Maybe the Start of a Trend

The nation’s largest pension fund has announced that it will be liquidating its positions in 24 hedge funds and 6 hedge fund-of-funds.  CalPERS, Nation’s Biggest Pension Fund, to End Hedge Fund Investments reported in today’s New York Times.

Possibly someone read my recent blog post, Hedge Funds: Prudent Investments?

There is little complicated about this decision.  It comes down to fees, risks, and returns.

Not surprisingly, a professional with a hedge fund advisory firm explains, “Hedge Funds are the place to be now because people are expecting a major correction.”

Really? That’s the rationale?

Getting tickets to a Beyonce concert can be justified because it is “the place to be.”  I would suggest that fiduciary decisions to invest plan assets in any asset class would be based on something more than it being “the place to be.”

It bears watching whether plan sponsors begin liquidating positions out of hedge funds.  But, I could be wrong, maybe hedge funds will continue to be the “in” asset class of choice into the future.

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Once Again, Strong Process and Substance Matters

There is not much love lost by the Department of Labor for ESOP transactions.  The skepticism, even antipathy, is somewhat justified.  Some ESOP transactions don’t pass the smell test (see my prior post:  ESOPs: Common Sense Required).

And yet, ESOP transactions continue.  Notwithstanding the bad deals, there are economic benefits to ESOP structured transactions.  Fortunately, however, ESOP fiduciaries now can operate with clearer direction from the Department of Labor.

At the beginning of the summer, the Department entered into a Settlement Agreement in Perez v. GreatBanc Trust Co with respect to an ESOP maintained by the Sierra Aluminum Company.  This Settlement Agreement afforded the DOL the opportunity to issue guidance which has the look and feel of regulations, without having to go through the long process of issuing regulations.

In short, DOL requires that the fiduciary be an active participant in an ESOP transaction.  The fiduciary must determine that financial projections are reasonable, take steps to assess the accuracy of financial data, review the selection and valuation process of the expert appraiser, and generally assure that a prudent process has been followed and documented.  This is far from a passive role.

At Harrison Fiduciary Group we have drafted a set of fiduciary policies and procedures which closely adhere to the terms of the GreatBanc settlement.   In general these procedures focus on the following:

  1. Valuation Advisor — review of qualifications, selection process, no conflicts of interest, analysis of valuation work-product;
  2. Financial Statements — reasonable reliance on financial statements;
  3. Fiduciary Process — written documentation of processes, and reliance upon valuation report; and
  4. Miscellaneous — Preservation of documents, purchase or sale of securities for fair market value (debt not to exceed fair market value of securities), consideration of a claw-back.

In light of the GreatBanc settlement and the general enforcement pressure being brought to bear by the DOL on these transactions, some institutional fiduciaries are exiting the ESOP marketplace.  They are unwilling to assume the risks highlighted by the Department and the Courts. This market disruption might cause concern for some service providers, but at HFG we view this as a significant opportunity.   Our competency and expertise as fiduciaries should give comfort to both plan sponsors and to the Department of Labor.  As is true for each of its fiduciary engagements,  HFG rigorously complies with its own policies and maintains contemporaneous written documentation of its process. ESOP engagements will fare no differently.

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A Practical View From the Trenches

After the drama of a Supreme Court argument, multiple amicus briefs, and voluminous commentary, the role of a fiduciary (from the perspective of a fiduciary) after Fifth Third Bancorp v. Dudenhoeffer , in the end, looks very similar to the role of a fiduciary before Dudenhoeffer.  But, while the role may be the same, the biggest difference is that attention, directed by no less an authority than the Supreme Court, has now been focused on the responsibilities and potential liabilities  assumed by fiduciaries.

Simply put, post Dudenhoeffer, fiduciaries must determine that an investment of plan assets in company stock is prudent.  Sound familiar?

Even before Dudenhoeffer eliminated the Moench presumption, leading fiduciaries recognized that oversight of a company stock account required traditional fiduciary monitoring and analytics of the investment of plan assets in company stock.  This oversight would be judged against a prudent expert standard.  Neither the responsibility nor the standard has changed.

To meet this responsibility, at Harrison Fiduciary Group, we have established a disciplined practice with respect to company stock accounts which includes regular monitoring of

  • contributions/redemptions,
  • cash balances,
  • market price, and
  • public disclosures.

Although the Supreme Court acknowledged that fiduciaries can rely upon the market price of a security (effectively adopting a modern portfolio theory of pricing), we have established a research competency which takes into account:

  • SEC public filings,
  • Financial news reports,
  • Stock analyst ratings and reports,
  • Credit ratings, and
  • Price/volatility of options or credit default swaps (where available).

In other words, every time we purchase shares of company stock, we are in effect, making the determination that the investment is a prudent one.   Similarly, we also recognize that in the event that we determine that an investment in company stock is no longer prudent, then we would be obligated to begin selling the stock.

To repeat for emphasis, however, notwithstanding the Dudenhoeffer decision, none of this is really new.

What is new post-Dudenhoeffer, however, is the recognition that company stock fiduciaries have substantive roles to play and that there is real risk and liability for failure to discharge these responsibilities prudently.  Fiduciaries of company stock accounts are not mere recordkeepers, nor do they merely “rubber stamp” the decisions of others. The Dudenhoeffer decision makes this clear.

At Harrison Fiduciary Group we not only understand these responsibilities and maintain expertise in these fiduciary skills, but we will be accountable for all fiduciary decisions that we make.

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Fiduciaries Should Ask This Very Question

An esteemed ERISA litigation lawyer e-mail me the other day with a question, as follows: “Mitch, would you advise an ERISA plan NOT to invest in a hedge fund which uses an “expert network”, in light of the controversies surrounding network experts?”

My reply, “I have lots of issues with hedge funds, though the use of experts is low on my list.”

In my judgment, the overwhelming concern with hedge funds is whether the fees paid to the hedge fund managers are reasonable.

On the whole, hedge fund performance is somewhat average, mediocre.   Just what would be expected in light of the vast number of hedge funds. Paying the standard “2 and 20” management fee for mediocre performance is hard to justify as prudent. (Check out out, https://www.hedgefundresearch.com, for data on hedge fund performance.)

Sure, some hedge funds have outperformed the market significantly.  But, this assessment, as is always the case, is in retrospect.  Just like selecting active managers, the question is whether the managers can be identified beforehand.

Choosing an out performing hedge fund (thereby justifying high management fees) is further exacerbated by the fact the US equities market has been on an upward trajectory since 2009.   The S&P 500 is up 150% (dividends reinvested) with an annualized return in excess of 18%.

Outperforming, where it occurs, in an overwhelmingly up market is not an impressive accomplishment.  Effectively assessing a manager’s investment skill requires investment performance over an entire market cycle, up as well as down markets.

My prediction is that when the market eventually reverses itself, and over time it certainly will, the class action lawyers are going to catch wind of this issue.  Private litigation will eventually explode in this arena.

Hopefully, fiduciaries will have done their homework.

As for expert networks?  Fiduciaries must undertake their due diligence of the compliance processes employed my hedge fund managers.  Its enough to say, “Please, no insider trading.”  Instead, assure yourself that compliance processes are sophisticated and reflect best practices.

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