Hard to Value Assets, Hedge Funds and Investment Fiduciaries

As I have pointed out on multiple occasions, valuation is an integral part of investment risk management for several reasons. First, fees paid to asset managers are frequently linked to performance and performance calculations depend on reported values. If values are artificially inflated, returns are likely to be inflated as well. Second, imprecise values can skew asset allocation decisions, lead to hedges being too big (or too small) and possibly cause an investor to breach trading limits that are part of an Investment Policy Statement. It's no surprise then that valuation process questions about who does what, when and how continue to surface.

According to a May 9 Wall Street Journal article, the U.S. Securities and Exchange Commission ("SEC") is investigating "the way hedge funds value their thinly traded holdings and how they respond when investors ask for their money back." The SEC has been vocal about its concerns regarding asset valuations for awhile. In December 2012, Bruce Karpati, then Chief of the Asset Management Unit of the SEC Enforcement Division (and now in private industry), talked about a focus "on detecting fraudulent or weak valuation practices - including lax valuation committees and the use of side pockets to conceal losing illiquid positions - and the failure to follow a fund's stated valuation procedures." Click to read "Enforcement Priorities in the Alternative Space." (As an aside, some hedge funds buy and sell actively traded securities for which there is a ready market and full price transparency.)

The U.S. Department of Labor ("DOL") regularly broadcasts its concerns about "hard to value" assets, including financially engineered products that show up in certain defined benefit and defined contribution retirement plans. In September of 2008, I spoke before the ERISA Advisory Council, by invitation, to address valuation issues from the perspective of a trained appraiser and fiduciary best practices expert. Click to read "Testimonial Remarks Presented by Dr. Susan Mangiero." I talked at length about valuation questions to ask of service providers and procedural prudence considerations for institutional investors.

A few weeks ago, senior attorney Fred Reish addressed monitoring and uncertainty in his April 19, 2016 newsletter. He directed readers to Fiduciary Rule preamble text that urges an advisor and his financial institution to install an adequate monitoring process before recommending "investments that possess unusual complexity and risk, and that are likely to require further guidance to protect the investor's interests." Click to read "Interesting Angles on the DOL's Fiduciary Rule #1." It doesn't take a rocket scientist to conclude that a "complex" and "risky" investment could be hard to value and not particularly liquid. (I have purposely not defined the terms in quotes herein as they are often related to facts and circumstances for a particular investor.)

Expect to read more about this important topic of valuation, especially as applied to those investors in search of higher returns. In a "no free lunch" world, risk and return go hand in hand. It's not necessarily a bad thing to take on greater risk as long as there is an understanding at the outset as to what gives rise to uncertainty and how risks are being mitigated.

Hard to Value Assets and Pension Funding

Add wine and cheese to the picnic basket and the pension fund too. According to "Companies Substitute Tangibles, Like Cheese, for Investments" by Mary Williams Walsh (New York Times, April 19, 2013), gaps in funding status are tempting some sponsors to add "unusual assets" to their portfolio. Her list of in-kind contributions includes cheese, whiskey, water rights, precious stones, oil wells, a restaurant, a brewery and a slaughterhouse.

An obvious advantage to a plan sponsor is the preservation of cash when an intangible or tangible asset is instead contributed. Another benefit is the potential upside associated with an asset poised for capital growth. This is especially true if cash contributions would be parked in a low-interest rate security or fund.

The downside is that an expectation of higher returns almost always means a greater uncertainty of realization.

Requisite approval by the U.S. Department of Labor may or may not mandate the hiring of an independent fiduciary to in turn engage someone to assess the value of an intended in-kind contribution. As a trained appraiser, I would tell anyone who asks that there are multiple items that must be assessed as a precursor to determining fair market value of the asset in question. Some of the items are listed below. This is not an exhaustive tally by any means.

  1. Control - If there are multiple owners of an asset, it is important to assess the extent to which the ERISA plan can exercise authority over how an asset is used, disposed of and/or managed for purposes of adding to the asset's value.
  2. Priority of Economic Claims: Understand whether the pension fund will be first in line to receive cash from the service and/or subsequent sale of the item being considered for contribution.
  3. Collateral: If the value of the intended in-kind contribution item is supposedly dependent on other assets, it is critical to know whether that collateral is fungible and if there are sufficient assets in place.
  4. Customer Diversification: If all or part of an operating business will be contributed to an ERISA plan, someone must make sure that revenue is generated from a sufficiently large number of clients so that if one or more large customers disappear, the value of the asset being contributed will not be adversely diminished.
  5. Marketability: Not all assets trade in an active secondary venue. Discounts for lack of marketability need to be carefully examined so that the ERISA plan does not overpay.
  6. Legal Protection: The appraiser must know whether an item such as a trademark or patent or other type of intangible or tangible asset is protected under law in terms of ownership and/or restricted use.
  7. Quality of Management: If the pension fiduciaries are tasked with running a business or maximizing the value of an intellectual property asset to be contributed to a plan but do not have the time or requisite knowledge, someone may cry foul if the item loses value.
  8. Maintenance: The value of an asset such as real estate, a building or piece of heavy equipment will go down if not cared for in a timely fashion. The cost of upkeep and/or the speed of obsolescence are two of many considerations that cannot be ignored. If an asset requires significant cash to keep it in tip top shape, it could be a drain on scarce pension plan resources.

Besides the valuation-related issues, an objective third party needs to assess the prudence of including a particular asset in the plan's portfolio. Then there is the issue of how the intended in-kind contribution will impact regulatory reporting, financial statement representation and actuarial requirements, not to mention future cash inflows and outflows.

The decision to contribute an in-kind asset is far from trivial. Like any other decision for an ERISA plan, care and diligence must be demonstrated before taking action.

Fiduciary Shortcuts To Valuation Can Be Dangerous

Despite a plethora of information about how to implement shortcuts to enhance workplace productivity, fiduciaries need to ask themselves whether a "jack in the box" approach that equates speed with care and diligence is worth pursuing.

This topic of shortcuts came up recently in a discussion with appraisal colleagues about the dangers of using a "plug and play" model to estimate value. Although New York Times journalist Mark Cohen rightly cites the merits of having a business valuation done, he lists all sorts of new tools such as iPhone valuation apps that some might conclude are valid substitutes for the real thing. Rest assured that punching in a few numbers versus hiring an independent and knowledgeable third party specialist to undertake a thorough assessment of value is a big mistake, especially if the underlying assumptions and algorithms of a "quick fix" solution are unknown to the user. See "Do You Know What Your Business is Worth? You Should," January 30, 2013.

It's bad enough that a small company owner opts for a drive-in appraisal. It's arguably worse when institutional investors do so, especially as their portfolios are increasingly chock a block with "hard to value" holdings. In the event that a valuation incorrectly reflects the extent to which an investment portfolio can decline, all sorts of nasty things can occur. A pension, endowment or foundation could end up overpaying fees to its asset managers. Any attempts to hedge could be thwarted by having too much or too little protection in place due to incorrect valuation numbers. Asset allocation decisions could be distorted which in turn could mean that certain asset management relationships are redundant or insufficient.

Poor valuations also invite litigation or enforcement or both. As I wrote in "Financial Model Mistakes Can Cost Millions of Dollars," Expert Witnesses, American Bar Association, Section of Litigation, May 31, 2011:

"Care must be taken to construct a model and to test it. Underlying assumptions must be revisited on an ongoing basis, preferably by an independent expert who will not receive a raise or bonus tied to flawed results from a bad model. Someone has to kick the proverbial tires to make sure that answers make sense and to minimize the adverse consequences associated with mistakes in a formula, bad assumptions, incorrect use, wild results that bear no resemblance to expected outcomes, difficulty in predicting outputs, and/or undue complexity that makes it hard for others to understand and replicate outputs. Absent fraud or sloppiness, precise model results may be expensive to produce and therefore unrealistic in practice. As a consequence, a “court or other user may find a model acceptable if relaxing some of the assumptions does not dramatically affect the outcome.” Susan Mangiero, “The Risks of Ignoring Model Risk” in Litigation Services Handbook: The Role of the Financial Expert (Roman L. Weil et al, eds., John Wiley & Sons, 3d ed. 2005).

In recent months, it is noteworthy that regulators have pushed valuation process and policies further up the list of enforcement priorities. Indeed, in reading various complaints that allege bad valuation policies and procedures, I have been surprised at the increased level of specificity cited by regulators about what they think should have been done by individuals with fiduciary oversight responsibilities. Besides the focus of the U.S. Department of Labor, the U.S. Securities and Exchange Commission has brought actions against multiple fund managers in the last quarter alone. Consider the valuation requirements of new Dodd-Frank rules (and overseas equivalent regulatory focus) and it is clear that questions about how numbers and models are derived will continue to be asked.

For further reference, interested readers can check out the following items:

New PCAOB Report Finds Pension Valuation Numbers Wanting

According to a new report just published by the Public Company Accounting Oversight Board ("PCAOB"), valuation of pension plan assets was one of the audit areas with "deficiencies attributable to failures to identify and test controls." Given the importance of having proper pension valuations carried out by knowledgeable and experienced persons, it is no surprise that this oversight organization devoted an entire section of its findings to the topic of valuation of pension plans assets. The problems they found include the following:

  • Insufficient testing of controls over how pension plan assets are valued;
  • Testing of controls that were imprecise and therefore did not allow for an assessment of the risk of material misstatement by plan auditors;
  • Failure to properly test the valuation of pension plan assets; and/or
  • Relying on management or the person(s) who performed the reviews without seeking an independent assessment as to why "variances from other evidential matter" were occurring.

In response to these findings, a prominent ERISA attorney commented that the cited deficiencies were not surprising and that valuation problems will continue to grow for those retirement plans that are allocating more money to "hard to value" funds.

In his 2011 speech before the AICPA National Conference, Jason K. Plourde with the Office of the Chief Accountant, U.S. Securities and Exchange Commission ("SEC"), talked at length about the role of pricing services and how securities that are not actively traded should be valued. He suggested that management "may need to perform different procedures and controls when considering the information from pricing services regarding the fair value of financial instruments..."

Concerns about how best to value pension plan assets and regularly test methodologies and controls related to said valuations took center stage in 2008 when the ERISA Advisory Council working group on "Hard to Value Assets" met to discuss how best to improve things. This blogger - Dr. Susan Mangiero - testified on the topic of "hard to value assets," emphasizing that poor valuations lead to a cascade of problems. For one thing, inflated valuations translate into higher fees paid by ERISA pension plans. Second, incorrect valuations make it difficult to properly review and revise any of the items listed below, each of which are critical to proper fund management such as:

  • Asset allocation;
  • Exposure to a particular sector or fund manager;
  • Fee benchmarking for appropriateness of compensation paid to a manager;
  • Type and size of hedges;
  • Hiring and termination of an asset manager(s);
  • Regulatory funding ratio and related cash financing; and
  • Cost of pension plan de-risking for some or all of current defined benefit plan participants.

If you missed reading Dr. Susan Mangiero's September 11, 2008 testimony before the ERISA Advisory Council Working Group, click to read about "hard to value" assets in the context of ERISA fiduciary duties and pension risk management.

With more pension plans reporting large scale deficits, don't be shocked if further questions are asked about the integrity of asset and liability valuation numbers.

Louisiana Pension Funds and Hedge Fund Redemption Concerns

As I've written many times herein, understanding transferability restrictions is a "must do" for institutional investors who allocate monies to asset managers. While a pension, endowment, foundation or family office may decide to invest part of its portfolio in illiquid securities for strategic reasons, it is still necessary to understand how to exit if necessary. In "Hedge Fund Lock Ups and Pension Inflows" (July 4, 2011), the point is made that investors who want to redeem but are barred from doing so may seek redress in a court of law. Regulators are paying close attention too.

According to recent news accounts, several Louisiana pension funds that sought to withdraw some of their money from a New York hedge fund were given promissory notes with assurances that it could get cash in several years. Moreover, it may be that the hedge fund in question has counted assets under management more than once due to a feeder fund organizational structure that boasts over a dozen smaller vehicles which cross trade with one another.

In a joint statement dated July 11, 2011, the Firefighters' Retirement System ("FRS"), New Orleans Firefighters' Retirement System and the Municipal Employees' Retirement System ("MERS") describe how attempts by FRS and MERS "to capture some of the profits that had been earned in an investment known as the FIA Leveraged Fund" initially met with resistance on the part of the fund manager to provide cash right away. Instead, the two requesting institutions were told to expect paper IOUs while certain assets were to be liquidated in an orderly manner over a period of up to two years. The statement goes on to say that the pension plans had each been promised a return of at least 12 percent per annum and that if the "collateral supporting the preferred return declines to a level that is 20% above the systems' collective account values, there is a trigger mechanism requiring a mandatory redemption of the systems' investment" with the 20% cushion" designed to protect the systems' accounts against any loss in value."

Getting a promissory note has not made for happy campers who now worry about the liquidity of the FIA fund and "the accuracy of the financial statements issued by the two renowned independent auditors." The statement goes on to say that the hedge fund manager has been apprised that the pension plans intend to "closely examine" performance records by putting together a team that consists of their board members, internal auditors and investment consultant. A forensic economist may be added to the team.

Click to read the July 11, 2011 joint statement from these Louisiana pension plans about hedge fund liquidity concerns for this particular manager.

Having just checked the SEC website, this blogger does not yet see the formal inquiry statement. Speaking from experience, complexity is never a good thing. Someone somewhere has to understand what risks might give rise to material problems. Moreover, proper due diligence of funds that invest in "hard to value" instruments has to take into account how they are modeled and who is vetting the integrity of the model numbers. Regarding organizational structures that encompass multiple money pools, it is imperative to understand who exactly has a claim to assets in a worst case situation of forced liquidation.

A few years ago, I refused to continue with a valuation engagement of a hedge fund because neither the general partner nor the master fund's attorney could adequately answer my questions about priority of claims for a complex offshore-onshore ownership structure. In several recent matters where I have served as expert witness, concerns about restrictions of transferability and collateral monitoring have taken center stage. Be reminded that in distress, book values often fall seriously short of fire sale or even orderly liquidation (auction) values.

Let's hope that questions can be cleared up in a timely fashion.

Readers may want to check out these articles:

  • "S.E.C. and Pension Systems to Examine Fletcher Fund" by Peter Lattman, New York Times, July 12, 2011; and
  • "Pensions Want Look Into Fund's Records" by Josh Barbanel, Steve Eder and Jean Eaglesham, Wall Street Journal, July 13, 2011.

Prioritizing Risk Management

Since I launched my second blog in early 2011 to discuss risk management and investment best practices for a wider institutional audience beyond pension plans alone, I've seldom posted items in both places. Instead, I've tried to provide unique insights for employee benefit plan decision-makers on www.PensionRiskMatters.com and address broader regulatory, litigation and compliance issues on www.GoodRiskGovernancePays.com.

Today is an exception. I am reprinting my comments about risk management on both blogs because I believe so strongly in the importance of effective risk management as an integral component of investment governance. I hope you enjoy reading my comments, originally published on The Glass Hammer website. For those who are not familiar with the group, check out www.TheGlassHammer.com to learn about this award-winning blog and online community created for women executives in finance, law, technology and big business. See below or click on "Thought Leaders: Prioritizing Risk Management" to read the full text of this commentary about the benefits of risk mitigation well done and the costly consequences of inattention or sloppy practices.

Full Text:

Thought Leaders: Prioritizing Risk Management, July 14, 2011, 1:00 pm

Contributed by Susan Mangiero, PhD, Investment Risk Governance Consultant and Author

For those financial institutions which have yet to grasp the importance of identifying, measuring, managing, and monitoring risks on a comprehensive basis, time may not be on their side. Regulators and litigators alike are forcing change.

There are countless individuals who want better information from their service providers about risk and are prepared to vote with their feet if they don’t get good answers. After all, these institutional investors themselves are confronted with a bevy of new mandates that require transparency. The good news is that change opens the door to business opportunities. Enlightened organizations that have good processes in place and have nothing to hide can differentiate themselves from competitors. Providing clients with education and data tools offers yet another way for asset managers, consultants, banks, and advisors to forge stronger relationships with their pension, endowment, foundation and family office clients. On the flip side, those who are reluctant to explain how they manage their financial, operational and legal risks may lose clients or worse yet, could end up as defendants in a lawsuit.

Pay to play conflicts, questions about hidden fees, state and federal legislation and new accounting rules are a few of the forces at work to ensure that trillions of institutional dollars are in good hands. Effective investment stewardship is no longer a luxury. Recent surveys confirm that buy side decision-makers continue to emphasize governance and risk management for their organizations as well as providers of products and services. Institutional investors can ill afford to lose money after a tumultuous few years. Investment committee members who give short shrift to fiduciary duties could end up being investigated by regulators or sued. According to federal court data, the number of ERISA lawsuits is going up. Factor in investment arbitrations, enforcement actions and “piggyback” securities litigation allegations and it is clear that unhappy investors are not going to accept the status quo.

1. Fiduciary Focus

Besides efforts underway by the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Labor (DOL) has proposed an expanded definition of who should serve as a fiduciary to ERISA employee benefit plans. If adopted, countless more professionals will be tasked with demonstrating procedural prudence when it comes to the investment of over $30 trillion in money from corporate retirement plan sponsors. States are likewise seeking change in the form of trust law reforms that tighten accountability for the investment of monies held by endowments, foundations and charities. The questions now being addressed by judges and arbitration panels relate to “excessive” risk-taking, insufficient diversification, absence of independent assessments of hard-to-value instruments and oversight failures that have led to large losses that might have been highly preventable.

One asset management firm recently settled with the SEC for $242 million over a mistake with one of its risk management models. Another firm just settled with the SEC for $200 million due to problems in the way subprime securities were marked. A few years ago, a Northeast pension plan was sanctioned by the DOL for not having thoroughly vetted valuation numbers provided by one of its hedge fund managers.

When I testified before the ERISA Advisory Council in 2008, I emphasized that having good valuation policies and procedures is essential because it impacts so many decisions having to do with asset allocation, hedging and fees paid.

2. Data Mining for Gold

Data analysis is a cornerstone of effective risk management but only if inputs are considered good. Garbage in, garbage out can be disastrous and costly. The use of unreliable, incomplete or inaccurate data points can result in bad decisions being made about measuring and controlling risks. Since risk

management is integral to investment management, other decisions such as portfolio rebalancing may be flawed as a result. Moreover, data is not created equal. Consider a few examples. Yields for a constant maturity security are not the same as yields on particular financial instruments with a fixed maturity date. Betas can be levered or unlevered. Mutual fund returns may not include all relevant fees, let alone the timing as to when the fees are charged. Hedge funds that utilize side pockets will report performance numbers that are skewed as a result. For an institutional investor that is trying to decide how to best manage risk or make sure that its service provider is properly controlling risk, one has to first measure the numerous risks that can spell trouble if left unchecked.

I’ve been fortunate to have worked on various projects where I had to thoroughly understand data quality exigencies before I could conduct statistical analyses that in turn were used for risk management or compliance purposes. While pursuing my PhD in finance, I took extra math and statistics courses to strengthen my data analysis skills. My doctoral research on trading patterns and market liquidity required extensive vetting of transaction data that was provided by the New York Stock Exchange. When I worked in the treasury department of a Fortune 500 company, I had to review and assimilate large amounts of data about a $200+ million derivative instrument portfolio in order to make recommendations about hedging strategies and risk monitoring technology functions. When I now serve as an expert witness on financial litigation matters, I spend copious amounts of time with relevant data to first understand what it means and then evaluate what could have been done differently to avoid losses. Data analysis is an important component of estimating economic damages that a judge or arbitration panel will review for settlement or award purposes.

Making decisions based on numbers alone is not the way the business world works. There are qualitative and quantitative risks that cannot be ignored but, of course, decisions and data do need to be aligned.

3. Everyone is a Risk Manager

There is no sector of the investment management industry that is immune from risk management. Due diligence meetings increasingly focus on what asset managers, banks and other service providers are doing to manage their risks. Pension committee members are being asked to account for how they select managers and investments with more details about prudent process. Donors are reluctant to give money to non-profits without assurances that risks are under control. Auditors are tasked to ensure that models for hard-to-value instruments are regularly monitored for appropriateness. Board members and compliance officers are in the spotlight for their oversight of risk-taking and the extent to which investors are kept abreast about controls.

Risk management is an important means to an end. It is in everyone’s best interest to identify, measure, manage and monitor risks. Otherwise, it comes down to being lucky or not. Try explaining whim to investors, shareholders, taxpayers, litigators and/or regulators.

In addition to a plethora of articles about risk management and valuation, Susan Mangiero, PhD, CFA, FRM is the author of Risk Management for Pensions, Endowments and Foundations. She is busy at work on a new book about investment risk governance. Mangiero is the architect behind an award-winning, syndicated blog found at www.pensionriskmatters.com. A second blog found at www.goodriskgovernancepays.com focuses more broadly on investment risk governance for all types of institutional investors and their advisors and attorneys.

Hedge Fund Lock Ups and Pension Inflows

Various sources tout increasing inflows to hedge funds from public and corporate pension plans.

In "Strong start to hedge fund activity in 2011" (April 1, 2011), Pensions & Investments reporter Christine Williamson writes that "First-quarter institutional hedge fund activity, including net inflows and pending searches, totaled $18 billion - the highest since the intense investment pace of the first quarter 2007, which saw $25 billion in activity." James Armstrong of Traders Magazine describes the billions of dollars going to hedge funds in recent months as a catalyst to "increased trading volumes for the equities trading business." See "Hedge Funds Could Juice Volume" (June 2011). Imogen Rose-Smith of Institutional Investor gives readers a detailed look at the love affair with hedge funds in "Timeline 2000-2011: Public Pensions Invest in Hedge Funds" (June 20, 2011).

Fortune writer Katie Benner says "wait a minute" to what seems to be an upward trajectory in retirement plan allocations to hedge funds with a 51% increase since 2007 and a doubling of the mean allocation to 6.6% (according to a study by Preqin). In "Hedge fund returns won't save public pensions" (March 30, 2011), she cites willful underfunding and a "mish-mash of accounting tricks" as fundamental problems that will not be corrected with more money in alternatives.

In her May 16, 2011 article for Pensions & Investments and entitled "Promises, promises: $100 billion still locked up," Christine Williamson writes that assurances made to institutional investors in 2008 and 2009 about redemptions are not being met by some hedge fund managers. At that time, jittery pension funds, endowments and foundations that wanted out were asked to be patient rather than force hedge funds to unwind hard to value positions at sub-par prices. Quoting Geoff Varga, a senior executive with Kinetic Partners US LLP, a consultancy for asset management firms, there is an estimated $100 billion in "exotic" or non-standard investments that were stuffed into "emergency side pockets." He adds that it is hard to come up with an exact number, especially since managers' valuations of these illiquid positions are not always realistic.

Certainly the issue of side pockets is unlikely to go away any time soon. On October 19, 2010, Emily Chasan reported that the U.S. Securities and Exchange Commission ("SEC") had filed a civil complaint against several hedge fund managers for overvaluing illiquid assets. See "SEC charges hedge fund of inflating 'side pockets'" (Reuters). Click here to read the SEC complaint and October 19, 2010 press release from the SEC. On March 1, 2011, Azam Ahmed with the New York Times Deal Dook described another case in "Manager Accused of Putting $12 Million in Side Pockets."

This blogger, Dr. Susan Mangiero, has written extensively on the topic of hard to value investments and liquidity and served as expert witness on cases involving due diligence allegations. Acknowledging that not all hedge funds invest in hard to value instruments, the following items may be of interest to readers:

Public Pension Risk Management and Fiduciary Liability

A few weeks ago, Attorney Terren B. Magid and Dr. Susan Mangiero jointly presented on the topic of pension risk management and fiduciary liability with a particular emphasis on public plans. Attorney Magid's insights reflect a particularly unique perspective inasmuch as he served as executive director of the $17 billion Indiana Public Employees' Retirement Fund ("PERF"). Dr. Mangiero shares her views as an independent risk management and valuation consultant, author, trainer and expert witness.

Click to download the 25-page webinar transcript for public pension fiduciaries entitled "Are You Properly Mitigating Risk? Assess Your Fiduciary IQ" with Attorney Terren B. Magid (Bingham McHale LLP) and Dr. Susan Mangiero (Fiduciary Leadership, LLC). Comments about ERISA plans are provided when applicable.

Topics discussed include, but are not limited, to the following:

  • Public Pension Transparency Act
  • Discount Rate Choice
  • Dodd-Frank Wall Street Reform and Municipal Advisor Registration
  • Expanded Definition of ERISA Fiduciary
  • Fee Disclosure Under ERISA 408(b)(2)
  • Failure to Pay and Actuarially Required Contribution ("ARC")
  • Benefit Reductions
  • RFP Process
  • Fiduciary Audits
  • D&O Policy Review
  • Vendor Contract Examination
  • Qualitative and Quantitative "Investment Risk Alphabet Soup"
  • Interrelated Risk Factors
  • Key Person Risk
  • Hard to Value Investing
  • Model Risk
  • Stress Testing
  • Pension Litigation
  • Fiduciary Breach Vulnerability
  • Characteristics of a Good Model
  • Side Pockets and Investment Performance.

Comments are welcome.

Asset Allocation Alchemy


Asset allocation seems to be on the minds of many these days. This is not surprising since empirical studies repeatedly suggest that how monies are apportioned across sectors and instruments is a primary driver of returns.

Some states such as North Carolina are legislating more choices for state retirement funds. According to "Pension fund to get new options" by The News & Observer reporter David Ranii, the Tar Heel State Treasurer will soon have the ability to allocate to junk bonds and Treasury Inflation Protected Securities ("TIPS").

In "Asset allocation survey 2009," Mercer LLC queried European pension funds and uncovered a "continuing focus on risk management and recognition that good governance can improve the investment performance of institutional investors." Notable is the result that mature defined benefit plans tend to reduce their exposure to equity markets in favor of fixed income.

In contrast, Dr. David Gulley, Managing Director at Navigant Consulting, suggests that an exit from equity could be ill-advised for investors seeking returns over many years. In "A Surprising Bear Market Lesson About Bullish Projections" (Law360, July 2009), Dr. Gulley writes that "a substantial and objective body of evidence shows that equity returns are reliable in the long term" and that a positive equity risk premium is "actually a requirement enforced by the market's ability to deny money." If true, the impact is potentially sweeping. For one thing, a migration to Liability-Driven Investing ("LDI") which tends to favor fixed income might prove costly later on. Pension plan decision-makers seeking to reallocate away from long only strategies might incur transaction costs now, only to add opportunity cost to the mix if and/or when the sun rises again in stock land. The net result could be a doubling up of bad news bears (or worse).

Absent a universal acceptance about the role of stocks versus everything else, the debate about optimal strategic and tactical asset allocation mix will no doubt continue for many years to come.


FAS 157 is Heeeeere!

As of November 15, 2007, those organizations who did not adopt FAS 157 early on will be obliged to disclose much more information about their "hard to value" assets and liabilities. Despite industry's attempts to forestall compliance for another year, the Financial Accounting Standards Board reiterated its intent to force implementation for financial assets and liabilities. Read "FASB Rejects Deferral of Statement 157 for Financial Assets and Liabilities" (November 14, 2007 FASB press release).

For those seeking a user friendly version of this new accounting rule, check out "A FAS 157 Primer" by Mark Gongloff (Wall Street Journal, November 15, 2007). Also check out "A Summary of Statement No. 157" on the FASB website. One important element of FAS 157 is the requirement that items be categorized as belonging to Level 1, 2 or 3 in order of ease of valuation with respect to observable prices (or lack thereof). Predictions abound that FAS 157 will force larger asset write-downs, creating jitters for pensions, endowments and foundations who invest in Level 2 and Level 3 sensitive funds. In a November 15, 2007 CNBC video, economist Nouriel Roubini warns of an impending global recession and a financial meltdown that could roil financial markets for months to come. He is not alone.

In "Why FAS 157 strikes dread into bankers - Just when we hoped the worst was over," William Rees-Mogg (The Times, November 12, 2007) cites research by financial analyst Martin Hutchinson. Financial giants such as Bear Stearns, Lehman  and J.P. Morgan Chase account for more than $100 bilion of FAS 157 Level 3 assets, requiring mark to model information not heretofore provided. The author adds "Even these figures may be understated, since the banks have themselves decided whether assets belong to level three or the more acceptable level two, and they have an interest in placing as little in level three and as much in level two as they reasonably can." Noteworthy is Hutchinson's analysis that Goldman Sachs has disclosed $72 billion of Level 3 assets. That number is relatively big or small, depending on the point of comparison - a $900 billion asset base but capital of $36 billion.

Lest pension decision-makers think they are immune from valuation issues, nothing could be further from the truth. Decision-makers for both 401(k) and defined benefit plans are squarely on the hook for vetting external money managers. This absolutely includes asking copious questions about managers' valuation policies and procedures. A poor job, or ignoring the issue altogether, is going to keep the plaintiff's bar busy indeed.