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A bad bet for pensions

Paul Woolley has an urgent message for giant public pension plans like Florida's that want to boost returns by investing in hedge funds, private equity deals and commodities.

Don't do it.

The only ones to benefit, Woolley said, will be the outside managers who take most of the profits. By pouring the public's savings into short-term investment deals, pension funds not only get short-changed on returns. Woolley says giant pensions are contributing to instability in global financial markets that could lead to nothing less than the collapse of capitalism.

Before dismissing him as a wild-eyed alarmist, consider that Woolley, 70, is a former banker, investment fund manager and International Monetary Fund economist. In 2007, he pledged more than 5 million pounds sterling of his own money to fund academic research centers on "capital market dysfunctionality" bearing his name at the London School of Economics and the University of Toulouse.

His thesis: Economists have overlooked the critical role outside fund managers or agents play in the relationship between investors and financial markets. Because these agents want to quickly maximize returns — and their own fees — this conflicts with the long-term interests of pension funds. It also leads to "bubbles and crashes and all sorts of mayhem," Woolley said.

Based on his centers' research, Woolley, who has a Ph.D. in finance, issued a 10-point "manifesto" in late May calling for dramatic changes in the investment behavior of the world's biggest public, pension and charitable funds.

"What we're doing is seeking to rewrite finance theory," Woolley said in a phone interview with the St. Petersburg Times last week. "It changes everything."

If you were a Florida resident and you learned the public pension intended to increase its allocation to alternative investments like hedge funds to make up for funding shortfalls, what would you do?

I can't comment on the investment strategy of any particular pension funds. But in general, I advocate going back to basics and long-term investments. I think pension funds should cap turnover of the portfolio's assets at 30 percent a year. If it's more than that they're using momentum investing, which is just chasing trends. Do not pay performance fees.

I would say no hedge funds, no private equity investments because the agents (fund managers) capture the bulk of the gains. No commodities because having investment funds going into commodities distorts prices and bedevils central banks' attempts to manage inflation.

Insist on total transparency of agents' (outside managers) strategies. I wouldn't invest in anything that's not traded on the public exchange. No funny business. Keep it simple. I'd use a benchmark for performance such as growth of national GDP, plus a premium for risk.

Secure full transparency of banking service costs incurred by the companies you invest in. Provide full disclosure to all stakeholders and for public scrutiny of your fund's compliance with these policies.

I reckon using these measures would boost returns by 1 to 1.5 percent per year and that's probably understating it. And I believe the rewards will show in relatively few years.

What kind of response are you getting to your manifesto?

It's still early, but frankly I've found an extraordinary level of interest. Giant funds are struggling, given they've had only 1 to 2 percent real return per year over the last 10 years. If we have a double-dip recession and the euro falls apart, huge deficits are going to open up in pension funds. So I think that's why there's a level of interest shown in what we're saying.

We will not have an easy ride. The agents (fund managers) won't like what we're saying. But one of the attractions of age is being able to say what I like.

This is an academic venture, not a political opportunistic statement. I thought we'd be doing research for another few years, but there are policy implications that spill out of what we're doing. I think it's extremely important somebody stands up and talks about an alternative to regulation and taxes.

Why won't more government regulations be enough to prevent future busts?

We really have to get an international agreement because no country is going to do anything that disadvantages itself seriously. And bankers will always resist regulation and they will seek to game it. That's part of their trade. I'm not saying no regulation, but that's a negative approach, a sort of constraint.

I perceive that there's a huge opportunity which is positive and it's one of harnessing the self-interest of giant investors. Investors benefit individually if they do what I propose by seeing higher returns. If enough investors do this collectively, they will stabilize the market and do what regulations fail to do.

Do you really feel the future of a capitalism rests on the ripple effects that occur when giant pensions invest in things like hedge funds?

It's not a ripple effect. It's a tsunami.

Any assessment of the last crisis shows it originated in the financial sector. It was the CDOs, the mortgage-backed securities, the opaque, obscure strategies of things not traded in the public market that brought the whole jamboree to a screeching halt. Bank profits had accounted for 40 percent of all corporate profits in the U.S. and U.K. The first year they failed to make profits of that order, they needed to be bailed out at $2 trillion of cost, which is a huge burden. It required increasing taxes and loss of GDP growth in the Western world of between 5 to 10 percent. The social cost of this is unparalleled since the Great Depression of the 1930s.

By engaging in unnecessary trading, charging high fees and creating unstable markets, the finance sector is capturing the bulk of the gains of the productive economy. It is bleeding the real economy dry.

When did you realize the error of your ways as a fund manager?

I don't blame the finance sector. It is acting optimally and rationally in its own self-interest.

At my investment firm (Grantham, Mayo, Van Otterloo & Co.), we were using a very good long-term value approach and we stuck to our guns through the tech-stock bubble. But we were also using momentum investing (following the trends) to minimize our losses against the index.

I had this sudden realization that we were contributing to the market distortion at the same time we were exploiting it. I realized we were a microcosm of what every other fund manager was doing.

Once I articulated that, I realized that, because of the nature of our contract with our clients and our own commercial self-interest, we were not doing anything socially beneficial.

Kris Hundley can be reached at khundley@sptimes.com or (727)892-2996.

Read more

The website for the Paul Woolley Centre for the Study of Capital Market Dysfunctionality is www.lse.ac.uk/collections/paulWoolleyCentre/

A bad bet for pensions 07/02/10 [Last modified: Friday, July 2, 2010 6:36pm]
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