It has barely begun

On Thursday, I attended a Goldman Sachs investment conference in Lucerne. Jim O'Neill, the firm's chief strategist, gave the keynote presentation containing an outlook for the world economy, which was surprisingly optimistic (this year's global growth rate is expected at 4.4% vs 3.9% consensus). To my question where deleveraging was in that picture, he answered that it wasn't because there is no reliable information about leverage available, and that we shouldn't trust anyone who claims to have it.

It appears to be more than a little cavalier to ignore a presumably major phenomenon simply because it is hard to measure. It is therefore very timely that MGI has just published a major report on debt and deleveraging. MGI looks at the buildup of debt at a per country and per sector level and distills four archetypal deleveraging scenarios from past episodes: Austerity, Inflation, Default and Growth. Unsurprisingly, they find that deleveraging has only just begun in a quite moderate way, as private sector debt reduction is compensated by increasing public sector debt.

Extreme risk

Watson Wyatt has just published a short paper on Extreme Risk with an assessment of impact and possibles hedges. Interesting stuff - I particularly liked the reference to Extreme Value Theory and the Association Matrix. The Association Matrix gives hints as to how some reverse engineered risk scenarios might have looked like if the team would have taken some more time to formulate them.

XBRL covers 60% of global market cap

Doing some research in preparation for a draft answer to CESR's Call for Evidence on standard reporting formats, I was curious to find out how much of the world's capitalisation is already covered by an XBRL mandate. I've thrown together a list of jurisdictions provided by Mike Willis that either already have a mandatory scheme of XBRL disclosure for issuers in operation or decided about its introduction. Using country weights of the MSCI World Index for developed countries (i.e. without China or India and others, both of which have or will soon have a scheme in place), this adds up to slightly above 60% of the "developed" world's equity capitalisation that is already covered by a mandatory XBRL disclosure scheme today.

While this is an encouragingly large share, it is still some ways away from the 90+% that I reckon to be necessary to encourage global investors to migrate the information infrastructure of their analytical processes to XBRL. Bringing the EU's market cap on board would bring us substantially closer to that important threshold.

UNCTAD on fair value

I've had the honour of addressing the Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting, twenty-sixth session in Geneva yesterday. The subject matter was implementation issues of fair value accounting in an IFRS context. To my great surprise, there was hardly any criticism expressed of the approach, neither from the panel nor from the floor.

Clones doing well

FT Alphaville points us to a paper "How do hedge fund clones manage the real world?", comparing the performance of 21 commercially available hedge fund replication products ("clones") in the period between April 2008 to May 2009. While the observation period is inevitably short, it nevertheless contains turbulent markets. The paper's conclusion is thus all the more remarkable, namely that clones perform competitively at a fraction of the cost of the underlying, and without much of the liquidity constraints of hedge funds also.

Separately, EDHEC finds the performance of cloning methodologies to be systematically inferior to the real thing. However, this study performs a proprietary cloning methodology. The significance of its finding is thus limited to the quality of those strategies. While being performed over a longer time period, we think that the above mentioned assessment of commercially available products is more practically relevant to investors.

Are you prepared to be compared?

These are the slides which I used at the breakfast presentation yesterday, hosted by Likemind at the SwissRe tower in London.

No return on closing DB plans

The July/August issue of FAJ has an intriguing article looking at empirical evidence of whether freezing DB pension plans would increase company value. Since cost and volatility impact on earnings are the justifications most often referred to for closing DB plans, the default expectation should be that it would. Yet, the authors cannot find any significant evidence of that.

They have been looking at the price reaction in four different event windows of 82 US announcements of frozen / closed DB plans between 2003 to 2007 in various industries. Interestingly, there seems to be a correlation between closure events and the generic business cyclicality of the firm's industry sector. Event firms exhibited stock market underperformance compared to their peers in the years leading up to the event.

Results indicate no systematic empirical evidence for positive abnormal returns associated with DB plan freezes / closes. Separating freezes and plan closures exhibits a small, yet unexpected diversion: Plan freezes generated a negative abnormal return, whereas the (small) sample of closures (for new employees) produced a more pronounced positive return.

In sum, it seems that DB pension plan closures / freezes tend to be short-term, ineffective measure adopted by managements to counter performance pressure.

BIS on the crisis and remedies

"And, in the future, a financial firm that is too big or too interconnected to fail must be too big to exist."

The Bank for International Settlements Annual Report is probably the only one that I read regularly for its content, rather than mine it for data. It contains authoritative interpretation of recent economic and financial developments, and is thus an important source of consensus narrative. This year's report is no exception.

Of particular relevance going forward is its chapter VII, outlining the current thinking about capital requirements by evaluating a Systemic Capital Charge and a Countercyclical Capital Charge. However, these capital charges appear to continue to rely on portfolio theory's (stable?) correlations, which is conceptually flawed, as we now know. Nevertheless, it is encouraging to see that countercyclicality is addressed not with perceptional placebos such as modified accounting standards, but with measures aiming at the economic heart of the matter, namely leverage and the capital base. Last, but not least: if Too Big to Fail were a victim of the crisis, it would have been worth it.

Victims IV: The real crisis

The Economist deserves praise for having featured a special report on the impact of ageing populations in this time of crisis, which overrides longer term requirements with its fiscal profligacy. The majority of industrialised countries were already on an unsustainable fiscal path before the crisis struck. It is difficult to see how government finances will ever be able to return to a trajectory that is stable longer-term.

It goes without saying that the foreseeable instability of public finances has a dramatic impact on capital funded retirement systems. At this juncture, the jury is still out on the prefix of instability, i.e. whether we will see inflation or deflation. Either way, the contradictory demands on the investment strategy of individual funds are anything but trivial and may need to be implemented consistently in very short order once the dust settles. Scenario analysis and preparation is the name of the game. I look forward to a workshop producing a Shell/Oxford-method scenario analysis on Switzerland 2030, to which I have been invited by the federal crisis management education unit.

Impact of accounting and prudential regulation on pensions

"A long-term view involves short-term risk, whereas a short-sighted strategy involves increased risk over the long term."

EDHEC just released its impressive report Impact of Regulation on the ALM of European Pension Funds. Even though we disagree in some instances, we think this is mandatory reading for anyone in the pensions investment space because it highlights those areas of regulation which will be of increasing consequence for pension funds' investment strategies in the near future, as we have continued to stress over the recent past.

At the core of the report is the development of an asset allocation model in the presence of liability constraints. The solution involves the components cash, risky assets and the liability hedging portfolio. The state of the art model takes inflation and longevity risk management into account as well.

There is not enough space nor time for an in-depth review of this valuable piece. Nevertheless, I would like to mention two issues that have slightly moderated my enthusiasm for the report:

• There seem to be a few at least implicit factual inaccuracies in the parts describing the regulatory environment. The most glaring of which may be the assumption that the EU pensions directive is applicable in Switzerland - it is not.
• Accounting standards seem to be understood to effectively determine investment action. While it is not unheard of that managements structure transactions in such ways as to optimise their reporting, this clearly goes one step too far. We are well aware of the interdependence between perception (qua accounting standards) and (economic) reality, but at least in an academic report, the latter needs to retain some vestige of predominance over the former. Remember: pension funds' long-term time horizon, as accounting standards can and do change.

Behavioural finance

Behavioural finance is a fashionable topic, of course, and an interesting one at the same time. It is useful to be aware, if that's possible at all, of the cognitive limitations of our decision making processes. Yet, I still have to see a useful active behavioural tool for investing - much of those uses seem to be limited to technical analysis.

This video reminded me of a similar presentation by Richard Thaler at this year's CFA Institute annual conference in Orlando. The biggest surprise in that presentation was that XBRL featured prominently in it as an important tool for improving financial decision making.

P.S. This podcast interview�with Ariely gave me some food for thought. There is probably a fruitful tension between the rational expectations axiom and what Ariely calls predictably irrational. It can be a rational to expect collective irrationality.�

On 2nd derivatives, green shoots and inflection points

We don't do investment advice on this blog. But all the hopeful talk about green shoots has also provoked this nice�Buiter comment. To turn bullish on the news of an inflection point after what may easily have been the world's sharpest inventory rundown in human history requires a foolhardy degree of optimism, given that the economic growth trajectory is no sinus curve - another inflection point may easily occur before we're actually coming across a turning point.�

Moving GIPS to the 21st century

Here is an idea that I am currently working to promote to the Global Investment Performance Standard community:

MOVING GIPS TO THE 21ST CENTURY

Context

CFA Institute's�GIPS�are similar to Accounting Standards in that they prescribe in some detail the concepts, requirements and procedures for reporting performance of asset managers' investment vehicles. The purpose of GIPS is to make asset managers' reported performance numbers consistent and comparable across several providers and facilitate manager selection by investors on the basis of the manager's track record. According to the CBRM, financial reporting is made for investors. The same applies to GIPS reporting. Therefore, the same compelling logic that has driven the SEC to mandate the�XBRL�format for business reporting of all listed entities and mutual funds in the US should apply in the case of (voluntary) GIPS reporting, at least in so far as the premises for XBRL reporting of GIPS numbers should be prepared.

In the course of the GIPS 2010 project, it is essential to lay the groundworks for bringing GIPS online, i.e. making GIPS reports even more quickly available and comparable with XBRL.

What is necessary?

As with financial reporting, the key requirement to enable GIPS reporting using XBRL is a�taxonomy. The GIPS taxonomy, like FASB's US GAAP taxonomy or the IASB's IFRS taxonomy, contains all the concepts and relationships of GIPS without impeding the reporting entity's flexibility in disclosing additional items by using its built-in extensibility. Taxonomies are usually created and maintained by cross-sectional working groups of stakeholders under the umbrella of an XBRL jurisdiction. The extent of the effort to build a taxonomy depends on the standard it is intended to represent. In the case of GIPS, it seems natural that CFA Institute takes on the responsibility for creating and maintaining the standard GIPS taxonomy.

What can be achieved?

The availability of a GIPS taxonomy is a necessary, but not a sufficient condition for establishing XBRL GIPS reporting. Preparers and users have to follow suit and establish practice. However, if the example of accounting standards is any indication, it is crucial that the Standard Setter (CFA Institute) endorses XBRL by creating a taxonomy for its standard and thus providing the infrastructure on which usage can be built.�

As�multiple case studies�show, deploying XBRL in the reporting value chain of GIPS will result in smarter, cheaper and faster GIPS reports: They are smarter because the validation procedures built into XBRL taxonomies from the start massively reduces errors in reports, thus also reducing the cost of preparing and verifying them. They are faster because they can be made available online immediately and can be compared automatically without re-keying any information.

Given XBRL's widespread and quickly expanding application in financial reporting, competing IT tools at all stages of the reporting process are already available and are improved continuously. These tools are usually agnostic of the taxonomy they are applied to, thus they are usable on GIPS reporting. It is easily imaginable that the�SEC's Mutual Fund Viewer�could be applied to GIPS reports, provided that they collected in a single location online. Perhaps there is another role for the CFA Institute in this? The ongoing parallel development of IT tools handling XBRL formated financial reporting constitutes a very important synergy that GIPS can take advantage of effortlessly.

"Resistance is futile ..."

And yet, the Borg are�effect-fully�resisted in Star Trek. Clearly, GIPS is a well established global standard�that works. It is therefore not immediately obvious to practitioners in the field why the plumbing of the process should be changed. Incidentally, there is no recognisable�need�to move to XBRL at the present.�

Yet, the transformation of the financial reporting process to XBRL has met and is in the process of overcoming the same resistance globally. The potential gains in transparency and process efficiency are too large to dismiss.�

Finally, there is another factor that makes the case for adopting XBRL in GIPS even more compelling: GIPS is not mandated anywhere (to my knowledge) and thus fully dependent on voluntary adoption as well as market demand. The availability of a GIPS taxonomy and CFA Institute's encouragement of the usage of XBRL in GIPS reporting would send a clear signal about how GIPS is being future proofed and made increasingly transparent and user-friendly.

XBRL - A Guide for Investors

CFA Institute has just published XBRL - A Guide for Investors. The title is pretty much self-explanatory. I'm glad to have contributed to it. Enjoy!�

Also on the XBRL channel: Yesterday, L'Agefi published an article I've written. But when you follow the link, you'll see that it is written in excellent French, which cannot be me. Thanks for the contact and the translation goes to Marc Barbezat, member of XBRL CH!

Investing in infrastructure

OECD has an informative recent overview paper Pension Fund Investment in Infrastructure. The author looks at whether or not infrastructure deserves to be classified as a separate asset class (the evidence is inconclusive), risk-return profiles and benchmarks and other key items. But most interesting is the assessment of the barriers to pension fund investments, of which there are a great many. These are probably hard to overcome, except for the best run of institutions.

The tyranny of the present

In a recent issue of its flagship publication Sigma, SwissRe described Scenario analysis in insurance, identifying scenario analysis as a key tool to analyse fat-tail risks and their impact on profitability and competitive position of insurers. One of the pioneering sources of scenario analysis is the approach developed by Shell. Whereas scenario analysis is referred to as a key tool for both strategic planning as well as enterprise risk management of insurance, Sigma reports with some degree of astonishment that banks do not use it to assess their total enterprise risk exposure.

Applying the concept of scenario analysis to pension funds should be self-evident, not least if you think of a pension fund as the insurance subsidiary of your firm. It faces a set of opportunities, threats and parameters quite similar to those of an insurance, yet scenario analysis is not common in the pensions industry. Nevertheless, a number of pensions-specific scenarios easily come to mind: a jump in longevity due to unexpected medical progress, prolonged negative real interest rates, a pandemic (as explained in Sigma), regulatory changes to the competitive landscape ...

The Economist Intelligence Unit has just come up with its own bleak exercise in scenario analysis (hat tip Global Guerrillas). Its central forecast of stabilisation is assigned a probability of just 60%, whereas the more disruptive instability scenarios are assigned 30% (de-globalisation) and 10% (collapse in USD) respectively. Scenario analysis has been posted as a means to escape the tyranny of the present, but being where we are today, we are not so sure this is a good thing.

Capital preservation

As an institutional investor, we are always interested in informative long-term charts. This one fits the bill, even though it is probably meant to shock today's investor with its implicit statement that there was no money to be made in 43 years of investment in the Dow.

However, some qualifications need to be made. The obvious one is that the chart is just a price chart corrected for inflation, but without taking into account the dividend yield, which is probably about 5% p.a. by now. Getting that kind of return on top of real, inflation-adjusted capital preservation on a long-term basis is no mean feat indeed!

Mortality-linked securities

The Pensions Institute has an excellent new paper on�Mortality linked Securities and Derivatives. The paper describes the problem (longevity risk) and what conclusions can be drawn from present experience in pensions buyouts and securitisation transactions. They also discuss the pricing of longevity risk in the absence of a liquid mortality-linked capital market. For a complete picture, we'd be interested in the fallout of the present turmoil in the asset-backet securities and credit derivatives space on mortality-linked securities ... �

Victims (III): Prudent Person in Switzerland?

Until the beginning of this year, Swiss pension funds were obliged to follow a detailed set of investment restrictions laid down in a government regulation, or obtain a formal waiver to deviate from these restrictions. The more sophisticated institutions have made use of that opportunity, which is why what once was supposed to be an exemption now had effectively become the rule.

This has changed with the new investment guidelines of articles 49 ff. BVV 2 which have entered into force on 1 January. The number of investment restrictions has been curtailed substantively and the alternatives asset class has been made available. Yet, the government has stopped short of introducing the prudent person rule as there are still a large number of small iorps which appear to feel more comfortable following a prescribed asset allocation, despite their objective needs. That is probably the line of thought that MPs followed who criticised the changed guidelines massively.  They seem to think that parliament knows best what an appropriate asset allocation strategy should be. It is unfortunate that even the most moderate of reasonable changes come under political pressure as a consequence of the crisis.

Effectively, the new investment guidelines are a reluctant, small step in the right direction. But they clearly fall short of the EU's state-of-the-art Pensions Directive 2003/41 in fundamental ways, most evidently in the restriction on equity investments to 50% rather than 70% as per the Directive. Also, a target return in line with money and capital markets and real estate returns seems to be at odds with member interests. Consequently, it is hardly surprising that the magic triangle of Risk, Return and Liquidity is cut down to a single Risk-Return line. There is also a degree of over-diversification in the prescription that alternatives exposure can only be taken through (expensive) collective means. Finally, there seems to be an editorial error in art. 60, which appears obsolete, given art. 50.4/5 (deleted by subsequent Regulation). There is a lot left to do. Here's to hope that the crisis will not preclude the necessary changes.

Wikinomics in finance?

I quite enjoyed reading Wikinomics, although it took far too long. It's an interesting and engaging overview of the latest impacts that mass collaboration has on all sorts of business models. I was particularly surprised to see how many big names were already successfully active in that space. Which begs the question why, apparently, none of them are in the finance industry?

In essence, the Wikinomics principles�consist in Being open, Peering, Sharing and Acting globally. Classifying these as principles implies that they are to be applied diligently and carefully as they might kill off any business model otherwise.�

Much of what being open, peering and sharing stands for appeared to be synonymous to me at first, so let me try to identify the differences. Transparency, or being open, could be seen as a catch-all term for peering and sharing. In the Wikinomics sense, it means to provide some sort of access to one's business model. Peering refers to a non-hierarchical production mode where control can only be exercised in a very limited way (for instance by providing a rule book and/or a platform). Sharing means that control over pieces of intellectual property is given up, implying that others can take advantage of it if they discover profitable ways to do so. Wikinomics impressively demonstrates the application of these principles in a number of industrial settings, mostly dealing with immaterial assets such as engineering knowledge, software, IP and other know-how.�

Those principles of wikinomics seem to be anathema to the domain of finance, though. Historically, this industry is rife with control, secrecy and exclusion. Is it inevitably so, though? I don't think so. It is probably inevitable when it comes to the client relationship (yes, the Swiss perspective) and the deployment of capital, which is exclusive by nature. Also, the characteristic of finance as a regulated industry will constrain the applicability of wikinomics as long as it is not embraced by the regulator.�

When it comes to all other aspects of know-how in finance (risk management, asset management, investment research etc), however, I see no reason why they could not be profitably opened up to wikinomics, especially when there is a premium on transparency in times of crisis. The Tapscotts themselves propose to apply wikinomics to risk management, but unfortunately, they stick rather close to the surface IMHO. It will be interesting to watch IBM Data Governance Council's initiative for XBRL in risk reporting.�

However, without regulatory leadership or at least explicit support, such initiatives are destined to fail or thrive only in un-regulated niches, which are likely to shrink going forward. �A pet project for Ms Schapiro? Here's to hope!

Redefining Old

Nomura has an excellent piece of research out that goes well beyond what that genre usually entails in the brokerage space. The Business of Ageing is an extensive discussion of the key risk of the pensions industry that is longevity, its implications for the real economy, financial markets and the major industries. I particularly value the section about longevity with its discussion of the technophysio approach which, in combination with longevity convergence across countries, is posited as leading to rapid longevity growth. Where official UN projections arrive at an average life expectancy of ca 85 years in 2050, Nomura models predict ca 90 years.�

Redefining Old refers to another interesting aspect of the paper: Whereas a social security definition in terms of years lived will lead to an increasing share of the "old" cohort burdening social security, the authors argue that with increasing healthy life expectancy due to morbidity compression, it will be reasonable (i.e. necessary) to expect people to work (much) longer. The authors pinpoint that age at about 80, which would be suicidal for any politician to ask for. Note that this blog has argued for the same number before.

Virtually unseen in brokerage research is the extensive, up-to-date scientific apparatus provided. The label useful is fully deserved.

As a side comment: In spite of Switzerland's claim of having an exemplary retirement system that is the envy of the world, her only (and favourable) appearance in the paper is in a table about obesity ...

Death and taxes ...

This is an excellent presentation by Governor Jens Thomsen of the National Bank of Denmark, on how to hedge and invest in an environment where average life expectancy rises by over 5 hours every day. He proposes that governments should issue more ultra-long term bonds to create a hedging substrate for that time horizon.�

What Thomsen does not address, however, is the challenge to such instruments arising from an investment environment with massively higher government debt, as it is foreseeable in many countries. The temptation to apply the inflation tax to reduce such debt may be overwhelming, which is why such ultra-long bonds should be issued with an inflation protection.

Accounting politics

On Saturday, Finanz und Wirtschaft has published an article of mine in which I discuss�the background to the current tensions in accounting politics between the EU and the IASB. To the casual observer, this conflict may look like it is entirely related to the financial crisis, but it is more about the independence of the IASB than anything else. That's where the interest of every investor should come into the equation.

Innovative ways of financing retirement

In this day and age where financial innovation is (wrongly!) blamed for the end of capitalism and the world as we know it lock, stock and barrel, the title of SwissRe's latest edition of Sigma is courageous. Nevertheless, it is a comprehensive assessment of the growing role that insurance will have to play in the provision of old age retirement funding, where insurance is to be understood in a functional rather than an institutional sense.�

An important section of the study is dedicated to managing retirement product risks. Longevity risk is identified as prominent among them, but its management is limited by the rather shallow depth and breadth of longevity risk markets. Notably absent from that section, however, are considerations on valuation techniques. If there is one thing that we can learn from the current crisis, then it is how crucially important it is to value & stress test innovative products properly over their entire life cycle.

XBRL for Investment Professionals

It's nearly a month that said conference took place in London, and I have yet to blog about it ... some of the reasons for that delay probably co?ncide with the reasons why a relatively small group of less than fifty professionals came together for an event that has been organised by CFA Institute, EFFAS and the IASCF, namely current market dislocations. In the face of that, an infrastructure undertaking such as XBRL takes second place with many.

Nevertheless, participants tended to be quite happy with the conference and commented favourably on the quality of the audience as well. The relatively small size of the audience made it possible for the audience to interact with each other and to participate actively in the Q&A session, which is very helpful when you're the moderator ...

Here are the presentation slides. It's a pity that David McGraw's slides are not available, because his and Homi Byramji's presentations struck a strong chord with me. In David's case it was the breadth of the potential applicability within a leading institutional investor's processes, and the challenges that XBRL has to respond to (data governance!), whereas Homi was demonstrating clearly that, other than Encyclopedia Britannica, Thomson Reuters is not going to be asleep on the wheel in the face of the challenge to the middle man posed by XBRL. Personally, I am fairly confident now that XBRL is a sustaining innovation for information intermediaries.�

Shortly before the conference, Finanz und Wirtschaft published an XBRL update that I wrote. And there is one more update: XBRL CH is now officially a provisional Jurisdiction!

Deconstructing financial mythology

In its aptly numbered working paper 666, the Minneapolis Fed deconstructs (for the USA) what it claims to be the following four credit crisis myths from publicly available data up to 8 October 2008:

1. Bank lending to non?nancial corporations and individuals has declined sharply.
   
2. Interbank lending is essentially nonexistent.
3. Commercial paper issuance by non-financial corporations has declined sharply and�rates have risen to unprecedented levels.
   
4. Banks play a large role in channeling funds from savers to borrowers.
   

There is not much reading to do as the authors rely on graphical evidence. (via MR)

P.S. And here's follow-up ... I'm sure there's more to come.

Truth or dare?

EDHEC has made available an interesting survey of current European investment practices, comparing actual practice with recent state of the art in the investment literature. It's a feature of such a survey that practice cannot really look all that good since there will invariably be a time lag between conceptual groundworks and practical implementation. But it transpires from the results that practice does not seem to look to finance literature for competitive advantage by implementing the latest innovations, such as how to handle tail risk.

This conservative approach is probably due to a behavioural bias in the investment community to avoid the risk of being wrong and alone, and it is not likely to change anytime soon, what with the bad press that financial innovation has these days. But in true contrarian spirit, I'd like to point you to this insightful�praise of financial innovation.

Consult the survey and compare it with your firm's practice for your own private game of truth or dare ...

Evaluating short extension funds (130/30)

The current issue of the FAJ has a great piece about How variation in signal quality affects performance. On the face of it, the article deals with the generic perception that any relaxation of investment restrictions (read: long only) will invariably result in better performance. This is the selling proposition of currently fashionable 130/30 funds. But it doesn't - or only in the special case of an information coefficient which is stable over time. Managers with unstable ICs will see their performance deteriorate with increasing short positions.�

This approach delineates a way to help evaluating 130/30 funds which do not have a long enough track record in the product (i.e. the majority of vendors), but a more significant one in long only mandates. If that track record were to exhibit an unstable IC in long only portfolios already, then there might be a problem in the short extension.

Prediction markets

Let me be explicit from the start: I have a problem with the judgmental connotations of the term speculation. In my view, there is no meaningful distinction between investing and speculating. Investing as well as speculating is about the assumption of risk in return for the uncertain possibility of reward. There is only inappropriate investment or speculation, but not bad speculation per se.�

The cause for these rather philosophical considerations is my interest for prediction markets such as intrade, where you can effectively trade in all sorts of event probabilities. Literature has it that predictions produced using a bid/ask mechanism with real money will be of significantly better quality than survey forecasts for instance. Naturally, they cannot tell the future, but they will be more efficient at processing all currently available information than any one expert. Therefore, these markets serve two important purposes: If reasonably liquid, they offer high quality, quantified predictions of event probabilities of presidential elections or hurricane landfall severities, and they offer a hedging possibility, although the liquidity is definitely a limiting factor there at this point.

It is very timely that the CFA Institute has just published the results of its last Monthly Question survey about prediction markets. 65% of respondents think that such markets offer valuable information, and a majority of 54% think that they are fit for investment purposes (mostly hedging).

Challenges in Quantitative Management

At last, I got round to finishing Challenges in Quantitative Equity Management, a freely available CFA Institute Research Foundation monograph by Fabozzi, Focardi and Jonas. The book is based on surveys and conversations with practitioners of quant management, capturing the collapse in industry outperformance following the summer of 2007. I was particularly interested to find out whether there would be any attention paid to XBRL, which I suspect should be quite relevant to quant management, but it wasn't even mentioned throughout the book. That's not to say it is considered to be irrelevant: Too many people using similar models and the same data was considered to be one of the major challenges to the quant approach going forward.�

Nevertheless, it is a worth while read for a number of thoughts and discussions, such as the distinction between quantitative and judgmental investment processes, the style correlation of quant management (which tend to be value-driven), the negative correlation between fund capacity and alpha-generation and, last but not least, the adaptive markets hypothesis as opposed to the efficient markets hypothesis.�

A Plunge Protection Team?

While certainly no friend of conspiracy theories, I feel distinctly uncomfortable reading this well documented piece by a reputable source about the US government's alleged involvement in undercover equity market manipulation, a.k.a market stabilisation, in the name of national security (via naked capitalism).�

CEIOPS State of Pensions Report

CEIOPS'�Report on financial conditions and financial stability in the European Insurance and Occupational pension fund sectors has a good section (starting p. 22) about recent developments in the European pension funds market, giving insights into last year's changes in a number of countries and a statistical overview, based on Eurostat.

XBRL for Investment Professionals

The CFA Institute, EFFAS and the IASC Foundation are hosting the first XBRL conference for Investment Professionals in London on 26 September 2008. Thanks to the recent rule proposals of the US SEC applicable to corporate filers and mutual funds, there should be a lot of interest in that topic. Registration is now open!

nomos vs. thesis

High quality private banking investment commentators with an independent mind are few and far between. The most prominent instance in the Swiss market is Konrad Hummler, partner of Wegelin & Co. His monthly investment commentary is well considered, independent and often controversial - and available in English. The current May issue deals with the moral hazard of banking supervision in its current zero failure mode. Recommended reading.

Financial anti-matter

The recent paper "Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures" approaches this extraordinarily timely question from an unusual angle: practice. The fashionable economics ingredients promise to make it no less appealing: behavioural finance, disequilibrium and reflexivity theory. The authors question some of the most basic assumptions of the commodities futures markets and propose a hedging response model that distinguishes between four different market scenarios which may result in markedly different systematic roll returns. While the predictive value of this model is not immediately obvious, its ex post explanatory power is quite impressive. Most surprisingly, it is a good read, too. Here is their answer to the question:�

Answering our own question is managed futures is an asset class? It is anything, but ... If anything, it is the "anti-asset class". It is an observable materialization of behavioral finance, where risk, return, leverage and skill operate un-tethered from the anchor of an accurate representation of beta. In other words, it defies rational expectations equilibrium, the efficient market hypothesis and allied models?the CAPM, arbitrage pricing theory or otherwise?to single-handedly isolate a persistent source of return without that source eventually slipping away. (...)�Unbeknownst to modern finance, the commodity futures markets may be the shoals against which rational expectations equilibrium, the "de facto ruling paradigm of financial economics," is eventually shipwrecked.

In view of this and particularly this, it may perhaps be time to indeed revisit one's CF long exposure, which has been entered into on the possibly naive assumption that the futures markets are tightly monitored net zero sum games that have no impact on the spot markets.�

Analysis of competing hypotheses

The US Central Intelligence Agency's reputation for analytical accuracy may have been tarnished lately, but nevertheless it can provide useful generic tools for analysis under uncertainty. The chapter on Analysis of Competing Hypotheses from the publication Psychology of Intelligence Analysis�is such a case in point: it describes in some detail the procedure how to arrive at the most likely hypothesis by way of analysing competing hypothesis, knowing that - against intuition - the hypothesis with the least evidence against it is often the best guess. The rigour of this approach may be excruciating, but it is also the most promising in my view.

Counterparty risk in credit markets

As pension funds increasingly seek to efficiently manage their balance sheets, they invariably come to rely on OTC derivatives, by way of which they become exposed to counterparty risk. On 20 February, thus shortly before 16 March which saw the US Fed-assisted emergency neutralisation of Bear Stearns counterparty risk, Barclays Capital issued a research note that assessed the transmission vectors and systemic fallout of a major counterparty's default. The knock-on effects due to immediate re-pricing of credit risk would amount to an estimated USD 36 - 47 bio for an imputed outstanding notional of USD 2'000 bio. Bear Stearns' notional was well over six times that number.

The (Mis)Behaviour of Markets

Benoit Mandelbrot's The (Mis)behavior of Markets: A Fractal View of Risk, Ruin and Reward (2004) is quite an intriguing read during these days of murderous market volatility. The list of his Ten Heresies in Finance goes a long way in giving a hint of his thinking, which is centred around his claim that the use of normal distributions in financial market modelling is a capital mistake:

Markets are turbulent.

Markets are very, very risky - more risky than standard theories imagine.

Market timing matters greatly - big gains and losses concentrate into small packages of time.

Prices often leap, not glide. That adds to the risk.

In markets, time is flexible.

Markets in all places and ages work alike.

Markets are inherently uncertain, and bubbles are inevitable.

Markets are deceptive.

Forecasting prices may be perilous, but you can estimate the odds of future volatility.

In financial markets, the idea of Value has limited value.

Oil money

The McKinsey Quarterly has a great piece on The new role of oil wealth in the world economy. For me, this raises two broad issues. The first one is a continuation of the closing concern of the piece, namely the question whether higher oil prices can be good for the world economy. I think on a macro-level, this is possible. As long as the majority of the oil revenue is�re-funnelled�into the financial markets (i.e. is not being spent for consumption), it is tantamount to (forced) higher savings by net oil consumers with - admittedly - an ownership transfer of those savings to oil producers. So, oil producing countries build capital in�lieu�of the US citizen.�

Secondly, Sovereign Wealth Funds (SWF). These vehicles have captured a lot of attention lately. Unjustly so, in my view. The operational question is: What is the difference between SWF and regular institutional investors of the same size? Allegedly, the SWF is sovereign, i.e. it is controlled by (typically foreign) politicians who cannot be trusted to have commercial interests only. This argument is moot for two reasons: 1) regular institutional investors (especially, but not exclusively of foreign origin) may not only be motivated by strictly commercial reasons either, and - 2) if a controlling investor in a country's strategic asset abuses her property rights, the country of residence can, as a rule, limit that investor's property right, which is a function of the country's legal framework. Such ad hoc interventions are much preferable to introducing permanent limits on the free flow of capital, which invariably will create costly distortions.

The future of public pensions

Richard Ennis' article�in the current issue of the Financial Analysts Journal may be aimed at the�ailment�of US public pensions, �but its tenets are equally applicable to European (including Swiss) public pension plans as well. A key issue is that of valuation, where current actuarial valuations are traditionally predominant under the pretext of perennial solvency of the state sponsor. Ennis convincingly demonstrates that the "issues are the value of the obligation, the cost to extinguish it, and on whom the burden of that cost falls. In a word, the concern is accountability." From a Public Choice perspective, his tenets are unlikely to be put into action just now, unfortunately. The increasing gulf between public and private pensions will have to get wider before this can be addressed fundamentally.�

EDHEC alternative investments days

Very commendably, EDHEC Risk has decided to make the full documentation of its recent Alternative Investment Days 2007 available to the general public. This includes the much discussed - and dearly sold - paper about passive hedge fund replication�as well as a lot of other interesting stuff.�

CDI vs. LDI?

Wilshire has a fairly interesting white paper out with the title Commitment-Driven Investing (CDI): LDI as We 'C' It. The paper's rather semantic focus on commitment rather than liability is probably a consequence of its US accounting context, so we are not going to hold that against it. The thrust is certainly correct, namely that CDI, i.e. the Wilshire variety of LDI is aimed at managing the true economic funding ratio of pension plans and is therefore inherently a risk management technique.�

Confusing at best however is the frequent reference to two equally important (but partially conflicting) goals of CDI, whereas the only correct objective (from the sponsor's perspective) must be to minimise the cost of running the plan at a given level of benefit security. Also, the authors seem to be struggling - quite fashionably, one might add - with the rationale behind marking-to-market of pension liabilities. The impending revision of IAS 19 will deal with that issue.

Their conceptual conclusion, nevertheless, is an intriguing one: The�commitment discount rate is set to be a random variable described by the expected inflation characteristics of the individual plan's benefit stream. This is where the authors can start their optimisation engines, hopefully without being blinded by the light of past correlation stability.�

While we feel more comfortable with the more comprehensive approach recently proposed by Waring & Siegel, the authors deserve a prize for originality as this paper is the first that I know of to include the complete lyrics of a Springsteen song.

Impact of funding risk

Interesting material our way comes! Watson Wyatt has had a close look at the funding status of Fortune 1000 companies 2004 - 06 with effective numbers becoming available for 2006 thanks to FAS 158. WW has developed a Pension Risk Index, which estimates the loss of the pension plan in percent of the corporate's market cap at a 5% probability of unfavourable market conditions, given the plan?s asset allocation, liability structure and sensitivity to interest rates.

An excellent article in the current issue of the Financial Analysts Journal goes an important step further: The author estimates the correlation between pension fund deficits and associated credit spreads. The results are statistically significant and show interesting characteristics: The sensitivity of spreads to unfunded pension liabilities is about five times larger for junk bonds than for investment grade bonds. Also, the sensitivity to pension liabilities is much larger than to ordinary long term debt - double for investment grade, triple for junk. The model was also run for samples from the UK and Japan, but those results only confirmed a generic sensitivity.

This is where the relevance of pensions for corporate finance becomes evident. We expect that the relevance will increase thanks to better, more relevant accounting information and increasing market attention.

Sustainability investing

In its 2007 Business in Society Anthology, The McKinsey Quarterly has - among numerous other interesting articles - an interview about Socially Responsible Investing with upcoming Nobel laureate Al Gore and David Blood, partners in Generation Investment Management.

In related news, the World Bank has identified impact and source vulnerabilities of the world's countries in order to delineate country stakes in upcoming climate negotiations. Countries with high source vulnerability face above average negative consequences of climate change measures, while countries with high impact vulnerability are expected to suffer most from the consequences of climate change. As shown on the map, the two types of vulnerabilities are far from congruent, which means that negotiations will be very difficult.

CFA Institute podcasts

The CFA Institute is revving up its web based offering with interesting educational audio content that you can subscribe to, a.k.a. podcasts. Right now, it's only the audio stream of presentations and articles, but I hope that the presentations will soon be complemented by the slides that the speakers talk about. Here are the links to the RSS feeds in iTunes: Conferences and Events, CFA Institute generated items, CFA Institute Pubs.

Global Graying Report

Standard & Poor's has an interesting update of its Global Graying Report, which projects the current fiscal policy stance in conjunction with forecast demographic expenditures to arrive at hypothetical future ratings. It is a pity that Switzerland is missing from the simulations - France for instance goes from AAA today to Speculative in 2040.

Valuation of Swiss IORPs

Well known Swiss accounting and pensions expert Carl Helbling has a highly relevant piece on the valuation of Swiss pension schemes. In it, he comes to a rather disturbing conclusion: "Accounting standards IFRS and Swiss GAAP FER are too undifferentiated and can only be a limited basis for valuation [of pensions]." He lists a substantive number of instances, where, for legal reasons, apparent over- or underfundings of Swiss plans cannot be utilised as expected economically. Thus, accounting numbers may be substantially different from effective values.

Now, this is not exactly news as IAS 19 is hardly known to reflect economic reality thanks to its built-in shortcomings. But the instances listed do not even appear to be related to IAS 19 features to start with, but rather to what needs to be considered as accounting artefacts in the light of (legal) reality. One wonders how such numbers can be presented as true and fair?

Sovereign wealth funds

Deutsche Bank Research has a comprehensive piece about sovereign wealth funds, including an overview of the most important funds, their systemic risk factors and of control mechanisms for foreign direct investments. Deutsche asks for increased transparency and a global code of conduct for such vehicles - both highly sensible petitions.

Global upward trend in profit share

The BIS has an interesting working paper #231 on The global upward trend in the profit share. The paper addresses the rising share of value added going to capital rather than labour, a trend which is in evidence since the mid-1980s. The authors claim that this is not a cyclical development (unless you take Kondratiev-cycles into consideration, which they do not), but a fundamental shift explained by faster technological obsolesence of capital goods. The implications of this assessment are far reaching, not least with regards to the sustainability of equity valuations.

Lifetime financial advice

The Research Foundation of the CFA Institute has issued a new monograph on Lifetime Financial Advice - Human Capital, Asset Allocation and Insurance by four distinguished authors: Roger G. Ibbotson, Moshe A. Milevsky, Peng Chen CFA and Kevin X. Zhu. For a summary, let me quote from the foreword:

The largest asset that most human beings have, at least when they are young, is their human capital? that is, the present value of their expected future labor income. Human capital interacts with traditional investments, such as stocks, bonds, and real estate, through the correlation structure. But human capital interacts in even more interesting and profitable ways with life insurance and annuities because these assets have payoffs linked to the holder?s longevity. The authors of Lifetime Financial Advice present a framework for understanding and managing all of these assets holistically.

This complex issue is approached in a systematic, model based fashion from the perspective of the individual investor. It may not, therefore, hold as much interest to the traditional institutional investor managing retirement monies collectively. Private wealth & insurance product managers should be able to find plenty of food for thought, though. But not only them: this short monograph should be essential reading for everyone who needs to be financially literate.

Pensions directive to be revised 2008

In its annual report, CEIOPS gives an overview (p. 47f) of its past & current activities. Its Occupational Pensions Committee (OPC) is working on putting together materials for the revision of the Pensions Directive that is scheduled by the Commission for next year. Areas of material legal uncertainty to be clarified are concepts such as fully funded, ring-fencing or the calculation of technical provisions.

Incentives for DB plans

The Governor of the Bank of Canada, Mr David Dodge, has been singing defined benefit pension plans' praises in a recent speech. He recognised that "an effective defined-benefit pension system is a tremendous asset for individuals, for employers, and for our society as a whole", but is currently hampered by a number of disincentives, which favour DC over DB for sponsors. Specifically, he lists

uncertainties over the legal status of actuarial surplus

overly restrictive solvency requirements,

transition from smoothed accounting numbers to fair value accounting

group longevity risk

insufficient transparency about cost / financing of newly introduced benefits

lack of large multi-employer DB plans.

We agree with both parts of the analysis, namely that DB plans are preferable to DC, and that there is currently a lack of incentives for DB plans. We strongly disagree however with Mr Dodge's opposition to fair value accounting. He claims, essentially, that we are not interested in today's values, but in expected values far into the future. We think that analysts of pensions are very much interested in today's values. For one, every expected future value can be discounted to a current present value (assuming that the term structure holds). Thus, Mr Dodge's distinction would essentially become moot.

More importantly however, it is not at all clear at which specific point "far into the future" the expected value would need to be formed - surely that cannot be discretionary? How about changes to those expected future values, based on variations of underlying assumptions? Finally, the volatility introduced to sponsors' balance sheets is not artificial, it's an economic fact. Cognition of that fact is a prerequisite of sponsors' ability to manage the inherent economic risk of their DB plans and, therefore, an enabler of an effective defined-benefit pension system.

Corporate Finance meets pension management

"Pensions are being transformed from off-balance sheet operations with results smoothed over many years, to large consolidated business units with high potential short-term volatility, bringing them to center-stage for executive managers."

Earlier in the year, JP Morgan has come up with a white paper that is very much in line with our thinking: Corporate Finance meets Pension Management: A new era for pension leaders. The paper is obviously targeted to the US market struggling with implementing the Pension Protection Act of 2006 and US GAAP SFAS 158, but as accounting (and regulation) follows economics in Europe, too, Europeans are well advised to consider this a sneak peek preview of their own not too distant future.

JP Morgan established a set of three strategic pension metrics, namely shareholder equity at risk, corporate cash flow at risk and earnings at risk. These metrics measure the impact of pensions on the respective variable of the sponsoring corporation. Putting the metrics into action will lead to important changes in the pension plans' risk exposure: JPM expects a shift from the currently too high equity exposure into an allocation of 25%-35% in non-traditional assets. As the paper originates from JPM's asset management arm, I have a feeling that the wish may have been father to the thought ...

"Prudent investor" for Switzerland?

NZZ reports the results of a survey among 172 Swiss institutional investors with CHF 211.7 Bio (EUR 128.3 Bio) assets under management. They have been asked to give their opinion on the rather restrictive set of detailed investment rules applicable to Swiss occupational pension funds. A majority of funds voiced their preference for the prudent investor rule to replace the incumbent detailed set of rules. The available exemption from detailed rules of Art. 59 BVV2 is reported to be used by 80% of funds and thus has become the rule.

Unfortunately, detailed results of the survey appear not to be available online.

Regulatory distortion

IPE refers us to an interesting OECD study modelling the optimal asset allocation for an identical pension fund, over a 30-year period, according to the regulations of five OECD pension jurisdictions. It found an identical pension fund which was fully funded according to UK standards would appear 87% funded in the Netherlands and 69% funded under German rules. Optimal asset allocation strategies also differ between the jurisdictions. Since good regulation should at least attempt to not distort economic reality, this certainly looks like an interesting paper.

Institutional hedge funds?

Some will find this excessively dogmatic, but I still subscribe to the view that there is no conclusive evidence yet of the need for hedge funds (meaning active absolute return strategies) in the institutional asset management business. To provide such evidence, it would be necessary to demonstrate that hedge funds' risk-adjusted performance after fees is located on the efficient frontier over an entire market cycle, and that would have to hold in the present constellation with relatively huge allocations to the segment.

In my view, hedge funds are perfectly appropriate for private wealth because of individual investors' known disproportionate avoidance of loss. In the case of institutional investors whose equity is subject to volatility of assets and liabilities, absolute return strategies may be net inefficient at best, or they may even create additional asset/liability mismatch and thus be entirely counter-productive if considered from a comprehensive balance sheet risk management perspective.

That being said, the traditional distinction between hedge funds as providers of absolute return strategies on the one hand or alpha engines on the other becomes increasingly blurred. It is therefore advisable to keep a close watch on the industry, especially given the recent competitive pressure on excessive and asymmetrical fees exerted by institutional investors (epn story).

Commission addresses differential taxation of investment income

Following complaints by the EFRP, the Commission has initiated Treaty infringement proceedings against a number of member states which do not grant the same preferential tax treatment of investment income (interest, dividends) to pension funds resident abroad as domestic funds receive. Even though there is no direct reference to the Pensions Directive in the text, the relevance of this step to an efficient investment regime of cross-border pension funds is obvious. (FT)

Mitigating cost of ageing

McKinsey has an interesting Chart Focus displaying the mitigating effect of direct & indirect policy measures on the opportunity cost to growth of ageing societies. By far the largest effect could be had in Germany by raising the average rates of return on savings, which would not appear to be outlandish, given the notoriously conservative nature in which German savings tend to be invested. Immigration and higher fertility pale in comparison.

Institutional Life Markets Association

IPE has an interesting story about the recent foundation of Institutional Life Markets Association (ILMA), a non-profit trade association to ?encourage best practices and growth of the mortality and longevity related marketplace?. Founding members of this potentially highly relevant association are Bear Stearns, Credit Suisse, Goldman Sachs, Mizuho International, UBS and West LB AG. The association does not appear to have a website, yet.

CFA Magazine finds

The CFA Magazine often is a good source of interesting material, written in a competent, yet conversational style. Cases in point are Stephen Brown's article about RIXML, an electronic data format similar to XBRL, but specialising on research information and therefore not quite as pervasive as XBRL, and John Rubino's excellent piece about global liquidity, providing insights into the global yield curve and failing monetary policy in the presence of free flows of capital and the carry trade.

Draft Swiss pension law

Swiss pensions association ASIP has published a concise draft of a revised occupational pensions law to assist the ongoing debate about simplifying the overly complex current law. Surprisingly, this draft still does not refer to the prudent person rule in its asset management section. Encouragingly, the draft does away with politically set rates such as the conversion rate or the guaranteed minimum return.

At the same time, ASIP has published the executive summary of a research paper examining the alleged over-capitalisation of the Swiss second pillar with a view to reducing the full coverage requirement. Some of the arguments proffered are truly surprising: foreign investments are used as evidence of an over-abundance of capital. Unsurprisingly, the authors conclude that there is no indication for too much saving and that it is reasonable to maintain the full coverage requirement.

2007 asset allocation survey

Mercer IC published its periodic asset allocation survey of European pension funds. Of the 651 funds surveyed, 75% still reside in the UK, thus the survey's cross country comparison may not be entirely reliable (via VF).

Financial investments in commodities

Commodities investments have caught the supervisory eye, it seems. In its latest Quarterly, the BIS published interesting research about Financial investors and commodity markets. Specifically, it addresses the questions whether the exploitation of perceived profit opportunities by financial investors has fundamentally changed the relationship between prices and the physical characteristics of commodity markets and whether the broadening of the investor base has led to significant market deepening and hence affected features such as short-term price fluctuations.

The latter question is answered quite in the affirmative, while the former is more difficult to address. The BIS notes a significant divergence of long-dated futures prices (in crude oil and copper) from estimates of current marginal production costs since 2003. In efficient markets, expected marginal costs should act as anchors for long-dated futures prices. However, the research offers several fundamental reasons for such divergences, hence they are not necessarily a consequence of portfolio investments.

Annuities: a private solution to longevity risk

Its title may appear a bit facetious, but the latest issue of SwissRe's Sigma is anything but. It contains a comprehensive overview of the challenges to capital based retirement provision arising from increasing longevity. The prime focus of the publication is on insurers and insurance products, naturally, but most of its considerations and precepts are directly applicable to non-insurance pensions providers. A very worthwhile read for everyone in the retirement business!

Commodities investing

The UK Financial Services Authority has just issued a paper about risks and challenges in the growing commodities investment segment. Most of the paper is a wrap-up of conventional wisdom, but it is nevertheless worth mentioning that the FSA recognises the wide use of algorithmic trading (with associated technical risk) and that, surprisingly, UK pension funds are barely invested in this asset class to date. Consequently, the consensus view is that the growth of portfolio investment in commodities is set to continue.

Regulatory risk in Poland

Sometimes, Poland can be a confusing country, especially when it comes to pensions. Therefore, it is valuable to have the occasional helicopter view paper, such as the IMF's recently published Technical Note on Competition & Performance in the Polish Second Pillar. The paper contains a description of the structure & function of the Polish retirement provision system in general and the second pillar in particular. That's where appearances can be confusing: The Polish second pillar is evidently not equivalent to occupational pensions in the sense of the Pensions Directive, which is why the Directive's investment guidelines are not directly applicable. Nevertheless, the systemic home bias of the Polish second pillar remains an issue, probably even a self-re?nforcing one thanks to the considerable asset accumulation in the industry. epn also has an interesting piece covering that issue.

Global institutional investors

The Committee on the Global Financial System hosted by the BIS recently published a paper on "Institutional investors, savings and asset allocation". This paper tries to assess the impact of ongoing regulatory and accounting changes on the behaviour of institutional investors, whose assets under management are seen as rapidly catching up with those of the banking system, therefore warranting central banks' interest with a view to the stability of the financial system. The impact of regulatory changes on market rates and asset prices is another important consideration. The report's main theme is the ongoing transfer of risk from institutional balance sheets to the household segment.

Two side notes on Swiss pension funds: Available information about their assets & allocation is two years older than other countries', and their equity exposure is considerably below average.

The chocolate connection

Last Tuesday saw an interesting convention on the shores of lake Geneva at the sumptuous estate of Baron Rothschild and his company. The topic of the well attended conference was pan-European pensions in general and the Belgian incarnation thereof in particular. The list of speakers could not have been of higher calibre: The Prime Minister together with two cabinet ministers and high level representatives of the EU Commission and the Belgian pensions supervisor. Their objective was to introduce the Belgian legal framework for the newly created legal entity Organisation for Financing Pensions (OFP). They did this quite effectively, albeit on the only neutral territory in Europe where the Pensions Directive is not applicable.

The OFP seems to be a highly attractive entity to provide pan-European pensions with. It operates on zero (income, capital, VAT) tax, it can provide solidarity across several pension plans (which is attractive for efficient capital allocation), it reflects no other restrictions on asset management than the Directive's prudent person principle, it may rely on Belgium's extensive network of double taxation treaties, it takes advantages of Belgium's recent transition to EET, it is not encumbered by a Pensions Protection Fund levy and last, but by no means least, the valuation of its liabilities may be based on a discount rate that incorporates expected returns, thus may go as high as 6%. A word of caution may be in order here, though: It is not clear whether the long term consensus expected return used to derive that attractive discount rate takes into consideration recent literature on the proper calculation of expected rates of return.

Jean-Pierre Steiner of Nestl� Capital Advisers shed some cold water on participants' hopes that pan-European pension plans might fully replace local plans in the near future. In his view, this is an ambitious long-term objective reaching beyond his active lifetime. Nevertheless, he put Nestl�'s considerable weight behind the support of Belgium as the currently most attractive location for pan-European pension funds.

Also of interest was Mr Van Hulle, the EU Commission's representative's comment that he wasn't opposed to supervisory shopping, which is of course tantamount to regulatory shopping - something that tends to be frowned upon elsewhere. Equally interesting to Swiss listeners was Mr Wymeersch's note that Belgian first pillar institutions may be falling under the Directive, which seems to be in direct contradiction to the Directive's scope and is of particular interest to Liechtenstein as well.

Financial Analysts on Pensions

The January/February issue of the CFA Institute's Financial Analysts Journal is fully dedicated to pensions and retirement provision from an asset management perspective. Essential reading for all subscribers to this blog!

Mortality bonds

Our earlier story seems to have been very topical. epn also has an interesting piece on the securitisation of longevity and recent developments therein. All this co?ncides (probably not randomly) with an extreme mortality securities for some mortality risks in France, Japan and the US being successfully issued by SwissRe in November of last year.

Securitising mortality

SwissRe's latest issue of Sigma is dedicated to Securitisation - new opportunities for insurers and investors. It presents a good overview of structures, instruments and recent developments in the market for insurance linked securities (ILS), which has been booming in recent years, and is expected to continue to do so because of its more favourable regulatory treatment in the context of Solvency II and a dearth in insurance capacity otherwise.

The hitherto virtually untapped market segment of extreme mortality might prove to be exceptionally interesting for pension funds because of its potentially long duration, its size and its natural hedging capacity for pension funds: a mortality bond's payout is negatively related to longevity, which is one of the principal risk factors affecting pension funds' liabilities. To be an effective hedge, the populations covered need to overlap significantly, though. SwissRe estimates a current market size of USD 5'500 bio, which it expects to grow to USD 7'000 bio by 2010.

A word of caution is in order, though (which is notably absent from the SwissRe paper). Insurance capacity is a highly cyclical asset with short cycles and high variance. Therefore it is likely that broader capital markets will be tapped when capacity is relatively scarce & expensive. Insurers will thus tend to offer relatively less favourable terms in order to take advantage of the broader market's limited sophistication & knowledge of insurance cycles.

IAS 19 to enter the risk-return continuum?

epn has an fascinating article about a possible approach to new pensions accounting, based on deconstructing any plan's risks into four distinct risk categories, accounting for them separately:

asset value risk

interest rate risk

mortality risk

compensation risk.

This way, it should be possible to move away from the current standard's black or white approach to classifying pension plans as DB if they do not match distinct DC criteria. Much of the article is dedicated to the analysis of Swiss and Belgian plans which by law feature a mix of DB and DC characteristics that force such plans to be accounted for as DB.

Faithful representation of the economic reality of plan liabilities appears to be much better warranted under such a structured approach. Furthermore, corporate sponsors' risk management towards pensions liabilities will be much improved, if not enabled, since the industry has built a lot of experience in structured instruments. Some preparers may be fazed by the approach's additional complexity, but once they realise that it might actually help them to better mitigate risk, they ought to embrace it.

A Commissioner's philippic

Here is the text of Commissioner McCreevy's speech at today's IPE Awards. He expresses his disappointment in some member states' defective implementation of the Pensions Directive, especially with regards to national investment limits. He describes the Directive as a "harmonising framework" "to allow the best pension fund managers to administer pension schemes across the single market and pension providers to compete fairly on a pan-European basis". He also announced that court cases have been initiated against three member states today - these are probably Slovenia, the UK and Italy. Interestingly, he singles out Liability Driven Investment as a market innovation to better manage risks. Clearly, deficient implementation will not be cut a lot of slack.

The core focus of the speech was dedicated to the third pillar and forthcoming changes in the regulatory environment as well as existing challenges in the marketplace, such as insufficient availability of annuity products. (More from IPE)

Asset management under the Directive [CH]

Here are the slides of my presentation held today at the IZS seminar on Pan-European Pensions from a Swiss perspective. The main focus of that presentation was on the prudent person rule, which is a new concept in the Swiss market. Co-sponsoring (together with Winterthur) Bank Sarasin's auditorium in Basle was fully packed, and I have a feeling that this was a rather important event for the Swiss market place with most participants' awareness of the challenge raised.

Allianz goes pan-European

Allianz-CEO Diekmann reveals in an interview that Allianz is going to launch a "new pan-European pensions offer" later in the year (i.e. soon). He declines to give any details at this point, so it is not clear how this offering will be structured, but evidently demand from corporate customers has been sufficiently strong to warrant this development.

Of latency trading & algo-busters

This IBM report about algorithmic trading may not appear to be immediately relevant to any investor with a time horizon greater than a business day. But if you have fiduciary responsibility for best execution, it certainly helps to be aware of these developments.

Recent research

(IPE) A recent paper from the Centre for Research on Pensions and Welfare Policies (CeRP, not to be mistaken for the CEPR) looks at the effectiveness of pensions reforms in Austria, Belgium, Finland, France, Germany, Italy, Portugal, Sweden & the UK in the 1990ies by evaluating the changes in private savings rates these reforms caused. Researchers worked on the assumption that the pensions reforms aimed to make public PAYG systems more fiscally sustainable in the light of demographic ageing, thus reducing public saving. This in turn should raise the propensity for private saving. Unfortunately no such significant increase in the private savings rate could be found. Thus, these reforms appear to have been largely ineffective from a macroeconomic point of view.
In my view, there could be two explanations for this: 1) The reforms effectively lowered public saving, but the public has not yet become aware of the need for correspondingly higher private savings. The consequences of this would be dire. 2) The reforms did not have the effect intended to reduce public saving. In any case, this paper's macroeconomic perspective on policymaking is rather refreshing.

Initially mistaking the CeRP for the CEPR, I subsequently checked their (also not RSS equipped!) site and found two not so recent, but even more interesting and fascinating reports focusing on the respective microstructures of two highly relevant markets for European pension funds: the European corporate bond market and the European government bond market. Those markets' structures are analysed with a view to increasing their transparency, liquidity and efficiency, ostensibly by means of EU regulation. A combination of an up-to-date description of market structures and a game theoretical assessment of the impact of regulation on said criteria make for a highly educational read for everyone who is interested in European fixed interest markets.