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Are Fiduciaries Paying Attention?

There are always naysayers.  Prognosticators and analysts who even in the best of times foresee disasters looming on the horizons.  I am very prone to be influenced by those cautious advisors.

However, over the course of my 25 year career, I have learned that more often than not the extremes rarely materialize and decisions based upon more moderate outlooks usually prevail.

And yet, right now, the magnetic pull of impending disaster and hyper-vigilant caution feels overwhelming.

Where will a crisis materialize? To name just a few potential catalysts, some of which were identified by global leaders at a recent gathering in Lake Como, Italy:

  1. Collapse of the Euro
  2. US Fiscal Cliff
  3. Middle East — either the Arab Spring or Israel/Iran
  4. Hard Landing in China
  5. Hyper-inflation.

Any one of these factors alone could trigger financial and/or political upheaval the likes of which our generation has never experienced.  But, what if 2 or 3 erupt concurrently.  I shudder to imagine.

As a fiduciary I worry about these things.  I’m required to make prudent decisions which can have long lasting implications for people’s retirements.  I take this responsibility very seriously.  Workers and retirees have worked long and hard to assemble their retirement nest eggs.

Of course, I can’t predict which crisis will occur or the consequences of any of these crises.  And, I’m very skeptical of anyone who offers any predictions, especially predictions with specificity.

Ever cautious, however, I’m trying to understand how to plan around these various potential crises.  Most importantly, I want to know how other investment fiduciaries are planning;. or if not planning, whether they are thinking about each of these various factors as they manage other people’s money.

I’m particularly concerned due to the general herd-like mentality of Wall Street, investment professionals and retirement professionals.   For the most part everyone does the same thing.

For example, before the 2007 financial crisis, and as $billions were being directed into various mortgage-backed securities and derivatives, industry professionals from various disciplines were all taking comfort in VAR — Value At Risk.

I never understood VAR, and I still don’t.   However, it was a numerical representation of the “risk” inherent in an investment portfolio.  Investment professionals cited VAR as if it was the holy grail. Everyone felt that they had mastered risk because the VAR calculations indicated so.

In retrospect, VAR proved to be overly narrow and somewhat simplistic.  VAR was meaningless as markets plunged and portfolios were depleted.  VAR was ephemeral, but the losses were real.

I’m nervous about today’s equivalent of VAR, and I don’t even know what it is.

Today’s $18.9 trillion of ERISA assets (as reported as of March 31, 2012 by the Investment Company Institute), are all generally managed the same way.  Steeped in the principles of Modern Portfolio Theory, retirement plans hire consultants who develop intricate asset allocations, spreading risk among all the asset classes.  Plan sponsors then hire multiple managers with proven track records in the specific asset class.  The industry supporting this system is gigantic.

This system has been in place for 25+ years.  In the explosive boom years beginning in 1982 all has worked well — for the most part.  However, the 2007 Financial Crisis revealed fissures in the extraordinarily complicated and intricate edifice constructed by the retirement investment industry.

What about the storm clouds forming on the horizon?  Are the foundations of the edifice strong enough?  Are fiduciaries exploring whether any levees are in place, and if so, whether the levees are capable of weathering the storm.

At a minimum fiduciaries should be talking about these issues.  They should demand that other investment fiduciaries outline their analyses and their proposed responses.  The debate on these issues should be robust and rigorous.

Unfortunately, my sense is that many are simply hoping that the clouds dissipate never gaining the force of a full fledged storm.

Personally, I often carry an umbrella when there is the slightest hint of rain.  Now, I’m concerned that an umbrella will be a mere cipher in an upcoming devastating storm.

Fiduciaries, what do you think?

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Asking the Right Questions — a Fiduciary Responsibility

Sovereign debt (Greek and others) continues to plague financial markets.  My last few posts have tried to illustrate that these are not abstract issues, but can have real impact on money market funds, securities lending and stable value programs.  Fiduciaries must understand these implications.

Today the NYTimes reports that many money market funds have been paring back their exposure to european bank debt.  Wary Investors Shun European Banks.  As explained in the article,  European Banks rely heavily on short term funding provided by U.S. money market funds.   And, let’s not forget that most US investors turn to money markets as safe investments.

Not surprising, there is a wide spectrum of investment views on european sovereign and bank debt.  The Times points out these different views and, these differing views make markets. Again, no surprises here.

When asked about money market funds’ exposure to european debt, Deborah Cunningham, a senior portfolio manager at Federated Investments commented, “We’re always rethinking it and assessing it, but we’ve not come up with a different answer,” she said. “We don’t feel there’s any jeopardy with regard to repayment.”

Similarly, a spokesman from Fidelity Invetments, Adam Banker explained, “We’re very comfortable with our money market funds’ European bank holdings, including French bank holdings.”

Both Federated and Fidelity are huge players in the 401(k) retirement arena.   The article reports that they manage $114 billion and $428 billion, respectively in money market funds (note, the article was explicit about the Federated money market assets under management, where as the Fidelity number was not specifically identified as money market assests. However, Fidelity reports that it currently manages $1.5 trillion of assets, so it is reasonable to assume that $428 billion is held by money market funds).

The real point is that Federated and Fidelity collectively manage more than $500 billion in money money market funds.  Thousands of plan participants are relying upon their judgment with respect to the safety and security of the participants retirement assets.

The volatility of financial markets these days is historically very high.  In large part due to questions raised by European Debt.

Fidelity and Federated must do better than “we’re very comfortable”  or “we don’t feel there’s any jeopardy … “.  Those are nice quotes for a NYT article.  But for fiduciaries these quotes should constitute red flags.  If we have learned nothing else from the financial crisis, bland statements issued by corporate spokespeople have the potential to hide serious issues.  According to the Times article, Federated has about 13 to 17 percent of assets … invested in French bank debt”.   That is not insubstantial.  It begs further explanation.

For any Plan Sponsor whose retirement plans offer Fidelity or Federated money market funds, pick up the phone today.  Just ask a few basic questions.  Remember, other smart investment professionals are not comfortable.  They in fact see potential jeopardy ahead. Fidelity and Federated must explain their positions.  Here’s a few questions for starters:

  • Why are you comfortable?
  • Why isn’t there any jeopardy?
  • How did you analyze your investment positions to reach this conclusion?
  • What assumptions did you make?
  • What are the weakest points in your analysis.

As if often the case …. a few open ended questions can spark a very enlightening discussion.

Plan fiduciaries have an obligation to ask these questions and assess the reasonableness of the responses.

Rarely would I turn to Ronald Regan for wisdom, but here goes,  ”Trust, but verify.”

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Credit-Related Strategies Warrant Heightened Scrutiny

It’s called the Great Liquidation.  As reported in today’s NYT, The Haggling for Troubled Assets Begins, “hundreds of billions of dollars of bad investments …are going up for sale”.  Fiduciaries must ensure that these bad investments do not end up in retirement plans.

Notwithstanding TARP, QE1 and QE2, financial institutions still hold impaired or “bad” assets.  This simply means that the assets are still held by institutions at values that are likely far in excess of their fair market value.

And so, the Great Liquidation begins.  The term — coined by Fortress Investment Group — refers to the prediction that “you’re going to see in the next five years, more financial asset liquidations than you’ve seen in the sum total of the past 100 hundred years.”  An exaggeration?  Ok, let’s assume it’s simply more than in the pat 50 years – that’s still a lot of assets being put up for sale.

If this appears daunting, don’t worry.   Fortress already has $12.7 billion of assets devoted to credit-related private equity and hedge funds.  No doubt the entire spectrum of the Wall Street herd — investment banks, commercial banks, hedge funds and private equity firms — will be bulking up in this area, if they haven’t already.

Just imagine a 2% management fee and 20% of profits on “hundreds of billions of dollars”.  Now that’s a nice bonus pool!

Before the Great Liquidation Orgy (my term) begins, however, Wall Street is going to need to raise money to indulge in this financial bacchanalia.  Certainly there will be private investors, wealthy individuals, sovereign wealth funds.  But the $16 trillion pool of pension assets is the granddaddy of all funding sources.

I can just see the entire pension investment consulting industry working itself into a frenzy cranking out their graphic laden presentations recommending Credit Related investment strategies and firms.  The graphs and the statistics, no doubt will be very impressive – worthy of PhDs.  But Beware.  “Its déjà vu all over again”.

Think back to the early 90’s.   Who had heard of hedge funds?   Private equity firms were still referred to as LBO firms.  In terms of financial markets and products it was a different era.  As the new century dawned, however, investment strategies and products exploded in complexity.  Simultaneously, in order to remain relevant, the pension consultants began touting these new products.

In time, consultants were recommending significant shifts in allocations to “Alternative Investment Classes”.  It was not surprising to see allocation recommendations of 8%, 10%, 15% or more to alternative asset classes.  In fact, in the summer of 2008, I had lunch with the Chief Investment Officer of a university endowment who said that they had allocated 45% of the endowment to hedge funds.

We all know the outcome of this story.  In the end, the investment returns of many plans were negatively affected by these allocations.  No one knows yet, if in the long run the plans were better off or worse for these significant allocations to Alternative Asset Classes.

We do know one thing, however.   Consultants merely make recommendations.  Plan fiduciaries hold the real power in making allocations to asset classes and to specific managers.

Without a doubt fortunes will be made in the course of the Great Liquidation.  The question is whether retirement plans need to venture into this arena.  Fiduciaries must invest assets prudently.   When a new asset class emerges, such as credit-related investments, how is a manager evaluated?  What’s the track record?  How is risk measured?  How are projected returns evaluated against the risks that are assumed?  What about due diligence on investments?

The list goes on and on.

The Media is going to feature the newly minted credit-related billionaires.  Investment returns may likely be huge.  The allure of jumping into these investments will be strong.  The consultants will be putting on a hard press.

Plan fiduciaries must be very wary.  For those who do decide to play in this game, make sure you do your homework.  Remember, you are investing other people’s hard earned retirement dollars.  Keep the financial debacle of 2007-2009 at the forefront of your mind.  And, tread carefully.

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