Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

When I was a young MBA pup (New York University), an investment professor asked students to purchase "Security Analysis" by Benjamin Graham and David Dodd. Not an unusual choice until one noticed the 1940 copyright. My reaction at the time was to think that this scholar needs to retire soon if he can't find a more modern text. Alas, the marvels of youthful ignorance, heh?

This flashback came to mind in reading the flurry of newspaper articles about the intended $23 billion purchase of Wm. Wrigley Jr. & Co. by private candy giant Mars Inc. Helping to finance things is no other than Warren Buffett who negotiated an approximate 10 percent of the deal for Berkshire Hathaway. With a stake in Sees Candy and the Coca-Cola Company, this uber value investor is familiar with beverages, salty snacks and sweets. (Note that Thomson Financial News, via Forbes.com, reports that Moody's Investors Service has put some of the Chicago gum giant's debt ratings under review as a result of the proposed structure.)

According to "Mars to Buy Wrigley’s for $23 Billion" by New York Times reporter Andrew Ross Sorkin (April 28, 2008), Wrigley's sales revenue just topped $5 billion. The National Confectioners Association reports that "gum sales continue to surge growing 9.3% over the latest fifty-two weeks" with the "key growth engine" being "seasonal confectionary products."

This news item is interesting but even more so after reading "Inside Citi, a Hedge-Fund Push Blows Up" wherein Wall Street Journal reporter David Enrich describes sales enthusiasm gone amuck. Having sold interests in "safe" fixed income hedge funds Falcon and ASTA/MAT to retail clients, global wealth management staffers are wrestling with a lawsuit, unhappy brokers and disgruntled investors. The article continues that Citi sold "only to clients with large, diversified portfolios." As litigation ensues (assuming it does), more will be known about sales practices and representations made to clients, existing and prospective.

Will an ordinary stick of gum pave the way for riches and leave certain "exotic" alternatives in the dust? One wonders - shades of the tortoise versus the hare? What are the lessons for retirement plans as billions of dollars are making their way into non-traditional securities?

Editor's Note: Here are a few fun facts about the confectionary industry.

• Halloween is a top 10 "candy buying day" according to The Nielson Company.
• U.S. and UK consumers think that food companies should be doing more to make healthier goodies.
• Sixty-five percent of Americans who consume chocolate prefer the milk variety. See www.candyusa.org.
• January 3 is National Chocolate-Covered Cherry Day, April 12 is National Licorice Day, May 23 is National Taffy Day and August 30 is National Toasted Marshmallow Day. See www.candyblog.org.
• "The first patent for chewing gum was issued in 1869 to William F. Semple, a dentist from Mount Vernon, OH" as reported by the International Chewing Gum Association.
• Bubble gum is pink because the inventor had no other colors left. See http://www.betteroralhealth.info/orbit_us/about-wrigley/fun-facts/index.htm.  

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 New York Times reporter Alina Tugend ("Pick a Planner Who Can Spell ‘Fiduciary’," April 26, 2008) writes about the importance of doing proper homework when it comes to selecting an investment advisor, stockbroker or financial planner (consultant). Her rule? Ask someone you are thinking of hiring - Are you willing to wear the hat of fiduciary? Since not everyone is required by law to embrace the fiduciary mantle, and some do so only in exchange for additional compensation, the question is far from trivial. She quotes Sheryl Garrett, author of Personal Finance Workbook for Dummies (John Wiley & Sons, 2007) as urging individuals to document agreed-upon terms, including those that relate to the discharging of fiduciary duties such as care and loyalty. Fees and conflicts of interest are other considerations. For example, a compensation structure that includes commissions may encourage the sale of unsuitable securities to small investors.

As more employees migrate (by choice or force) to defined contribution plans, investment literacy is critical. Interested readers may want to check out the following resources:

•  "Final Report on Financial Planner Standards of Conduct" by the FPA Fiduciary task Force, June 1, 2007
• Investor Protection Trust library
• "SEC to continue assault on fiduciary protection in 2008" by Diahann W. Lassus (Investment News, January 7, 2008)
• "Can you trust your financial advisor?" by Liz Pulliam Weston (MSN Money, date not given) - Cites 2005 complaint count against advisors with almost 4,000 taking the form of "breach of fiduciary duty" 

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Several recent experiences inspire this post. On the positive side, two weeks ago, I had the pleasure of spending time with my step niece, a darling little girl of 3. After just 15 minutes, I realized that her favorite way of getting attention is to scream "excuse me" as many times as it takes until nearby adults acknowledge her. Cute at first, it annoys after a few shouts but Lilly certainly gets her way.

On the other end of the experiential spectrum, my Sunday foray to Starbuck's introduced me to "Miss Manners Not." Though I was first at the counter and obviously not yet finished paying for a handful of gift certificates, a lady customer thrice reached over me and then pushed me aside to order a cup of joe. Not being shy, I murmured "sorry to be in the way." To my shock, she replied "it's okay." Yes, my first response was to tilt my cup in her direction ("oops") but give me credit for being an adult who quickly cooed sotto voce, "let it go." (You've met folks like this gal, right? Gotta love 'em for their arrogance and cluelessness.)

Here's the connection to all things pension.

Everyday brings new headlines about the retirement crisis. Just a few days ago, New York Times reporter Mary Walsh cites a new study that shows that 2007 investment gains for America's giant pension funds are fast being erased by early 2008 market tumult. Likely to add to the funding gap and compelling a need for cash infusions is a strategic move away from equity. More disturbing is that jumbo plans, in distress, could "swamp the federal insurance system," already reeling from certain airline and manufacturing company woes. Piling on is the Fed's lowering of interest rates which pushes up the size of defined benefit plan liabilities, exacerbating things. Given tighter funding rules, courtesy of the Pension Protection Act of 2006, plan sponsors have much less latitude in riding out the storm, if even possible. (See "Market Turmoil Has Taken a Toll on Big Pension Funds" by Mary Walsh, April 17, 2008. Also read "2007 Gains Reversed in First Quarter of 2008" by John W. Ehrhardt and Paul C. Morgan, "Milliman 2008 Pension Funding Study," April 2008.)

In January 2008, the U.S. Government and Accountability Office ("GAO") released an alarm bell in the form of its report entitled "State and Local Government Retiree Benefits." They concluded that "58 percent of 65 large pension plans" had funding ratios of about 80 percent in 2006, a decline since 2000. By extension, this means that 42 percent are in bad shape. (There is continuing controversy over whether 80 percent is deemed "safe" or instead suggests a need to worry.)

For individuals, new research cites the need for a long-term, relatively stable mix of stocks and bonds. In "Hitting or Missing the Retirement Target: Comparing Contribution and Asset Allocation Schemes of Simulated Portfolios," Professors Harold J. Schleef and Robert M. Eisinger argue that the likelihood of having enough money to retire comfortably is depressingly low. As New York Times contributor and money talking head, Mark Hulbert, points out, life-cycle or "target date" maturity funds may not perform "in line with their long-term averages." (Read "The Odds for a Retirement Nest Egg, Recalculated," New York Times, April 20, 2008.)

Of course, if Louis Lowenstein, author of The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do About It is right, fees and revenue-sharing arrangements will continue to erode retirement savings (meager for most), making it tougher to reach even a low savings goal. While employers shed their traditional benefit plans, they nevertheless have a vested stake in wanting their employees to be self-sufficient. Happy workers are typically productive workers who spin gold for shareholders and performance-compensated executives.

For the still clueless pension decision-makers, oblivious to the merits of effective asset-liability management (the equivalent of my coffee shop lady), hopefully the onslaught of economic and regulatory indicators will create a stir. If not, perhaps my young niece will take her "excuse me, excuse me, pay attention" show on the road.

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I'm a big believer that we can learn from a variety of decision-makers. So it is with appreciation (and the proverbial hat tip) to Robert Elder for pointing out comments made by Frederick "Shad" Rowe, chairman of the Texas Pension Review Board. Robert pens an interesting Texas-centric blog called "Public Capital" and draws attention to Rowe's April 11, 2008 criticism of investment time travel that emphasizes past performance.

Recounting a Wayne Gretzky quote that "he skated not to where the puck was, but where it was going to be," Rowe excoriates investment consultants who "lead their clients not to where the puck is going to be or even where it is now, but instead to where it was three years ago." A 35-year investment veteran, Rowe further suggests that pension trustees are unwise to eschew long-term oriented investing in favor of strategies du jour such as (his words) "so-called 'alternative' investments, including private equity, where investment consultants are attempting to reduce what they call 'risk' and patching together a crazy quilt of 'uncorrelated' assets." Regarding commodities, he offers that the markets are too small to absorb the billions of dollars being thrown their way. Not a fan of international currency plays, Rowe thinks that pressure on the U.S. dollar will likely worsen economic conditions stateside. He urges pensions to think twice before investing in activism strategies that ignore company fundamentals.

Click to read Rowe's comments in their entirety. (In the spirit of encouraging productive debate, this blog welcomes comments from investment consultants about time orientation.)

Editor's Note: According to their website, the Texas Pension Review Board is "mandated to oversee all Texas public retirement systems, both state and local, in regard to their actuarial soundness and compliance with state law." Interestingly, there is a section about how the board is appointed. Worth reading, it is a rare example of documented experiential requirements. In this case, three of nine board members must have "experience in the field of securities investment, pension administration, or pension law." The board must also consist of an actuary, someone with "experience in governmental finance" and "a contributing member of a public retirement system."

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As a big advocate of yoga pants and sneakers, wearing high heels is typically a "must do" versus a "want to do" item. I imagine that most men feel the same way about wearing ties. A recent article caught my eye wherein Wall Street Journal reporter Christina Binkley writes that "high-heeled pumps are the feminine equivalent of wingtips." Does that mean that penny loafers and ballet shoes put one on the slow track for promotions? (See "High and Mighty: Seeking Comfort in the Power Heel," April 10, 2008.)

So what does this have to do with pension funds? Allow me to explain.

In a literal battle of the fashionistas versus the style-challenged, my keynote presentation at Pension Bridge was followed by a public plan trustee who urged service providers to clearly explain investment concepts. Getting the audience to laugh about asset allocation and risk control is no small feat but that's what he did with his "plain folks" request. To paraphrase, "We say 'get out' as opposed to waxing poetic about contagion and geometric drift and so on.

Don't get me wrong. Math has its place for sure just as high heels add a note of perfection to that special outfit. However, do we want to start with number crunching and rocket science or focus first on fundamentals? I'd much rather start a discussion with plan sponsors that focuses on big picture risk drivers. Getting a feel for qualitatively what keeps people up at night is a great start to hunkering down to solve problems, improve practices and keep promises to participants.

What might service providers learn from Mr. Trustee's commentary? Here's a thought. Replace the fancy multi-colored slide decks (or at least augment) with some "101" conceptual illustrations BEFORE the quantitative heavy lifting begins. After all, if an investment decision-maker is uncomfortable with topics such as correlation, stochastic modeling and portable alpha, no sale is likely to occur and neither side brings closure to what could be a win-win.

There is a lot to be said for comfort and practicality some of the time.

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Following on the heels of our March 15 post about emotions and retirement planning, another just published article addresses the role of the brain with respect to risk proclivity. In "The Science of Risk-Taking," TIME reporter Kate Stinchfield writes that thrill-seeking has a chemical payoff. Research suggests that higher risk tolerance relates to the reabsorption of dopamine, a neurotransmitter. Serotonin is a factor as well. Normal levels prevent erratic behavior. Testosterone is yet another consideration, with lower (higher) amounts linked to risk aversion (taking). Stinchfield quotes Professor Marvin Zuckerman (University of Delaware) as saying that "high-sensation seekers tend to underestimate the risk."

So does this mean that current excesses of financial risk-taking are tied to unusual brain activity? Can "bad" body chemistry interfere with the prudent process of implementing and monitoring risk controls?

"Sorry your honor, my chemical levels made me take wild, zany risks with other people's money." This sounds like the financial equivalent of the Twinkie Defense.

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More than a few people have declared the beginning of the end. A reference to halcyon market conditions, it looks like they are right (at least for now). A flurry of headlines address what this blog author has been saying all along. Watch the collateral, assess liquidity risk and take stress testing seriously. Where does one begin?

1. On March 5, a Pension Governance sponsored webinar (Fiduciary Risk, Trading Controls and External Asset Manager Selection) emphasized to need to be wary of the risks you don't know and manage the ones you can measure. In his remarks about global bank and pension regulation, Mr. Gavin Watson (Institutional Business Strategy Head, RiskMetrics Group) correctly pointed out that risk management is no longer a luxury. Basel II seeks to better link capital reserves with banks' economic risks. UCITS III (Undertakings for Collective Investments in Transferable Securities) requires asset managers to have a daily risk monitoring program that is easy to understand. Pension plans are not immune from new rules. Risk forecasting is a statutory reality for Dutch plans. UK plans must take underfunding risk into account or pay a punitive levy. The Pension Protection Act of 2006 in the US imposes a variety of rules that relate to fiduciary risk mitigation, including the selection of a proper advisor for 401(k) plan investment selection. Mr. Anthony Turner (Principal - Financial Tracking Technologies) talked about the need to examine managers' holdings and track deviations from approved limits.

2. In a separate webinar on March 6, I urged audience members to pay attention to the quality, quantity, price behavior and transferability restrictions attached to pledged collateral. Part of "Liquidity Risk Managemenft," hosted by Knowledge Congress and co-sponsored by Pension Governance, LLC, my presentation addressed liquidity red flags, including but not limited to the following:

• Undue Concentration in a Few Number of Holdings
• Low Trading Volume
• Infrequent Trading
• Limited Number of Market Participants
• Contractual Limitations on Whether, How and When Withdrawals Can be Made
• Volatile Market
• Form of Withdrawals, if Permitted
• Correlation Changes
• Contagion 

3. In today's paper, famed New York Times reporter Gretchen Morgenson refers to investors as guests in Hotel California since "they have checked into an investment they can never leave." Referring to auction rate notes (debt instruments with long or no maturities that reset weekly), author of "As Good as Cash Until It's Not" describes how this market has screeched to a halt in recent days. Finding few bidders, mostly municipal issuers worry about growing budget gaps. Investors, on the other hand, are left holding the bag after investing in what they perceived to be relatively "low risk" securities.

4. In "Hedge Funds Frozen Shut," Business Week journalist Matthew Goldstein reports that "Since November at least 24 hedge funds have barred or limited investors from taking their money out, tying up tens of billions of dollars for an indefinite period. Among them: GPS Partners, a $1 billion fund that bets mainly on natural gas pipelines; Pursuit Capital Partners, a $650 million portfolio with troubled debt; and Alcentra European Credit, a $500 million fund that owns slumping loans used to finance private equity buyouts. For those institutional investors who failed to read the fine print allowing managerial discretion, these lock-outs are bad news. Arguably, hedge funds want to prevent a mass exodus of their investors for several reasons. First, a drain on assets makes it harder to recover losses (if possible at all). Second, fees drop as the size of their portfolio falls due to redemptions and sub-par performance. Making matters worse, prime brokers are turning off the money tap, create illiquidity problems for hedge fund managers at the precise moment when they need cash to stay in the game. Goldstein suggests that redemption restrictions may be postponing an inevitable collapse for some hedge funds.

I'd say "take two aspirin and revisit the situation in the morning" but that solution fars short of what looks to be rough times ahead.

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Despite colorful tales of medieval historians disputing its shape, most people then and now realize that the earth is not flat. We won't get to the end and fall off. Indeed, we're arguably more interconnected than ever before. So it's not surprising that a galaxy of international speakers convened in Sydney with many of the same problems, challenges and concerns as US peers. A recurring theme emerged for everyone in attendance at the Asset Allocation Summit 2008 - Investment management is all about risk. Identification, measurement and control are important,. regardless of plan design and country of origin. In fact, the similarities as to what keeps folks up at night are eerily striking, whether voiced by a plan sponsor from Europe, Asia, Australia or North America. Here are a few concerns that resonated with all in attendance.

1. How can investment fiduciaries minimize their liability exposure, especially when investment strategies are becoming more complex and diverse?

2. What is the responsibility to defined contribution plan participants, knowing that many will retire without ample means to maintain a particular lifestyle?

3. How can one avoid paying "excess fees" to managers?

4. What is the proper way to separate beta from alpha?

5. What is the role of infrastructure investing?

6. Should allocations to 130/30 strategies (and equivalents) come from equity or alternatives?

7. Will a recession be global in nature?

8. How much oversight is required by internal fiduciaries who delegate manager selection to consultants?

9. Is ESG (Environmental, Social, Corporate Governance) investing a plus or minus in terms of fiduciary duties?

10. How should derivatives be properly used and by whom (the plan, the money manager or both)?

Sound familiar? If so, perhaps we should be thinking about how to operate within a flat pension world. Credit Thomas Friedman for pointing out the oneness that pervades global thinking. In his best-selling "The World is Flat," he emphasizes the connections among seemingly disparate markets. Should we care about the governance of pension funds outside our borders? In a word, "yes." What is done elsewhere impacts an increasingly "flat" network of capital which in turn influences the investment opportunity set within our borders..

Isolationism is over for most everyone. What about you?

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Free market advocate and famed author Ayn Rand is said to have explained communism with the use of an old Russian tale. It goes like this.

• In a liberalized environment, Farmer A gets a new cow. Farmer B admires his neighbor's addition and works hard to buy a cow of his own.
• In a state-run society, Farmer A gets a new cow. Farmer B realizes that he must work to pay taxes to feed Farmer A's cow. With a fixed wealth pie, levies diminish Farmer B's money pot, thereby giving Farmer B an incentive to destroy what he must support. He plots to get rid of Ms. Moo, making Farmer A worse off and arguably costing Farmer B time and money to pursue his wicked ways.

Friction is inevitable when players are encouraged to abide by a "you win, I lose" mentality. Reward silo decision-making and don't be surprised that people behave accordingly.

If the "me generation" characterizes your place of work, look out. Risk management is going to be a tough challenge. Effective enterprise wealth creation requires fluid communication and seamless operations. One hand must know what the other is doing in order to properly identify how various determinants of economic value either offset (hedge) or accelerate loss (leverage, correlation, lack of diversification).

Given its historic, just announced, write-down of $16+ billion, Merrill Lynch is taking the cow tale to heart. When asked by the Wall Street Journal to address "what shocked" the new CEO the most when he took the reins, John Thain replied - "Two things. One was the lack of understanding of the risk in these positions, and the lack of balance-sheet control. The balance sheet really got out of control, and traders were able to put on positions that were way too big, and I don't (think) there was a good understanding of what the risk was." He also added that "Merrill had a risk committee" but that "It just didn't function." (See "Merrill's Risk Manager" by Susane Craig and Randall Smith, January 18, 2008.)

Thain's response? Don't kill the cow. Encourage people to work together. In the same interview, Thain describes a newly mandated weekly meeting with the respective heads of fixed income, equity and risk. The goal is to avoid undue risk-taking that could bring down the house, not just for one group but for everyone - employees, shareholders and so on.

Pension fund managers can learn a few things from the Parable of the Bovine and Merrill's painful progress in managing large losses.

• Acknowledge the value of working across divisions and job functions. Don't make investment or plan design decisions in a vacuum.
• Don't empower one or more players to "run away" on their own. Internal controls are imperative. That includes a proper assessment of how external asset managers, custodians, consultants and the like manage their own financial process. If they are exposed to potential trouble spots, so are you.
• Understand that a buy-in of good risk management practices by you and your peers raises the bar for everyone. Good team players should be rewarded by how the organization fares, not a particular division.

The Cow Theory may not push the Dow Theory off the investment map but it should be heeded nevertheless.

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According to Global Pensions (January 10, 2008), Canadian, US and UK public pension fund investors are satisfied private equity investors. Surveying 108 institutions, Private Equity Intelligence Ltd (Preqin) found that "private equity out-performed for these pension plans in 82% of cases." In another survey, Preqin found that "95% of these investors predicted their private equity investments would out perform public market returns from a 2% advantge to over 4% in coming years."

Acknowledging the huge amount of money making its way into private equity, this blog's author wrote about the 4P's on December 31, 2007 - Pensions, Private Equity, Performance and Placement. We urged readers to study the risks, alongside the expected benefits, adding that valuation of private company economic interests can be challenging.

In response, Mr. Doug Miles, CEO of Globalprivatequity.com, Inc. wrote that life has surely changed when it comes to estimating value. We hope you find his commentary interesting. We welcome guest bloggers on any topic related to pension investing and risk management (which importantly includes the topic of valuation). Drop us a line if you want to share your thoughts with our fast-growing audience.

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Bloomberg reporter Christine Harper reports an average Wall Street bonus of just over $200,000, from a wealth pie of $38 billion, spread out over 180,000+ individuals. In stark contrast, she adds that "Shareholders in the securities industry are having their worst year since 2002, losing $74 billion of their equity." About this same time last year, USA Today reported an average investment banking bonus of $137,580. (Read "It's a Wall Street bonus bonanza, December 20, 2006.)

With approximately 45 percent more in year-end goodies to take to the bank, financial professionals will be in fine mettle to celebrate Thanksgiving on November 22 this year. Yippee!

Even folks like Freddie Mac CEO's Richard F. Syron must be happy in the piggybank department. According to the Washington Post, their accounting of 2006 rewards ("Top 100 Executives by Total Compensation") lists his take as a mere $1.1 million in salary but $15.5 million in aggregate. Never mind that a November 20, 2007 press release reports a third quarter loss of $2.0 billion, reflecting "a higher provision for credit losses and losses on mark-to-market items" and "total GAAP mark-to-market losses of $3.6 billion," including $1.5 billion in "interest-rate related items."  (Read "FREDDIE MAC REPORTS THIRD QUARTER 2007 NET LOSS OF $2.0 BILLION OR $3.29 PER DILUTED SHARE: Core Business Growth Offset by Credit and Valuation Losses.")

Even if you believe in the power of free markets to determine performance-linked compensation (and further acknowledge that some Wall Streeters contributed to shareholder wealth), these big numbers don't play well in Peoria. They especially don't go over well in pensionland.

At a time of strained state budgets and company layoffs, enticing qualified persons to work on pension issues is not a walk in the park. As we've discussed MANY times, it's tough to attract experienced, knowledgeable persons to sign on as fiduciaries. The payoffs are asymmetric at best. Do a great job and the reward is small. Do a bad job and the liability is great.

How will they express gratitude when the discussion turns to pecuniary rewards?

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In discussing his relationship with service providers, a plan sponsor recently told me that he feels like a juicy steak to a hungry lion. Everyone wants his business and he struggles to keep up with the many requests for meetings with consultants, actuaries and asset managers. According to "Pensions may be outsourced : Banks look to take the plans and their assets off the hands of employers" (October 31, 2007), that fiduciary may be even busier now, fending off requests to assume his company's defined benefit plan(s).  As Los Angeles Times reporter Jonathan Peterson describes, Citigroup has just received an okay from the Federal Reserve to "take over" a $400 million retirement plan, sponsored by Thomson Regional Newspapers.

If a harbinger of things to come (and banks are definitely gearing up for this business), risk management acumen and internal controls should be front and center. After all, if a liability is transferred from the original plan sponsor to a large bank, it will be discomfort indeed if that bank struggles with keeping its own house in order. The stakes are too high. Lest you think that big always means better, keep in mind that we've just gone through a rollercoaster summer with a handful of financial giants reporting losses.

As regulators examine the efficacy of pension buyouts by banks in the U.S. and elsewhere, this blog's author recommends that a bank's pension-related risk control abilities be made publicly available for analysis and review. The last thing we need is a concentration of pension assets in a few shaky hands. Better that everyone is comfortable upfront with the buyers' abilities in the areas of risk management, operational processing and good pension governance.

 

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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.

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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.

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According to Wall Street Journal reporter Craig Karmin, some legislators want public pension funds to shun companies that invest in terrorist countries such as Iran. Citing efforts by Missouri State Treasurer, Sarah Steelman, Karmin lays out the pros and cons of forced liquidation. (See "Missouri Treasurer's Demand: 'Terror-Free' Pension Funds," June 14, 2007.)

As part of a June 14 interview with CNBC's Maria Bartiromo, I offer four considerations (as much as I could say in a short on-air appearance). First, selling stocks because of statehouse mandates could cost taxpayers and plan participants in the form of "unexpected" transaction costs. This would in turn exacerbate funding problems for any states already in the red. Second, trustees would have to decide how to invest the proceeds of disposed equities, possibly earning less than before. Third, there could be a conflict for fiduciaries in terms of duty. Do they follow new rules that require divestiture, even if it forces them to violate state trust laws that demand careful analysis before deciding on an "appropriate" strategic asset allocation? Fourth, plan fiduciaries will likely need to spend considerable time and money in order to identify which companies offend, now and regularly thereafter.

No one supports terrorism but this "solution" might invite more problems. There is never a free lunch. Someone, somewhere pays.

Click here to watch the interview.

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Pension Governance, LLC is proud to sponsor a brand new section of the Social Science Research Network (SSRN). Part of SSRN's Financial Economics Network (FEN), Pension Risk Management publishes working and accepted paper abstracts covering a range of topics in the field. These include liability-driven investing, fiduciary assessment of hedge fund and private equity investments, organization and governance of defined benefit and defined contribution plans, selection of default investments such as target date funds, appropriateness of company stock for 401(k) plans, evaluation of money managers' fees, strategic asset allocation, fiduciary duty to hedge and use of derivatives.

Working with the SSRN team, co-editors Dr. Shantaram Hegde and Dr. Susan M. Mangiero encourage contributions in this exciting and critically important research area. At no other time has there arguably been such an urgent need to understand pension investment risk issues and competing solutions. 

Dr. Hegde is Professor of Finance at the University of Connecticut and author of many papers on derivatives, market microstructure and risk management. Click here to read his bio. Dr. Mangiero is author of Risk Management for Pensions, Endowments and Foundations. An Accredited Valuation Analyst and certified Financial Risk Manager, she is President and CEO of Pension Governance, LLC. Click here to read her bio.

Joining Dr. Hegde and Dr. Mangiero as part of the Pension Risk Management Abstracts Advisory Board is a team of experts in the areas of risk management, valuation and actuarial science:

Dr. Stephen Figlewski - Professor of Finance (New York University)

Allen Michel - Professor of Finance (Boston University)

Steven Siegel - Research Actuary (Society of Actuaries)

Gavin Watson - Business Manager for Asset Managers (RiskMetrics Group).

According to Dr. Mangiero,  "With many challenges facing pension fiduciaries, our goal is to help facilitate a conversation about pension finance, risk and valuation on behalf of investment stewards for millions of plan participants worldwide. The Pension Governance, LLC team is deeply grateful for the commitment of this top-notch team to promote good ideas in these areas. We look forward to making pension risk management the topic of choice for academic researchers and practitioners."

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Having read more than a few blog posts about a company called Monitor110, I decided to spend some time at their website. While I know nothing about the company other than what I read, their graphic of the "New Information Dissemination Cycle" fascinates. If true that blog content, local news and other types of non-traditional venues offer a competitive edge to investors, capital markets could be turned upside down.

Just in the last ten or so years, rocket speed transmission of data - aided in part by advanced technology developments and cross-border deregulation - has improved efficiencies, thereby reducing costs and shrinking diversification potential. Some posit this is a good thing. Others complain that it makes it difficult to "beat" the market by accessing and analyzing information not widely known by others. This is a topic that is near and dear to my heart, having spent several years writing a doctoral dissertation about market microstructure. (I looked at information economics in the form of bid-ask spreads for NYSE-traded stocks across levels of institutional investor ownership and analyst following. Send an email if you would like a copy.)

According to their website, Monitor110 envisions revolutionizing "financial services by enabling Institutional Investors to turn Internet information into alpha generation." At a time when countless pensions, endowments and foundations are scrambling for returns, potential wins have great appeal. (This is not an endorsement of any particular company or strategy. Readers are responsible for their own analysis.)

The role of information in making investment decisions is a topic of great interest to us all. Debating the economic value of information deserves far more space than can be provided here. However, the notion that blogs - and other "non main stream" sources of information - contain pearls of wisdom not yet assimilated by the market certainly merits discussion. One question that arises. Do blogs lead or lag major news announcements? Journalist Chris Nolan has an interesting take on the power of blogs in an article for EWeek.com, writing that, beyond politics, "their value as forums for collective knowledge is becoming known in other areas as well."

What did people do before the Internet came along?

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