BlackRock Solutions Needs to Shed Light on Valuation Methods

Today’s Wall Street Journal, BlackRock’s “Geeky-Guys” Business, focuses a spot light on BlackRocks Solutions — a small business unit tucked away in the bowels of BlackRock, complete with its own elevator entrances, computers and separate office floors.  If nothing else, haven’t we learned from the ’08-’09 financial crisis, that “Geeky-Guys” hidden away from view have the potential to inflict great harm on our financial system.

Let’s give BlackRock Solutions (BRS) the benefit of the doubt — they have some really smart people who work really hard.  And, during the height of the financial crisis BRS assisted with the management of portfolios which held a lot of funky assets.  The system and US government (including the taxpayers) needed BRS.

As the WSJ reports, BRS provides various risk management services, including asset allocation, to major pension plans — both public and private.  As part of these services, BRS also values hard to value assets according to its own proprietary algorithms and processes.  These valuation process are secret — according to the WSJ.

While I obviously am not privy to the contracts between BRS and its clients, I have strong suspicions that BRS is hired as a fiduciary to provide these services.  Furthermore, the people at the pension plans who hire BRS are likely fiduciaries themselves.

Based upon these two assumptions, I have 2 simple questions:

1) If valuation processes are secret, how do the fiduciaries which hire BRS know that they are prudent processes?

2) Are the fees which BRS charge dependent upon these secret valuations?

These are not sophisticated questions.  But, the answers go to the heart of our pension system.

ERISA is very clear.   Plan fiduciaries are able to hire and delegate responsibilities to other fiduciaries.  If they do so, the decision to hire and delegate these responsibilities must be a prudent decision.  Furthermore, the plan fiduciaries must continue to monitor the hired fiduciaries.  How can the decision to hire BRS be prudent if the valuation methods are secret?  Furthermore, how can anyone monitor whether BRS is discharging its responsibilities in the face of secret valuation methods.

Finally, I also strongly suspect that BRS  charges a fee based upon the assets under management.  If this is the case, then the secret valuations placed upon the assets can directly effect BRS’s compensation.  This is a problem under ERISA.

Yes, the professionals at BRS are smart, and we should trust them.  But, that is besides the point.  Assuming that they are fiduciaries, secrets can’t be permitted.

Continue Reading


A Never Ending Source of Fees for the Pension Industrial Complex

Roger Lowenstein refers to our public pension system as The Great American Ponzi Scheme.  While supportive of the policy needs to provide pensions to public workers, I suspect that he comes to his Ponzi Scheme conclusion because of the vast gaps in funding of many state and municipal plans. Many current retirees enjoy healthy payments, while the system remains significantly underfunded.  A little bit like the Madoff investors who took out big returns as other investors were making additional contributions.

With respect to the funding issues, Lowenstein is right on point.  And, the funding issue is probably the biggest challenge facing the public system.  However, Lowenstein overlooks another critical dynamic of the pension system; that is, the investment of retirement assets and the fees paid to all of the various vendors.  Again, in the aggregate, the funding issue looms larger.  But, every dollar paid to a vendor is one less retirement dollar paid to retirees.  Research shows that these fees have a significant impact on investment returns.

If the funding system is a ponzi scheme, then the investment process for public plans is also, in many cases, a sham of another sort.

Last spring I spoke about fiduciary matters at a conference sponsored at Harvard Law School for trustees of public pension plans. The vast majority of the participants were policeman, fireman, teachers and other public employees who serve as trustees for the their retirement plans.  After spending a day working in small workout groups with the conference participants, I was struck by two significant insights:  1) the vast majority of these trustees are earnest and take their responsibilities very seriously and 2) notwithstanding this earnestness, they are no match for Wall Street.

I suspect that for some of these trustees, their formal education may have stopped at high school.  And particularly for teachers, their college careers were directed to towards degrees in education.  In contrast, the investment management industry is filled with algorithm yielding MBA’s and finance PhD’s from Ivy League schools.  In fact, one session of the conference was devoted to a liability-matching strategy so loaded with math and investment jargon that I’m convinced that my CFA partners would have been challenged to translate the strategy so that I could digest it.

This is not the exception, but the rule.  Investment concepts and the intricacies of investment products have become so extraordinarily complicated that even the best intention plan trustee cannot understand the fundamentals.   And yet, public funds continue to direct assets to the latest hedge fund or strategy pumped out by the investment management industry.

Sanity must be injected into the system.  Not only are public pension funds under funded but,  their assets no doubt are invested in expensive products, the majority of which produce average returns.  The math is not good.   Average returns and high expenses mean overall lower returns for retirees.

For the past 20 years the investment industry has fed at the trough of the $ trillions held by public pension plans.  The industry has profited beyond its wildest dreams.  Unfortunately, the retirees have not been so fortunate.

Continue Reading


What is the Future of Retirement Plans?

Felix Salmon, an insightful finance blogger for Reuters, writes in yesterday’s NYT about Wall Street’s Dead End. Salmon notes that the sale of the NY Stock Exchange to the Deutsche Bores combined with the significant decline of companies listed on major exchanges point to a future in which corporate wealth and control is pushed into the hands of a small financial elite.  For Salmon the very notion of shareholder democracy is at stake.

And yet, much more than shareholder democracy is at stake.  The retirement and pension plans of millions of retirees (many of whom are baby boomers about to tap into their nest eggs) are also at stake.

Our retirement system depends upon robust equity markets.  It was not always so.

In the not so distant past, most retirement plans were invested in bonds.  Pension plan liabilities were projected by the actuaries and bonds were purchased to meet those liabilities.

By the mid-to-late 1970s,  a confluence of events created the pension investment world as we now know it:  1) modern portfolio theory gained traction, 2) analysts began reporting that stocks generate higher returns than bonds, “over the long term”, 3)  ERISA codified the concept of diversification, and 4) the seeds were planted for the pervasive investment and business culture which bloomed in the 80’s and beyond.

Since pension costs are “real” costs, meaning that they are a hit to earnings, CFO’s and CEO’s were all too thrilled to adopt stragegies to reduce these costs.  With pension plans it became easy.

If equities generate higher returns than bonds, and riskier equities generate even higher returns (so says modern portfolio theory), then it is an easy logical progression to shift pension plans into riskier assets.  But, forget logic …. These were real dollars, real increases in earnings and therefore real increases in share prices.

The tsunami of pension assets flowed from fixed income, to domestic equities, then international equities, to emerging markets, along with real estate, joint venture, private equity.  Even in the fixed income arena, boring treasury and corporate bonds were jettisoned for international and emerging market bonds, and bonds backed by everything from mortgages, credit cards, car loans and now even life insurance.

And of course, the Holy Grail:  the Hedge Fund.  Managers given the unfettered discretion to zap investments around the globe in any asset class, at any time.  Whatever suits the fancy of the omniscient hedge fund manager.

While Salmon might decry the loss of shareholder democracy ….I’m a little bit more selfish and I’m thinking about my retirement, and our whole retirement system.   This system is critically dependent upon the very shrinking capital pool that Salmon has identified.

The issue goes far beyond even the shrinking pool because, in fact, the pool hasn’t shrunk. Instead, as Salmon implies, it has simply passed into the control of a small elite.  The thousands of well educated college students who marched through the top rated business and law schools over the past 3 decades who now populate the investment industry.

The critical problem, however, is that our retirement system requires access to these markets and securities.  In effect, the demand has remained constant but the financial elite now controls access.  Like the robber barrons of the 19th century,  the financial elite are able to extract a high trarriff on the commodity they control.  This tariff takes the form of a “2 and 20 fee” — 2% management fee and 20% performance fee.  This entire structure (and the financial theories which underlying it) merely reinforces the control and wealth of the financial elite.

The robber barrons met their match in Teddy Roosevelt’s trust-busing zeal.  This current system is far more resilient.  In fact, a global financial crisis, a legislative overhaul of the financial system, and a joint congressional inquiry could not lay low the power of the investment industry.  Hedge Fund managers and their brethren still earn billions of dollars in a single year.

Rather than turn to our elected officials for a systemic change (remember, their campaigns all seek funding from the financial elite), I suspect that the solution lies in the streets of Tunis and Cairo.  Please bear with me.  This is not so farfetched.

Again, in yesterday’s Times, the lead article, Tunisian-Egyptian Link That Shook Arab History, explains that collaboration among educated professional young Tunisians and Egyptians, as facilitated by various forms of social networking, contributed enormously to the toppling of these regimes.

Collaboration by educated, well informed and connected people works.

While I do not want to suggest parity between the needless physical and emotional suffering of exploited populations and the inequities of our financial system.  I do think that the techniques of reforming entrenched power structures can be similar.

Our system has gotten to where it is, in part, because retirement plan decision makers –our financial stewards — have allowed it to develop.  They continue to pour money into hedge funds, private equity and other similar investment strategies.  The allure of these returns is too great.  Unfortunately, individual returns can fall far short of promised possibilities.  And, the huge fees remain.  And these managers remain empowered.

The solution? Retirement plan fiduciaries must, “Just Say No”.  No more to extravagant fees; no more excuses for underperformance; and no more allowing managers to avoid fiduciary responsibility.  Collectively and loudly they must object to this entrenched system.

Plan fiduciaries must demand that investment managers put client interests first.  Not simply as an advertising campaign, but as statements of their core values and business ethics.

Systemic transformation does not come form a change in rules by those vested in the status quo.  That is a recipe merely for change at the margins.  True change comes when people tap a latent but unrecognized source of power. This power transforms behavior which in turn transforms systems and institutions.  Yes, the answers can be found in the streets of Cairo and Tunis.

Continue Reading


Beware Real Estate Hubris

In the late 1970’s/early 1980’s, AT&T unveiled an attention grabbing new corporate headquarters on Madison Avenue — complete with its chippendale crown.  On 1/1/84, however, AT&T was dismantled, broken up into its regional operating companies.  Twenty-five years later, Lehman brothers presented its sleak new global headquarters.  And, poof in September of 2009, Lehman was no more.

Remembering this architectural and corporate history, I read with great interest about 510 Madison Avenue — a fancy new “trophy” home for hedge funds.

Could this herald the beginning of the end of hedge funds?

The Times reported, last week, that 510 Madison suffered a significant detour (namely the ’08/’09 financial crisis) in its quest to capture $100/ft rents paid by ever-flush hedge fund managers.  Under new ownership and a brighter financial environment, however, high-end amenities are once again playing well to the Hedge Fund set.

Characterized as “more like country clubs, than workaday offices”, 510 Madison includes, a spacious lobby, restaurant, pool, and fortunately, a landscaped terrace.  I mean doesn’t everyone need a terrace to relieve the stress of managing $ billions of other people’s money.

And yet, here’s the problem …. It is other people’s money (OPM) as the cognoscenti well know.

While many hedge fund investors include high net worth and super high worth individuals — presumed to be sophisticated and capable of making their own investment decisions — most hedge fund managers also welcome the deluge of pension assets they have received over the past decade (as long as the pension assets don’t constitute more than 50% of the fund.)

It is not too hard to connect the dots and recognize that the hard earned pension assets of millions of workers are supporting the lavish work digs (not to mention the mansions, summer homes and private planes) of many hedge fund managers.

Sarcasm aside — plan fiduciaries must answer a pretty difficult question before investing assets in a hedge fund.  Are the “2 and 20” fees (2% management, 20% performance fees) justified?  Or, more appropriately are these fees “reasonable”.  Hedge fund managers can only afford their toys and lush office towers because fiduciaries sign-off on these fees.  And remember, ERISA requires that the fees be reasonable.

Last year the S&P 500 returned slight more than 15%, whereas the Barclay Hedge Fund Index returned 10.9% (other indices reported even lower performance). That is pretty expensive underperformance for 2010..   Of course, one year is not a fair comparison. However, before any fiduciary can justify investing in hedge funds, they need to examine, carefully, very carefully, the  3, 5 and 10 year performance returns.

Pension plans are under enormous pressure to generate competitive returns.  Unfunded pension liabilities are staggering.  However, reaching for the latest hedge fund du jour can lead to disappointing and mediocre investment results.

The beauty of the hedge fund business model, however is that even if performance remains mediocre, the managers remained ensconced in their fancy offices, sipping lattes on the landscaped terraces. Unfortuantely, the brunt of the pain is borne by the pension plan investors.

Certainly, ERISA didn’t contemplate these results.  And someday, fiduciaries are going to have to justify the reasonableness of their actions in authorizing these investments.

Continue Reading