Risk Moment RES

Structured debt investments aimed at US retail investors

By Richard Beales in New York

Published: May 29 2007 20:25 | Last updated: May 29 2007 20:25

US stock market retail investors could soon have access to complex structured debt investments previously accessible only to hedge funds and institutional investors.

Investment vehicles linked to fund managers such as Bear Stearns Asset Management and Highland Capital have sought regulatory permission to list on US stock markets. They own credit assets including “equity” tranches of collateralised debt obligations – investments that carry high returns but which can be wiped out by the first few defaults in the portfolios of underlying debt that back them.

Some CDOs include exposure to risky debt such as US subprime mortgages and loans for leveraged buy-outs.

Similar vehicles are listed in the UK, including Queen’s Walk Investment, run by hedge fund Cheyne Capital. But until now such structures have not emerged in the US.

The listings would mark a new chapter for US credit markets but they also raise questions over the ability of US retail investors to understand and value CDO investments.

Janet Tavakoli, a consultant on structured finance, says: “Valuing CDO equity presents difficulties even for forensic accountants. Obviously, this is beyond the capabilities of the general investing public.”

The Bear Stearns vehicle, known as Everquest, also involves potential conflicts of interest – they are extensively disclosed in the prospectus. The investment bank’s asset management unit manages some of the CDOs Everquest owns; it is involved in managing Everquest in return for hedge fund-like fees; and Bear Stearns is the only underwriter, so far, of the listing.

Valuations are to be checked, at the time of the offering, by an as yet unspecified “independent underwriter”. But in its current form the Everquest prospectus does not suggest valuations will be verified independently on an ongoing basis – something hedge fund investors, for example, are increasingly demanding of fund managers. Bear Stearns declined to comment.

Meanwhile, proponents say the new vehicles present a way for fund groups to establish new sources of capital that are more permanent than hedge fund investments.

A lawyer involved in one of the deals says, “It is a very significant trend and an exciting development.”

Experts point out that there are listed companies that have business models that are difficult to understand. The key, they say, is that disclosure be adequate.

But these latest credit structures are designed to fall outside the investment company classification, easing the regulatory load.

It is also worth bearing in mind that in the UK, the expected flood of copycat deals has not materialised after Queen’s Walk’s listing. One reason is that investors value the listed vehicles solely for their yield.

Any threat to that can trigger a slump in share prices – as Queen’s Walk found in March when shares fell 25 per cent after Cheyne said US subprime exposure, among other things, would hit dividends from the fund.

Copyright The Financial Times Limited 2007

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Elephant in the corner

Published:  15 May, 2007

Managing agents effectively is something providers can stick their head in the sand over, partly due to its inevitability and partly because it’s a pain in the neck

Distribution is now the key driver in the life and pensions market. The pace of change in the market has accelerated at such a rate in recent years that we are left with an industry that seems occasionally to be a little unsure of its role; particularly for the life provider. The direct salesforce has been removed, back-office processes and IT are often outsourced and responsibility for distribution has been outsourced to the IFA. Life providers have spent tens of millions on building their brands but no longer have control over their distribution. This presents a unique set of challenges in terms of managing the various agency partners a life company may deal with on a day-to-day basis.

A changing industry

Furthermore, new entrants have changed the benchmarks for distribution in terms of productivity and customer orientation. Outsourcers and other entrants to the market have ‘raised the bar’ in terms of cost management and process efficiency and the ways in which they can interact with distributors. As a result, existing companies and distribution channels will face an increasingly difficult challenge to remain competitive. We should expect further rationalisation of the life and pensions industry and, along with it, a shift towards more innovative forms of distribution. No-one has yet found the silver bullet for cost-effective distribution for the mass market, although we can expect bancassurance and direct writing to be the main winners in the evolving market.

Ignoring the obvious

Managing agents effectively in this confusing world is a headache for providers of all types. Indeed, it is the ‘elephant in the corner’ – everyone in the industry knows it’s there, but many have been studiously ignoring its looming bulk, precisely because it is a pain to deal with.

Distribution dilemmas

So what are IFAs really looking for from providers? Firstly, providers need to keep investing and developing e-services, as well as supplying advisers with a consistent level of information. Commissions need to be paid in a timely and accurate fashion, whatever back-office solution is in place at the adviser firm. In this current climate of increased regulation and compliance, advisers need to maximise their time spent advising clients rather than dealing with administration. IFAs spend on average 40% of their time on commission management and reconciliation – anything a life and pensions company can do to reduce that workload is going to make it a very attractive product provider.

One thing is clear – IFAs are looking for improvements in the way providers work with them, and in the way commissions are paid. If a provider is struggling to get to grips with the different requirements the IFAs have, it’s likely the distributor will eventually look elsewhere. But from the providers’ side, it’s notoriously difficult to justify an agency management overhaul because agency management impacts so many areas of the business.

Integral to the agency management dilemma is the well-documented issue of legacy systems. Providers will typically run several systems, either developed over time or gained by acquisition, and running on disparate technologies. These systems are typically creaking under the demands of managing, rewarding and incentivising thousands of different types of agencies. The distributors themselves are increasingly requesting flexible commission and benefits payments to match the vagaries of their business, and there is simply no way for most of the extant legacy systems out there in the market to be able to deliver this.

Good intelligence

Good agency management is not just about automating the administration of complex incentive plans to multiple advisers, though. Agency management is a key business intelligence issue for providers – or, at least, it should be. Providers need to understand which products are selling well and which channels working are well. They also need to understand which types of buyers are plumping for particular products. All of this information can be monitored through an intelligent agency management solution in order to continually improve and refocus the provider’s product sets. Competition to sell life and pensions is now fierce, and the web has made it far easier for consumers (and advisers) to compare and contrast the different products. In this increasingly commoditised business, it’s crucial to gain an understanding of what is working and what isn’t.

Bad for business

Providers who don’t sort out their agency management arrangements will lose business in the long run – indeed, given that it will take at least two years to implement and integrate a new solution, many providers may well find themselves reaching a ‘tipping point’ where they will be unable to support new deals. It’s imperative to be able to offer flexible distribution arrangements to keep up with movements on the IFA side – we can now see IFAs joining forces to do a single deal, and then parting again. As things stand, many providers are not set up to cope with this – and they need to be.

Trish Henry is head of sales and marketing at Mastek

http://www.pensions-management.co.uk/

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Putting dampener on derivatives

01 April, 2007

Amid all the enthusiasm for Ucits III regulations, a number of doubters are beginning to voice opinions that could ruin the party

There is a slight degree of panic creeping in among Europe’s fund managers. While many say Europe’s Ucits III regulations – allowing use of derivative instruments in cross-border funds – are a good thing, not all toe the official line.

A PWM event at London’s Cass Business School addressing the use of options, heard asset management SVM’s Colin McLean, one of the industry’s better managers, paint an interesting picture. In his spare time, Mr McLean chairs the UK Society of Investment Professionals and plays an important educational role in the funds industry.

Are his members clamouring to find out more about how to correctly use derivatives in their funds? Unfortunately not. In fact the subject barely comes up. And when it does, some members slide down into their seats and try to hide from reality. Only half of UK managers are happy with derivatives, believes Mr McLean. The other part of his membership consists of “those long-only managers who want to see if the whole thing blows over and might collapse.”

These sentiments are fuelled by research from Cass’s resident professor of asset management, Keith Cuthbertson. His research suggests using derivatives does not necessarily improve fund performance and can actually reduce it. He believes Ucits III presents a

dangerous development, a Las Vegas style free-for-all, with investors gambling money rather than investing it. “Although Ucits III opens up more opportunities for fund managers, we could get to the equivalent of a supercasino of products, proving dangerous to the investor if handled wrongly,” says the professor.

Many manufacturers are more positive, of course. Ucits III gives opportunities to market a new set of concepts, such as the 130/30 fund, which allows for some short positions. But private banks also need to be wary of this. In some jurisdictions, wealth advisers requesting particular hedge funds are being fobbed off with 130/30 funds, because the real McCoy has no capacity left. The manufacturers are going back to the banks and saying: “Sorry, our hedge funds are full, but we have something quite similar we can put your clients into.” In many cases, the differences between the strategies are much bigger than any similarities.

But let us not put too much of a dampener on Ucits III. To paraphrase Abbey’s head of products, John Kelly, you’ve got to be in it to win it. In other words, there are some market conditions you can not exploit unless you are using derivatives. Yet he also warns distributors: make sure you back-test any funds you select against all type of market conditions. Only in this way can you evaluate the performance promises of the providers.

http://www.pwmnet.com/

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DB liabilities hurting restructuring
Published:  01 January, 2006

— Ellison: sees DB schemes as slightly poisoned chalice

The Pensions Act 2004 continues to have an effect on corporate restructuring as it is making corporations do things differently to what they would normally do.

More . . . 

Pensions Management

Pensions remain prominent while backbenchers revolt

Published:  15 May, 2007
Press day is here again, and despite the usual fatigue and eye strain, I can’t help but feel very privileged indeed, as my letter to you has practically written itself for the second month in row.

Last month, the chancellor’s Budget announcement confirmed that despite all the months and years of consultation it has forced the industry through, it only hears, and never listens.

Although HM Revenue & Customs has moved somewhat on its position towards pension term assurance – see page 4 – it is still being shut down.

The same goes for alternatively secured pension, and it makes me wonder how much time and effort, not to mention resource, has been expended in fighting an unnecessary battle with the industry and consumers over a process that would affect a relatively tiny number of individuals. Individuals who would still be contributing to the exchequer through inheritance tax or income tax when benefits are drawn. I hope it was worth it, but I fear it wasn’t.

Anyway, occupational pensions are currently at the forefront of Brown’s mind, thanks in part to a frosty reception to his announced augmentation of the Financial Assistance Scheme.

Only today during prime minister’s questions, David Cameron called for the government to amend the pensions bill to offer greater assistance to those who have lost their occupational pensions.

Tony Blair responded by saying that there would be no “unfunded commitment” of more help to those whose schemes went under between 1997 and 2005. He added that the “cruellest thing” the government could do would be to tell people it “can make that commitment and bail them out when it transpires we cannot.”

During the pensions bill debate, pensions minister James Purnell said: “The government should not write a blank cheque, but organise a remedy.”

But what could be crueller than offering something that you know makes two look like three and calling it a “remedy”?

A remedy it is, but of the kind peddled by mountebanks. And we all know how long they last – just long enough for those selling them to clear town.

Still, the government faces a tough time over this, with around 30 backbenchers believed to be prepared to back the opposition’s amendments to the bill.

And there’s more. The debate on the impact of the decision to abolish ACT relief (see page 5) is inseparable from this issue and there is plenty of life left in it yet. Who ever said that pensions were boring?

This issue has the first of a series of surveys looking at the life and pensions outsourcing market. This one surveys the attitudes of senior execs to BPO (see page 26).

As life offices in particular ready themselves for the new, fast-approaching DC world, we look at how systems will be used to service the occupational market (page 48).
Pádraig Floyd, editor

URL Pensions Management (EU)

Small funds suffer in PPM fee hike

Published:  07 May, 2007

Niche funds getting too expensive and may disappear from premium pension system

The new fee structure for funds within the PPM, the Swedish national premium pension system, has reignited the debate on whether or not there are too many funds within the system. The new fee structure, which came into force on 1 April makes it less profitable for fund companies to offer a large number of fund choices within the PPM and it is likely to result in some investment houses withdrawing their smaller fund offerings.

“Large fund companies will no longer be able to afford to set up new funds and the selection of funds in the system will be significantly reduced,” said Fredrik Nordström, CEO at AMF Pension Fund Management.

Indeed, AMF Pension is now considering dropping one of its eight funds from the PPM.

“The new discount model for PPM funds will remove a lot of the profitability of offering funds. It will lead to companies being forced to reconsider their niche funds within the PPM. In time, our small companies fund is likely to be withdrawn,” said Mr Nordström.

Managers have to give part of the investment fees they collect from savers back to the PPM, which are then returned to investors. On 1 April this amount increased. On average, the new model reduces the costs for the savers from 0.4 per cent to 0.3 per cent of the managed capital. The way fees are calculated also changed to take into account the total assets a manager has listed on the system rather than the assets it has in each of its individual funds.

Less interesting alternatives

Anders Alvin, CEO at Kaupthing Fonder, which offers eight PPM funds, also believes this will make the provision of a lot of smaller funds untenable for some managers. “The new system will make it less interesting to offer a large number of alternatives,” he said. “It won’t be profitable to keep certain funds in the PPM, in particular niche funds. We will probably remove our least popular funds.”

Daniel Barr, chief economist at PPM, denies that the aim of the new fee structure is to force a cut in the number of PPM funds. “Our aim has not been to try and decrease the number of choices. We have no such mandate, but if that was our ambition, there are more efficient ways of doing so,” he said. “I don’t believe the new fee structure will lead to a reduced number of funds, but rather the number of funds in the system will stay the same and will not increase.”

A fund manager that fulfils the basic regulatory requirements is free to register its fund on the system. There is, however, a limit of 25 funds that each manager may register. PPM is able to negotiate a significant discount on management costs by being a large player. Although the pension savers choose the investment funds, PPM is the owner of the fund units and is therefore in a position to demand a quantity discount from the participating fund managers. The new discount model is said to increase the amount of money paid back to the savers by roughly ?27m. Last year, savers got back ?110m. These are reinvested in funds on behalf of the pension savers.

The PPM system has long been under criticism for offering too many fund options, which is said to make it impossible for pension savers to understand all of the investment choices. Since its launch in 2000, the number of funds listed has grown from around 460 to almost 800. Despite the fund options available, around 90 per cent of the money within the system has been invested in just 150 funds. A survey from 2005 showed that only 6 per cent of savers agreed that they had sufficient knowledge to manage their premium pension savings.

Others believe that the PPM should offer the same amount of funds that exist on the open market and that the savers who wish to make an active choice should be able to do so without restrictions. A large number of fund options are also believed to increase competition among the fund managers.

Cutting fund numbers

A review of the premium pension system in 2004, headed by Karl-Olof Hammarkvist, professor at the Stockholm School of Economics, suggested that the number of funds should be cut to 150. He also recommended offering Swedish pension savers better guidance on different investment products and opening up AP 7’s Premium Savings Fund, the default option for savers who do not wish to actively manage their funds, for active selection.

Peter Norman, president of AP 7, has also been a strong critic of the large number of funds and has advocated just three simple risk-adjusted choices. PPM has also advocated the possibility of it being able to remove funds from the system that do not fulfil certain criteria.

In 2006, PPM hired WassumRating and Standard and Poor’s to rank the approximately 800 funds housed within its national pension savings platform. The contracts will run until the end of 2009, but the agreements may be extended by a further 12 months.

No changes to the current system have yet been enforced or decided upon.
CL

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Stress testing the hedge fund sector

By Gillian Tett

Published: May 24 2007 17:33 | Last updated: May 24 2007 17:33

Imagine for a moment that you were suddenly told that 700 hedge funds had collapsed. Would you react with merely a nonchalant shrug of the shoulders? Or experience a sense of panic?

It is not a hypothetical question. Last weekend the Financial Stability Forum – a committee of international policy makers – released its most comprehensive analysis of the hedge fund sector since 2000 (or when the world was still reeling from the implosion of Long Term Capital Management fund). This provides a fascinating snapshot of the explosive growth seen in this sector this decade. But it also highlights a fascinating fact: namely that while 1,518 new funds were apparently created last year, another 717 were liquidated too. That represents a death rate equivalent to about one 12th of all funds.

To be sure, not all of these funds necessarily “collapsed”. Some may have died because their managers retired to the beach; others quietly shrivelled as bets went wrong. But some funds undoubtedly imploded too: just remember Amaranth’s $6bn losses on natural gas bets. Yet what is striking is that the financial sector absorbed not just the Amaranth debacle – but another 700 deaths too. Moreover, it did this with barely even a minor tremor, let alone the type of panic that the media normally associates with hedge fund deaths.

To a certain extent, this simply reflects the fact that market conditions are extraordinarily benign, while the majority of these funds were undoubtedly also very small. But the trend also highlights another point: namely just how much the financial world has quietly matured since LTCM.

After all, if you step into any large fund in Mayfair or Greenwich these days, you will see a veritable army of compliance officers, risk managers and technology staff. Or talk to a prime broker, and you will be regaled with tales about how they now track credit lines to hedge funds more accurately than ever before. The type of scenario that unfolded in LTCM, in other words, seems difficult to imagine today.

Yet, just as generals have a nasty habit of fighting the last war, there is a constant danger that risk managers will focus on yesterday’s traps. And the FSF report points out that while banks have made amazing strides in managing their direct counterparty exposures to hedge funds, it is still far from clear that they are properly aware of all indirect exposures.

This second point matters because as the hedge fund industry has exploded in size, indirect links between banks and funds have grown too. Banks, in other words, do not simply lend to funds, but trade with them, and offload risky assets to them, on a massive scale. Indeed – and amazingly – the FSF suggests that prime brokerage now accounts for only a fifth of all bank revenue from hedge funds.

That, the FSF suggests, creates large indirect counterparty exposure risks – and it urges the banks to spend more time analysing this issue. Still, amid all the exhortations for extra number crunching, there is one other tactic that risk managers and regulators might also consider: embracing a little anthropology (or micro-level cultural analysis).

After all, the history of financial crises shows that when these erupt, human beings rarely behave precisely as models predict; instead, they have a nasty habit of panicking in ways that can seem unpleasantly irrational to the egg-heads. (In the case of LTCM, for example, some of its former managers are still startled that when the crunch came, their counterparties panicked in an “irrational manner not forseen by the LTCM models”.)

So if the banks respond to the FSF report by producing better stress testing models, they wlll certainly deserve at least one cheer. Indeed, that would rise to two cheers if they started properly addressing indirect exposures too. But what would be better still would be if regulators and bankers grabbed a clipboard as well – and analysed the micro-level incentives and stories playing out in the hedge fund world. Not simply at the disasters such as LTCM – but also at the 700-odd other funds that died last year without ever causing a panic.

Copyright The Financial Times Limited 2007

Market insight: How investors should respond to the M&A boom

By Mohamed El-Erian

Published: May 29 2007 17:10 | Last updated: May 29 2007 17:10

The mergers and acquisitions boom rolls on, slowly but surely changing the financial and corporate landscape. Spurred on by a record surge in private equity flows and enormously accommodating debt markets, the momentum of this shift is showing little sign of fading.

The impact is being felt across markets, particularly in the US where several indices have reached record levels.

But the M&A boom has helped to accentuate the contrast between buoyant market valuations and concerns about a US economy facing headwinds on account of a difficult housing market, a subprime mortgage debacle, high energy prices and large consumer debt

The joy of equity investors, especially leveraged ones, also contrasts vividly with the frustration of others. Investors betting on continued historical aberrations in market trends have continued to benefit so far. In contrast, those looking for markets to “revert to the mean” have been left frustrated.

The latter have continued to observe stark historical inconsistencies in market valuations, volatilities, correlations and liquidity. Yet their attempt to exploit these inconsistencies has been repeatedly disturbed by yet greater market aberrations. The “Theory of Second Best”, which dates back to the 1956 work of two economists Kelvin Lancaster and Richard Lipsey, provides a useful framework for thinking about all this.

Essentially, this theory looks at what happens when, in certain circumstances, one of the optimal conditions of a model is not fully met. Intuitively, when this happens, it might be supposed that the second-best solution involves continuing to meet the other optimal conditions of the model. The Theory of Second Best cautions against this. Instead, it suggests that a better outcome may involve deviating from these conditions.

When applied to today’s financial markets, the second best theory illustrates one of the ways in which investors have had to adjust their approach to take into account the manner in which emerging economies are allocating their large and increasing reserves.

These economies’ large “non-commercial” purchases of US fixed income products have introduced and sustained significant pricing distortions. And, as the Theory of Second Best suggests, the next-best solution for investors has implied betting on additional historical anomalies in other markets.

How has this worked? Large foreign purchases of US bonds have led to an unusual compression in bond yields and credit spreads. The resulting misalignment versus the equity risk premium has encouraged increasingly large leveraged buy-out activities which, in turn, attract even more capital to private equity.

No wonder M&A activity has surged. And, as the corporate landscape changes, companies with large cash holdings have been forced in, with some playing defence and others offence.

How long can this go on? For a while; but not forever. In the short term, the phenomenon has significant momentum that can only be derailed by a series of economic and technical dislocations. A single dislocation will not suffice as illustrated by the temporary setbacks of May-June 2006 and February 2007.

Over the longer term, valuations will be excessively divorced from the underlying economic realities, especially if the US economic slowdown intensifies. In addition, the risk of regulatory and political backlash will rise. Finally, the distortion that lies at the heart of it all – the non-commercial allocation of sovereign wealth funds – will slowly fade as emerging economies face pressure to increase the rate of return on their reserves and to allocate more funds to domestic uses.

Therefore, the basic challenge for investors is an outlook that is inherently fluid and potentially dualistic. The solution may well have three principal components: a strategic asset allocation that emphasises secular themes and a long-term destination; portfolio overlays that recognise the reality of an historically unusual journey; and a risk management process that is sensitive to the nature and evolution of the underlying market distortions.

 Mohamed El-Erian is president and chief executive of Harvard Management Company.

Copyright The Financial Times Limited 2007

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