Biting the hand that feeds

The FT last week published a story looking at a recent Saïd Business school study on Pension Fund Consultants, and their lack of value added. In fact, they seem to be value destructive according to the study.

This immediately made me think of Leo Kolivakis’s recent Pension Pulse article on Hedge funds, and how the consultants tend to push large funds over small, despite small funds getting better performance.

This is not a new phenomenon, and it is not just confined to the Pension Fund industry. Back in the 70’s and 80’s, it was well known that “No-one ever got fired for buying IBM”. I remember as a junior US analyst opening my FT one morning to see an advert by Compaq, who were setting all sorts of records at the time for revenue growth, S&P inclusion, etc. “and no-one got promoted for buying IBM either”.

There are many reasons for these trends, but I would suggest career risk is actually the biggest. As Leo put it:

“Fifth, there is a herd mentality among large investors who pretty much all invest in the same large brand name funds. Much easier to go in front of your board if some well known fund you invested in is performing terribly and say "everyone was invested in this fund, they had stellar performance in previous years and we were caught off guard by their recent dismal performance." It's all about managing career risk and those allocating to hedge funds rarely, if ever, stick their necks out to invest large amounts in smaller hedge funds because if something goes wrong, they're cooked!!!”

When I tried to set up my own funds and I had managed to get myself in front of consultants and managers here in Canada, they told me the same thing; They knew I could do the job as well as any “known” firm, but if this was the year I had bad performance, their bosses would crucify them. I could come back in 3 years, with at least $100M under management, and then we might talk.

I was told recently that one of our major Pension funds here had no Canadian managed funds in their external portfolio. Funds normally suffer from Home Market bias, the tendency to view more favourably the markets one knows best, so one would expect Canadian managed funds to be overrepresented, not under.

When I look through the list of Emerging Markets mutual funds offered to retail here, I am always shocked how few are managed here. The list of fund continues to grow, but when you drill down, they are managed outside of the country, even when sponsored by our largest banks.

Would I be pushing the bounds of credulity to suggest that there is a correlation between the lack of support for start-up firms and the outsourcing of so much of our funds under management?

Now many people will come back that there are fiduciary duties to uphold and due diligence to be performed, all of which is true. Regulations were, at least in theory, put in place to protect against some kind of problem.

And despite all those regulations and due diligence to protect us, we still have Madoff, SAC, and a host of others.

I have described a particularly Canadian situation, but the Saïd study above is for American funds. I would hazard a guess that you would see similar results if you analyzed European funds. Local differences abound, but the underlying problem remains: the playing field is tilted too steeply against new funds.

Not all is lost. I was talking to Ramy Zakher at OMERS recently who told me they had started to look at firms who had only $50M under management, but they would be looking to take a stake in the company for their funding. This is a huge step forwards.

Here in Quebec, we have, at least in theory, a scheme to support new funds, but sadly, execution so far has been less than adequate. So bad in fact that the backers of the program have started to ask why the managers are sitting on their hands, and starting to hold them accountable

What solutions would I propose?

I would recommend everyone involved, but especially the beneficiaries and trustees of schemes, to start asking what their managers and consultants are doing to recommend smaller firms. Given that these funds have better performance, don’t trustees have a fiduciary duty to be asking the question?

I would recommend regulators introduce more asymmetric regulation, with sensibly easier rules for smaller funds. When I managed long - short for High Net Worth clients, I was doing it on a managed account basis, so I had no access of any sort to the client funds, and all the trades I executed were reported directly to the clients, who were all accredited investors. Yet I had to put up the same regulatory capital as if I were a hedge fund, which ended up killing the project.

Many US States have rules to invest minimum amounts with minority owned firms. How difficult would it be to extend that to firms below say $250M AUM?

For large State funds, the press should be asking why so much is outsourced to external managers. Some administrations have a problem paying “Wall St” wages, but are happy to pay millions in fees to Wall St. There are a lot of good managers and analysts who would be very happy making a good salary at a State fund. Ontario Teachers’ Pension Plan would be a fantastic role model for them.

Consultants need to be more proactive. They need get involved at a much earlier stage and to set up platforms that are easy for anyone to promote themselves, even a dart-throwing monkey. Instead of complaining that smaller funds need to do a better job marketing themselves, they should be helping them market themselves – the whole point is that you want the smaller funds to be managing money.

I am probably wildly optimistic, but I believe that if small firms can get this kind of support, it can rapidly become a self-sustaining “ecosystem”, as successful funds grow, and unsuccessful ones die, their seed capital gets returned to the pool to seed the next generation.

Post Script.

As I was proof reading this, the FT published a follow up article on consultants here

Slow Money Moving Slowly Forwards

I participated this week in a conference at Quebec’s Caisse de Depot, the Provincial Pension Fund Manager. Before they were recently over taken by CPPIB, they were the largest Government fund in Canada, and for 12 years I ran their Emerging Markets Equities team there.

I used the opportunity to talk to friends and former colleagues, and to get an update on what they were doing in Emerging Markets. I have to say it was reassuring to hear that so many of the strategies I had helped initiate with Ghislain Parent, the former CFO, were still progressing.

It was also interesting to hear the list of countries they were targeting for increased infrastructure investment; It was a short-list of countries that the press today insists are about to undergo major crises. They confirmed my point from last week that the duration of any crisis would be so short compared to not only the construction cycle but also the life of the project as to be irrelevant.

This is slow money moving slowly forwards.

Every year the Caisse holds a conference on sustainable investment, this year’s conference was on the subject L’EAU EN ACTION$
Implications pour les investisseurs.

From the title alone, it should be clear that this was the Caisse looking ahead years and decades rather than weeks and months; slow money moving slowly forwards.

Why do organizations like the Caisse take such a long view, and why are they not as panicked as the press by all these imminent crises?

These funds have very long-term liabilities, and their planning needs to match that. Here in Canada, our main pension funds are regularly tested to make sure they are actuarially sound for 70 years. That may seem obvious, but too many pension funds across the world are in deep trouble precisely because their sponsors failed to plan adequately; Detroit’s recent bankruptcy filing was merely the tip of an iceberg.

By planning this far ahead, the Caisse and others identify new and up coming opportunities to invest in AND threats to their existing investments. They get to invest in horseless carriages and pocket calculators rather than continuing to invest in buggy whips or slide-rules.

Growing up in rainy England, we had regular droughts through the 70’s and 80’s, as the storage of all that rain was simply inadequate. Here in Canada, we tend to think of water as a limitless resource, but even that can be over optimistic. The dormitory town I live in just out side of Montreal is looking for their second new water supply in only 5 years because the previous new water wells are already silting up.

China has about 20% of the world’s population but only 6% of the world’s usable water. Most people are aware of the air, ground, and water pollution in China even if they haven’t even been there, so it is probably uncontroversial to say even that 6% is optimistic; I have never been to that part of China, but I am told the water behind the Three Gorges Dam was basically an open sewer before the dam was even finished. China has even started blocking new production facilities because the designs do not include adequate plans for water supply or treatment.

India is in many ways worse than China, with 16% of the world’s population, yet only 4% of its water resources. Recall also that India’s population is expected to outstrip that of China in a few years.

I borrowed the chart below from the presentation by Pierre Fournier of National Bank, which shows the historic and UN Projections for increases in demand for various agricultural products – Meat, Milk Products, Cereals, and Vegetables

It illustrates nicely how increased wealth leads to increased protein consumption.

If we combine that idea with another of his charts, below, that shows how much water is currently used in the manufacture of 1KG of production, we get to see how agricultural demand for water is set to skyrocket.

Luzerne is Alfalfa in English.

We can repeat this analysis for many different sectors, and get similar results, from Industry to Energy.

It would be easy to simply dismiss this as an Emerging World problem, to say water shortages will derail the Chinese economic miracle, but we in North America will be unaffected. Unfortunately such isolationist thinking misses the point, and emphasizes the importance of organizations like the Caisse holding conferences like this.

China is currently the world’s largest car market, and a huge source of profits for GM, Ford, et al. GE, Coca Cola, and many other household names have tied their future growth to the growth of these markets. If that growth gets derailed, they get derail; think about the recent hype over whether Apple would introduce a low-end iPhone for the Chinese market.

Many places in Europe, such as the UK and Germany face similar water shortages to China, whilst Belgium is worse than India, according to the World Bank.

North America is no longer immune to disruptions in global food supplies. In recent years we have seen spikes in the overseas price of rice, and wheat translate into higher prices domestically, whilst the underlying prices of meat on the CME continues to rise, see chart below.

Inflation can be a major threat to pension providers like the Caisse over the long-term, as it erodes real returns whilst increases index linked liabilities.

What then is the opportunity? According to McKinsey $57 Trillion needs to be spent on infrastructure, of which $11.7 Trillion alone needs to be spent on water infrastructure, between now and 2030. China expects to spend $850 Billion over the next 10 years on water infrastructure, including a 4-fold increase in desalination facilities.

India currently has about 1/5^th the storage capacity of China. Much of the Monsoon water just floods the land then runs off, so there are plenty of opportunities to build storage dams, which could be linked to hydropower as well. India is also building desalination plants. The Minjur desalination plant, at 36.5 million M³ is South East Asia’s largest.

There is also a huge need for improved treatment of wastewater – India treats only a fraction of its used domestic wastewater.

Again, it would be easy to dismiss some of this as yet more infrastructure spending, especially in China, in countries that are economically too dependent on infrastructure spending, but as José Serra showed in Brazil, increasing spending on water treatment can reduce healthcare costs, as fewer children catch and die of gastrointestinal diseases. Remediating wastewater may not return rivers to their former glory, something like 28 000 in China appear to have stopped flowing, but turning rivers like the Tietê and Pinheiros from open sewers to at least livable-with makes citizens lives less unpleasant.

For an organization like the Caisse, these represent a variety of opportunities. Desalination plants can be built and operated under long-term concessions, as can municipal water services. Municipalities may issue infrastructure bonds, backed by utility taxes. The companies that actually construct these plants may list their shares, or raise project finance.

The companies providing these services may be from Quebec, they may be European like Suez, or they may be part of the Emerging Portfolio; one of the first Indian construction companies I ever met had just finished building a new sewer system in the unfashionable part of Saudi where I had lived as a teenager.

I am embarrassed to say, I do not know how long it takes to build a desalination plant, but I would guess 5 years including permitting and land acquisition – possibly less in China, more in India. So what are the chances of a crisis during the life of the project?

India last had a Foreign Exchange crisis in 1991. It has been obvious for a while that a new one is brewing, even if not as bad as ’91, so if India has a major crisis ever 25 years or so, that puts the probability of a crisis during the construction phase at about 20%, and during a typical 25 year concession period 100%.

Brazil had a mini crisis a year or so after the introduction of the Plano Real, as the euphoria wore off. It had a major crisis following the Russian default, then again when it became clear Lula was going to win the Presidency in 2002. If we add the current correction to the list (I think that is pessimistic) we get a minor crisis about every 5 years, so we would get one crisis during the construction period and 5, at least one of which could turn major, during a 25 year concession.

So stepping back, it is clear that taking such a long view of investing makes perfect sense for organizations like the Caisse or CPPIB, even if voters do occasionally complain. I think the many citizens in the US and elsewhere will be soon wishing their Governments had been so forwards thinking.

It is also clear why so many of these firms like the Caisse and the Norwegian Pension Fund take Socially Responsible Investing in all its forms so seriously. Only then can you really quantify the spectrum of risks they face going forwards.

It was a great conference and my compliments to Meggie Daoust and Johanne Pichette for such a great job.

An Introductory Post

I was honoured to be mentioned by Leo Kolivakis in PensionPulse this week; you know you must be doing something right when he gives you a mention.

His article on Emerging Market investment was well timed. There has been a lot of comment across various media this year about the end of GEMs and an impending crisis.  At the same time I have had several enquiries from Pension and Fund managers here in Canada about what they should be doing about finally getting involved in this area. Why the dichotomy? I'll try and keep this simple.

GEMs are like any other market, which is to say they are completely different from anything else. The factors at play are no different to those in Germany or Greece; some countries may go as bankrupt as Greece, some may roar like the German export machine, whilst others may splutter like France.

Hans Rosling’s GapMinder is an entertaining yet informative way of looking at the world. He slices and dices it so many different ways, and yet the message remains the same – Living standards are converging across the world. It is that simple; Convergence is what drives Emerging Markets investing. Everything else is just noise.

Watch the clip he did for CNN in 2010, and you see that even 3 years ago he was reminding everyone that a slowdown in China was inevitable. I say reminded, because every long-term projection about China, India, or any of the other countries I have seen includes growth slowing at some point. When I was running the largest Emerging Markets fund in Canada at the Caisse de Depot, even whilst negotiating a QFII quota with the Chinese authorities, we included expectations of a slowdown in our formal proposal. 

Bringing that back to day, the OECD recently reduced expectations for 2013 growth in the Emerging World whilst raising expectations for the Developed World. For many, this was the final proof that the Emerging story is over. And yet, even under these revised expectations, Emerging Growth still outstrips Developed by more than 2X!

Some people will argue that I am being too optimistic and point to specific countries and their specific problems. India, for example, is running large twin deficits in its Current Account and Government budget, a combination that is invariably toxic. Despite these twin threats, the Government seems intent on passing legislation that only makes the deficits worse at a time when capital is increasingly scarce.

All this, and more, is very true. What is equally true is that the inevitable moments of crisis are also the points at which meaningful reforms are passed; it is a truism of both the Emerging and Developed Worlds that the reforms that should be passed during economic good times only happen when backs are to the wall.

I would go farther and say Emerging Countries often have a better track record of implementing worthwhile reforms outside of a crisis, such as those recently proposed in Mexico.

Even when there are set backs, such as Brazil in 2002, they are increasingly followed in short order by substantive recovery. There are many reasons for this, but simply put it is the difference between “fast” money and “slow” money.

Fast money comes mainly from the securities markets; the retail investor piling into the latest mutual fund craze, the Hedge Fund Manager chasing an arbitrage opportunity, or a pension fund changing its asset allocation from 50% overweight Emerging Markets to 50% underweight. 

Slow money may be a Canadian Pension fund buying a toll road in Brazil, an Australian fund buying an interest in a port in China, or GE setting up a new plant in Indonesia. They are buying for the very long haul. To slow money, short-term economic weakness is an opportunity.

When I made my first investment trip to Latin America in 1992, there was no slow money investing in the region, and fast money was pretty rare; Argentine Taxis were 25 year old Ford Falcons, whilst in Mexico they were the old style VW Beetles, running leaded gas.

They don't build them like this anymore - Thank God!

Back then; we were talked about the establishment of domestic capital markets, and domestic slow money, like AFPs and Afores. Today we have those, and more.

Read here  about how Ontario Teachers Pension Plan got involved in Brazil from 2005 onwards. Having travelled to Brazil with OTPP and CPPIB, I have nothing but respect for them. They plan ahead in decades not months.

My Canadian confreres were not particularly interested in quarterly production numbers from Petrobras, or whether CBD’s margin was meeting targets. They wanted to know where they could buy the malls where CBD stores were located, or a slice of the port Petrobras was unloading at.

When I first invested in Latin America, CPP was a simple pay-as-you-go plan, and CPPIB didn’t exist as a fund. Today it is recognized as being one of the world’s most sophisticated investors. As Leo reported, Japan’s PAL only started investing in Emerging Markets this April. One of the many reform proposals before Norway’s $750BN pension fund is to increase Emerging Market Investment beyond 10%, but it will be a year or so before they even decide let alone start to implement that decision.

And we haven’t even mention SAFE, ADIA, or Temasek.

None of these funds were there during the Mexican devaluation, the Asia crisis, or the Argentine default, but they are there now, and they are there for the long haul.

Finally, it should be evident from the Global Financial Crisis and its aftermath that Global linkages today are much deeper and stronger than they were during the Asian crisis. The kind of crisis many have predicted for the Emerging World would toss the Developed World back into the pits of depression. Going back to the example of India, by most metrics their “dangerous” debt situation is no worse than many European countries, and better than France or the UK.

Any withdrawal of QE that would plunge the Emerging World into a crisis would send the Developed World there too, and that is the last thing the Fed wants.