Tuesday, January 30, 2007

P&I Top 1000

The annual Pension & Investments 1000 provides a good profile of the portfolio implementations of the top US pension plans. The Top 1000 corporate DB average asset allocation at 9/30/2006 was; US fixed income 26%, domestic equity 41%, international equity 16.5%, real estate 3.3% and 14.2% all other. A small year over year rise in corporate plan bond allocations was suggested as evidence that sponsors are starting to employ liability driven strategies. The relative level of indexing remained static, though an shift to more exotic “betas” has been observed. Enhanced indexing strategies grew as sponsors continued to look for opportunities to increase returns.

Of the top 200 Plans, 153 offer defined contribution plans. The aggregate aset mixes remained stable though diversified fund assets grew. 50 plans offered age based lifecycle or risk based lifestyle funds while 14 offered REITS and 13 offered TIPS. Index and enhanced index options grew as well.

Monday, January 29, 2007

Empty Voting

The lead story in Friday's WSJ, "How Borowed Shares Swing Company Votes" adressed the topic of "empty voting". In empty voting, equity shares are lent/borrowed prior to their record date and returned afterwards. This has traditionally entitled the borrower to the voting rights. Through this practice, borrowers can establish control over a large block of votes without mantaining any continued economic interest. Empty voting can be used to promote interests other than those of the fiduciary shareholders.

It has grown along with the securities lending business. Estimates of the size of the equity securities lending markets are in excess of US$700 billion, with significant participation from mutual funds, pension plans, endowments and insurance companies. The history and issues involved in Empty Voting are outlined in both the referenced study by University of Texas professors Hu and Black and by Charles Nathan in his article “Empty Voting” and Other Fault Lines Undermining Shareholder Democracy: The New Hunting Ground for Hedge Funds.

Securities lending and the separation of voting rights from the economics of stock ownership may be of concern for plan fiducaries. Legally, a transfer of title normally occurs when a security is loaned. Therefore, fiduciaries may have no explict responsibility to follow ERISA proxy voting rules as established in the DOL Interpretative Bulletin on Proxy Voting.

However, language in the Bulletin might broadly suggest that fiduciaries have an explicit responsibility to weight the benefits associated with securities lending activity against the "value" of voting rights and the potential that those rights could be voted in a manner that is contrary to participants best interests.
" the responsible fiduciary consider those factors that may affect the value of the plan's investment and not subordinate the interests of the participants and beneficiaries in their retirement income to unrelated objectives.....The named fiduciary must carry out this responsibility solely in the interest of the participants and beneficiaries and without regard to its relationship to the plan."
Though the extent of empty voting is unknown, the potential costs and conflicts of interest of securities lending may be growing larger than prudent fiduciaries can ignore. Fiduciaries should be aware of any securities lending activities that involve their plan assets. They should also inquire about how their agents prevent or detect abusive activity.

Thursday, January 25, 2007

Bo Knows Investments


Professional investors select investments such as mutual funds based on their expected “investment value”. Investment value is determined by carefully reviewing and comparing a variety of quantitative and qualitative characteristics to benchmarks and other alternatives. Non-professional investors, including many retirement plan fiduciaries, on the other hand, tend to select investment providers and investments based on little more than their “franchise value”. Franchise value is the popularity of a brand name with consumers. Starbuck's, and McDonald's are industry leaders because consumers recognize and value their corporate identities as much as their products. The same is true for the Fidelity’s and Goldman Sachs’ of the financial world. Their brands have been carefully designed and managed to serve as proxies for quality.

Investors often use short cuts in their investment decision making. We know this through our own observations and through numerous research studies such as one performed by the Consumer Federation of America. This study concludes that most mutual fund investors do not follow the practices recommended by experts. When selecting mutual funds, investors give little weight to elements considered important by experts such as; cost and information provided in the fund’s prospectus. The wide use of franchise value as a short cut for sorting and selecting amongst a large universe of investment alternatives is well recognized by regulators and marketers.

Brand based purchasing behavior is a particular risk in markets characterized by information asymmetry. Information asymmetry exists in markets where sellers are better informed about product characteristics than buyers. In the financial services and asset management markets, buyers are not always capable of assessing the long run risk return nature of the products they are encouraged to consume. Extensive regulation and disclosure requirements in these markets recognize this disparity and seek to limit the seller’s advantage. ERISA fiduciary responsibilities and the “prudent expert” standard of fiduciary care were no doubt designed to protect investors from the inadequacy of naïve investment decision making using factors such as franchise value.

Financial services companies fully understand the economic value in establishing or terminating ie PBHG or Strong a high level of brand recognition and franchise value for their business. High franchise value is becoming a major competitive asset for financial service firms as it; creates demand, allows for premium pricing and stifles competition. Not coincidentally, they are spending huge amounts on branding and celebrity endorsement. Anecdotal examples in the most recent issue of Investment News include:

  • London-based Barclays agreed to pay nearly $400 million over 20 years for the right to have its name on an arena in Brooklyn.
  • Prudential Financial Inc. agreed to pay $105 million over 20 years for the name PrudentialCenter on a new arena.
  • Citigroup Inc. agreed to pay the New York Mets $400 million over 20 years to call the team’s new baseball stadium in Queens, N.Y., Citi Field.
  • Principal Financial Group Inc. is hoping that Hall of Fame pitcher Nolan Ryan will help the company win customers as the new national spokesman.
  • Bo Jackson now is teaming up with the Guardian Life Insurance Company of America in New York.

    The lesson, particularly for investment fiduciaries, is that a favorable inclination towards certain investment providers or funds is probably an insufficient and unsupportable basis for a fiduciary decision. As Fred Reish notes:

    "fiduciaries must engage in a prudent process. That is, they must: determine what information is needed to make an informed decision; gather, examine, and understand that information; and then make a reasoned decision based on that information. While this process is straightforward, it may seem daunting to many fiduciaries because it requires an understanding of sophisticated investment concepts and an analysis of detailed information about investments. For example, US Department of Labor guidance and court cases make it clear that fiduciaries are expected to understand and apply generally accepted investment theories such as modern portfolio theory and prevailing investment industry practices such as the quantitative and qualitative analysis of the mangers of mutual funds."

    The Rock, leather bound presentations, Paul McCartney, You & Us, gold leafed educational packets, lava lamps, Higher Standards, Lance Armstrong, erudite investment commentary and the Red umbrella don’t guarantee results and won't keep you out of court!
  • Sunday, January 21, 2007

    Mutual Funds UnderPerform - Agency Issues?

    A study entitled Economies of Scale, Lack of Skill or Misalignment of Interest? A Study on Pension and Mutual Fund Performance by R. Bauer, R. Frehenc, H. Lumb and R. Ottenc implies that agency conflicts of interest may account for the fact that mutual funds were found to significantly underperform retirement plan investments. This study concludes that:

    • DB and DC pension fund investment net returns were nominally less, though substantively similar to the performance of their benchmarks,
    • mutual funds underperformed their benchmarks by at least 150 to 200 basis points per year,
    • index mutual funds posted the smallest under-performance, around 50 basis points,
    • mutual fund returns exhibited modest persistency in returns while pension funds exhibited none,
    • mutual fund underperformance relative to pension funds was larger than could be attributed to their differences in cost, risk or style leading to the study's conclusion that a misalignment of interests between mutual fund companies and their investors was responsible .

    It was unclear why DC equity returns were comparable with DB equity returns when about 50% of DC assets, at least in the US are in mutual funds. Several possible reasons:

    • DC average equity in the study was $617 million, indicating a higher probability that the DC equity was managed via unitized separate accounts
    • Research indicates DC plans have better access to and generally utilize "better" mutual funds than the mutal fund average,
    • Index fund representation may be higher proportionally in DC plan universes than in mutual fund averages due to fiduciary standards,
    • statistically, any active selection process, even naive performance chasing avoids mutual fund "perma-dogs" which are contained in mutual fund averages.

    Rewarding, Very, Very, Very Rewarding


    The 401(k) business has been very rewarding for investment product and service providers. Financial institutions and asset managers around the world have achieved record profits and profitability over the last four years in a row, in part due to the growth in 401k plans, increasing plan contributions levels and steady capital market appreciation. They have a highly leverageable business and economic model. Their consumers generally; accept the value added premise and fees associated with active management as they equate positive short-term performance with skill rather than random chance, prefer the ease of bundled services and fees and rely on brand name as a proxy for quality.

    The demise of DB plans and the provisions of the Pension Protection Act, passed in August 2006, promise to generate even greater growth in the 401K market in the years ahead. Morgan Stanley predicts that DC plan inflows will increase to $30 billion in 2008, peaking at $37 billion in 2010. In addition, providers that can establish corporate 401(k) relationships receive an extremely valuable free dividend, hundreds or thousands of plan participant relationships, which they can leverage outside the 401k domain. Recognizing the growth opportunity and the free call option on participant relationships, merger and acquisition and hiring activity in the 401(k) industry is on the rise.

    Unfortunately, a portion of the financial success of the 401(k) business has been directly and unknowingly subsidized by Plan sponsors and participants. The recent 401(k) litigation highlights areas where asset managers and service providers have arguably generated excess revenue at the expense of 401k plans. Asset based revenue matched with fixed cost administrative services, the failure to recognize asset management economies of scale by using fixed price retail mutual funds and closet indexing are examples .

    The courts will determine the fiduciary prudence of past practices given the “facts and circumstances then prevailing”. The implications however, could be substantial given the prevalence of these practices. Plan fiduciaries have been put on notice and must now be more proactive in dealing with expense and investment value issues or they invite tremendous liability. In light of this, plan fiduciaries should critically re-evaluate their plan structures and provider programs and embrace new options under the Pension Protection Act to reduce their fiduciary liability.

    Index- 401K plan fiduciaries retain the responsibility for prudently selecting and monitoring the investments they make available to plan participants. Excluding actively managed investment opportunities represents a substantial opportunity to rationalize plan structure, minimize expenses and hidden costs and reduce sponsor risk and liability. According to William Sharpe “properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs”. This logic is irrefutable and provides a sound fiduciary basis for indexing. Decades of equity mutal fund research also indicate an inability of fund managers to beat market indices. As the separation of “beta” or market returns from “alpha” or active manager relative returns becomes a more commonly accepted way of looking at both investment returns and costs, the potential excessive cost of alpha in many actively managed products could very easily become the next cause of action against plan fiduciaries. 40 sof research indicate equity mutual funds

    Unbundle- Unbundling is where plan sponsors select the best provider for each service element of their 401K plan such as; administration, investments or education. Unbundling tends to reduce the embedded conflicts of interest and cross subsidized services that create fiduciary risk and require fiduciary effort to understand. Research indicates that services can be acquired less expensively if separately negotiated. Though larger plans may benefit most from unbundling, the growth in DC plans as well as the number of new competitors in the market means the opportunity and benefits from unbundling apply to a larger population of plans. The introduction of single fund solutions (target retirement funds) and ETF’s make unbundled solutions more competitive in the smaller plan market as the need for investment education, materials and technical support diminishes. Providers who can provide competent recordkeeping and compliance at much lower prices can compete more effectively in a world where 401(k) investors make a single lifetime investment decision.

    Plan fiduciaries should consider the economic present value of their 401(k)relationships, including their growing fiduciary liability, when selecting and negotiating product and service agreements with vendors. On the whole, the more rewarding the 401(k) business is for asset managers and service providers, the more exposure plan fiduciaries will have.

    Tuesday, January 16, 2007

    2006 Capital Market & Fiduciary Review

    Investors enjoyed strong returns across a broad spectrum of assets classes in 2006 as ample liquidity and low market volatility encouraged and rewarded risk taking. Pension plans generally improved their funding status. Asset increases, averaging 12% for moderate risk diversified portfolios, outpaced a 1.2 % increase in average liabilities according to Mellon Financial. Despite improving pension plan economics, the regulatory and accounting changes enacted this year increase the defined benefit plan burden for many plan sponsors. As defined contribution plans shift from being a supplemental to a primary retirement resource, political, regulatory and legal scrutiny is on the rise.

    Capital Markets Trade Higher in 2006
    Global capital markets traded higher in near unison as a combination of cash, generated by strong corporate profits, petrodollars and Asian central banks, and financial leverage, provided by cheap debt, sought investment opportunity. Though market activity seemed generally rational, there were signs of momentum buying in certain areas.

    Domestic equity –Almost half of the S&P 500’s 15.7% return for 2006 was delivered during the strong 4th quarter rally. Though market capitalization and style performance return differentials narrowed through the year, value investing maintained its global market leadership, marking a 7 year trend. The Russell 3000 growth index retuned 6.2% during the 4th quarter (9.5% ytd) vs. 8.1% for Russell 3000 Value (22.3% ytd). Investor’s reluctance to adopt growth investing - a residual of the tech boom, continued as elevated oil prices and a huge level of private equity transactions supported value style investing.

    Despite expectations to the contrary, US small cap stocks dominated larger capitalization stocks again in 2006. The Russell 2000 small cap index returned 8.9% (18.4% ytd) for the 4th quarter vs. 6.7% (15.5% ytd) for the Russell Top 200 large cap index. Small cap strength can be attributed to the market’s low risk aversion as well as by private equity and hedge fund interest and the increasing use of ETF’s which may proportionately favor small caps.

    In the US, indexing outperformed active management. Only 19% of all funds in the diversified stock fund category were able to beat the S&P 500 vs. 61% last year according to the WSJ. The “mega cap” discount and value and international active management biases provided less of an advantage to active managers in 2006. In addition, fewer than ½ the companies in the S&P beat the index according to Merrill Lynch, making stock selection more critical.

    International Equity - Returns were equally strong based on strong global earnings growth, moderate equity valuations and a foreign currency kick for US investors. The MSCI EAFE Index returned 10.4% (26.9% ytd) for the quarter. Mutual fund investors piled into the non domestic markets in 2006 as an estimated $5 flowed into non domestic equity funds for every $1 that went into a domestic equity fund. Strong trends in flows like this can be self perpetuating as momentum investors tend to follow and reinforce the trend. Trend reversals however, can be equally powerful. Emerging markets recovered from a sharp sell off in the spring and retuned 17.6% (32.6% ytd) for the quarter according to the MSCI Emerging Markets Index%. Value and growth enjoyed similar gains in emerging markets, perhaps indicating less discriminating buying.

    Private Equity - Fund raising set a new record in 2006, collecting over $320 billion as pension plans and institutions added or increased allocations to make their “8%”. With this kind of money to invest (over $1 trillion levered by with 3-4 times debt), private equity funds did bigger deals and started looking beyond the safe, high cash-flow companies they normally prefer. Questions abound as to whether traditional private equity approaches will continue to work in an era of mega buyout deals and how these investments will fare in a more difficult economic environment.

    Commercial Real Estate- The rally continued in 2006, providing returns of 34.4% per NAREIT. The top performing REITs targeted international real estate, REIT privatization (Equity Office Properties Trust) as well as apartment REITS, which benefited from the reduced affordability of single family homes. US REIT share prices are rising faster than earnings, driving dividend yields below Treasuries, indicating a speculative element in this market.

    Hedge Funds - Overall, hedge funds returned 12.1% in 2006 according to the Greenwich Global Hedge Fund Index. While research indicates that portfolio diversification rather than returns is the primary reason why hedge fund allocations are increasing, the correlation of hedge fund strategies to the equities markets have increased significantly over the last few years. It will be interesting to see if a new breed of low cost hedge fund “indexes” can successfully mirror the “beta” or market component of these strategies and absorb some of the growing demand for absolute returns.

    Fixed Income – The anticipated turn in the credit cycle didn’t materialize in 2006 and credit spreads remained tight, perhaps not fully reflecting market risks or the growing but unknown impact that the dramatic increase in credit derivatives might have in less serene times. US bond yields reached a peak at mid year and drifted lower as the market anticipated Fed easing in response to slower economic growth. Credit risk was generally rewarded while duration was not.

    Three month T–Bills returned 1.3% (4.8%YTD) for the quarter vs. Long Term Governments .48% (1.8% YTD). The yield curve remained inverted at year end, with yields on short term bonds (5.02% - 3 month T Bill) exceeding those of long term Treasuries ( 4.71% - 10 year Note). This has traditionally been a recessionary signal and continues to puzzle the markets as it contradicts the consensus forecast for a “soft landing” in 2007. Event risk challenged investment grade corporate bonds as leveraged acquisitions and new debt issuance put downward pressure on credit ratings.

    Investor appetite for higher yield debt drove the boom in leveraged buyouts and boosted returns, yet compressed yield spreads, in the high yield bond market. High yield bonds returned 4.1% (11.6% ytd) for the quarter vs. the Lehman Brothers Investment Grade Bond Index 1.2% (4.3% ytd). Defaults, another driver of high yield bond prices, remained low at 1.3% in 2006 vs. a 20 year average of 4.5%.

    Emerging market debt provided substantial returns for the quarter 4.6% (11.6%) according to Merrill Lynch.

    Housing and Rates- Key to 2007
    US economic growth slowed throughout 2006, particularly in the second half, largely due to a sharp falloff in housing activity and weakness in the motor vehicle sector.
    At the same time, corporate profits and consumer demand remained strong and decreases in energy prices have substantially reduced overall consumer price inflation and core inflation showed signs of slowing. New job formation and low unemployment also suggest continued strength. The markets seem priced for an economic “soft landing” in 2007. According to John Neff, “the Goldilocks school has a very large class.” The future direction of housing and Fed action on interest rates will probably have a primary impact on US economic and market direction in 2007, not withstanding other wildcards like oil prices, geopolitical strife, etc…

    For now there is much uncertainty about where we are in the housing cycle and its future impacts. Though there have been early signs of stabilization, significant evidence suggests more trouble ahead. Housing prices have decreased but remain historically high vs. rents and rates and while sales seem to have stabilized, cancellations which are not accounted for in government sales and inventory figures, have risen significantly.
    The Fed has been encouraged by expected downward tilt in inflation but seems satisfied with its current monetary policy and will probably be satisfied to hold rates to ensure the positive trend is structural and not simply related to recent oil price and inventory adjustments.

    Capital Market and Fiduciary Challenges Ahead

    In 2006 ERISA fiduciaries had to confront substantial regulatory and accounting changes. With regard to defined benefit plans, sponsors are beginning to consider liabilities as their asset benchmark and broadening their asset allocations to include alternative non-correlated assets to diversify risks and improve returns.

    Liability Driven Investing (LDI) – Recent regulatory and accounting reforms penalize under-funding and plan surplus volatility. As a result, plan sponsors are becoming more aware of their risk versus plan liabilities. LDI focuses on managing assets versus a liability benchmark rather than an asset benchmark. LDI strategies can be implemented in a variety of ways, but typically involve a combination of fixed income and derivative instruments, and can also include alpha transport components. The practice of LDI will be driven by large firms with the resources to develop products. Broader acceptance of LDI will likely be limited to plans that are fully funded and wont go down market until cost effective products are developed to allow plans to match liabilities but not altogether forego equity risk premia.

    Increasing Portfolio Diversification - Equity losses during the late 90’s and a low expected return environment is altering pension plan and institutional investing behavior.
    Pension plans are systematically diversifying portfolio into riskier asset classes, justifying their inclusion by the statistical risk reducing property of non-correlated returns. This diversification is conceptually warranted based on the idea that portfolios can simply expend a different risk in each of these uncorrelated asset classes. For instance illiquidity risk (private equity, private placements, commercial real estate), credit risk (high yield, emerging markets bond), skill risk (actively managed funds, hedge funds).

    This has worked splendidly in hindsight. However, there is substantial estimation error implicit in the risk, return and correlation inputs used to model these new “asset classes”. We suspect that “crowded trades” and the reality that all correlations go to 1 when investors most need diversification will moderate this trend at some point in the future.

    As Defined Contribution plans transition from being supplemental to primary sources of retirement security, fiduciaries will face increasing scrutiny and risk but, thanks to the Pension Protection Act, have additional ways to limit their liability,

    Additional Disclosures - Defined Contribution Plan sponsors have been systematically disadvantaged by “asymmetric information”. Nobel Prize winner George Akerlof pointed out the implications of a market in which sellers are better informed about product quality and characteristics than buyers. The prevalence of negative alpha, poor investment benchmarking and obtuse fee structures in the 401k industry are all reflective of the information disparity in this market. In these kinds of markets, vendors focus on marketing and brand name development as proxies for the quality and attributes of the investments, which buyers often can't discern.

    At least a dozen large lawsuits have been filed against large industrial company plan sponsors as well as retirement plan providers including Fidelity and some of the major insurance companies such as Nationwide, Principal, ING and Hartford Financial Services group. The common claim is that fiduciaries did not have and did not disclose sufficient information on plan expenses to enable prudent fiduciary decisions. While regulators will likely attempt to level the informational playing field via broadened disclosure requirements, fiduciaries will need to allocate more time and resource to stay current with the growing domain of disclosures.

    Better Liability Protection - As fiduciary risks are better recognized, sponsors will increasingly take advantage of the new safe harbors in the PPA legislation. Life Cycle funds will capture an even bigger portion of plan allocations in 2007 as sponsors take advantage of the likely fiduciary safe harbor associated with their utilization. Unfortunately, Lifecycle fund choices will proliferate beyond what is necessary, making prudent selection more difficult. At the extreme, some sponsors may choose to reduce their liability further by eliminating all actively managed single asset class options from their plans and offering strictly index funds or life cycle retirement funds.

    We think structural risks in both the capital markets and fiduciary domain have risen over the past year. Liquidity and the search for yield has likely driven interest rates and risk premiums to unsustainably low levels making a broad swath of assets vulnerable to risk reappraisal. Maintaining broad diversification to core assets and limiting substantial new mandates to risky assets seems a prudent approach for 2007. Proactively understanding and managing emerging fiduciary risks remains a high priority in 2007 as well.