Harrison Fiduciary

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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Can We Learn from History?

In the summer of 1982 Henry Kaufman, the legendary Dr Doom announced that interest rates had peaked.  I was a summer associate working at a law firm, but I remember that the stock market instantly skyrocketed.  Interest rates had peaked, inflation was licked, and it was smooth sailing ahead.

Essentially, my entire career (and the careers of an entire generation of investment professionals) has been spent in a falling interest rate environment.  From 1981 through 2012, the yield on the Treasury Bond has fallen from just below 16% to below 1.5%.

This decline in interest rates corresponds with an explosion in stock prices, both here in the US and globally; in developed markets and developing markets a like.  Furthermore, this same period is also reflects a benign inflationary period in the U.S.

I’m not stating anything new or earth shattering.  However, I do wonder about the effects of this generational experience upon the professional investment industry.  There are few advisors or managers out there who successfully managed assets in a steadily increasing rate environment or during periods of rapidly increasing inflation.

Are rates rising?  What about inflation? Who knows?  And, I certainly do not even begin to posses the skills to analyze these issues.

However, I can look at a simple graph and see trends … or the lack of trends…. and it flies in the face of reason to think that low interest rates and low inflation will continue forever. Therefore, if nothing else, fiduciaries should begin thinking maybe even worrying about inflation and an eventual upturn in interest rates.

While I would never shill on behalf of one manager over another, I nonetheless attended a very impressive presentation by a highly regarded investment management firm in which they laid out their case for the building inflationary pressures and their proposed solutions for this potentially new environment.

Historically, certain asset classes perform well in an inflationary environment: inflation linked bonds, currencies, gold, commodities, real estate. While they are not suggesting a dramatic shift to these asset classes, they nonetheless do recommend gradually incorporating exposure to these assets.

Fiduciaries should evaluate these proposals.  If they choose, they should also feel free to reject them in favor of other perspectives or strategies.  The real issue is that Fiduciaries should not simply rely on the “same ol’, same ol’” practices.  To do so, would be imprudent.

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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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Are Plan Sponsors Up to the Task?

The responsibility for managing and overseeing a corporate retirement plan use to be back a backwater support function at most companies.  The Department of Labor, however, has just significantly upped the ante for overseeing these plans.

Yesterday, Gretchen Morgenson reported on the new fee disclosure requirements pertaining to $401(k) plans, The Curtain Opens on 401(k) Fees.  As the open curtain metaphor suggests, transparency will be important.  However, the new rules can’t simply be fulfilled through transparency.  It’s going to take more… a lot more.

Morgenson explains that the new rules will require plan sponsors to calculate and disclose expense ratios for each of the investment options offered to the plan participants.  With access to greater information, it is assumed that plan participants will be able to make more informed decisions with respect to their investment selections.  For everyone knows, that higher expenses eat into investment returns.

Just as plan sponsors are being required to assume additional responsibilities, however, Morgenson also reports that many managers of corporate plans are shockingly ignorant about the nuts and bolts of the operation of their retirement plans; specifically, on the expense structure of the plans. I have previously commented on then dangers of executive ignorance with respect to retirement plans. Fees & Expenses: A Perfect Storm.

The importance of these new regulations, however, is not simply that they demand greater transparency.  The significant challenge lurking under the surface for corporate managers or retirement plans is that they will now be fiduciaries with respect to the fees and expenses paid by the plans.

That is, it is not enough that they properly disclose all the various fees and expenses paid by the plan.  In addition, they will also have to sign off on the reasonableness of these fees and expenses.

Disclosure is a somewhat passive activity.  If it were merely a matter of disclosure, then plan sponsors would simply hire consultants to calculate the expense ratios and then pass those ratios along to the participants.

As fiduciaries, however, the plan sponsors must make the affirmative decision that the fees and expenses are reasonable.  This requires that they understand the economics and the entire expense structure of the plans, and affirm that the charged expenses are reasonable.

Approving fees and expenses will require a thorough understanding of the range of services and pricing for all aspects of maintaining and operating retirement plans.  The fiduciaries must make their decisions in their capacities as prudent experts.

No doubt, plan sponsors will hire consultants to assist with these determinations.  However, it is axiomatic under ERISA that plan fiduciaries cannot merely rubber stamp a recommendation made by consultants.  Or, if in fact plan fiduciaries do rubber stamp consultant recommendations, they are opening themselves up to liability.

And remember, under ERISA, fiduciaries are personally liable for breaches of fiduciary liability.

Maybe it is time for companies to get out of the plan management business.  The best course of action would be to delegate the responsibility for management and oversight of plans to proven fiduciary experts.   Independent professionals who are experts in the business of maintaining and operating plans.

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Let’s Remember Who Owns the Assets

“At base, having a small elite with vast wealth is good for the poor and middle class”, explains Edward Conard, former partner of Mitt Romney and author of the soon-to-be published, Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong. Conard’s views are explored in an article in yesterday’s Magazine Section of the New York Times, by Adam Davidson, The Purpose of Spectacular Wealth, According to a Spectacularly Wealthy Guy.

As befits a private equity guy, and a graduate of an Ivy League business school, Conard’s argument is simply that the rich are smarter than you and me, and the “poor and middle class” would be in a better place if they, the elite, were left alone to run it.

Let’s for a moment assume that Mr. Conard and his various colleagues in the super elite are very smart,  there is, however, one glaring factual inaccuracy which woefully undermines his argument.

Davidson, after illustrating Conard’s enthusiasm about the virtues of eliminating a fraction of a penny on the cost of every can of soda, further explains that according to Conrad there are other investor looking to make similar “micro improvements”; “They are also wealthy investors like him who are willing to risk their own money to finance improvements that may or may not work.”

Wait a second.  “Willing to to risk their own money.”  Let’s stop and pause.  I would venture a guess that Mr. Conard never risks his own money in his deals and potential improvements.   Or, as I’ll explain in a minute, if he invests his own money, then likely it is all the “house’s” money anyway.  So, it is not really much of a risk.

I’ve never met Mr. Conard, but I’m going to assume for a moment that Mr. Conrad is an archetype of a prevalent, albeit elite, cohort pounding the streets of New York in the early 1980’s.  Armed with a business degree from Harvard, but probably not much capital of his own, he first landed a job at Bain & Company, then moved along to a stint at Wassserstein Perella, and then landed back at Bain Capital.  While I’m sure that he made a very good salary and received good bonuses in his pre-Bain Capital days, the odds are pretty slim that he would have amassed a large enough fortune to become an “investor willing to risk [their] own money to improvements that may or may not work.”

Instead, he became a hard working, no doubt diligent private equity guy in the early days of the private equity bonanza.  Eventually, he made a fortune, not by putting his money at risk, but rather by putting other people’s money at risk.  The classic OPM game.

Private equity typically works as follows.  A Private Equity Firm (PEF) creates a partnership, it raises money from investors as Limited Partners, and then typically creates an entity to serve as the General Partner.  The General Partner is usually thinly capitalized (at least compared to the size of the entire fund), and its stake holders are typically insiders at PEF.  As a last step, the General Partner, on behalf of the fund, enters into a management agreement with PEF.  Included within these inter-locking relationships are various fee structures which compensate  PEF and the General Partner.  This compensation consists of the holy grail of all fees, the “2 & 20”, a 2% management fee and a 20% carried interest.  This is how fortunes are built in private equity.

Once the capital is raised from investors, the fund then goes out and borrows additional capital, usually multiples of the original equity investments.  That’s why these transactions use to be called leveraged buyouts.  In fact, most of the money “put at risk to finance improvements that may or may not work” is borrowed money …. and, the investors, including the General Partners are not on the hook if they lose it.

With Mitt Romney’s presidential bid, the whole discipline of private equity has come under scrutiny and no doubt will be dissected under a microscope in the coming months.  I’m not interested in getting into the argument as to whether private equity is good thing.  That is a subject for another time.

However, I am objecting to the notion that professionals such as Mr. Conard create a false narrative suggesting that they are great investors putting their money at risk.  No doubt, after 15 years of managing private equity deals in a wild bull market, private equity professionals have likely amassed great fortunes.   And, no doubt, they do re-invest in their own deals.  However, as I said above, they are essentially investing with “house money”… it’s easy to double-down, once you’ve assured yourself a nest egg (with multiple homes and private planes), to leave money in the deals.

The real investors are not the Ivy League MBA’s.  Instead, the real investors are you and me.  A significant portion of the capital for private equity comes from pension plans, both public and private.  In fact, public pension plans tend to be some of the most coveted clients for private equity firms.

The reality is that the true investors, people with money at risk, are not an elite group of risk assessing and risk taking investors.  Instead, they are hard working employees of large corporations and public entities.  These are the same employees who stand by helplessly as their jobs are eliminated or they learn that their pension plans are underfunded by staggering amounts.

These are the real investors in “improvements that may or may not work”.  And, these are the real investors who have funded the private equity industry.

Don’t get me wrong, some of my best friends are private equity professionals.  They are hard working, some of them are charitable and they are good citizens.  And, some firms have generated significant returns for their investors.  This is good and beneficial.  But, let’s not glorify them into a power wielding elite who “know” best for American.

I am further skeptical about an elite which potentially doesn’t understand  the distinction between personal assets and client assets.  In my judgment it is enough to disqualify someone from the elite.

Warren Buffet, arguably the greatest allocator of capital ever, always acknowledges that he invests capital on behalf of the Berkshire shareholders.   Go back to his oldest shareholder letters and he refers to shareholders as his partners.  He means this not in a legal sense, but it an ethical sense.

If Mr. Conard is hell bent on supporting an elite of master investors, then lets make sure that this elite embraces the proper values and behavior which in fact would be best for the poor and middle class. Let’s create an elite of financial experts who also understand and abide by fiduciary principles.  Professionals who at all times know that they work for plan participants and beneficiaries, and subordinate their self-interests to the interests of the clients.  Professionals who tolerate no conflicts of interest, and importantly, who don’t rig the game for outsized profits for their own benefit.  Yes, we may need an elite, but let’s have an elite of ethical and prudent behavior.

As a fiduciary, I recognize that my prescription may be viewed as self-serving, but one can only wonder if certainly elements of the Financial Crisis may have been avoided or tempered, if the leadership of the financial community took their roles as fiduciaries seriously.

Let’s judge the elite by their values and ethics, not by the size of their assets.

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Heighten Regulation and Executive
Ignorance:  A Bad Combination

Pension & Investment reports that many executives are “clueless” about the plans they oversee, DC Execs Clueless About Key Plan Data.

The P&I article is shocking.  Survey data reveals that on multiple levels Plan Execs don’t know the nuts & bolts of the business of running and administering their plans.  And, worse, some have just “thrown-up their hands”.

In many cases these execs are plan fiduciaries, or advise plan fiduciaries.  The problem is that plan fiduciaries can’t just “throw-up their hands”.

And yet, the role of overseeing retirement plans keeps getting more complex and sophisticated, not less.

The Investment Company Institute just reported that as of Q3, 2011, total US retirement assets were $17 trillion.   That is a big pool of assets against which various service providers can charge fees.

As the financial services industry has exploded over the past decades, the Department of Labor has finally focused the spot light on the fees and expenses charged against plans. New regulations go into effect this summer under which plan fiduciaries must approve the reasonableness of fees and expense charged to plans.

Notsurprisingly, these regulations are very intricate and complicated.  In effect, the regulations reflect the elaborate fee structures and business models which have evolved enabling various service providers to increase their revenue streams from retirement plans.

And so, a “perfect storm”, rages.  Complexity increases, the government is demanding greater oversight, and key executives and fiduciaries remain ignorant on basic facts and details with respect to the plans they oversee.

Of course consultants stand ready to advise plan executives and fiduciaries.  But, before the consultants can provide advice, the plan executives and fiduciaries MUST understand the business models for administering their plans. Otherwise, the advice is being delivered into a vacuum. How can one evaluate the advice if they don’t even understand the basic features and terms of their plans and do not understand the business of administering a plan?

At Harrison Fiduciary Group, we are proponents of an entirely  new model for the delivery of fiduciary services.  With respect to Fees & Expenses, we are experts. Our combined 30+ years in the retirement-industry has provided us with the experience and knowledge to analyze plan structures and the related fees.  The devil is in the details, and we understand the details.

By delegating this authority to HFG, plan executives and fiduciaries will not have to become experts on an area that bears little impact on their core business competency.

Perfect storms need to be heeded wisely.  Allowing ignorant plan execs and fiduciaries to make significant fiduciary decisions can lead to disasters.

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Fiduciary Values

To our Clients, Friends and Supporters —

Thank you for your trust, confidence and support in 2011.  We are looking forward to a strong and robust 2012 and hope to enhance our reputation for integrity and judicious investment decision making.

Over the holidays, I read High Financier, The Lives and Time of Siegmund Warburg, by Niall Ferguson.    Siegmund Warburg was part of the extended Warburg banking family.  After his Hamburg bank was Aryanized by the Nazis in the 1930’s, Warburg moved to London and started his new firm from scratch, S. G. Warburg & Co.  Hewing to traditional values of trust, honor and client service, he built not the largest nor the most profitable merchant bank, but probably one of the most innovative and trusted financial firms.

For Warburg, corporate values were not merely a matter of branding or marketing.  Instead, they were the very organizing principles of his personal and professional life.

The reputation of a banking firm for integrity, generosity and thorough service is its most important asset, more important than any financial item.  Moreover, the reputation of a firm is like a very delicate living organism which can easily be damaged and which has to be taken care of incessantly, being mainly a matter of human behavior and human standards. [SG Warburg’s personal papers, Box 64; Ferguson, p. 233]

These words leapt off the page at me.  They capture the essence of my vision and goals for Harrision Fiduciary Group.  Warburg speaks of banking, but in today’s world, banking now includes, trading, private equity, hedge funds and all aspects of investment management.

Simply put, in each of these endeavors, professionals are entrusted with assets properly belonging to others.  It is an honor to be put in such a position of trust.

However, words like Trust, Honor, and Integrity have been excessively diluted in our current culture and financial system.  Either they are scoffed at as relics from a bygone era or they have been turned into cliches by facile marketing campaigns on behalf of firms whose conduct actually belies these very values.

Given the prevailing financial excesses and market volatility, an understandably cynical view pervades our financial markets and the various players in these markets.  We need to recapture the meaning and behaviors embraced by these values.

Ours is a small firm. Our vision and mission are simple to articulate.  We want to be the industry leaders and set the standard for fiduciary services with respect to Trust, Honor and Integrity.   At HFG we will always put the interests of our clients ahead of our own.  We will never stand on the other side of a transaction from a client.  We will never engage in a conflict of interest, and will never use client information or positions to advance our own.

While these ideals may sound lofty and therefore beyond one’s grasp, they actually are easy to implement.   Like S.G. Warburg & Co, Harrison Fiduciary will neither be the richest nor the largest fiduciary services firm.  However, we hope to be known as a firm which always acts in the best interest of its clients.

We wish all of our clients and friends the best for 2012.

With appreciation.

Mitchell

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Plan Fiduciaries Should be Paying Attention

Will the European Central Bank step into the market and buy European Sovereign Debt?   That’s the $ trillion question.

Articles abound trying to predict the future.  Will the ECB cave or not?   No one can be responsible for an accurate prediction of the future.

These debates have been brewing for 18 months.  Bankers, however, are getting nervous.In Banks Build Contingency For Breakup Of the Euro, Liz Alderman reports that banks are developing plans in the event that unimaginable break of the Euro in fact comes to pass.

While analysis and hand-wringing serve a purpose to highlight and issue, nothing takes the place of contingency planning.

Beginning with my blog post on July 25, 2010, Debt, Debt, Debt, I have been warning plan fiduciaries that they need to be monitoring the impact of the European debt crisis on their own portfolios and trading strategies.

If the Banks, which were universally “asleep at the switch” in the lead up to the sub-prime crisis are now wrestling with contingent planning with respect to the impact of European sovereign debt, it behooves plan fiduciaries to be engaged in similar planning.

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“All the News That’s Fit to Print” and More

Who doesn’t love a deal, especially in today’s economic environment?  This past Sunday’s NY Times, 23 October 2011, not only offered an update on global current events, but also serves as a virtual handbook for retirement plan fiduciaries.  [Go fish it out of the re-cycling bin … yes, I still read the physical newspaper; one of life’s daily pleasures.]

Starting with a bold graphic representation of the European credit crisis sprawling across two pages of the Sunday Review, Bill Miller’s,  It’s all Connected: An Overview of the Euro Crisis is clearly worth more than 1000 words.   At first blush, it seems too confusing … just too much to get one’s head around.  It’s much easier to turn the page.  Better yet, flip to the Travel or Arts & Leisure Section.

Retirement plan fiduciaries, however, don’t have that luxury.  Ignoring the financial issues brewing in Europe would be irresponsible and imprudent.

And yet, even for a responsible fiduciary, where does one begin?  If only there were a true sage, who had all the answers and could predict the outsome.

Fiduciaries don’t have to be sages.  They simply need to be prudent and responsible.  At the very least, every fiduciary committee, whether for state & local plans or for corporate plans, should be exploring the impact of the European issues on their plans and on their investment policies.

A daunting proposition, but plan fiduciaries don’t have to operate in a vacuum.  Instead, they should turn to each of their investment fiduciaries and pose the following questions:

1. What is your analysis of the European debt crisis?
2. Does this analysis have any impact on your investment strategy and our portfolio?
3. What’s the weakest link in your analysis?
4. Have you constructed contingency plans?

No doubt, every investment advisor will have a different answer, and fiduciaries will need to piece together conflicting data points.  But, in the end, plan fiduciaires must make sure that their investment fiduciaries are themselves being prudent.  Fiduciaries can’t predict investment results, but they can, and must, ensure prudent processes and decision making.

If the above advice seems too general, and therefore too simplistic, and maybe even worthless, then let’s turn to the front page.  Gretchen Morgenson and Louise Story’s, Bank’s Collapse in Europe Points to Global Risks, examines the bailout of  Dexia Bank whose problems, in part, stem from gorging on too much sovereign debt.  Using Dexia as an example, Morgenson and Story extrapolate various scenarios, and related policy issues, raised by potential rounds of bailouts of banks and their trading counter-parties.

I’d supplement their analysis by drilling down to an equally ominous set of challenges to which they allude: repos, securities lending and short-term commercial paper.  Most all banks (domestic and foreign) fund their operations, in large part, through repos and other forms of commercial paper.  Remember what happend to Lehman when no one would fund their short term paper?  And, what about securities lending pools stuck with rapidly declining collateral?  Just ask plan fiduciaries who were unable to terminate investment managers becaus securities were tied up in frozen securities lending pools.

Need more questions to ask?

Let’s not forget about money market funds.  Gretchen Morgenson, in the Business Section,  How Mr. Volker Would Fix It, also wrote about Paul Volker’s blunt recommendations about reforming the financial system; starting with money market funds and the residential mortgage market. Money market funds are huge purchasers of sovereign and bank debt.  As has also been previously reported, many of these funds have been paring back their European exposure.  Plan fiduciaries overseeing 401(k) plans holding money market funds need to be questioning their managers about strategies for addressing these global banking issues.

Plan fiduciaries, however, also have to ask about STIF’s (short-term investment funds).   Every custodial bank runs $ Billions in STIF’s, unregulated funds which no doubt are also chock full of sovereign and bank debt. Fiduciaries, are you asking your custodian banks about their STIFs?

If Miller’s graphics and Morgenson”s and Story’s articles don’t arm fiduciaries with sufficient questions, then turn to The Little State With the Big Mess, an eye opening article about Rhode Island.  The tiniest state, but the biggest pension woes.  Hard to know where to begin asking questions about the Rhode Island mess, but how about starting with the newly revised investment return assumption of 7.5%, down from 8.25%?  Is that a prudent decision?  Where did that number come from?  An easy question to ask, but maybe the answer is not so simple.

Finally, turning from the newsprint to the magazine, Daniel Kahneman, Nobel prize winner in Economics, Don’t Blink! The Hazards of Confidence, writes about the behavioral phenomena that confidence in our own judgments creates a bias that can lead us to ignore hard facts which contradict our judgments.  Focusing on investment performance, Kahneman explains that notwithstanding quantitative proof that certain investment managers added zero value to the investment process, these managers were nonetheless awarded bonuses on the assumptions that they “added value.”  Assumptions die hard.

By the way, maybe someone should forward a copy of Kahneman’s article to the fiduciaries of the Rhode Island state and local pension plans.  I’m still struggling with 7.5%.

Fiduciaries beware.  Don’t be so confident.  Ask lots of questions and work hard not to be so confident in your assumptions.  You are not just investing your own assets … instead, you are investing on behalf of hard working plan participants and retirees.

And I thought that I’d relax with a cup of coffee and a leisurely read of the Sunday paper.

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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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