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

According to Financial Times reporter Deborah Brewster ("Investors pull out of mutual funds," April 27, 2008), nearly all U.S. mutual fund managers saw a drop in assets in Q1-2008. Sagging returns are a main driver on the retail side. Citing Strategic Insight, Brewster writes that individuals and institutions have pulled $100 billion from American, European and Japanese equity funds.

Money market funds, charging lower fees, seem to be picking up the slack. This suggests an inevitable decline in profitability for the asset management business. In "Has the Financial Industry's Heyday Come and Gone?" (April 28, 2008) Wall Street Journal reporter Justin Lahart writes that "the businesses of borrowing, lending, investing and all of the middlemen in between" are slowing and thereby creating ripples throughout the U.S. economy. With documented job cuts in the financial sector, new regulations and questions about "excess" risk, a discernible shift is underway. A shrinking financial sector and reduced availability of credit hits consumers and corporations hard.

In addition, defined benefit plans are moving assets away from equity to alternatives and fixed income. In "CalPERS to shift $44 billion" (December 24, 2007), Pensions & Investments reporter Raquel Pichardo describes the giant retirement plan's move into international equity, real estate, private equity and a "new inflation-linked asset class." On April 17, 2008, New York Times reporter Mary Williams Walsh offers insight into what some of American's biggest plan sponsors are doing to manage market volatility. Referring to a new study by Evaluation Associates in "Market Turmoil Has Taken a Toll on Big Pension Funds," Walsh writes that General Motors, Ford, Boeing and Deere are a few of the large plans to turn from equities.

The issue is important for many reasons, not the least of which is the impact on statutory funding requirements, cash flow and related share price. In March 2008, money manager Charles Gilbert spoke to a Society of Actuaries audience about the double whammy of falling interest rates (increases the defined benefit liabilty) and unhealthy stock returns (reduces portfolio value).

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Hedge fund Amaranth Advisors, LLC has settled an SEC complaint regarding violation of Rule 105 of Regulation M  which makes it "unlawful for any person to cover a short sale with offered securities purchased from an underwriter or broker or dealer participating in an offering, if such short sale occurred during the . . . period beginning five business days before the pricing of the offered securities and ending with such pricing.” Click here to read the SEC-Amaranth document.

Zurich Capital Markets Inc. has settled with the SEC on an issue relating to hedge fund trading. According to the order, "ZCM, an entity that provided financing, aided and abetted four hedge funds that were carrying out schemes to defraud mutual funds that prohibited market timing. Specifically, ZCM provided financing to four market-timing hedge funds that employed various deceptive tactics to invest in mutual funds. ZCM and these hedge funds knew that many mutual funds in which they invested imposed restrictions on market timing activity. In order to buy, exchange and redeem shares in these mutual funds, these hedge funds employed deceptive techniques designed to avoid detection by these mutual funds. ZCM came to learn that the hedge funds were utilizing deceptive practices to market time mutual funds, and nonetheless ZCM provided financing to them and took administrative steps that substantially assisted them. By providing assistance to the hedge funds, ZCM aided and abetted the hedge funds’ violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder." Click here to read the SEC-ZCM document.

One takeaway for pension fund investors is that a review of the manager absolutely must include a thorough assessment of trading practices.  Some of the many questions in search of answers include the following:

• What trading controls, by category, exist?
• Who oversees compliance?
• How are violations detected?
  
• What is the penalty for internal policy breach?

A second takeaway is to ask serious questions about the entire chain of command related to trade processing, reporting and who gets paid to do what.

Look for news next week about our hedge fund webinar series for pension fiduciaries. The Hedge Fund Toolbox^SM will cover many important topics such as valuation, risk management, fee structure, disclosure and ERISA considerations.

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Wall Street Journal reporter, Eleanor Laise recently wrote that an increasing number of mutual funds are "venturing into the risky world of private-equity investments", "because of the prospects for higher returns." While SEC rules limit assets to no more than fifteen percent in illiquid holdings, Ms. Laise describes potential problems. Higher legal expenses for more complex deals, difficulty of unwinding a position and valuing private investments are far from trivial challenges. She cites one SEC investigation of a mutual fund that allegedly undervalued its private company positions to give the impression that it had not breached the fifteen percent limit. "The SEC also has charged funds with inflating the value of illiquid investments. Mutual-fund managers have an incentive to overestimate the value of these holdings because they collect fees that are calculated as a percentage of total assets in the fund." (See "Mutual Funds Delve Into Private Equity" by Eleanor Laise, Wall Street Journal, August 2, 2006.)

Applying a version of the transitive property from mathematics, the implication is clear. Some pension funds have increasing exposure to private equity investments that do not trade in a ready market.

1. Pension funds allocate money to mutual funds.

2. Mutual funds buy private equity.

3. Pension funds are exposed to private equity as an asset class. (This is in addition to any direct allocation by pension funds to private equity.)

The message is clear. For those pension funds investing more money in private equity (indirectly or directly), the valuation issues are real and cannot be overlooked.

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