis. Until it fixes the former and creates broad-based growth, it can't meaningfully address the latter.

I totally agree with many points expressed in this article, especially the last point on America's jobs crisis being far more important to fix than the debt crisis. Right-wing pundits have been busy spinning the debt crisis but the reality is unless there is a meaningful and sustained jobs recovery, the debt crisis will never be addressed. And don't believe anyone who tells you otherwise.

How do I know this? Just look at Greece. Austerity is a disaster, pushing their economy to the brink. Greece doesn't have a manufacturing base and relies almost exclusively on tourism and shipping as the pillars for its economy. Young and smart Greeks are leaving the country not because they want to, but because there are simply no opportunities in the private sector. Greek policymakers are doing absolutely nothing to address serious structural issues in their economy.

That brings me to my next point. The real crisis behind the jobs crisis in the US and pretty much the rest of the developed world is the leadership crisis. Politicians and policymakers are spewing the same old ideas. Liberals want to increase deficit spending while conservatives want to decrease taxes and cut spending. Same old, same old. There is nothing new in these policies based on ideology. Nobody has the courage to take on interest groups and admit that there is a fundamental problem with the current trajectory.

What really worries me from a social perspective is that the disconnect between the financial system and the real economy is widening income inequality. QE2 hasn't done much for the real economy yet, but it's been a boon for traders and money managers. The financial oligarchs couldn't care less about what's going on in the real economy, and neither do America's corporate titans. All they care about is their total compensation which continues to rise to record levels while millions struggle with unemployment.

Unless something is done to address structural issues in the labor force, including the ever widening income gap between the haves and have-nots, a whole generation of workers will suffer from chronic unemployment and along with it, loss of job skills, loss of dignity, and most worrisome, chronic mental and physical health problems that will put additional pressure on public spending.

Now is the time for our political leaders to step up to the plate and address the jobs crisis. If they don't act quickly and forcefully with fresh and courageous ideas that work, then capitalism as we know it is doomed. If this sounds too "Marxist" for you, then you're ignorant of history and how human beings always repeat the same mistakes. Somewhere down there, Marx is grinning in his grave. I leave you with an interesting discussion from ABC's This Week on the prospects for the class of 2011.

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Should Pensions Be In The Seeding Game?

I spent the day in Toronto on Thursday visiting pension fund managers with the commodities relative value manager I met a couple of weeks ago. Went down there by train on Wednesday afternoon and he gave me a lift back to Montreal after our afternoon meeting. I was too exhausted to blog late last night so I decided to write my comment this morning.

Below are my bullet points on this trip (please take the time to read them all):

• I took the train down to Toronto. Booked Via Rail business class one way and left Wednesday afternoon. Cost me $246.36. If I planned it in advance, I could have flown there for less with Air Canada or Porter, but it was last minute and I like the train (business class was a perk I treated myself to but it wasn't worth it).
• Brought a copy of Dan Ariely's book, The Upside of Irrationality: The Unexpected Benefits of Defying Logic, which I highly recommend. The first chapter, Paying More For Less, Why Big Bonuses Don't Always Work, is brilliant. Big bonuses are often not doled out to the most competent managers who are aligning their interests with shareholders (or pension fund beneficiaries).
  
• Stayed with a buddy of mine in Toronto who trades currencies for a living. He lives out in Oakville, Ontario, about 30 minutes outside Toronto when there is no traffic. I typically stay at the Fairmont Royal York which is downtown and right across the train station, but he insisted I stay with him and his family. His wife spoiled me with a nice meal and had everything ready for me, including a laptop to write my blog and my vitamin D drops which I forgot back in Montreal (thank you Nancy, you're a sweetheart!).
  
• On Thursday morning, I had an eight o'clock meeting with Jim Keohane, Senior VP and CIO at Healthcare of Ontario Pension Plan (HOOPP). My buddy warned me that we have to leave the house at 6:15 or else we'd get stuck in traffic. Woke up at 5:30 naturally but didn't feel great and by the time we left it was 7:00 a.m.
• Disaster! The traffic in Toronto is horrendous! It took us over an hour and a half to come downtown. I emailed Jim to reschedule for a little later in the morning. I also emailed Andy Moysiuk, Managing Partner at HOOPP Capital Partners to see if he was available to grab a coffee before my meeting with Jim. Luckily, he was.
• Driving in from Oakville and being stuck on the highway, I noticed a lot of nice cars on the road: BMWs, Mercs, Porsches, etc. Told my buddy "there is a lot of money in this city. He replied: " Yup, no thanks to the Parti Quebecois. There are lots of showoffs too. Torontonians are more like Americans; they want to display their wealth. Montreal's rich are more European, they are a lot more low key" ( a point that Andy Moysiuk reiterated during our meeting).
• As we were stuck in traffic, we talked about seeding hedge funds, business opportunities in Greece (imports to Canada), and listened to some talk show on why women prefer "bad boys" (LOL!). The radio commentator read an email from one lady who wrote in "I prefer to have great sex for one year with a jerk than make love to a nice romantic man for 10 years." My buddy and I looked at each other thinking how some women can be so stupid (not that men are any better as many like chasing skirts with attitude!).
• Anyways, grabbed a coffee with Andy Moysiuk at Mercato, a nice little coffee shop right next to HOOPP's offices. Andy is a smart private equity investor. I don't agree with all his views on pension investments but he knows his stuff, especially in private equity and venture capital.
• We didn't have much time. Our discussion was on seeding funds, not just hedge funds but funds in general. Andy sees this as a strategic partnership. "You're nurturing a business, not just a fund. You want to make sure this will be a success, and you want to make sure the manager will not pack up and leave at the first sign of trouble leaving you, the seeder, holding the bag."
• This is an excellent point. When you are seeding a fund, any fund, you are nurturing a business. You want to make sure the manager is committed to the business (it's not just about managing money). The pension fund is there for the long-term and wants to realize gains on their seeding activity. The last thing any pension fund manager who seeds a fund wants is to pull the plug fast. They want to realize gains on the business as it grows and eventually IPOs.
• I also talked to Andy about board governance at pension plans. Told him I know he sits on a board of a fairly large church pension fund along with Diane Urquhart an several other experts. He told me: "It's a good board and well managed fund but every board member brings their baggage. The actuaries tend to be overly-sophisticated, sometimes to the detriment of the investment process." I can relate. Often, it's best to keep things simple.
  
• My meeting with Jim Keohane, SVP and CIO at HOOPP was brief but excellent. Jim is incredibly smart, he really knows his stuff across all public and private asset classes. Told him that Andy warned me not to trash derivatives but I added: "I have nothing against derivatives, only pension fund managers who take stupid risks using derivatives".
• HOOPP is a derivatives powerhouse. They know exactly how to use derivatives wisely to match assets with liabilities, do enhanced indexing, overlay and absolute return strategies which they do exclusively internally (no allocations to outside funds in public markets and limited ones in private markets).
• I asked Jim why not allocate more to outside funds. He replied: "It's all about cost of delivery. When I got here 15% was allocated to outside managers but they were underperforming the market. By indexing using swaps, we got our beta, lowered the volatility and reduced costs substantially."
• I told Jim that Leo de Bever did the same thing at AIMCo, substantially lowering the costs, but the media in Edmonton harped on bonuses he doled out to internal managers (some reporters are so stupid!). However, Leo de Bever kept managers in public and private markets that earned their fees, delivering alpha that cannot be replicated internally. Again, I asked Jim why doesn't HOOPP do the same thing? If they're worried about risks, they can use managed accounts and have full transparency and control over the investment portfolios.
  
• Jim replied: "We are doing a good job creating alpha internally. Maybe that will change in the future, but right now there is no point of outsourcing we can can do the job internally at a lower cost of delivery." This is a bit of a sticking point with me because I believe true alpha exists in long-only and absolute return strategies and the best managers are not working at pension funds, they're running their own fund, charging fees for this expertise. As one pension fund manager told me later in the day: "If they're that good, they'd be charging 2&20 managing their own fund."
  
• Importantly, it's in the best interest of pension fund beneficiaries to discover these fund managers and allocate to them. No doubt about this in my mind. It's just that most pension funds are not approaching their allocations to outside managers in an intelligent way, using managed accounts in public markets or co-investing in private markets, negotiating hard on fees and extracting maximum knowledge leverage off their external partnerships using solid investment management agreements with clauses that list exactly what they expect from the partnership.
• Something Jim said about the big private equity funds did make perfect sense.: "Pension funds investing in these large PE funds are going to underperfom large cap stocks. Because of their size, these mega buyout funds are taking out large public companies at substantial premiums. It just doesn't make sense to pay fees and take on illiquidity risk for these large deals. "
  
• Thanked Jim, told him I wish HOOPP was managing the pensions of all healthcare professionals across Canada, and went off to my next meeting where I hooked up with the commodities fund manager and the External Portfolio Management team at a large pension fund. It was an excellent meeting, I mostly listened and observed the manager and the team that was evaluating his presentation. The manager covered a lot of ground and the team asked good questions.
  
• At the end of that meeting, I asked the head of External Portfolio Management team whether they plan on seeding funds. He told me that they're looking into it and if "they think it makes sense, they'll recommend it. Maybe even partner up with other funds on such a venture." Maybe I was a bit bitchy yesterday morning but I answered back: "I've sat in your shoes and done many board presentations. If I'm sitting on your board, I don't want to hear 'I think it makes sense', I want to hear 'IT MAKES SENSE' and here is the research from PAAMCO on emerging funds to prove it."
  
• Afterwards, the relative value commodities fund manager told me "nothing personal, but it shows you haven't done a lot of marketing, interjecting at times and telling the guy how to do his job." I replied: "Let's get something straight, I am here as an independent, not to market your fund. We have not signed any legal agreement. I believe in you and this fund which is why I opened the doors using my senior pension contacts and got you meetings in record time. My comment to the head of this team was not intended in a malicious way but more to make the forceful case for seeding funds and why it's in the best interest of pension fund beneficiaries. No offense taken and will take your constructive criticism and recommend that you speak more slowly during our afternoon meeting."
• We parted ways at lunch as he had to meet someone. I ate outside, enjoying the sun and exchanged some emails with Colin Carlton, former Vice President, Investment Research at CPPIB, telling him I was in the vicinity. Colin was recently replaced by Jean-François L’Her, formerly of the Caisse, but he has consulting mandates to complete at CPPIB.
  
• Colin told me that he was busy writing large parts on CPPIB's 2011 Annual Report. I appreciate the time and effort it takes to complete these annual reports and told him one of my former employers, the Business Development Bank of Canada (BDC), has a whole team dedicated to corporate planning and drafting the annual report. It's a lot of work!
• I praised him for the annual report but did mention that the whole discussion on benchmarks and value added needs more clarification as it's overly complicated. Colin said they have simplified it and will do more.
• I also asked him about his future plans and told him I see a huge gap in pension consulting. He agreed and is looking into some options but told me he's not interested in expanding a new business and having a crazy work schedule. "My wife is my boss now." Colin is an intelligent and nice man and I wish him success in his new projects, wherever they lead him.
• Hooked up again with the commodities relative value manager and headed to our afternoon appointment with another large pension fund. In the lobby, I ran into the president, greeted him and introduced the manager. We then proceeded to meet with the VP of Alternative Investments and his portfolio and assistant portfolio managers.
• In my opinion, this meeting was even better than the first. The VP of Alternatives couldn't stay long but let his portfolio manager ask the questions. Before the VP rushed off to his next meeting, I asked whether their investment policy precludes them from seeding funds. He replied: "Not at all. If it makes sense and fits in our portfolio, we will seed a fund."
• I asked him if he can let the CIO know I am in their offices but he was in a rush so I emailed the CIO myself to let him know I was in a meeting at their offices and would like to say hello after. To my surprise, the CIO came into our meeting wearing a golf shirt, holding a cup of Starbucks coffee, introducing himself and asking if he can sit in. I loved it!!!
• The portfolio manager was asking amazing questions. This guy is simply the best at analyzing hedge funds and strategies (told him to write a book). The manager answered all the questions and even gave numerous examples on his strategy and how he mitigates risk (excellent exchange). The CIO listened carefully and then asked the important business questions on fees and why they should consider seeding his fund. He got the answers to his questions and walked out of the meeting after 30 minutes. Before walking out, he told me he liked my last comment on reducing risk and told me that Roger Martin, dean of the Rotman School of Management sounds like a "frustrated professor" in his op-ed (totally agree).
  
• We wrapped things up with the portfolio manager who explained the next steps. He also stated he likes the relative value commodities strategy, the liquidity, the fact that it fits on their managed account platform, but needs to do more background checks. The manager provided him with a list of references and urged him to call them.
  
• We then proceeded to drive back to Montreal. It was a long drive, we stopped off at Chalet Suisse for dinner, but I really enjoyed my conversation with this relative value commodities manager. He's exceptionally bright, driven, has the entrepreneurial mindset, right work ethic and values which he and his wife instill in their three children. We got into a lot of personal discussions during this car trip and I admire the depth of his character given the personal challenges he's faced growing up as an orphan at an early age. I honestly marvel this individual and know the pension fund that seeds him and his team will not regret their decision just like I have no regrets whatsoever introducing him to these two large pension funds.

That's the end of my long comment on my trip to Toronto. I wish you all a great weekend. Enjoy the sun as summer has finally arrived!

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Reducing the Risk?

Roger L. Martin, dean of the Rotman School of Management and author of Fixing the Game: Bubbles, Crashes and What Capitalism Can Learn from the NFL, writes in the Ottawa Citizen, Reducing the risk (HT: Bill Tufts):

In the wake of the spectacular 2008 financial markets crash, much has been made of the fact that no one has been held to account. Life has returned to near normal, and other than the failures of Lehman Brothers and Bear Stearns, little has changed in reaction to the mortgage meltdown.

The too-big-to-fail banks received hundreds of billions in bailout funds. Compensation for corporate executives is back on the upswing -by 11 per cent in 2010, according to the Wall Street Journal. Citigroup's Vikram Pandit, almost turfed back in the darkest days of the crisis, just received a nearly $17-million bonus package aimed at keeping him in his job through 2015.

But the most concerning number for many pundits is zero. That's how many corporate executives have been charged, indicted or convicted of malfeasance related to the crisis. It seems unimaginable -billions of dollars in wealth wiped away through risky, profit-maximizing deals and not one individual crossed the line into illegality.

This outcome has had many clamouring for greater regulation of the financial markets -more oversight, tighter controls and new regulations on complex derivatives. Unfortunately, those clamouring for greater accountability for private sector firms are fighting the wrong battle. As just one small player in a global economy, there is precious little Canada can do in the way of regulation in the financial markets to prevent another crash.

But, instead of ineffectually regulating at the margins, we can take clear and decisive action on one of the real root causes of the meltdown: the 2&20 formula.

The 2&20 formula is shorthand for the way in which hedge funds and other large market makers are compensated. They receive a base fee of two per cent (or three per cent or five per cent) of assets under management, plus 20 per cent (or 30 per cent or sometimes more) of any upside returns -called "carried interest." This fee structure is almost identical to the stock-option compensation models that came into vogue in Silicon Valley in the late 1990s. Those kinds of stock options fell into disrepute when it became clear that allupside options give executives precisely the wrong kind of incentives.

Give a CEO a good base salary and significant stock options, and you've given her a mandate to swing for the fences, taking on huge risk in hopes of accruing huge rewards. If the risks don't pan out, the CEO can fall back on that base salary, even as the company takes substantial losses. If the risks do pan out, however, the CEO gets massively rich.

The same structure applies to a hedge fund with a 2&20 formula. The fund gets two per cent of assets under management no matter what. So downside losses aren't terribly worrisome when balanced against the potential reward of a huge home run on the upside. Hedge funds are therefore incented to take massive, risky gambles in the market. And the nature and size of those risks have the effect of actually increasing the volatility of our capital markets.

Of course, hedge funds aren't going anywhere, and the Canadian government would have a limited capacity to regulate a massive global industry regardless. So, what can we do to better regulate and de-risk our financial markets?

Simple: We can better regulate some of the hedge funds' biggest customers -public sector pension funds and endowments. Canada's public sector pension funds are incredibly sophisticated and many, notably the CPP Investment Board, are exceptionally well run. But far too many have fallen under the thrall of "alternative investments" -which run directly counter to the best interests of their pensioners. The funds, whether university endowments or public sector union pension plans, should have incentive to generate long-term, steady growth in order to meet their future commitments. Yet those same funds have been chasing the high-risk, massively volatile, all-or-nothing returns promised by hedge funds.

This misalignment came into stark relief in 2008. In the lead-up to the crisis, pension funds began chasing higher and higher returns, wary of being found in an underfunded position relative to future commitments. Soon, they were caught up by promises of supernatural returns and public sector funds found themselves holding toxic and worthless alternative vehicles from funds of funds and the like. As the market declined, the pension funds lost billions. My own university's endowment fund lost more than a quarter of its value in fiscal 2009, as it unwound its alternative investment strategy.

Clearly the public sector funds were chasing returns, and they used hedge funds and risky investments to do so. They need clearer direction about the appropriate risk profile for the investment of public pension funds. They need clearer regulations to prevent them from heeding the siren call of hedge fund investing. In short, they need to be banned from investing with any firm that uses a 2&20-type formula.

Public pension funds should be permitted to invest only in funds that charge either an asset fee or a carried interest, but not both. The funds in which they invest must have some downside risk along with the investor.

Only under this structure would the needs of pensioners be better aligned with the incentives of their money managers.

Mr. Martin makes an excellent point on hedge funds becoming large asset gatherers, collecting 2% management fee and ignoring the 20% performance fee. When hedge funds have more sales staff than investment professionals, run away, they're not aligning their interests with their investors who are looking for high risk-adjusted returns (that means you protect the downside).

But Mr. Martin is completely wrong blaming hedge funds and public pension funds who invest in hedge funds and alternatives as the root cause of the financial crisis. You can blame greedy bankers, but not the hedge funds or private equity managers. By throwing the baby out with the bathwater, he demonstrates his ignorance on hedge funds.

While 2&20 can be a problem when assets explode, the truth is it aligns interests with investors because the best managers focus on delivering high risk-adjusted returns. Unlike mutual fund managers and bank prop traders, hedge fund managers have ther own personal wealth in the fund - - skin in the game which is why they focus on minimizing downside risk.

Admittedly, the bulk of hedge funds are just selling beta as alpha, but there are plenty of managers that are generating real alpha. Should we do away with management fees? Maybe after a hedge fund passes a critical asset threshold. The other option is to use managed accounts and negotiate lower fees. This is where more and more of the large pension funds are heading because it allows them to have full control of their hedge fund investments, allowing them to control liquidity and operational risk.

I disagree with Mr. Martin. Public pension funds should be investing and even seeding hedge funds, but they should be going about it in an intelligent way, using managed accounts. Only then will they be truly aligning their interests with their stakeholders. Finally, as far as Mr. Martin's university endowment fund and other endowment funds, I know for a fact they took stupid risks that had nothing to do with the alternative investments they invested in (like asset-backed commercial paper).

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