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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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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Dark pools remind me of revenue sharing.  Not much good can come from business practices or products with descriptive titles of this nature.

Whereas an avalanche of class action litigation has shed light on the practice known as revenue-sharing, New York Attorney General Eric Schneiderman, Barclays Faces New York Lawsuit Over Dark Pool and High-Frequency Trading, has focused the spot light on dark pools by filing a law suit against Barclays over its private stock trading platform… otherwise known as dark pools.

The law suit essentially claims that certain high-frequency traders were favored over other participants in the pool and that various practices were not properly disclosed.

Many of the other banks and financial services firms run similar “platforms”, so the entire financial industry has a stake in the litigation.  Schneiderman is not the only regulator involved, the SEC, charged with maintaining integrity in the financial markets, is also a key player.

And so … here goes another financial services industry free-for-all.   Mind you, these dark pools are big revenue producers, so the stakes are high.

The issues are serious and complex for Wall Street, however, I am much more interested in the fiduciary issues at stake.

Make no mistake about it, plan fiduciaries have oversight responsibility for the trading of securities held by the plan.  At a minimum, the trading practices must be reasonable, prudent and, generally, managers are required to seek “best execution.”  And, of course, this analysis must includes a review of trading costs and expenses.

The challenge and tension revolves around the fact that fiduciaries require transparency, whereas the name dark pools suggests the opposite — opacity.

At the outset, Fiduciaries need to determine whether plan assets were traded through these dark pools.  If the answer is yes, then a whole series of questions follow:

Did the plan assets get best execution?

Are other pool participants advantaged over the plan assets?

What fees are charged for trading in the pools?

Are these fees reasonable?

Are the fiduciaries assured that trading via the pools did not constitute a prohibited transaction?

How are pool operators compensated?

Are there any conflicts of interest?

Has the fiduciary been monitoring these trading practices on a regular basis?

This is merely an initial list of questions.  But, posing the questions is the easy part.  Understanding the answers is far more challenging.  In my many years of serving as the General Counsel of a global investment management firm, no area was more confusing or harder to get my arms around than the issues related to the trading desk.  Traders use a lingo and jargon that is all their own.  Sometimes getting satisfactory answers in this area requires the best of prosecutorial skills.  It can be tough going.

If they haven’t already, Fiduciaries are best advised that they begin asking these questions.  If they do not, certainly class action lawyers and the Department of Labor, most certainly will.

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An Independent Fiduciary Protects All Parties

With rising interest rates and CEO’s tired of pension-related balance sheet surprises, the volume and size of annuity transactions is bound to explode.

Experience teaches that exuberance in financial markets and products can lead to some very painful losses.  The Department of Labor is concerned.  It has seen this movie more than once.

Multiple factors go into the corporate decision to “de-risk” the balance sheet by purchasing annuity contracts.  Months of work go into this decision.  One key factor is the cost of the annuity, as well as the cost of executing the transaction.  While these transactions can be expensive to execute, senior corporate managers are also incentivized, and have a duty of loyalty to the company, to minimize these expenses.  Lower expenses enhance earnings.

However, annuity pricing is efficiently correlated to the credit quality of the issuer of the annuity.   In other words, lower credit-quality issuers charge less for their products.  The corollary is also true; higher credit-quality annuities are more expensive.

Left to their own devices, corporate managers are incentivized to purchase the cheapest annuity available even if it reduces the credit quality of the issuer.  This pressure is very strong.

Plan fiduciaries and participants, however, have a different view.  They are interested in the strongest credit quality issuer available, price be damned.  Remember, prior to the annuity purchase, the pension plan is funded by a diversified pool of assets, thereby mitigating investment risk.

An annuity purchase,however, substitutes a single issuer for this diversified pool.   The pensions of thousands of plan participants are dependent on this single issuer.  The issuer goes bankrupt, the pensions are lost… forever.

The conflicts for senior managers (some of whom are plan fiduciaries) in executing these transactions are real.  Should they pay up for higher credit quality; or, should they sacrifice credit to enhance earnings.

ERISA provides a single answer.  Fiduciaries must act in the interests of participants.

In the early 1990’s the bankruptcy of Executive Life Insurance Co. provided a huge wake-up call.   Many plans were invested in Exec Life products and they absorbed huge losses.

In response,  the DOL issued guidelines in IB 95-1 setting forth numerous requirements regarding the purchase of annuity contracts.  Post-Executive Life,  the DOL requires that a plan purchases the “safest available annuity”.   In reaching this determination, the DOL requires that 6 six factors be analyzed, price of the annuity is not one of the factors.

Recognizing the potential conflicts of interest and the competing pressures of corporate managers, these IB 95-1 suggests that an independent fiduciary be hired to make the the “safest available annuity” determination.

Unfortunately, plan sponsors don’t like hiring Independent Fiduciaries. They don’t like paying the fees and they don’t like a second set of eyes reviewing their judgments.  If corporate managers want to purchase an annuity from XYZ Insurance Co, they don’t want a third party telling them that they should purchase the annuity from DEF Insurance Co.  And, they really don’t like that an Independent Fiduciary will retain its own lawyers and advisors for the transaction.

Ironically,  the intensity of the resistance by senior managers to hiring an Independent Fiduciary actually illustrates and proves the very conflicts of interest outlined above.

Corporate managers who forgo an Independent Fiduciary might one day be in the position of having to prove to the Department of Labor that they transcended these conflicts and acted in the interests of plan participants.  In the context of large losses (possibly $ billions) That will be a hard argument to make.  The DOL will be very suspicious.  Remember, there is personal liability for breaches of fiduciary duty.

In the end, an Independent Fiduciary will make decisions in the interest of the plan participants.  However, the corporate managers can take great comfort from knowing that the conflict of interest is significantly mitigated by the hiring of the Independent Fiduciary.  Whether they understand it or not, the Independent Fiduciary provider significant protections to the corporate managers.

Corporate managers should focus on executing their corporate strategies.  Let the Independent Fiduciaries wrestle with the complexities of purchasing annuity contracts.

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Only if We Let It Be

As one year ends and the next begins, it is important to ask whether the past predicts the future.  Ironically, the investment management industry is built upon a widely disclosed truism: “PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE PERFORMANCE”.  Warnings of this nature accompany every investment product.

While the past does not predict the future, actions taken in ignorance of the past can be risky, and dare I say, imprudent.  In my last post I focused on inflation, however, the concern goes way beyond inflation.

Floyd Norris reviews over 60 years of bond market history, Reading Pessimism in the Market for Bonds, and without resorting to overwhelmingly sophisticated analysis (an analysis that even I, a mere lawyer can follow) identifies 30 year swings in the bond market.   From the the bear market of 1946-1981 and the bull market from 1981- present, he anticipates the start of another 30 year long grinding bear market in bonds.

Given this trend, the mere flip of the calendar page from 2012 to 2013 should give us pause.  If this is not sufficient to cause some hesitation and concern, look to the historically meager interest rates being paid to bondholders.  At some point, and probably some time sooner rather than later, the deluge of investment into bonds will reverse its course. The reverse tidal wave could be devastating to investment portfolios of all stripes. .

While the practical implications of a down bond market concern me, I am even more concerned about whether the investment managers and other decision making fiduciaries are up to the task of making the significant intellectual paradigm shift from bull market to bear market.

Within Norris’ column, Michael Gavin, the head of U.S. asset allocation for Barclasys, identifies a fact which I have also addressed before… with great concern.   Most investment fiduciaries have never operated in a bear bond market.  The skills that they have honed and perfected (whether in equities, fixed income or alternatives) are all products of a 30 year bull market in bonds.

What happens when that market changes, fundamentally? Not a mere blip such as 1994 which saw a short-term uptick in interest rates, only to be followed by the overwhelming bull market trend which has lasted almost another 20 years, but the real McCoy;  a long 30 year trend of rising interest rates and falling bond prices.

Let me be clear.  I am not suggesting that I have the answers.  However, when I turn to other investment fiduciaries, I am not looking for the same re-heated, cliched solutions of the last 30 years. Instead, I am looking for managers and advisors who are able to look at the past 60+ years of investment management trends and investment philosophies and extract principles and lessons which are applicable today.

And yet, it is not all about the past.  The present presents challenges and a new world.  In 1982 as the bond market started its ascent, baby boomers were hitting the work force and engaged in their own ascent up the corporate ladder.  Today, retirement looms, pension savings must be accessed thereby putting even further downward pressure on the bond market.  Debt explodes everywhere: invididuals, corporations and sovereign nations.  These are merely a few of the most obvious challenges.

For the past not to be prologue, I am keeping my eyes open for the investment managers who know their history, are fluent with the challenges of the present, and most importantly, have fashioned an investment approach with a full understanding of both.

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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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In 2009 mortage-backed securities, and other related instruments, wreaked havoc on Securities Lending programs.   Many institutions froze assets in their securities lending programs because of illiquid securities held in the collateral pools.

Flash foward two years later and the specific details may have changed, but the principles remain the same.   Rather than mortgaged-backed securities, its now sovereign debt and the short-term paper of European Banks.

Remember, securities lending is a trading/investment program which attempts to capture the spread between the yield on the cost of the “loan” and the yield on the investment of the collateral pool.  By definition, collateral pools are managed to capture higher yields.  This can create, and has created, significant investment risk.

One would hope that Plan Sponsors learned their lessons in 2009.   But, in the event they that resumed business as usual, here are a few simple steps to engage in proper fiduciary oversight.

1.  Request a face to face meeting with the portfolio manager of the collateral pool.

Many different skills sets and functions contribute to the operation of a securities lending program.  However, no one is more important than the portfolio manager.  You need to understand how the collateral is managed.   Don’t have your questions deflected to a client service professional or anyone else.

Any resistance to allowing you to talk with the portfolio manager should result in you conducting a search for a new securities lending manager, ASAP.  It’s that simple.  You are the client.

2.  Review the portfolio against the investment policy statement and investment guidelines.

The first step is simply assessing the holdings of the portfolio and determining whether the portfolio is being managed consistent with the investment guidelines.  Ask the portfolio manager to walk you through the composition of the portfolio and explain the investment rationale concerning any holdings in the portfolio which you may not understand.

With each explanation, ask yourself a simply question:  “does this sounds prudent?”

3.  Request a face to face meeting with the head of compliance.

After the portfolio manager, the senior compliance person responsible for oversight of the securities lending program is the next most important person you need to meet.  Again, any resistance to this meeting should clearly question the long-term nature of your relationship with the securities lending provider.

Ideally, this meeting should be solely between your staff and the compliance professional.  Neither the portfolio manager nor anyone with business line operational experience for the securities lending program should attend this meeting.  You want to be sure that the compliance professional operates with autonomy and independence.

This meeting should cover three distinct topics:  1) the reporting structure of the compliance group, including a description of the flow of information and communication in the event that a significant problem is uncovered; 2) a detailed description of each of the processes and procedures designed to monitor the securities lending program; and, 3) a review of any compliance violations and the corrective actions taken in response to the violation.

As the meeting approaches its conclusion, you should ask the compliance officer to describe their own internal processes for reviewing and updating the compliance department.  Ask about any weaknesses or where they might be directing added resources.   No organization is perfect and no organization is exempt from the obligation to learn from experiences.   An honest response to these questions will engender significant trust btween you and the securities lending manager.

The success of any securities lending program is dependent upon generating high investment yields in the collateral pool.   This “yield chasing” can produce some significant unintended consequences.  As investors continue to “chase yield”, it is the plan fiduciary’s job to make sure these activities are prudent.

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An Independent Fiduciary Can Be Your Best Friend (and Security Blanket)

No one has the right answer.  This weekend’s news papers and financial blogs are filled with every prediction imaginable (from economic disaster to boons) and financial advice to fit each prediction.

With the markets swinging 500 points in opposite directions, this is not the time to embark on market predictions and changes in investment strategies.

Steep, drastic price plunges are not fun.  Like the free-fall drop on a roller-coaster when your stomach does its own loop-de-loop, these prices plunges elicit a real and physical reaction.  Panic is scary.  A racing heart beat, cold sweats and sleepless nights are subjects of cliches.  But, when you are experiencing it yourself, it ain’t a cliche.  It is very real.

From the deepest wells of our very being, panic surges forward.  The visceral emotional response becomes its own reality.  Emotion as reality.  That is never a good place to be. And certainly, not a time to be making decisions.

Prudence on the other hand, provides the required antidote to panic.  In the perennial push and pull between heart and mind, prudence provides the counter-weight to panic. Defined as “care, caution and good judgment, as well as wisdom in looking ahead” (see, www.dictionary.com), prudence requires the mind to prevail over the heart.

The key to extracting oneself from the distorted reality of pure emotions, one needs a trigger, or a technique to break the panic spiral.  Within the world of managing and overseeing retirement assets, care, caution and good judgment can be supplied by an Independent Fiduciary who can review and assess your portfolios against the plan’s Investment Policy Statement (IPS).  Call her.  She is paid to be prudent.

Hopefully drafted with the assistance of professionals and during a period of lessened volatility and other external pressures, an IPS reflects the prudent judgment of plan fiduciaries.  The IPS, in effect, is the road map for wisdom in looking ahead.  An Independent Fiduciary should always have the IPS in hand.

Have the investment performance of each of the plans’s asset classes evaluated.  Determine if any portfolios need to be re-balanced in order to reflect the allocation among assets classes envisioned by the IPS.  Instruct your Independent Fiduciary to make certain recommendations and then implement them.

Taking specific prescribed actions can deflate the power and energy of panic.  The key is to make sure that these actions had been well thought through before the specter of panic arises on the horizon.  An Independent Fiduciary can help allay the fear and the imprudent actions which a volatile market environment can inspire.

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