The Real Expense of Safety

This Just Doesn't Add Up!

N.B. The college tours continue:  my wife and I are taking our daughter Caroline to University of Virginia this weekend.  Caroline has already been accepted, but wants to take a final look before making any final decisions.

Accordingly, the next post of Random Glening will be Tuesday, March 20.

Yesterday I questioned the asset allocation decisions of the California Public Employees Retirement System (CalPERS).

Specifically, I noted that CalPERS allocates just 48% of their $220 billion investment portfolio to equities. Part of the remainder is stashed in low-yielding bonds, while the rest resides in "hold and pray" investments in private equity or real assets.

If the latter do not achieve the stated investment goals - which recent history would suggest is certainly a possibility - reaching CalPERS's assumed actuarial rate of 7.50% might be a challenge.


As luck would have it, columnist Steve Syre addressed the same subject in this morning's Boston Globe, except that Mr. Syre was focused on the $50 billion Massachusetts Pension Reserves Investment Trust (PRIT).

According to Mr. Syre, Massachusetts State Treasurer Steve Grossman believes the 8.25% assumed actuarial rate for PRIT is too high.  Instead, Mr. Grossman has proposed lowering the rate to 8%, which will increase the state's pension liability by $1.25 billion.

http://www.bostonglobe.com/business/2012/03/15/lower-investment-bar-for-massachusetts-state-pension-fund/3KqsXQcw83Z8XxYBr4eE5H/story.html

Fair enough.  But here's the problem:  PRIT has not earned anywhere close to 8% for the last decade, despite the fact that PRIT's relative performance compared to other state retirement plans is around average.

According to PRIT's annual report (found at http://www.mapension.com/publications/), here are the fund's total investment results for the year ending June 30, 2011:

1 year:  +22.4%
3 years: +1.7%
5 years: +4.4%
10 years: +6.5%

Ah, you say, but this is in the past.  Going forward, is it not possible that we will see considerably better returns in the next decade?

Yes, I would agree, but only if the investments are focused on areas that offer at least the mathematical possibility of achieving a blended rate of 8%.

So I turned to how PRIT is invested, and here's what I found (all figures as of June 30, 2011):

Domestic equity:   22%
International equity (including emerging markets):  29%
Fixed Income: 19%
Private equity/real estate/natural resources:  22%
Hedge funds:  8%

However, in September 2011, PRIT decided to cut its equity allocation in favor of alternative investments:

As part of a new asset allocation mix approved in August, Mass. PRIM has allocated $1bn each to hedge funds and local currency emerging markets debt, a  new area for the top 10 US retirement system, and cut around $3bn from its equities allocation to fund the new mandates.

PRIM’s global equity allocation will drop to 43% from 49%, specifically cutting international to 17% from 21%, and domestic large-cap equities from 17% to  15%. The retirement system allocated 2% of its portfolio to local currency emerging  markets debt. 

http://www.afmmagazine.com/article/mass-prim-adds-local-currency-em-debt

In other words, just like California, Massachusetts decided to cut its equity allocation last September, and so has so missed the entire +25% move in the S&P 500 since the end of September 2011.

This isn't just semantics, in my opinion.  This is real money.  By allocating assets away from the one class that could possibly deliver the returns necessary to achieve returns at least equal to 8%, PRIT has increased the state's pension liability, which will eventually have to met by the state's taxpayers.

Why didn't PRIT take the money from fixed income?  Why did they continue to allocate to hedge funds at a time when there is increasing evidence to suggest that hedge funds have largely failed to deliver the goods?  Why continue to hold more than 12% in illiquid real assets as an inflation hedge when deflation continues to loom as the greater threat?

Just asking.

The True Cost of Avoiding Risk

We need higher returns!

The California Public Employees Retirement System (CalPERS) is one the largest investment portfolios in the world.

Totaling more than $220 billion, the investment strategies of CalPERS are widely followed among institutional investors.

So when CalPERS announced yesterday that it might be reducing its anticipated rate of return on its investment portfolio from 7.75% to 7.50%, it received considerable attention.

Moving from 7.75% to 7.50% may not seem like a big deal, except when you stop to consider that you're talking about billions of dollars.

Moreover, reducing the assumed rate of return on the CalPERS pension plan probably means that the contributions from the participants will need to be increased - just at a time when most municipal entities in California are already in precarious shape.

Here's how the Wall Street Journal described it yesterday:

A panel at Calpers voted Tuesday to lower a crucial investment target at the nation's largest pension fund, a step that could lead to higher retirement-plan costs or more job cuts in cities and counties across California. 

Calpers's pension and health-benefits committee recommended an assumed annual rate of return of 7.5%, down from the current 7.75%. If the pension system's board approves the change in a meeting Wednesday, it would mark the first time Calpers has lowered its overall investment assumption in nine years.

http://online.wsj.com/article/SB10001424052702304537904577279572284025222.html?mod=wsj_share_tweet

It would seem to me that this change is long overdue.

According CNBC, the average annual return for the CalPERS portfolio has averaged around 4.5% for the 10 years ending 12/31/10.

I have not been able to track down 2011 results, but even if they were good (and CalPERS CIO Joe Dear was quoted as saying they were "fabulous") it still means that the overall return for the fund for the past decade was well below its assumed rate.

With this in mind, then, it would seem logical that CalPERS should be allocating more assets to investment choices that offer at least the potential of boosting returns (i.e. stocks) while reducing their holdings of investments offering virtually no chance of getting anywhere close to 7.50% returns (i.e. bonds).

But that's not they're doing.

Here's a report from CNBC last September, right before the market started to rally:

The California Public Employees Retirement System is as worried as any investor about the uncertainty in the U.S. and Europe.

That's why Calpers, as it is known, is a "longterm trader" that is playing down equities, Chief Investment Officer Joe Dear told CNBC Wednesday. He indicated the Calpers portfolio is "underweight" equities by about 4 percent from its typical allocation. 

http://www.cnbc.com/id/44705064/Calpers_Cuts_Stock_Allocation_Sees_Low_Returns_CIO 

When you go to the CalPERS website, you see that just 48% of their portfolio is invested in public equities.

Meanwhile, 22% of the fund is invested in either "income" or "liquidity", both of which are essentially yielding less than 2%.

http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/assetallocation.xml

You would think that CalPERS would have investments with a very long term time horizon.  Most of the beneficiaries of the plan will be drawing their benefits for many years, but the yearly outflows are only a small fraction of the overall fund size.

But instead the group is investing with their eyes fixed firmly in the rear view mirror.  They have investments that will guard against inflation - with virtually no signs of inflation on the horizon.  They have huge investments in real estate and private equity, whose eventual returns are totally unknown.  They have hedge funds which, as a group, are probably barely earning their fees.

But common stocks - boring, large cap stocks trading at the most attractive level of valuation to bonds in more than 40 years - are getting a cold shoulder from the group, since they have been disappointing performers in the past decade.

This decision is not only likely to hurt returns, but also will cost the taxpayers of California. At a time when public services are being cut in many towns around the state, California municipalities are being forced to pony up more funds to keep the public pension plans funded.

Lessons to be learned for all investors.

The Rally That Wasn't Supposed to Happen Continues

Then one day you find
Ten years have gone behind you
No one told you when to run
You missed the starting gun

-Pink Floyd

Three years ago, in March 2009, the S&P 500 reached a low of 672.

Investor mood was understandably downbeat - the credit crisis had taken a toll on the economy, and most of the talk centered on recession, rising unemployment, and government bailouts.

No one wanted to buy stocks - equities had failed to deliver on the promise of longer run returns.  No, the most successful investors three years ago were those that had placed outsized bets against the U.S. housing markets, like John Paulson.

The S&P 500 has now doubled in three years. 

Indeed, had you bought stocks in March 2008 - right before the collapse of Lehman Brothers lead to a near total collapse of the financial system - you made nearly +15% on your money. Not a spectacular return, to be sure, but much better than cash or even intermediate Treasury notes.

Yet investors continue to flee the market.

Retail investors have been continually selling their equity positions in favor of bond funds, despite the prevailing low level of interest rates.  Most pension and endowment funds have been continually cutting their positions in publicly traded equities in favor of bonds or alternative investments like private equity and commodity funds.

Could stocks continue to go higher?

While it is certainly possible that we could see a market correction - after all, the S&P is up +11% year-to-date - I think that stocks could continue to move higher.

Here's a quote from one market strategist on CNN:

"This market's got legs," said Doug Cote, chief market strategist with ING Investment Management, whose year-end target for the S&P 500 is at 1,425. "We now have an effective fence built around Europe's debt crisis, and can focus on the underlying strength in fundamentals."

Cote said the biggest driver of stocks will be robust corporate earnings. In 2011, companies in the S&P 500 booked the best profits in history. While the pace of growth is expected to slow, Cote said earnings will continue to come in at record levels. 

"How can you not be in the equity market when we're seeing all-time highs in corporate profits?" asked Cote. "We're advising our clients against waiting for a pullback because we don't think they've missed the big rally -- the market has a ways to go before it catches up with fundamentals."

http://money.cnn.com/2012/03/14/markets/stocks-bull-market/

Yet widespread doubts persist.  For example, the Financial Times carried a piece that basically said, yes, the market indices are reaching new highs, but this is only because a few stocks like Apple are moving higher so strongly:

Fears about the sustainability of the Wall Street bull run have grown, with many stocks sitting out a rally that has taken the S&P 500 to a fresh post-crisis high. 

There were 72 stocks in the S&P 500 that hit 52-week highs on Tuesday, according to data from FactSet, compared with more than 100 when the market last peaked on April 29 last year. 

http://www.ft.com/intl/cms/s/0/0b4c4962-6d16-11e1-a7c7-00144feab49a.html#axzz1p6IZteTD

The article goes on to note, however, that 83% of the industry groups moved higher last week, perhaps contradicting the idea that only a few stocks are driving this market higher.

So here's where we are:  investors continue to hope that stocks move lower, and that interest rates stay around 2% or lower so that the bond investor is rewarded for their caution.

But here's what's happening:  stocks are moving higher, and interest rates are spiking higher as well.  The 10-year Treasury now yields 2.25%, up 45 basis points from the end of January 2012.

There's an old Wall Street expression that discusses "the Pain Trade". This occurs when markets move in the direction that the consensus does not anticipate.

And right now there's a lot of pain going on.