Is Private Equity Riskier than Public Equity?

Jonathan Jacob of Forethought Risk, an independent risk advisory firm, sent me a recent blog posting, Private Equity - Riskier than Public Equity?:

Is private equity riskier than public equity?

What if it exhibits lower volatility? Is that lower volatility real or based on some measure of appraisal bias?

My tendency is to believe that there is a measure of appraisal bias which dampens the volatility of private equity - how many business valuation experts would mark down a private equity portfolio by 60% when the broad stock market drops by 50%? Conversely, would they mark up private equity by more than the market's positive performance?

Two heavyweights showdown on this issue - CPP vs OMERS

CPP, on page 28 of their 2011 annual report, demonstrate how they manage portfolio risk with a private equity deal. In order to purchase $100 worth of private equity, CPP sells $130 of public equity then purchases $30 of fixed income and $100 of private equity. In their opinion, the $30 of fixed income is there "to adjust for the higher risk of embedded leverage in a private equity asset".

OMERS disagrees. In their 2010 report OMERS states "the more predictable and sustainable performance of private market assets will underpin total Fund returns during times of depressed returns in the public markets". (p 11)

Personally, I am not a huge subscriber to the efficient market hypothesis - I believe there are opportunities in the markets that can be exploited by those with superior ability in this field. However, I do believe that the idea of private markets as a saviour of pension funds due to its lower exhibited volatility is based on an illusion - that of an appraisal bias in the mark-to-market of those investments. If we valued these assets based on what a 3rd party would pay, that would be more reflective of reality.

I asked a senior pension fund manager to weigh in on this discussion. Here is what he shared with me:

It's cumulative IRR that is the measure that counts. Full stop. Net of currency. Any other measure is misleading or irrelevant.

Also, the only public comp worth anything is a takeover bid that succeeds. If the stock market drops 50 percent, the enterprise value of any specific listed business may well be unchanged.

Have you noticed most takeovers occur at large premiums to the market? Should PE mark to the stock market, and then add a 20 to 50 percent enterprise value premium? That would actually make some sense. The public market bias is hard to shake.

I told him that there is a private market bias too, just look at the LinkedIn IPO. He responded: "LinkedIn is not worth $9 billion, that's the market cap based on the small issue that floated."

I'll tell you from personal experience that nothing pisses off the public market people at pension funds more than the bogus benchmarks and big bonuses that private market investment managers get. One portfolio manager still gets visibly agitated with me when discussing this topic: "It's such bullshit! Would love to see these private market pension managers try to consistently beat the S&P 500. All they do is fly around the world and write big checks to big funds. And they have the gall to call this alpha!?!?"

The private equity pension fund managers respond by stating that public market managers are terrible at beating their benchmarks, so it's best to exploit opportunities in private markets where there is more information asymmetry. Moreover, they claim that the skill set in private equity is in demand and harder to find so they should be paid more than their public market counterparts.

I think pension fund managers should focus on delivering alpha wherever they can find it. Look, my views on private market benchmarks are simply based on economic theory. They should reflect the leverage, beta, and liquidity risk of the underlying portfolio, which is why I prefer a spread over some public market benchmark (even if it's not perfect because of lag adjustments). I also agree with Jonathan's analysis above, the way CPPIB allocates risk between public and private markets reflects these risks (albeit they really complicate things to the nth degree! The KISS principle should apply here too.)

But that senior pension fund manager I quoted above is right. At the end of the day what counts is cumulative IRR net of currency. Everything else is irrelevant. Whether a pension fund invests or co-invests in direct PE investments to save on fees, or through fund investments, at the end of the day cumulative IRR net of currency and fees is what counts!

I have worked in private equity and spoken to a few reputable fund managers. Guys like David Bonderman at Texas Pacific Group (TPG) aren't a dime a dozen (never met him but met other big PE managers). And even he got into some bad deals in the past. I want you to take a close look at the Canada Pension Plan Investment Board's fund partners in private markets. A lot of these funds are the cream of the crop in private markets. Doesn't mean they're infallible, but they have added significant value added over the years and will likely continue to do so. Unlike public markets, there is much stronger evidence of performance persistence in private markets.

Finally, I agree with Jonathan, private markets are not the "saviour" that pension funds make them out to be. Appraisal values smooth volatility and senior pension fund managers often will mark private market assets down in bad years to mark them up when the recovery comes. This helps them collect the big bonus based on 4 year rolling returns. I've seen this so many times that it's become standard practice among the large pension funds.

But I'm also seeing a lot of outright manipulation in public markets. Big hedge funds and big bank prop desks engaging in naked short selling via multi million dollar high-frequency platforms. At one point, pension funds get fed up and say "screw public markets", we're going to move all our assets into private markets and have more control over them. Obviously they can't move everything into private markets and there is a symbiotic relationship between public and private markets, but the shenanigans in our corrupt public markets are part of the impetus behind the institutional shift of assets into private markets.

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CPPIB Gains 12% in FY 2011

The Canada Pension Plan Investment Board (CPPIB) released its FY 2011 results, CPP Fund Totals $148.2 Billion at 2011 Fiscal Year-End:

The CPP Fund ended its fiscal year on March 31, 2011 with net assets of $148.2 billion, compared to $127.6 billion at the end of fiscal 2010. The $20.6 billion increase in assets after operating expenses marks a new all-time high for the Fund. The Fund increase resulted from $15.5 billion in investment income and $5.4 billion in net CPP contributions. The portfolio returned 11.9% for fiscal 2011, compared to 14.9% in the prior fiscal year.

“Fiscal 2011 was an excellent performance year, with the Fund benefiting from strong results across all asset categories and geographies,” said David Denison, President and CEO, CPP Investment Board. “By adhering to our long-term strategy during and following the recent financial crisis, the Fund has benefited from the recovery in the global public equity markets and has generated total investment income of $31.7 billion over the past two fiscal years.

“During fiscal 2011 we were able to take advantage of the deep expertise of our investment teams to make some notable additions to our private equity, infrastructure, real estate and private debt holdings.”

Some highlights:

• Partnering alongside Onex Corporation, we completed the largest global private equity transaction during calendar 2010: the acquisition of Tomkins plc with an equity investment of $1.1 billion. This was the second consecutive year that we were involved in the largest global private equity transaction.
• On the real estate front, we successfully acquired interests in two prime Manhattan office buildings whose combined value is $1.6 billion, representing an equity investment of $700 million. In London, we acquired a 25% interest for $468 million in Westfield Stratford City, a new 1.9 million square foot retail and entertainment development next to the 2012 London Olympics site. In Australia, we purchased a 42.5% stake for $604 million in the ING Industrial Fund, a portfolio of prime industrial properties.
• We also completed our largest infrastructure investment to date with two concurrent transactions involving the acquisition of a 40% interest in the 407 Express Toll Route outside Toronto as well as an interest in a toll road in Sydney, Australia. Our total initial investment amounted to $4.1 billion, a portion of which we then syndicated to a group of other institutional investors for a combined interest of approximately 29%.
• Our Private Debt group has now grown to 22 professionals. Last year we established a team in our London office and have made great strides in expanding the European reach of the program. Since its inception less than three years ago, our Private Debt Group has completed 41 transactions totaling $4.4 billion.

Five and 10-year Returns
Although CPPIB reports on a quarterly and annual basis, longer-term results are more relevant given the multi-generational nature of the CPP itself. For the five-year period ending March 31, 2011, the CPP Fund generated an annualized rate of return of 3.3%, or $20.9 billion of cumulative investment income. For the 10-year period, the Fund had an annualized rate of return of 5.9%, or $51.8 billion of cumulative investment income.

“Our 10-year annualized rate of return has recovered to a level that is consistent with the 4.0% prospective real rate of return that the Chief Actuary has incorporated in his latest report confirming the sustainability of the CPP, even though the sharp equity markets decline experienced in 2008 and 2009 continues to weigh down the five- and 10-year returns ,” said Mr. Denison. “We remain confident that we have designed the mix of assets within the CPP Fund so that it is well positioned to achieve the 4.0% real rate of return required over the longer term.”

Performance Against Benchmarks
CPPIB measures its performance against a market-based benchmark, the CPP Reference Portfolio, representing a passive portfolio of public market investments that can reasonably be expected to generate the long-term returns needed to help sustain the CPP at the current contribution rate. CPPIB’s strategy is to invest actively with a view to outperform the passive benchmark.

In fiscal 2011, total portfolio returns outperformed the CPP Reference Portfolio by 2.07 % or $2.7 billion. For the five-year period since the inception of the CPP Reference Portfolio, the cumulative outperformance was 1.80% or $1.7 billion.

“Many of our investment programs such as real estate and infrastructure are very long-term in nature, and we are pleased that the benefits of those programs are materializing as private market valuations start to reflect the economic recovery of the past two years,” Mr. Denison said. “The full range of CPPIB’s investment programs contributed to the Fund’s strong absolute and value-added returns in fiscal 2011 showing the benefit of the broad diversification we have achieved.”

Portfolio performance by asset class is included in the table below (click on image to enlarge). A more detailed breakdown of performance by investment department is included in the CPPIB Annual Report for Fiscal 2011, which is available on www.cppib.ca.

Long-term Sustainability Reaffirmed
The Chief Actuary of Canada conducts a financial review of the Canada Pension Plan every three years. In his latest triennial review completed in November 2010, the Chief Actuary reaffirmed that the CPP remains sustainable at the current contribution rate of 9.9% throughout the 75-year period of his report. The report also indicates that CPP contributions are expected to exceed annual benefits paid until 2021, providing a 10-year period before a portion of the investment income from the CPPIB will be needed to help pay pensions.

Asset Mix
We continued to diversify the portfolio by risk/return characteristics and geography during fiscal 2011. At the end of fiscal 2011, the Fund’s assets were valued at $148.2 billion, a year-over-year increase of $20.6 billion net of operating expenses of $328 million or 24 basis points.

Canadian assets represented 48.3% of the investment portfolio, and totaled $71.7 billion. Foreign assets represented 51.7% of the investment portfolio, and totaled $76.6 billion.

• Equities represented 53.5% of the investment portfolio or $79.4 billion. That amount consisted of 38.2% public equities valued at $56.7 billion and 15.3% private equities valued at $22.7 billion.
• Fixed income, which included bonds, other debt, money market securities and debt financing liabilities represented 30.1% or $44.6 billion.
• Inflation-sensitive assets represented 16.4% or $24.3 billion. Of those assets:
  • 7.3% consisted of real estate valued at $10.9 billion;
  • 6.4% was infrastructure valued at $9.5 billion; and
  • 2.7% was inflation-linked bonds valued at $3.9 billion.

More details on CPPIB's FY 2011 results are provided in their Annual Report 2011. I urge my institutional investors to read this and other annual reports very carefully as a lot of time and effort is put into them. CPPIB's President & CEO, David Denison, delivers his message starting on page 5. Below, I focus on a few passages:

As we implemented our active management strategy over the past five years, we began building internal capabilities for investment areas in which we have comparative advantages. These advantages include our very long investment horizon, the relative certainty of both our asset base and the amount and timing of future cash inflows to the CPP Fund, and the large scale of our investment portfolio. We also forged relationships with external managers who have proven skills and capabilities that complement those we create internally.

A key strategy goal for the past five years was to increase the proportion of the CPP Fund’s holdings in private market investments. In particular, private equity, real estate, infrastructure and private debt. Our comparative advantages are especially valuable in these areas. Achieving scale in private market investing is challenging. Success requires experienced and skillful teams able to originate and complete what are often very complex transactions. Over the past five years we have increased our private asset holdings from $7.8 billion to $46.8 billion, and from 8.8% to 31.6% of total Fund assets. This is a testament to the many talented and dedicated professionals we now have within the CPP Investment Board.

Having internal teams focused on private market investing not only plays to our comparative advantages, we also believe it to be a very cost effective approach for the CPP Fund. As an example, we estimate that it would cost between $200 million and $250 million per year to have an infrastructure portfolio comparable in size and composition to our own managed externally, compared to the total costs of approximately $24 million we incurred in fiscal 2011 to manage this internally.

Since the start of our active strategy, we have also diligently increased the scalability of our public market investing programs. There are now six distinct investment units within our public markets area, all executing active programs that capitalize on our comparative advantages. Two indicators of growing scalability are: we increased the number of fundamental research analysts in our Global Corporate Securities unit from six to 26 over the last two years and the notional size of our long/short investment program has grown to $17.4 billion from $4.3 billion.

Building human capital is equally important in building organizational capabilities which is why we continue to focus on the ongoing work we do to ingrain our culture based upon our Guiding Principles of Integrity, Partnership and High Performance and to develop our people. This year we significantly increased the time and attention devoted to talent assessment, development and succession planning. These efforts are critical to our long-term success and remain a priority for fiscal 2012.

We also made very good progress in improving operational capabilities which represent another important aspect of organizational scalability. In planning for this decade’s doubling of the CPP Fund, we know we have to build very strong operational, technology and data management infrastructure. The aim is to handle much greater volume and diversity of activities without requiring a proportionate increase in staff and other resources. To achieve this, we need very well-designed and integrated processes for research, transactions, risk management, valuation, analysis and operational requirements across the organization. This is no simple task. In fiscal 2011, we made great strides in capitalizing on the new portfolio record keeping and performance measurement systems we implemented April 1, 2010. We also greatly improved our management of the vast quantities of data that are essential to our investment, research and risk management activities.

While I could cite numerous other areas of progress in fiscal 2011, I would also say that there is still much for us to do in order to achieve the kind of operational scalability that is our goal and this will remain an area of focus for fiscal 2012.

Looking ahead to fiscal 2012 and beyond, we continue to believe that CPP Investment Board’s strategy is sound and will enable us to create long-term value for the CPP Fund that we manage.

Successful execution of our strategy requires us to be increasingly global in our orientation. So, a key priority for us in fiscal 2012 will be to further expand the staffing and breadth of activities in London and Hong Kong. We will also assess other geographic locations where it may be important for us to establish a presence with a view to potentially opening additional offices in fiscal 2013.

Our key corporate objectives for fiscal 2012 are:

• Executing our investment programs strategies – continue to focus across all investment departments to refine and expand our investment programs and capabilities;
• Balancing scalability and complexity – focus on creating sustainable and scalable processes across the organization to effectively manage the growth of the CPP Fund;
• Building scale in emerging markets – strengthen our investment footprint in key emerging markets with a focus on Asia and Latin America; and
• Development and continuity of leadership and talent – introducing programs that focus on developing management talent and capabilities.
  

I like David Denison. Whenever I email him, he always responds in a timely and polite manner (same goes for Mark Wiseman, CPPIB's CIO). I also like what I'm reading above. A lot of critics take shots at CPPIB without understanding the benefits of how these investments are managed. It's easy for some stupid traders to piss all over CPPIB because they're not managing hundreds of billions. Myopic traders do not understand the problem of scalability these large funds face.

As reported by Bloomberg, the results beat the 11 percent average return of the country’s pension funds over 12 months as Canadian stocks surged, according to an April 20 report by RBC Dexia’s investment services unit. The Canadian benchmark Standard & Poor’s/TSX Composite Index rose 16 percent in the period.

Moreover, private-equity investments abroad were among the best assets in the year, with holdings in developed markets increasing more than 19 percent and those in emerging markets posting a 17 percent return. Both investments reversed declines from a year earlier.

CTV reports that another sign of the current deal-making environment occurred this month, after the end of CPPIB’s latest fiscal year, when Microsoft Corp. announced its $8.5-billion (U.S.) deal for Skype Technologies. CPPIB had been part of an investor group that bought a 65-per-cent stake in Skype from eBay in late 2009, and the pension fund has now more than tripled its money on its original $300-million investment. Skype was one of their best private equity deals ever.

When you have the deep pockets and long-term horizon of CPPIB, you have to take advantage, buying up assets that others are liquidating for all sorts of reasons, and then sit on them and wait for the recovery. It sounds deceptively easy but it isn't. The way you go about buying private market assets (though debt or equity) is very important when managing risk, and you have to be well diversified among sectors and geographical locations.

As far as public markets, the focus is on alpha but there is still way too much beta in the portfolio. Their size is the problem but they've made great strides addressing scalability. When you're the size of CPPIB or the Caisse for that matter, you're better off investing in global equities and not being too exposed to Canadian equities because you don't want to get caught long Canada when our fortune turns.

Yesterday I spoke with a Montreal hedge fund manger who manages roughly $260 million in an equity market neutral fund. Great fund and capacity will be reached at $700 million but the manager told me "we're too small for CPPIB because they don't want to represent more than 10% of any fund and they write big tickets." That's why if you look at CPPIB's investment partners in public markets, they're all large asset managers and many of them are overlay managers who can easily take on large mandates.

Finally, the Canadian Press reports that CPPIB is prepared for any expanded role, if that's what the Canadian government wants: "We're not advocating one way or another on reforms, but if it does translate into CPP expansion and we're asked to manage it — we can do it," Denison said.

You know where I stand on this issue. I'd much rather see expanded CPP run by CPPIB and other public sector pension plans than some half-baked private sector solution in the form of PRPPs. I have concerns about the size of CPPIB, including the size of their staff, operating expenses, and the benchmarks they use for compensation (need more clarification), but I'd much rather have CPPIB manage our pensions than handing over more gifts to banks and insurance companies who will end up screwing it up, costing us more over the long-term.

***Feedback from CPPIB***

Mark Wiseman, CIO at CPPIB was kind enough to share these thoughts on scalability:

On scalability, we do acknowledge that the fund is large and will get larger, but if used properly, scale can be a huge advantage to us. For example, very few institutions could have written the $4 billion cheque to acquire a 40% interest in the 407--- a great asset that will provide the fund with stable returns for the next 87 years. And, in terms of our size, we are still much smaller than then most of our international peers (i.e. Norway), at the same time that the capitalization of global private and public markets continues to expand substantially—much of that growth in emerging markets. Scale does make it tough to do things like Venture Capital, but other countries (Sweden and Australia for instance) are actually worried about their institutions being sub-scale and are thinking about consolidation. And, don’t forget about private assets managers like Blackrock, Pimco and others whose AUM is, in many cases, measured in trillions of dollars. Suffice it to say, I think that there is a very long way to go before our clear economies of scale become diseconomies.

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Investors Turning to Active Commodities Strategies?

I hooked up for lunch with commodity relative value fund manager I spoke to on Monday. He's looking to raise capital for this new fund which he will be managing with other experienced traders and we went through his pitch book.

I've sat with some of the best hedge fund managers in the world. The best of the best know the theory but more importantly, they can give you tons of examples of actual trades that went for and against them. That's exactly how this manager presented his views. He has the academic and industry credentials, but it's his actual commodity trading experience in Canada and the US that came through as he walked me through one trading example after another.

I love talented alpha managers. I'll repeat what I've been stating the last few posts, there is exceptional alpha talent in Quebec that is being underutilized or worse still, totally ignored. I met two of Montreal's best hedge fund managers today and I wouldn't bat an eyelash to invest in either one of them (the other is an equity market neutral manager).

The question I get from outside-Quebec investors is if they're so good how come the Caisse and other large Quebec institutions don't invest in these new and existing hedge funds? There are a lot of reasons. First, reputation risk. There have been quite a few scandals in Quebec with institutions getting burned with funds like Lancer, Norshield, Norbourg, and other frauds. The last thing any institution here needs is to read that some hedge fund they invested with blew up, especially if it's a local fund (the media in Quebec are merciless).

Second, unlike other places, Quebec lacks the entrepreneurial drive to develop the absolute return industry here in Montreal. There entrepreneurs and visionaries like Jean-Guy Desjardins over at Fiera Sceptre who are trying hard to change this. His fund runs both long-only and a good size equity market neutral fund.

But no matter how smart and successful Jean-Guy Desjardins is, he cannot change Quebec's absolute return landscape by himself. Quebec institutions like the Caisse, the FTQ, Desjardins, and the National Bank have to do a lot more to develop alpha talent within and outside their organization (Ontario Teachers' has seeded a few Ontario hedge funds and funds of funds).

At one point, Desjardins Asset Management had the largest fund of funds in Canada, but after the crisis they shut that operation down, cutting it at the worst possible time (terrible business decision and way too conservative risk management). Unfortunately, even when they were big, they hardly seeded any Quebec hedge fund and mostly invested in managers based out of New York and London.

There is this misconception out there that managers from New York and London are better. The commodity arbitrage manager explained it to me like this since he worked in both countries: "There are more CFAs per capita here in Montreal who understand theory well, but they lack money management experience. If you go to New York, there are a lot of good traders but they're not brighter than our investment managers".

Another prominent Quebecer who worked in both countries explained it to me like this: "Any bozo could open a hedge fund in New York. Lots of slick Wall Street salesmen who lost their jobs after the crisis were able to raise millions and start a hedge fund. That's why a lot of hedge funds suck and charge alpha fees for beta (we were discussing the Bridgewater paper, selling beta as apha).

That's another topic that I raised with this commodity arbitrage manager. How many bozos are able to make a lot of money in this business either because they can bullshit their way into a position or they're purely lucky and ride the wave for as long as they can. One of the smartest and nicest guys I know in this business works with the Fixed Income group at the Caisse and I can assure you he's not getting compensated anywhere close to what many bozos in finance are getting paid. That's what pisses me off about our business, too many snake oil peddlers are getting away with murder and getting paid way too much money while smart people get shafted.

And don't get me started on brokers. Most of them are pure financial whores who'll do anything to squeeze a buck out of their clients. There are excellent brokers, people who offer fantastic, actionable ideas, but they're a dying breed. That commodity arbitrage manager told me: "I don't shop around trading ideas. I reward brokers who offer me good insight, and trade with them even if they're more expensive." That's the way it should be, reward the brokers who offer you the best ideas.

We started discussing passive commodity indexes, and I told him I don't believe in them. Some of the larger ones are all about energy and even the ones that are more diversified are way too volatile to justify a sizable allocation. Moreover, the diversification benefits of these passive commodity indexes are exaggerated, and most of the returns can be explained by rebalancing and roll yield.

I do, however, believe in active commodities strategies. I listened carefully to his strategy and how it's based mostly on top down fundamental discretionary trading but also uses systematic models to help manage risk ("sometimes commodities move and you only find out later some hedge fund liquidated positions"). Unlike most commodity traders or global macros, their fund will cover several commodities across energy, base and precious metals, softs and grains. They use options to minimize volatility when entering long-term trades. He understands and trades several commodity futures and explained to me in detail the liquidity of each contract. For example, even if you place a tight stop on nat gas or sugar futures, you'll get killed if it gaps down and misses your stop.

He also explained to me how stocks are highly correlated to stock indexes but this isn't the case for commodities. "If Israel launches a nuclear bomb to Iran, you'll see oil spike but base metals will get killed. There are a lot of fundamental factors driving commodities which is why I don't rely on purely systematic approach. Lots of CTAs got killed in May, whipsawed out of positions in silver". He showed me his returns, which deliver low teens with low volatility (Sharpe of 1.0).

[My note: A couple of Montreal CTAs I know agreed that fundamentals are important but told me over the long-run, systematic approaches win out. That's their bias.]

Finally, this commodity arbitrage manager sent me an interesting article which appeared in Institutional Investor in early April, Investors Turn to Active Commodities Strategies:

As investors pour money into commodities, they’re no longer content to merely buy the index. At the $225 billion California Public Employees’ Retirement System, for example, active strategies make up 25 percent of the Sacramento-based pension fund’s $2.5 billion in commodities investments. “We’re seeing a tremendous amount of interest from institutional investors in fully active strategies,” says Michael Johnson, vice president of commodities portfolio management at Goldman Sachs Asset Management in New York.

As recently as 2005 global institutions placed nearly all of their commodities assets — then worth $73 billion — in passive, long-only strategies, according to Barclays Capital. Last year enhanced index and long-short vehicles claimed $55 billion out of $376 billion. “We’re still seeing strong inflows into passive strategies for diversification, but investors now are looking to generate alpha as well,” says Philippe Comer, Barclays’s New York–based head of commodity investor structuring for the Americas.

Demand for third-party managers is growing. “It is a natural maturation of the asset class,” says Adam De Chiara, co-president of Stamford, Connecticut–based Jefferies Asset Management, which manages more than $1 billion in commodities.

The unique challenges of indexing commodities have helped drive investors toward active strategies. Unlike broad equity indexes, commodities indexes turn over each month when the nearest-term futures contracts expire. Active investors can profit by rolling contracts before or after the scheduled trade. Such roll timing has recently added 30 basis points a year in outperformance, says David Hemming, portfolio manager at London-based Hermes Fund Managers, which invests $2 billion of its $40.1 billion in assets in commodities.

The shape of the commodities futures curve can complicate matters. Starting five years ago, the curves for crude oil and several other commodities became upward-sloping, with longer-dated contracts priced higher than those closest to expiration, reflecting expectations that demand from emerging markets and uncertainty about future supplies will boost prices. When index investors roll from the nearest, cheaper contract to the next, more-expensive one, they lose money.

To combat negative roll yield, money managers buy contracts several months out, where the price curves for many commodities tend to flatten. “I can be away from the immediate contract and roll from the third- to the fourth-month contract to avoid some of the negative impact on returns associated with a futures curve that is upward-sloping,” says Johnson of Goldman, whose firm manages some $4 billion in commodities.

Commodities can be rich sources of alpha, especially compared with equities and fixed income. Consolidated data on commodities is not widely available, says Michael Lewis, who is a principal and works in manager research at Mercer in Toronto. Also, because producers and consumers such as oil companies and airlines still dominate commodities markets and they generally seek to lock in prices, financial players willing to accept price fluctuations can earn a premium for taking the other side of the trade.

One manager with an all-in-one, passive-plus-active approach to commodities investing in a mutual fund format is John Brynjolfsson, CIO of Aliso Viejo, California–based Armored Wolf, subadviser to the Eaton Vance Commodity Strategy Fund. Most of the fund aims to match the Dow Jones–UBS commodity index through a total return swap. Armored Wolf adds an actively managed overlay component that can be long or short by as much as 5 percent of the index.

Brynjolfsson uses active strategies from roll timing and curve positioning to relative-value trades based on geographic or qualitative anomalies. He also makes directional bets on individual commodities. As of mid-March the Eaton Vance fund was up 19.75 percent since its April 2010 launch, versus 20.74 percent for its benchmark. The fund trailed the index partly because of a short-term cash position in the first weeks after inception.

Investment managers and consultants predict that active commodities strategies will become even more popular. “Even if you’re trying to invest passively, you need active management to keep up with the indexes,” says Payson Swaffield, chief income investment officer at Boston’s Eaton Vance Investment Managers.

I agree, active commodities strategies will take off in a huge way, but institutional investors beware! Make sure you're investing with experienced managers who can offer you true alpha, not camouflaged beta. Keep an eye out for this new Quebec commodity relative value fund as it will be a very successful fund run by experienced commodity traders. These professionals understand the theory and practice behind active commodities strategies and I wish them many years of success. We need more absolute return funds like this and others in Quebec.

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How to Deal With Excessive Risk Concentration?

Jonathan Jacob of Forethought Risk, an independent risk advisory firm, sent me his Benefits Canada article, How to deal with excessive risk concentration:

In my previous column, Examining portfolio risk, we discussed ex-ante risk, ex-post risk and how both measures can provide greater understanding of portfolio risk. In this column I would like to discuss the options that are available to a pension fund manager that discovers excessive risk concentration in a fund through ex-ante risk reports.

When a pension fund utilizes the services of multiple investment managers, there is potential for overlap of risk, causing excessive concentration of risk. Excessive risk concentration can be found in exposure to a single company, a sector of the economy, or a currency among others. If the pension fund manager receives ex-ante reports on risk which aggregate all investment manager portfolios, he or she may recognize an exposure as excessive prior to a potential blow-up.

One potential approach to the excessive risk is to ask one of the investment managers to trim risk to the asset with excess exposure. The investment manager will likely disapprove the request, justifiably claiming that the initial agreement did not include such restrictions and any future measurement of their performance will be tainted by this decision.

An excellent method of circumventing this issue would be the establishment of a “shadow portfolio,” a paper portfolio which would include the original positions desired by the fund manager. This shadow portfolio would not be subject to the restrictions caused by aggregate excessive risk concentration, while the actual portfolio would include those limitations. Over time, the shadow portfolio would once again converge to the actual portfolio either due to the investment manager removing the forbidden positions from the shadow portfolio or due to the pension fund manager lifting the restrictions since other investment managers have voluntarily lightened risk allocations to the asset in question.

A second approach to excessive risk concentration is the use of an overlay portfolio.

The overlay portfolio is a portfolio managed by the pension fund manager to mitigate aggregate risk of the fund itself. The advantages of this approach are its lack of interference with the individual investment managers and the flexibility it provides to the pension fund manager. Unfortunately, it requires greater oversight to ensure proper risk management principles are being adhered to and a lengthy approval process to create such a vehicle.

The final approach is simply an informative one.

The pension fund manager provides the board and trustees with the knowledge that risk concentration is high in a particular asset. The pension fund manager will engage in intense monitoring of the asset in question and only request liquidation of risk at predetermined loss thresholds. This approach allows investment managers freedom to pursue their investment strategies with interference only occurring when necessary. The disadvantage of this approach is the potential for the asset to gap lower, thereby creating losses far in excess of the original threshold. Furthermore, trigger points are occasionally ignored and must be enforced by an investment committee or board.

There are three potential approaches to managing aggregate risk concentration created by multiple asset managers:

1. immediate reduction of risk,
2. use of an overlay portfolio, and
3. the establishment of trigger points for risk reduction.

The optimal approach may vary, depending on the organizational structure of the pension fund. No matter how a pension fund manages the issue of risk concentration, ex-ante risk reports provide valuable information to the pension fund manager with respect to aggregate fund risk exposure and risk concentration.

I thank Jonathan for sending me this excellent comment and I want to expand on it a little. Jonathan correctly states if the pension fund manager receives ex-ante reports on risk which aggregate all investment manager portfolios, he or she may recognize an exposure as excessive prior to a potential blow-up.

Here is the problem: those ex-ante reports have to aggregate risk from all investment portfolios, which include both public and private markets. This sounds easy and straightforward but it isn't. In private markets (real estate, private equity, and infrastructure), you run into stale pricing due to infrequent valuations And in some absolute return strategies, risk aggregation can be very deceptive, especially if it's an illiquid strategy when a crisis hits.

Take a Canadian pension fund that is invested in the commodity and energy heavy TSX, then does private equity ventures in oil and gas, invests in commodity trading advisors (CTAs), in hedge and long-only funds, in commodity futures index, emerging markets, and is long the Canadian dollar. Risk aggregation could be a nightmare if it's not done properly across all portfolios, leaving a fund vulnerable to serious downside risk.

And as far as overlay strategies, you need a CIO responsible for all investment portfolios, internal, external across public and private markets to make the calls and reduce overall risk at a fund. To do this properly, the CIO needs to have excellent risk aggregation reports but that's not enough. This person needs to have a central research team that focuses on leveraging off all sources of information, including the pension fund's external and internal investment managers (knowledge leverage), to produce high quality quantitative and qualitative research for all investment portfolios. This research group acts like the central nervous system of the pension fund and needs to be staffed by senior investment analysts from all groups. Importantly, they need to work well together and work well under pressure, always focusing on total fund risk.

Long gone are the days where risk is only quant oriented. More and more large pension funds in Canada are leveraging off their external partners to add in-depth qualitative research based on rigorous economic and financial analysis. In this environment, you got to think like a Bridgewater. And the bigger you are, the more important this becomes because you have to react quickly, be nimble and be able to take advantage as opportunities present themselves (go back to read my comment on OTPP's Neil Petroff on active management).

Finally, concerning my personal portfolio, I can tell you excessive risk concentration can be very painful when you're concentrated in a certain stock or sector and it's going against you. I've had a wild ride making and losing money with a Chinese solar stock called LDK Solar. Just check out the price action over the last year, and pay attention to the last three months and days (ticker is LDK; click on image to enlarge):

LDK and Trina Solar (TSL) both got whacked on Tuesday, down on heavy volume after Trina guided lower on margins (click on image to enlarge):

OUCH! Talk about a sunburn! Should have listened to Jean Turmel's wise advice! Now, to be truthful, I've traded this stock enough and seen many crazy periods before. I tripled down on LDK when it double bottomed at $5 last year, and I'm getting ready to add to my position (already started and got burned today so now I am waiting).

Chinese solar stocks are not for the feint of heart. When they move, they move abruptly in both directions. You got to buy them when they're way oversold (or wait for them to base after huge down moves on big volume) and sell them when they explode up. A lot of big hedge funds are accumulating and manipulating these stocks, as I will show this weekend when discussing 13-F filings for elite funds in Q1 2011 (I will cover all sectors, not just solars).

Excessive risk concentration matters. It matters for your personal portfolio and it really matters when you're managing other people's money, which is what pension funds are doing. And to properly understand excessive risk concentration, these pension funds need strong quantitative and qualitative analysis across all investment portfolios in public and private markets. While this sounds straightforward and easy, most pension funds lack the tools, systems, external partner relationships and most importantly, investment professionals on the inside who are thinking properly about risk aggregation across all investment portfolios. It's total fund risk that ultimately matters, which is why a lot of large institutional managers got killed in 2008.

***Feedback***

One senior pension fund manager sent me this comment, which sums it up well:

Seeking to manage this risk on some sort of systematic data capture basis seeks false precision, and turns investment management into a giant IT project. What is needed is simply one person, even in a large organization, to stay on top of broad goings on, and on occasion commission staff to do special ad hoc analysis. We used to call this person of experience a chief investment officer...

And Jonathan Jacob added this comment:

Your commenter has a point – it can be difficult to obtain quality data from custodians and that data must be run through a quality assurance process. My article was not so much directed at those large pension funds with significant systems and employee resources but more toward those funds that are severely understaffed (2-3 employees) and who outsource the investment management function to external managers.

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Just Another Manic Monday?

On Monday, I hooked up for lunch with someone who works at a successful Montreal hedge fund. He complimented me on my blog and then we started talking about alpha talent in Quebec. There are some exceptional hedge fund managers in this province that are being totally ignored by Quebec's large institutions (for God knows what reason!).

I would like all the global funds that read my blog to contact me (LKolivakis@gmail.com) and I'll be glad to share more information on our alpha talent in Quebec. Many managers have worked in London, New York, Chicago and decided to move back to Montreal for personal reasons. I want to support them as much as possible because Montreal's hedge fund community is small but offers tremendous potential. I want Montreal to become the fastest growing hedge fund center and will do everything I can to support our talented alpha managers.

The person who I had lunch with today introduced me to another person who is in the process of starting a relative value commodity fund. I spoke with this manager late this afternoon and was blown away by how sharp this guy is. Unlike most commodity fund managers who mostly trade front end oil futures, this manager and his small team have years of experience trading all commodities, including energy, metals, corn, sugar, and other soft commodities.

We had a great discussion on the financial crisis. Like me, he was extremely bearish back in 2006. I told him I was researching all these complex CDO-squared and CDO-cubed structures and was petrified. He told me he wanted to buy out-of-the-money put options when the S&P reached 1400 but his manager didn't like the idea. "People do not want to hear bad news".

I laughed because it's so true. Just like permabears on Zero Hedge do not want to hear good news. My brother called me tonight to tell me to tone it down on Zero Hedge. I told him that I try hard to ignore the idiots who keep insulting me but once in a while I'll vent and tell them to "F off". But my brother is right, once you're in the public eye, any cyber idiot can insult you so it's best to strictly ignore these cowards.

Back to that commodity manager. He impressed me because he uses liquidity flows, technical and fundamental analysis to take positions in various commodities and understands the term structure of the commodities he trades, linking it to his fundamental analysis. He uses derivatives wisely and isn't looking to hit home runs every time. One thing he told me is that a lot of "superstar" commodity managers are one hit wonders (one fund was up 200% last year and lost 40% last month). That's why I tell all institutional managers to focus on process over performance.

We also talked about how crazy things got back in 2008. I told him to ignore hot money investors like Swiss fund of funds and find patient capital like large global pension funds. Interestingly, he explained to me what happened in 2008. Redemption notices were coming in hard at fund of funds and they first pulled money away from liquid strategies like commodity trading advisors (CTAs), global macros and L/S Equity funds. They also redeemed from illiquid strategies but those funds took longer to liquidate their positions. I remember, it was one redemption after another, forcing hedge funds to close the gates of hedge hell.

He told me some of that is happening now. Big moves in commodity funds, many of which are liquidating positions to shore up liquidity. He shorted silver and made a bundle last week. Lots of managers, especially CTAs, are getting whipsawed in these volatile markets. But he didn't tell me he was bearish on commodities. Quite the opposite, he sees the secular uptrend continuing but there will be plenty of volatility along the way (which he will play using derivatives).

When the time is right, I will reveal this manager by updating my blog post on Quebec absolute return funds. Just by talking to this guy, I know his fund will be very successful. Again, I urge global pension funds investing in hedge funds to visit beautiful Montreal. We need more patient capital willing to support our talented alpha managers, some of which have years of experience working at large financial centers and at the large Canadian pension funds on internal alpha strategies.

It was another manic Monday. If you visit Zero Hedge and read the commentaries, you'll want to slice your wrists. SocGen is now forecasting a Chinese slowdown and warns commodities will sell off hard. I say keep buying these dips because we're heading much, much higher (many solar stocks are way oversold as the big hedgies keep manipulating them to death!).

In another comment, Zero Hedge says bond king Bill Gross IS shorting Treasurys:

And while we wish we had an updated TRF holding (the last one is as of December 31, 2010), even using even stale data, we find that at the end of 2010 TRF had $608.3 billion in Net Futures held SHORT (link), and $588 billion in Eurodollar positions, which is precisely where his marginal synthetic rate bias/exposure is contained. Yes. This is a short equivalent position.

Bill Gross denied these allegations on CNBC, and says that Greece is the world’s biggest candidate for default (hmm, either those Norwegians are stupid for buying up Greek bonds or Bill is trying to pull a fast one on us again, snapping up Greek debt at default prices).

I asked the smartest fixed income analyst in Montreal to make sense of all this noise. Actually, this person is one of the smartest analysts I ever met and had the pleasure of working with and he's a great guy to boot. Here is what he wrote me:

"Debt tends to slow economic growth," Gross said in a live interview.

More accurately, slow growth leads to higher government debt.

The below matched my previous comments: Zero Hedge really didn’t pick up on the fact they are still long duration; they just have a spread position.

He blamed a "blogger" who created a "misconception" that Pimco had shorted Treasurys. The comment was an apparent reference to the zerohedge blog, whose author posted on Twitter that Pimco holds a negative duration weighted exposure to Treasurys.

Gross said only that Pimco is "very underweight" on Treasurys and that the firm is making money even though it has been on the wrong side of that trade in recent weeks.

"Pimco is doing just fine," he said. "We're outperforming 77 percent of the bond market universe because we're holding other bonds that are doing better than Treasurys."

Did you all get that? Pimco is still long duration but they have a spread position. He further explained this to me a couple of weeks ago:

They still have a positive duration, I believe, so the net Treasury short can be a viewed as a short Treasury-long spread product trade. But they are certainly playing up to the Zero Hedge crowd….

The fact that they have cash represents a curve position (or the residual of a curve position), so “charging a management fee for holding cash” is a bit unfair.

So I laugh when Bill Gross and others warn of a looming US debt crisis. They got the causation all wrong. Importantly, slow growth leads to higher government debt, not the other way around.

Finally, the Globe and Mail reprinted a Reuters article stating that U.S. taps pension funds as it hits debt ceiling:

U.S. Treasury Secretary Timothy Geithner told Congress he would start tapping into federal pension funds on Monday to free up borrowing capacity as the nation hits the $14.294-trillion legal limit on its debt.

The U.S. Treasury will issue $72-billion in bonds and notes on Monday, pushing the nation right up against its borrowing cap at some point during the day, according to a Treasury official.

Mr. Geithner said he would suspend investments in two government retirement funds, which will give the U.S. Treasury $147-billion in additional borrowing capacity.

“I will be unable to invest fully” in the civil service retirement and disability fund and the government securities investment fund, he said in a letter to congressional leaders.

The Treasury has said the suspension of the investments and other measures it could take would give the government until about Aug. 2 before it will start defaulting on obligations, such as paying bond investors.

Congress is in charge of increasing the debt ceiling, but Republicans are demanding deep cuts to federal spending for the price of their support in raising it.

Mr. Geithner reiterated previous pleas for action. “I again urge Congress to act to increase the statutory debt limit as soon as possible,” he said.

Previous administrations have also tapped the retirement funds at times to avoid breaching the debt limit. Over the past two decades, Treasury has suspended investments five times, with the most recent suspension in 2006.

“Federal retirees and employees will be unaffected by these actions,” Mr. Geithner said, since Treasury must make the funds whole once the debt limit is raised.

But the measures still disrupt Treasury’s operations, as it must run two sets of books among other things.

What do I make of all this? Just more noise. Go back and listen to ABC's This Week's roundtable discussion on the economy. Krugman is right, this is more fear mongering by Republicans who claim spending is out of control, ignoring how fragile the recovery is. Again, debt rose because economic growth slowed in the last couple of years. Once the economy recovers, government revenues will recover and debt will not be growing as fast.

This is all noise, noise NOISE! I do not believe we are heading into the abyss or that a looming US debt crisis is upon us. These pullbacks offer global pension funds excellent opportunities to snap up shares in energy, commodities, financials, and technology. You'll see, this is just another manic Monday. And please don't forget to support me by kindly donating any amount on the PayPal link under the pig at the top of my blog. Just because it's free doesn't mean you can't show your appreciation.

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Keep On Dancing Till The World Ends?

It was a rainy and cold weekend in Montreal so I spent most of it doing the one thing I hate the most, shopping. I bought a new mattress, a new television, some clothes and re-tailored my suits, jackets and pants because the first tailor did a terrible job (losing weight is healthy but expensive).

Tonight, I had dinner at my brother's house, saw my nephews and sister-in-law and enjoyed some BBQ burgers and hotdogs (once in a while, it's good to indulge!). My brother's neighbor was over with his two young girls and we talked shop a little. Montreal's investment community is small. Turns out he works at Stanton Asset Management, which is the portfolio advisor to O'Leary Funds, private clients and institutional clients.

According to their website, the investment team at Stanton is responsible for over $1 billion of assets under management, invested in Canadian and global markets, including investment grade bonds, high yield bonds, convertible bonds and equities. I know Connor O'Brien, Stanton's Chief Investment Officer, as he used to run a small fund of funds focusing on delivering high risk-adjusted returns.

My brother's neighbor told me the O'Leary Funds have performed extremely well with low beta, helping assets grow. It also helps to have Kevin O'Leary, who everyone knows as Canada's unrepentant dragon, to market the funds. I told him I'd be more than happy to plug Stanton on my blog and have other ideas that I'd like to discuss with Connor and Kevin O'Leary.

Speaking of marketing, before I get to my latest comment, I want to clarify something. Pension Pulse is a blog I created to share my perspective on markets and pensions. I don't care if you agree or disagree with my views, but take the time to read them carefully. I do not have a monopoly on wisdom but I try to offer a fresh perspective that most analysts do not bring.

I am not a permabull or a permabear. In fact, I was extremely bearish back in 2006 and it ended up costing me my job (they claimed I was too negative). It's all in the past for me but I recently started asking for donations on my blog and would appreciate your financial support, especially from the large institutions that read me on a daily basis. But there are others too, brokers, bankers, unions, federal and provincial MPs, government agencies, non-profit groups, etc.

You can click on the donate button at the top of my blog and give whatever amount you can. If your organization can't donate, then donate as an individual. PayPal calls them donations but they're not really donations. I'm not a charity; I'm the most underpaid pension and market analyst in the world and would appreciate your financial support. If I do not get support, I will start charging a flat annual subscription fee for my blog and close it off to only a few institutional clients. I prefer to keep my blog open to everyone but a free blog which provides a fresh perspective isn't compensating me for the time and effort I put into it (just the links on the right-hand side took me forever to put up and I keep adding more).

Back to business. Two years after I wrote my Outlook 2009 on post-deleveraging blues, I am still bullish on stocks for the simple reason that there is plenty of global liquidity to drive risk assets much higher. Liquidity is primarily coming from the Fed pumping billions into the financial system, but it's also coming from global pensions, sovereign wealth funds, endowment funds, mutual funds and insurance companies. Importantly, hedge funds are back with a vengeance, growing larger as assets set to surpass the 2008 all-time high. This too is a driving force behind stocks, bonds, commodities and currencies.

But the bears only see doom and gloom. Some of them act like religious zealots. Just check out the nasty comments I got on Zero Hedge following my last post on my lunch with a bear. There are a lot of smart people over there but they're so many idiots who just like to insult me because I do not share their views. I got thick skin and can take whatever they got to dish out but sometimes I engage them and then end up regretting it.

Most of the bears on Zero Hedge accuse me of being a "permabull" who only sees through rose colored glasses. Can't I see that the US dollar has tanked as stocks and commodities rise? Can't I see it's only the Fed's quantitative easing propelling risk assets higher? Of course I can but it doesn't change the fact that I've been right in telling people to keep buying the dips over the last two years as the liquidity tsunami will wash over whatever negative macro events come our way.

And my detractors love throwing my calls on Greek bonds and National Bank of Greece in my face. Both are priced for default (good contrarian plays). The reality is that Greece is hurting but last time I checked, it's still part of eurozone. My buddy tells me 40% of Greeks want to go back to the drachma. Ah yes, the good old drachma years where you have a worthless currency and you're stuck engaging in competitive devaluation hoping you can export your way out of your economic woes. These are short-term fixes, Greece needs structural changes.

But Nobel Prize winning economist Joseph Stiglitz is right, austerity measures “don’t work” and prevent countries from creating jobs needed to generate economic growth. Too much austerity can kill an economy, which is what is going on right now in Greece and what risks happening in the periphery economies and even the UK. At one point, people will just stop consuming because they can't get a loan and they're scared to death they'll lose their job.

One last thing on macro events. Lots of pundits are fixated on the US debt ceiling. Gurus like bond king Bill Gross and hedge fund legend Stanley Druckenmiller are warning of a catastrophe. I think you should all watch ABC's This Week's roundtable discussion on the economy and listen to what another Nobel Prize winning economist, Paul Krugman says about that (love him or hate him, Krugman is 100% dead right on the debt bogeyman).

Now, onto my latest topic. I called it "Keep on Dancing Till the World Ends" because after turning 40 recently, I'm listening a lot more to pop music. I got the radio on Virgin Radio 96 FM all day and listening to Britney Spears, Jennifer Lopez, Rihanna, Lady Gaga, and a bunch of other pop stars. It gets annoying after a while because they keep playing the same music over and over, but it's a perfect title for this post.

Those of you who haven't read it, should go back to read my comment about Leo de Bever on when the music stops. At one point, the music will stop, but for now, I agree with Britney Spears, you got to keep on dancing till the world ends. And despite what those bears on Zero Hedge think, the world isn't ending anytime soon.

I know, "sell in May and go away", the summer doldrums are just beginning. China will collapse, commodities and energy will tank, Greece will default and the world is a hair away from total calamity, but I remain bullish and ignore all this noise. It's more of a distraction that scares retail money away while elite funds load up on more shares.

Last week, I wrote an introduction on how I track activity from elite funds. I even gave an example of Greenlight Capital buying up Internet-giant Yahoo (YHOO) and electronics retailer Best Buy (BBY). If you read that comment carefully, I specifically stated that I use this information to build a portfolio of stocks I track across many industries but I'm careful not to buy any stock blindly, even if elite funds are buying it.

Picking your spots of when to buy or when to sell a stock isn't easy. It takes traders years to built up this skill and even then, they're extremely lucky if they're right 60% of the time. That's why I focus on a few stocks across 10 industries I track regularly, and try to pick my spots carefully, going in when a stock is tanking on high volume for no apparent reason (noticed it's best to buy towards the end of the day on such days).

Those of you who have tracked my stock comments know I love solar stocks. But I don't just track solars. I like medical device companies, healthcare, energy, software, networking, storage, and many other sectors. Solars are fun (for me) because they move strongly in both directions and offer good trading opportunities. But solars are not for most most investors because they're too volatile and a lot of people get scared away.

There are plenty of stocks out there. For example, one of the top performers this year is Green Mountain Coffee Roasters (GMCR, click on image to enlarge).


Now, have a look at their top institutional holders (click on image to enlarge):

Data is lagged but among the top holders, you have Fidelity (FMR), Blackrock, Wellington and some hedge funds like Coatue Management and Winslow Capital Management.

You might be thinking, who cares? I care more about what top funds are actually buying and selling then what some analyst is touting or what George Soros, Bill Gross and Stanley Druckenmiller are saying on the television. Show me your actual book, not what you're recommending on TV.

Next week, I'll get into specifics on which top funds I'm tracking and what are their top holdings. I want people to do their own research and due diligence as I don't believe in spoonfeeding anyone, but I'm going to give you the tools to be able to dissect the portfolios of these elite funds.

Finally, please be kind enough to donate whatever you can to my blog efforts. You can do so by clicking on the donate button under the pig at the top of my blog. And remember, these markets are a lot like Britney Spears, up, down and very volatile. But don't let those permabears scare you away. Have no fear, keep buying the dips and keep on dancing till the world ends. :)

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Lunch With A Bear

Earlier this week, I had lunch with a friend of mine. He was kind enough to articulate his thoughts in his blog, Frozen in the North:

Over lunch yesterday with a friend we discussed the direction of the American economy. I am naturally bearish and he is naturally bullish. So this lead to an interesting lunch. He asked me to articulate my thoughts and here they are:

I believe that the American economy faces heavy headwinds and that “business as usual” is just not on the cards. Moreover, the American economy’s make up, imposes some real limits to future growth.

Over the past two decades, personal consumption as a percentage of GDP has trended upwards. Looking back to the 80s and 90s personal consumption hovered around 60%. In 2010 it reached 70% – it is much higher in the U.S. than in the rest of the OECD. Secondly, more than half of all adult Americans have FICO score of less than 600, prohibiting them from obtaining a mortgage. Third, in some of America’s largest cities 8% of all homes are in default, where the home owners are channeling all expenditure away from mortgage payment to consumption.

What does this mean?

First, there is little scope for personal consumption to rise organically since it is already such a large percentage of GDP. Second, over the next two years many Americans that today “consume” their mortgage payments will begin to pay rent – reducing their ability to consume. The housing overhang will last for another 24 to 36 months, and it is unclear how it will clear since so many Americans are no longer credit worthy. Between 2002 and 2007 Americans have accessed their “home ATM” to meet their standard of living expectations. While 8% of mortgages are in foreclosure, about 25% are “underwater” where the value of the outstanding mortgage either equal or exceeds the value of the home. The home ATM source of disposable income for consumption has disappeared for good. Therefore, business as usual for the consumer is just not on the cards

The other part of the equation is government spending, which is set to fall. Federal, State and local governments account for about 25% of total GDP; whereas the Federal government is only now beginning to look at expenditure reduction, state and local governments have already facing to large budget deficits, and they are cutting. BTW state governments account for about 2/3^rd of all government expenses. It is also important to note that several state have resorted to increase in taxes, further reducing disposable income.

Finally, and despite what the GOP is preaching, there is no way to balance the Federal budget without some revenue generation strategies. The GOP may oppose increase in income tax, but the reality is that sales taxes are almost certain to be needed to bridge the gap, moreover, it is a more ”egalitarian” form of taxation. This will further reducing available income for consumption. Yes Americans are inventive, but it remains that a federal government that has a deficit equal to 10% of the GDP will have to take action soon, rather than later.

I am reluctant to get into the argument for growth in the private sector, but one aspect resonate across many sectors, while net profits continue to improve top line revenues remain sluggish. American corporations have become master at the art of cutting costs, but there’s a limit to this strategy (although Q1/2011 performance has been spectacular). Most American companies have indicated a reluctance to increase employment, until they see an upward sign in sales activities.

For all these reasons, headwinds for the American economy remain heavy. Moreover, one crisis (either in America or elsewhere) could cause systemic tension to explode.

He followed up with a comment on Friday the 13th curse:

Markets are tanking today! Numbers were not that bad, Greece is at the same place it was! Suddenly investors care. Aside from that Bloomberg released an analysis of the world's strongest banks -- In the top 15, 5 were Canadian, three from Singapore and two from Switzerland. None of the Canadian banks are rated AAA by Moody's (or S&P) in fact, National Bank of Canada (#3 in the world) is actually rated the weakest (in rating terms).

I point this out to make this story funnier, it turns out that Cyprus only two commercial banks have an exposure to Greece of about $30 billion, or about 170% of Cyprus' GDP. Today, everyone is talking write-downs on Greek debt (Duh!) with hair cuts of 40% to 75%. In this instance, a poor country that has not too much sovereign debt could find itself as the world's most bankrupt country in about 5 minutes.

I wonder what rating Moody's and S&P assigned to these two banks???

My friend makes several interesting observations but I don't share his bearish views. I reminded him that the US economy is the most productive economy in the world, and that productivity ultimately determines the wealth of a nation. I mention this because everyone is still focusing on the dismal US labor market (which is finally showing signs of a rebound) and not focusing on the true successes of American enterprise in both the old and new economy.

Another portfolio manager I know told me he attended a recent conference hosted by Steve Drobny of Drobny Global Advisors. He told me: "All the young hedge fund managers were bearish, waiting to make another killing like some managers did in 2008. The older guys were more sanguine, and more bullish. They were long homebuilders because they think that housing woes are concentrated in a few states but that inventories run the risk of being low in the future."

Like I said, I know it's fashionable to be short US, but I'm bullish on both the US economy and the US stock market (keep buying the dips!). On Sunday, I'll follow-up on last week's piece introducing secrets of elite funds.

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