Can Changing Investment Strategy be a Fiduciary Breach?
Click here to check out attorney Stephen Rosenberg's response to our October 27, 2007 post about 130/30 funds. His comments are thought-provoking.
Are 130/30 Programs Appropriate for Pension Funds?
After recently speaking to a group of public pension funds, I sat down to listen to other speakers, one of whom gave an eloquent talk about "130/30" strategies. Somewhat new on the investment scene, the goal of these "enhanced equity" strategies is to relax portfolio weight constraints that otherwise preclude a portfolio manager from expresssing a serious "thumbs down" for a particular stock. In addition, fund professionals are given latitude to emphasize favored stocks.
The mechanics are relatively straightforward. A 130/30 portfolio manager invests $1.00 in Stock X and sells $0.30 in Stock Y. Proceeds from the short sale are used to purchase an additional $0.30 of Stock X.
Advocates assert that 130/30 funds (or variations thereof) are transparent, can be classified as equity, can be easily benchmarked and offer a possible way to increase returns. Critics counter that higher fees, frequent trading (and related costs) and relatively short track records give one pause. In addition, many of the funds employ quantitative models to drive investment decisions. In the last few months, amidst a credit crisis, more than a few quants found themselves selling off long positions while buying other stock to cover short positions. A tumble in returns and increased volatility was the unhappy result.
After the speaker concluded, I asked him how a plan sponsor is able to justify investing in 130/30 funds if its Investment Policy Statement specifically precludes short-selling, whether by design or, in the case of some public plans, short-selling is expressly prohibited. His response that pension plans are modifying their Investment Policy Statements to accommodate did not sit well with me. If trustees or other types of fiduciaries have made a conscientious decision to avoid short-selling, why change mid-stream? Mind you, this blogger is not saying that 130/30 strategies are bad or good but simply pointing out that prudent process would suggest the need for a thorough vetting of the attendant risks associated with this type of short-selling.
I asked ERISA attorney Stephen Rosenberg for his thoughts. With permission, comments from this McCormack Firm, LLC partner and fellow blogger are shown below. (Click here to read his fine blog.)
<< The fiduciary exposure - or at least the potential exposure - for the plans really runs to the rationale and due diligence, or lack thereof, in changing the pre-existing policy to allow the plan to instead invest using this strategy. The fiduciary’s obligation is one of prudence, and presumably there was a rational, intelligent reason for precluding such investment strategies for the plan’s investments. If the plan switches its policy to allow for such investing, the plan needs to be able to show an equally rational and defensible reason for the change. Otherwise, the plan and its fiduciaries open themselves up to claims, in the event the investment declines in value, that the original policy forbidding such investments was correct and the change was neither prudent nor well though out, and thus represents a breach of fiduciary duty. It may or may not be the case that such investment strategies should be part of the pension plan’s investment mix, but what is necessary to ward off fiduciary duty claims, and to satisfy fiduciary obligations, is a well thought out investigation, prior to making the change, by knowledgeable parties, into whether changing the plan’s investment policies in this regard is appropriate. The best defense to claims that such a change violated fiduciary obligations is competent third party advice from someone with nothing to gain from the change, i.e. advice on this issue from someone other than the bank seeking the investment. >>
Notable is his emphasis on getting INDEPENDENT feedback about the efficacy of a 130/30 strategy. Moreover, his comments about process make perfect sense. Before committing millions of dollars to a 130/30 type strategy, a plan sponsor should be able to thoroughly explain a change of heart about its stance on short-selling. Hopefully, for those plans for which there is an outright regulatory restriction (by virtue of state law let's say), they understand the compliance implications.
As the "short enabled" market grows, it will be interesting to track which pension plans participate and why.
Bonanza Retirement Goodies for Merrill Lynch CEO
In today's issue, New York Times reporter Eric Dash ("The Price of Any Departure Will Be at Least $159 Million") writes that Merrill Lynch CEO Stanley O'Neal will be well off if asked to resign. With $30 million in retirement benefits, along with $129 million in "stock and option holdings," this is one top executive who won't need to celebrate National Save for Retirement week. Dash goes on to say that O'Neal is far from unique in tems of post-employment largesse for CEOs.
This blogger, a staunch advocate of pay-for-performance, is no critic of scrimping for those who create shareholder wealth (though, in the case of Merrill, large surprise losses are hard to explain as wealth-creating). Still, the constrast between those who are likely to find retirement a harsh financial reality, versus those who will quit in style, gives one pause.
Happy National Save for Retirement Week
Did you know that Congress has officially mandated a national weeklong holiday devoted to saving for life after work? Click here to read the June 21, 2007 press release that earmarks October 21 through October 27 as a time to "put those pennies away."
According to the Boston College Center for Retirement Research, anything to encourage saving for post-employment comes none too soon. Their National Retirement Risk Index suggests that "43 percent of households sampled in 2004 will not be able to maintain their standard of living in retirement even if they retire at age 65, which is later than the current average retirement age." Authors Alicia H. Munnell, Anthony Webb and Francesca Golub-Sass point out that early retirement and "reluctance to annuitize 401(k) balances or tap housing equity" increases the number of persons who are unlikely to be able to sustain a decent post-retirement existence.
Click here to read "Is There Really a Retirement Savings Crisis? An NRRI Analysis" by Alicia H. Munnell, Anthony Webb, and Francesca Golub-Sass (August 2007).
For this holiday, celebrate by not going out. Focus instead on how much money you are not spending.
Should Pensions Care About Valuation Fraud?
According to "Bonds' Pricing Is Questioned In Email Trail, Former Trader at RBC Alleges Mismarking Of Plain-Vanilla Issues " (October 26, 2007) Wall Street Journal reporter Susan Pulliam describes alleged fraud at one of the large Canadian banks. Whether government and corporate bonds were incorrectly valued to hide losses remains to be seen. However, if true, this is serious stuff.
Pension fiduciaries should be regularly asking external managers about their trading checks and balances. However, in light of recent negative headlines, one wonders (a) whether sufficiently tough questions are being asked (b) who is doing the investigation and (c) whether risk management and valuation best practices are more myth than reality at some organizations.
ERISA and state pension laws make it clear that fiduciaries have a solemn obligation to properly select and review external money mangers. Are breach of duty complaints likely to ensue for those plan sponsors who have selected "troubled" money managers and cannot provide evidence of a disciplined and comprehensive review of their risk management and valuation policies?
Our forthcoming November 6, 2007 webinar will look at trading controls and the selection and review of external money monagers. Click here for more information.
Webinar About Fiduciary Risk, Trading Controls and External Asset Manager Selection
Description:
Fiduciary duties mandate oversight of external asset manager selection. This includes a proper vetting of trading-related controls and the process used to determine limits, authorized persons, style drift early warning signals and liquidity traps.
Who Should Attend:
Plan sponsors, plan administrators, pension consultants, board members with responsibilities for selection of investment fiduciary advisors, regulators, fund of fund and hedge fund managers with (or seeking to attract) pension fund investors
Learning Points:
Persons who attend this 75-minute webinar will learn the following:
What Constitutes "Must Have" Elements of Effective Risk Management System
Ways to Detect Deviation from Management Style and/or Excess Position Concentration
Red Flags Regarding Possible Rogue Trading
Industry Best Practices for Trading Controls and Lessons Learned About What to Avoid
Speakers:
Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM - Moderator
President
Pension Governance, LLC
Mr. W. Anthony Turner - Speaker
Principal
Financial Tracking, LLC
Mr. Gavin W. Watson – Speaker
Business Manager for Asset Managers, Pensions and Insurance
RiskMetrics Group, Inc.
A Billion Here, A Billion There...
Though there is a question about whether former Illinois Senator Everett Dirksen ever said "A billion here, a billion there, and pretty soon you're talking real money," the statement is apt.
A quick read of the headlines suggests things are going to get ugly fast, and with little chance of a let-up anytime soon. Federal Reserve Chairman Ben S. Bernanke, in his October 15, 2007 address to members of the Economic Club of New York was no less sanguine. He offered that "Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time, and we may well see some setbacks." Click here to read the full text of his speech.
Billions of dollars in losses, due to sub-prime problems and related woes, pummeled recent earnings for more than a few organizations, sending the equity markets into a tailspin on October 19, 2007. Pundits report that the Dow had its worst day since early August, with worries about a looming recession being only one of several fears. Twenty years after Black Monday (October 19, 1987), the term "deja vu" comes to mind. At that time, this blog's author worked on a futures and options trading desk and well remembers the frenzy that ensued. Names then considered "too big to fail," no longer exist. Sobering lessons learned?
Hopefully.
At a time of unprecedented technological advances in terms of analytical capabilities and information flow, why is it that risk management is still anathema to some? Arguably there will be times when "tail" events occur, despite the best intentions to create, implement and periodically review back-office, middle-office and trading desk activities. One possible silver lining is that organizations (for which this applies) go back to the drawing board to design a more effective set of checks and balances. Improved risk architecture could include any number of things, including the following:
- Frequent and thorough testing of valuation models by independent third parties
- Regular and more granular correlation analysis that (a) takes into consideration the reality that market convergence does sometime occur and (b) then tries to identify when it is most likely to present itself accordingly
- Assessment of hedge effectiveness, and by extension, (a) what factors create "hedge leakage" and (b) thereby leave an organization exposed to adverse market conditions
- Identification of risk drivers, along with both a quantitative and common sense ("smell test") assessment of their likely behavior and probability of occurrence
- Identification as to how to improve collateral management
- Better training for everyone involved in trading activity and oversight
- Improved (or creation) risk budget that explicitly lays out how money is to be allocated on a risk capital basis.
Some will win as markets tremble but what about the losers? After today, equity-laden retirement portfolios won't look so good. Entire employee teams are shutting down as the credit crisis takes hold. Depressed times will certainly force plan sponsors to rethink their investment decisions.
How much money has to disappear before billions mean something other than zeros on a piece of paper?
U.S. Department of Labor Provides New Tool to Identify Fiduciary Status
Check out the new online "ERISA Fiduciary Advisor." Designed to inform about who is a fiduciary and what duties they are obliged to carry out, the Advisor "was developed by the Employee Benefits Security Administration (EBSA) in its continuing effort to increase awareness and understanding about basic fiduciary responsibilities when operating a retirement plan."
Click here to learn more.
IRS Provides Tool for 401(k) Plan Check-Up
In a special edition of employee plans news (October 2007), the Internal Revenue Service provides a link to its new web-based tool to help with 401(k) plan compliance. This 43-page document includes a chart that describes eleven "problem areas in retirement plans" as well as suggested ways to identify, correct and avoid such mistakes.
Click here to access the tool.
Statistics Save the Day for Louisiana Retirement Plan
Attorney Francis Pileggi, creator of the Delaware Corporate and Commercial Litigation blog, has an interesting post about a recent pension lawsuit. In Louisiana Municipal Police Employees' Retirement System v. Countrywide Financial Corporation, 2007 WL 2896540 (Del. Ch., Oct. 2, 2007), statistics played a central role in an option backdating case brought by the Louisiana Municipal Police Employees' Retirement System ("LAMPERS").
The court, citing the "close call" nature of the statistical evidence, nonetheless concluded in favor of the plaintiff. Pursuant to Section 220 of the Delaware General Corporation Law, LAMPERS will have some access to the financial records of Countrywide.
Click here to read this interesting October 10, 2007 post.
The Abracadabra of Valuation - Pension Fiduciaries Beware
Wall Street Journal reporters Susan Pulliam, Randall Smith and Michael Siconolfi fascinate with some interesting statistics about "hard-to-value" assets. In "U.S. Investors Face An Age of Murky Pricing Values of Securities, Tougher to Pin Down; Discord at Dillon Read" (October 12, 2007), they suggest that dollar volumes of securities that don't readily trade now likely outweigh those that do. Their comment that "money managers can no longer gauge with certainty the value of some assets in mutual funds, hedge funds and other investment vehicles" leaves one gasping for air. Adding to their assertion that some managers cannot sell at the level quoted by their brokers (quelle surprise!), I've heard through the grapevine that some banks and brokers are no longer willing to quote at all.
So where does this leave pension fiduciaries? The news is not good. If you are a plan auditor, treasurer, trustee and/or member of the investment committee, trying to (a) evaluate current portfolio performance (b) assess external asset managers (c) make changes in the strategic asset allocation mix and/or (d) undertake a risk management program, valuation numbers are paramount. If you are in the dark about what drives asset valuation in terms of identified risk drivers (and their behavior) or know little about how your fund manager addresses pricing, model validation, hedging effectiveness, trading limits and so on, look out. You are smack dab in the middle of the danger zone.
Moreover, if you are relying on a third party intermediary, ask if (a) they play the role of fiduciary and (b) the extent to which they vet managers' valuation policies and procedures. In addition, don't count on your fellow investment committee members to do the heavy lifting. Attorneys confirm my common sense conclusion. "Investing in something you don't understand is a no-no." If only one person on the committee understands the nature of a particular asset class or manager, that's cold comfort in the event of a lawsuit wherein fingers will point to EVERYONE who signed the allocation ok.
Regarding models, they are only as good as the underlying assumptions and how well they map back to reality. Who is testing the models used by your asset managers? Who is verifying the quality of input data? How often are so-called hedges evaluated for economic efficacy? Who is responsible for monitoring the collateral posted by fund managers? Do you have a system that can provide early warning signs that a manager has strayed from his or her stated approach? What needs to be added to your valuation policy (if one exists)? How are you measuring leverage and are your asset managers measuring leverage the same way?
The list goes on...
Valuation is arguably magic if it's arbitrary and capricious. There is an entire industry of valuation professionals at the ready, supported by a large and growing body of knowledge.
Poof or protect? How are your assets doing?
Click here to read one of many articles about model risk.
Dr. Susan M. Mangiero to Lead Valuation Masterclass
Pension Governance, LLC is proud to be a media sponsor of the Asset Allocation Summit Australia 2008. This blog's author is personally delighted to lead the master class about valuation. Entitled "Global best practices in hedge fund valuation and risk management ," the class will examine topics such as biggest risks for hedge funds in valuation, what makes for an effective valuation process and difficulties in valuing private equity holdings and complex derivatives.
Click here for more details.
See you "down under."
ERISA Litigation Calculus
Attorney Stephen Rosenberg, creator of the Boston ERISA & Insurance Litigation Blog, provides some interesting thoughts about legal trends. Citing yours truly about the surge in pension lawsuits, Rosenberg offers that courts will struggle with "new issues, or old issues under new fact patterns" with sheer numbers urging the judiciary to clarify. He adds that a pronounced switch from defined benefit plans to 401(k) offerings is likely to drive complaints, with plan participants demanding to know more about those individuals in charge of design and investment selection. Click here to read "ERISA Number of Suits + Questionable Practices = X" (posted on October 10, 2007) and other analyses by this prolific writer.
Pension Governance is a Proud Co-Sponsor of Workshop on Hedge Fund Valuation
Introduction to Hedge Fund Valuations
October 31, 2007 --- Loews Philadelphia Hotel, Philadelphia, PA
Program Focus:
At a time when the global hedge fund market exceeds $2 trillion and regulators are seeking ways to force more transparency, understanding valuation fundamentals is critical. This course is a unique offering that combines information about hedge fund industry structure with core valuation concepts. The course will examine the overall structure of a hedge fund, including standard partnership terms, revenue structure, liquidity restrictions, and impact of hedge fund strategy on value of hedge fund business itself. Special issues such as side pockets and high water marks will be discussed, along with a description of regulatory initiatives with respect to hedge fund operations.
What You Will Learn:
This four-hour course will enable attendees to:
Understand competing industry valuation standards and best practices
Understand basic structure of hedge funds and fund of funds
Differentiate between valuation of hedge fund and hedge fund portfolio
Understand basic regulation relating to hedge funds
Learn about various investment strategies and how they impact valuation
Understand impact of FAS 157 and AU 332 as relates to hedge funds
Who Should Attend:
Hedge fund general counsel, valuation practitioners, auditors, regulators, and institutional investors such as pension funds
Instructor:
Susan M. Mangiero, Ph.D., AIFA, AVA, CFA, FRM, president and CEO of Pension Governance, LLC, has over 20 years of experience in capital markets, global treasury, asset-liability management, portfolio management, financial risk control, and valuation. She has worked on three trading desks, in the areas of foreign exchange, fixed income, futures, and options. Dr. Mangiero is regularly invited to speak about valuation, risk, and governance with an emphasis on applications to pensions and hedge funds. She has addressed groups that include the U.S. Department of Labor, Chicago Board of Trade, New York State Department of Insurance, Merrill Lynch, Association of Public Pension Fund Auditors, Association of Forensic Economics, New England Public Employee Retirement Systems Forum, Global Association of Risk Professionals, American Society of Appraisers, the Wall Street Transcript, Strategy Institute, Connecticut State Department of Banking, Canadian Investment Review (keynote), Strategic Research Institute, Incisive Media (publisher of Hedge Funds Review) and the Connecticut Society of Certified Public Accountants. Her book, Risk Management for Pensions, Endowments, and Foundations (John Wiley & Sons, 2005), looks at risk management and valuation issues, with an emphasis on fiduciary responsibility and best practices.
Pension Risk and Hedge Fund Cherry Picking
An October 9, 2007 Wall Street Journal article describes new academic research that suggests foul play in hedge fund orchards everywhere. In "Pricing Tactics Of Hedge Funds Under Spotlight: Some Managers Select Favorable Valuations To Lift Performance," reporters David Reilly and Gregory Zuckerman cite empirical evidence that hedge fund managers may cherry pick prices of "hard to value" instruments as a way to pretty up performance.
The issue of valuing instruments for which no ready market exists is a challenge indeed. At a time when pension funds are allocating billions of dollars to hedge funds, private equity and venture capital pools, fiduciaries risk serious fallout if they fail to establish solid ground rules regarding valuation. There are any number of "must have" elements that comprise effective policies and procedures. Ignore them and plan sponsors lose a precious opportunity to detect possible trouble before things get out of hand.
Now is not the time to take shortcuts when it comes to valuing "hard to value" instruments or conducting proper oversight of portfolio managers who trade relatively illiquid stocks, bonds, derivatives and hybrids.
If you are interested in reading other posts about valuation, click on any of the links provided below. In addition, feel free to email us if you want to read some of our many articles on the topics of risk management and valuation.
Valuation Problems Are Going to Cost Plan Sponsors Big Time
Model Risk - Great Unknown for Pension Plans
Valuation Awakening - Does the Emperor Have Clothes?
Tulip Craze Redux and What Models Mean to Pensions
Survey Shows that Pensions Worry About Risk Management and Valuation
Pensions and Hedge Funds and Private Equity - Assessing Risks
Hedge Fund Toolbox - Webinars for Pension Fiduciaries
Courts Want Evidence of Valuation Expertise
Thanks to Russell Bailyn for a Nice Thumbs Up
Since its creation in late March 2006, www.pensionriskmatters.com has continued to attract attention. We love getting your feedback and hope this blog informs on a variety of important topics. Given my passion to keep the blog current and lively, I am delighted to get a nice "thumbs up" from veteran blogger, Russell Bailyn. I've excerpted part of his post below.
"I came across a great blog while doing research for my book which I’d like to share with my audience. It’s www.pensionriskmatters.com, written and maintained by Susan Mangiero. Based on the title, you may have caught on to the blog’s theme--mainly pension plans and the host of factors which affect them. The topic spectrum is fairly broad, such that anyone from a pension manager, plan sponsor, attorney, financial advisor, or even individual investor can learn something.
In an article written by Susan just last week, I learned about how the recent credit crunch is affecting institutional investors, including pension fund managers. As a financial advisor who deals mostly with individuals and small businesses, I hadn’t thought much about the affects going out 20 or 30 years of today’s credit issues and how institutional investors may be shifting their strategies to accommodate this newest area of confusion."
Click here to read the rest of the post and to check out Russell's blog, including an announcement about his new book. Entitled "Navigating the Financial Blogosphere," it's chock full of great resources about a host of topics ranging from life insurance to the role of the financial advisor. Click here to learn more. (Russell - best of luck with book sales!)
Pension Governance Woes in Public Sector
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Talk around the pension water cooler often turns to questions about which system will implode first. In a newly published article about pension governance, Governing correspondents, Katherine Barrett and Richard Greene, suggest that some public plans may soon make the "most wanted" list. Citing LongHorn state blues, Texas Attorney General Greg Abbott is quoted as saying that ”Inadequate governance will cause a pension fund to nose-dive and crash.” Other states are feeling the heat too, especially now that accounting rules have forced additional disclosures of post-employment health care benefit costs.
Conflicts of interest, fraud in some cases, political cronyism and little, if any, board training for persons making multi-million dollar decisions are some of the reasons to think the glass is half-empty. Uncertainty for retirees is bad enough but don't forget that taxpayers are ultimately on the hook for funding these benefits. (Click here to read our 2006 post entitled "Tea Party Redux: State Pensions in Turmoil.")
This blog's author is quoted in an accompanying featured Q&A. Offering suggestions to improve board performance, I likewise provided thoughts about the rise in pension fiduciary breach litigation and described a few of the many risk management standards for prudent investing.
Click here to read the Q&A interview and here to read the full text article entitled "The $3 Trillion Challenge" (Governing, October 2007 cover story).
Pension Funds Still Embrace Alternatives
In reading "Alternative investments still hot with pension fund managers" (Andrew Osterland, Financial Week, September 27, 2007), several things caught this blogger's eye. Summarizing a recent Citigroup Investment Research Survey of U.S. and European funds, the article states that "almost 90% of pension fund managers allocate assets to private equity investments vs. 50% to hedge funds." It was somewhat surprising then to read that "over 80% of managers expressed concern over the lack of marking-to-market of hedge fund investments."
Does that mean that pension investors are less concerned about the valuation of private equity positions? That seems odd. While true that many hedge funds actively trade (and therefore tend to have a shorter holding period than private equity managers), we've fielded valuation calls from more than a few defined benefit plan auditors and investment committees. Concern about how to fair value any position for which no ready market exists - hedge fund or otherwise - ranks high on their "watch out" list.
Though some believe that accounting rule changes are the primary reason for concern, the Private Equity Industry Guidelines Group reports the following:
FASB Statement No. 157 did not change GAAP, it includes "provisions which required subtle changes to the guidelines which could be deemed significant! Fair Value was required for PE investments prior to Statement 157. Statement No. 157 clarified the definition, usage and disclosures necessary when using Fair Value and in certain circumstances changes historic practice in the private equity industry as further outlined below." (Source: 2007 Updated Private Equity Valuation Guidelines Frequently Asked Questions)
With more than $1.0 trillion expected to flow into alternatives by 2010 (as per survey results), understanding hedge fund and private equity valuation is critical.
