Magical Investment Thinking

By James Kwak

From a Times article on pension fund investing:

Mr. Dear cautioned that there were big differences in how various alternative investments performed during the financial crisis.

He said that Calpers’s investments in real estate had been “a disaster” and that its hedge fund investments had not met their benchmarks and were under review. But he said that its private equity holdings had easily beaten public stock returns over the last decade.

“Over the longer term, that kind of outperformance represents real skill, not luck, and it’s worth paying for,” he said.

Holy confirmation bias, Batman! When one asset class beats the stock market that’s skill. But when your other asset classes do badly—that’s random variation? If high returns on private equity are evidence that you should continue investing in private equity, then low returns in hedge funds and real estate are evidence that you should pull your money out of them.

Public pension funds are obviously gambling on redemption. They don’t have enough money to meet their long-term commitments. They can only meet those commitments by getting unrealistic returns, so they are piling into alternative asset classes in hopes of getting those returns.

This is the same as S&Ls piling into wacky commercial real estate ventures in the 1980s. If you’re a pension fund manager, there’s only upside. Either the bets pay off and you become a hero (and move into the private sector), or they fail and the losses get shifted to taxpayers and public employees. And either way, the hedge fund and private equity fund managers get their guaranteed fees (along with the pension consultants who supposedly know which funds you should invest in).

29 thoughts on “Magical Investment Thinking

  1. No, Nemo – Obvious solution is to fully fund pensions, and creat economic disincentives for the private equity fund and hedge fund guys to FU&% around with other people’s money just to make a profit. But that’s too “Un-market-like” for the modern economy I suppose – making people actually suffer for their bad decisions instead of passing the suffering off to others.

  2. This might also qualify as magical thinking:

    An economy no longer needs jobs (all the jobs are out sourced) just consumers who fund their purchases through credit card debt and mortgages.

  3. I think they know this. Aren’t they essentially paying the hedge funds for the service of providing them the cover to extend and pretend, so to speak?

  4. Yes, it’s asymmetric risk. However, I don’t know if I’d entirely blame the pension managers. The pension problems are well known – they’ve been the subject of many studies and press articles. Thus, one has to imagine that it’s a decision made by the voters, and/or an outcome of the political process. The pension managers are doing exactly what they are incented to do – take excessive risks and hope.

    I read an article some time ago that I wish I could find – basic argument was that the debt situation in california is not due to the malfunctioning political process, but because the political process functioned perfectly to deliver to that generation of voters a precisely optimal outcome. That being – californians awarded themselves tax cuts, high pensions, and then moved out of state to avoid the cost of supporting those pensions.

    I’m sorry to say, there are serious intergenerational inequity issues in california. It’s one of the stronger arguments for individual (but heavily regulated) retirement accounts.

  5. > Abolish public pension funds and libraries

    Not a half-bad idea. Shifting the pensions to Social Security, and moving from paper books to e-books would save us a lot of money.

  6. Give the guy (dear) a break – according the a recent Times story, public funds like CALPERS assume an 8%+ rate of return, clealry impossible over the long term, so the guy is hosed no matter what – this is the problem faced by anyone who is way down – sicne they are almost certain to loose, they have no reason not to go for the hail mary
    Of course, I’m assuming they are not just thieve; me personally, I was making six figures at CALPERS, I’d be thinking, if I put a billion or two in a hedge fund, will they hire me on as a seven figure consultant ?
    Like Al Capone said, once is coincidence, twice is enemy action.

  7. So CALPERS lost money in the real estate market, did anyone mention the specifics of where the loses occurred. I think that CALPERS invested in the Met Life Apartment complex in NYC,2006, which at the time was one of the largest private housing transactions ever to occur. I believe that I read CALPERS lost $2 billion on the investment when it went bankrupt. Fortunately for us NYer’s it was not our money from our state pension fund. The real estate mogul from Tishman-Speyer who enticed the CALPERS experts on this deal is now an advisor to our Gov. Andy Cuomo and serves on his Committee to Save New York campaign committee. The experts make out whether they are right or wrong and the taxpayer get stuck paying the bill. Remember this in some future presidential campaign.

  8. @cinnamoncolbert writes: “CALPERS assume an 8%+ rate of return”

    In the 1980’s interest rates in Canada were 20% plus.

    This could happen again and in the United States.


    From the Homestead Act to this debacle – talk about getting whiplash across *generations* in the USA.

    Seems to me that the top 10 states have something in common – some gene pool or something. Would be interesting to *hot spot* the issue – figure out who the SMALL group is that is completely dependent on predatory living (savings and loan, enronistas, for-profit insurance ponzi schemers, etc.)

    Odd, why would anyone who is absolutely convinced that not everyone deserves a home and, when the test was run, they proved they didn’t deserve a home by FAILING at being a homeowner – well, how are *inwestors* going to manage all these retard renters from wrecking their rental? You could wreck a house in a couple of weeks, easy, and it’s costly to the landlord to redo plumbing, electricity, kitchens, septic tanks, etc.

    Nope, doesn’t seem like a good long term investment to rent all 70% of the distressed homes in Las Vegas, for instance, to undeserving and failed people – why bother turning a new shining city of 1.2 million like Vegas into a NYC slum lord’s castle as a business venture? I guess for the USELESS *inwestor class*, every cent collected in the scheme of one-month-and-toss-them-out (sub prime for rentors) can still be ponzied to feed the perpetual war machine in the ME where the REAL $$$$ is made – the *global* market of war lord, drug lord and slave lord BILLIONAIRES…

    Definitely clever, using a person’s money as leverage with which to – presto! – steal their jobs, homes, health care, food, energy, transportation – via *banking* arithmetic. Except for that pesky problem that goes along with overstepping every PRIMAL boundary of human needs….well heck, iPad social media to the rescue It’s okay to be enlightened enough to do *anything* for the FIAT money….?

  10. Since James is in law school, here is something on the topic of “magical” private equity for him to sink his teeth into. The Public Records Act of California, its state FOIA law, specifically exempts CA public pension funds from revealing almost any information about their “alternative investments” (private equity and hedge fund investments). So when Joe Dear crows about PE manager skill, I assure you, you are not going to be able to look at the data and thus have a basis for challenging his claim. This is unlike real estate, whose managers lacked the political clout to get exempted from the state FOIA regime. From CA Government Code 6254.26:

    (a) Notwithstanding any provision of this chapter or other
    law, the following records regarding alternative investments in
    which public investment funds invest shall not be subject to
    disclosure pursuant to this chapter, unless the information has
    already been publicly released by the keeper of the information:
    (1) Due diligence materials that are proprietary to the public
    investment fund or the alternative investment vehicle.
    (2) Quarterly and annual financial statements of alternative
    investment vehicles.
    (3) Meeting materials of alternative investment vehicles.
    (4) Records containing information regarding the portfolio
    positions in which alternative investment funds invest.
    (5) Capital call and distribution notices.
    (6) Alternative investment agreements and all related documents.

    The most shocking element of this law is, in my opinion, (a)6. a(6) says you are not legally entitled to see the contract that the pension fund entered into with a PE or hedge fund governing its investment. This is the only kind of contract, other than classified military ones, that government enters into that you can’t see. Want to know what the terms of the deal are? Too bad. Maybe the pension fund will tell you some “summary terms”, but these contracts’ terms are full of “Notwithstanding….” wrinkles that you will never know about that substantially alter the summary terms. This non-disclosure situation is an absolute atrocity that is a pure tribute to the political power of PE firms.

    Here’s a real world example (among many) of what gets swept under the rug by this law. After the dot-com collapse, many VC funds convinced their investors to unilaterally “forgive” claw backs that were owed to the investors by the VC firm partners. Not only was this move suspect from a fiduciary perspective for the pension funds, it was also extremely questionable whether the VC partners ever reported income to the IRS the for forgiveness of their clawback obligation (debt forgiveness is reportable income). This gives you a sense of why PE firms (VC is a flavor of PE) are so eager to keep these contracts outside of the public domain.

    Also, this exemption from FOIA disclosure for PE exists in almost every state, either as a formal statutory provision or as a “so sue me” posture of the public pension funds.

    I think this is a great topic for an entire post by James. I’d be happy to help.

  11. OMG! This whole FINANCIAL FIAT $$$$ crisis was caused by people needing housing and the occasional medical attention!!!! Who coulda thunk that? What low lives!

    It was Not, I repeat, NOT, caused by a decade long, billions of dollars a week *cheap rental* of war equipment!!! Wow, 4 years into the black hole of endless verbiage – rationalize rationalize – hey *ration* *the* *lies*! magic fetish words….

    I do like the graphs with this one, though :-) – especially the piece of the pie classic…give the student an *A*….!/1

  12. For the record, I could be wrong, but I don’t think Mr. Kwak is currently attending law school as a student. Although I’m sure Mr. Kwak is constantly trying to expand his knowledge base whether attending law school or not.

    I do find it fascinating the way some commenters communicate on this site. They seem to think that the shorthand of internet “chat” and texting now dominate the rules of grammar. For example the overuse of asterisks (or even the use of asterisks at all outside of footnotes). Also the habit of using exclamation marks to finish every sentence. I notice Chinese students (who are the renowned worst of ESL learners) like to use multiple exclamation marks as the standard of high writing. So I’m wondering when I see multiple asterisks in odd places and multiple exclamation marks to end every other sentence, which poor Chinese village is the person who is writing from?

    Here is some interesting news that I didn’t see had made it to any of the USA mainstream media. The young man named Yaron was a Israeli born researcher at MIT. No news on whether this guy has done his one year of service for the IDF, or if Yaron had made certain the two young children had met kosher requirements:

  13. The inept and corrupt pension managers, advisers, and fund managers will take the money and run and the shortfall will be dumped on taxpayers. This is just how this country operates. The student loan ‘crisis’ will ultimately be resolved by keeping tuitions artificially high by shifting debts to taxpayers. The housing related bailouts of financial institutions, speculators, and no money down borrowers is just the beginning.

    All of this will provide good ‘news stories’ and ongoing material for the political parties.


    Not all scientists are perverts. But certainly there is an accumulation of psychos in the *elite* universities and institutions, like FDA, because they are there not based on merit, but on being the rich man’s idiot son.

    And they are ONLY concerned with the EXTRACTION of wealth. They are not their because of the *love* of discovery that lifts all boats.

    Every HUMAN BEING has the *inalienable right* to make their lives less miserable through honest work.

    The global cabal of *economists* is giving us a *tomorrow* where we have to stand by and watch them EXTRACT everything until we are back in the cave.

    There will be a JUST WAR. It’s already ORGANICALLY organizing itself because the PRIMAL boundary has been breached. No word is that magically as to turn INIQUITY into “law”.

  15. I must agree that the comments on have deteriorated into lots of non-sequitors, expressions of sentiment, and inaccurate information. Take this comment from above:

    “For the record, I could be wrong, but I don’t think Mr. Kwak is currently attending law school as a student. Although I’m sure Mr. Kwak is constantly trying to expand his knowledge base whether attending law school or not.”

    Compare that with Kwak’s bio on this very web site:

    “James Kwak is a former McKinsey consultant, a co-founder of a successful software company, and currently a student at the Yale Law School.”


  16. This comment directed at “PE Guy”
    If you can read (it appears you can, but have problems with comprehension ) the part “I could be wrong” leaves the question open. If Mr. Kwak weren’t a very busy man with family, teaching duties, writing for the Atlantic, and no doubt many other duties, I am sure he would be happy to settle the question here in this comment thread.

    Be that as it may, it may come as a huge shock to you that people don’t feel the necessity to update their curriculum vitae or bio on a weekly basis. Your naivete on this matter is very adorable and cute though.

  17. For those of you similar to myself, as I’m not very computer literate sometimes, or maybe not good managing digital media, I thought I would put this link up for the regular/loyal readers of BaselineScenario. This is i-Tunes media so if you can play iTunes then this link should work. The show is called “Background Briefing” hosted by Ian Masters of KPFK radio. He gets some really great guests on (like one of my favs. Jennifer Taub).

    This show he had Mr. Kwak on, you want the April 5 (Thursday) Show (It was live Wednesday, but they have it labeled Thurs on the download), and you can catch him at roughly the 40minute & 10 second mark. You can download it like I did which is better if you use i-Tunes regular, or just press the small blue play button on the left, in which case, you’ll have to listen to other parts of the show, which is good content, but 40 minute wait to Mr. Kwak.

  18. For those too slow to have figured it out yet, Dylan Ratigan is an employee of General Electric corporation. Not exactly what you would associate with the phrase “power to the people”.

    I think I’m sure to find some of you people at the Occupy Wall Street protests underneath a homemade smiley emoticon poster with the caption “Banksters Is Our Friends and I’m All ‘Fired Up’ About It”.

  19. Annie
    20% canadian interest rate
    The 8% return is, I think, *real return*, return after inflation
    A year or so ago, the Times had this fabulous analysis of the stock market, where they asked, what was the rate of return for money invested starting in any year after about 1940, for any length of time (1 yr, 10, 20,…)
    over all this data, the avg rate was, if memory serves, 2.5%, which is pretty close to the astonishing chart I’ve seen in Mankiw’s blogs, showing that over the last 100 years, the real growth of hte US economy is 2.5% –

    as for this comment you made:
    Not all scientists are perverts. But certainly there is an accumulation of psychos in the *elite* universities and institutions, like FDA, because they are there not based on merit, but on being the rich man’s idiot son.
    idotic nonsense.
    I’ve worked, sort of by accident, at elite science institutions, doing drug discovery.
    And I gotta tell you, most of the Professors at MIT, and Harvard, etc, doing biomedical research, I know they are a lot smarter and harder working then me.
    They did not get their by being a rich mans idiot son
    In any event, if you spend even a few seconds googling, you will see that SAT scores at places like MIT, Wash U, etc are off the charts – those are really talented kids, hard working kids; its true a lot of them stated out with every advantage, but they ain’t rich idiots, they are rich smarties

    and, like people everywhere, some are honest, some are not; they are no more perverse or evil then the avg person, although, being scientists, working in a field well funded by VCs, they have perhaps more of an impact then most of us

  20. “…or they fail and the losses get shifted to taxpayers and public employees.”

    Just taxpayers. Or newly hired public employees. The existing public employees are golden since states can’t go bankrupt.


    No. Don’t abolish pension funds. Just abolish magical thinking. Social Security is mostly a transfer payment from the young to the old, assuming a 0% return above overall economic growth. Even the trust fund to get over the boomer bump invests in the lowest yielding, safest investment available: treasuries. That’s the proper model.

  21. @cinnamoncolbert, “…..although, being scientists, working in a field well funded by VCs, they have perhaps more of an impact then most of us….”

    You’re right, and their *impact* on most of us, lately, how’s that going…?

    I highly doubt that the gene pool has been so specialized among the *elite* in just one generation so that they all are truly the numerically-proven *geniuses*. I’d place my Vegas bet on the fact that they got those numbers in some other way….

  22. Anyone else notice how social engineering can be a big bust?

    There are, indeed, fewer Union members (congrats on getting rid of that evil org of *labor*), at the same time there is a proportionate increase in Gang memberships.

    How about a scholarly economic evaluation on which group (labor union or global *business* gang) will provide a bigger return on investment $$$$?

    Would like to see how big the *crime pays* numbers have become….

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