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.

Linking pensions to longevity

The OECD has issued an interesting working paper Life-Expectancy Risk and Pensions: Who Bears the Burden?, which looks into a number of OECD countries' relatively recent policy changes to share part of the longevity risk with pensioners. Given the proportions of the risk and the massive inter-generational skew in cost/benefit, this is perfectly reasonable and should be adopted universally.

For some undisclosed reason, Switzerland is virtually omitted from the scope of the analysis, even though there clearly is no linkage between longevity risk and pensions whatsoever. In the Swiss three pillar system, longevity risk is borne in the first pillar by the tax payer, by employers in the second, and by individuals in the third pillar.

Farewell America

Bank Wegelin's most recent investment commentary by the same title is remarkable. It provides an extensive explanation of the US taxation risks involved when investing in US securities as a non-US person. The fact that the status of US-person is left (intentionally?) unclear is of particular concern to Qualified Intermediaries (i.e. foreign banks) because they assume liability for their clients' putative tax liability. This is the reason why Wegelin is actively advising its clients to exit all US securities and may not sign the more rigorous QI Agreement. Wegelin's move receives particular attention in Switzerland because its Managing Director is also Chairman of the Swiss Private Bankers Association.

Non-US pension funds (and listed entities) may be eligible to an exemption from a new 30% compulsory withholding tax on US securities held by non-US companies, as explained by the Green Book.

Discounting pensions

The IASB proposes to modify the discount rate applicable to the valuation of pension liabilities in IAS19. The proposal would eliminate the requirement to apply government bond yields instead of high quality corporate bond yields where there is no deep and liquid market for such securities. The proposed modification is triggered of course by the massive expansion of the spread between corporate and government bonds in the wake of the crisis, which serves as an excuse for yet another instance of accelerated due process...

While I agree that applying government bond yields to discount pension liabilities makes sense in only a very limited set of circumstances, and definitely not as a generic fall-back position in the absence of a deep corporate bond market, the proposed discount rate suffers one important flaw. The Board argues (BC4) that comparability is served by reducing the range of rates used. Yet, the motive for not just fixing a single rate (maximum comparability in that sense) is probably that this would not reflect economic reality in any sense. But this purpose is not served by choosing high quality corporate bonds, either. What if the reporting entity is not of high quality (which is the rule rather than the exception nowadays)? The liability is overstated.

The economically correct discount rate to apply to the valuation of pension liabilities in my opinion is WACC. Cost of capital is calculated for each entity separately and thus cannot be compared uniformly, but it reflects the economic reality of financing decision making. As an analyst knowing about the many arcane ways in which pension liabilities are valued, I don't take the nominal amount of pension liabilities at face value anyway, so that comparison is of little interest.