Miles Johnson of the Financial Times reports, Goldman stars fall back down to earth:

Of all the Wall Street tribes rendered extinct by the financial crisis, few carried the same symbolism as the Goldman Sachs proprietary trader.

While many financial institutions employed traders to make bets using their own capital, the prop traders of Goldman managed to attain a near mythological status for their ability to make the bank, and themselves, vast amounts of money.

Archetypes of the modern day financial “Masters of the Universe,” the Goldman traders were revered inside the bank for the billions of dollars in profits they generated, and eyed suspiciously by outsiders for their pay packets, along with their potential to generate conflicts of interest with the bank’s regular clients.

But the party was brought to an end by the post-crisis “Volcker Rule” in the US, which effectively banned banks from speculating using their own capital. Scores of these often young, predominantly male, residents of the prop desk were shown the door.

The logical next career step was to continue trading by launching their own hedge funds. Helped by their own legend, many of Goldman’s highest earning prop traders raised billions in capital by investors who were confident they could replicate their success at the bank.

Yet several years on, several of the highest profile hedge fund launches of the alumni of the Goldman Sachs prop desk, referred to inside the bank as its Principal Strategies unit, have not gone to plan.

Last week KKR, the private equity group, closed a $510m internal hedge fund which Bob Howard, ex-head of Goldman’s US equities and credit proprietary unit, was hired to run in 2010, along with a team of traders from the bank.

Industry observers are asking why traders who managed to make consistent returns while at Goldman have struggled when operating within their own hedge funds.

While there is a long tradition of bank traders graduating to become fund managers in their own right, investors in hedge funds are quick to point out that running an investment business requires very different skills from working on a prop desk.

“When you are prop trading you only have one client: your boss at the bank. That is very different to running a hedge fund where investors will scrutinise everything you do,” says Troy Gayeski, a partner and senior portfolio manager at SkyBridge Capital, a $10.5bn fund of hedge funds investor.

“When you add in regulatory and compliance, and the need to raise money, it is a daunting task,” he says.

The closure of Mr Howard’s KKR hedge fund was the latest in a string of post-crisis hedge fund ventures by esteemed ex-Goldman traders that have shut down.

Edoma Partners, founded in 2010 by Pierre-Henri Flamand, a former co-head of Goldman’s prop desk, closed down just two years after raising $2bn in one of the most hyped hedge fund launches. Mr Flamand, who lost his investors 7 per cent of their capital, cited “unprecedented market conditions” for the closure.

Four months later Benros, a London-based fund co-founded by Daniele Benatoff and Ariel Roskis, both ex-Goldman prop traders, closed down after its largest investor pulled out its money.

One factor hedge fund investors point out as potentially disadvantaging former prop traders who go it alone is the absence of the same quality of information as when they were working in banks. While so-called Chinese walls are in place to stop any bank trader receiving non-public information, more general information relating to trading flows can help traders have a better idea of the direction of markets.

“We always ask them if they will be as ‘in the flow’ as they used to be when running proprietary capital,” says Alper Ince, managing director at Paamco, a California-based fund of hedge funds that selects emerging managers.

Similarly, where once bank prop traders were allowed to run books with high-leverage multiples – meaning that small profits, or losses, were vastly amplified – few investors in hedge funds will permit their managers to borrow at a similar level. This, says one veteran hedge fund manager in London who has never worked on a bank prop desk, can mean traders are unable to make the same returns once they are on their own.

However, most investors agree that the struggles of prop traders who set up hedge funds simply reflect a brutally competitive industry where any mistake is quickly made public, and few manage to stay in business for long. “Whether a new hedge fund will work well is idiosyncratic to each manager,” says Mr Ince. “While many have failed, there are also many examples of very successful prop desk spin-offs which have built strong track records”.

Not all of Goldman’s post-Volcker generation of former prop traders have failed at launching hedge funds. Morgan Sze, another former co-head of Goldman’s Principal Strategies group, raised $1bn in the launch of his Azentus fund in Hong Kong in 2011 and has increased its assets since.

Learning curve

While some of Goldman Sachs’s recent alumni have struggled in setting up hedge funds, the bank has a long record of launching the careers of some of the industry’s most successful managers, writes Miles Johnson.

Och-Ziff was founded by Daniel Och, a former Goldman proprietary trader, in 1994 and has since grown to become one of the world’s largest hedge funds by assets. Ahead of the financial crisis Mr Och took the then rare step of listing the company on the New York Stock Exchange.

Eton Park, another successful US hedge fund, was founded in 2004 by Eric Mindich, who had worked as a proprietary trader at Goldman for over a decade, as did Kenneth Brody and Frank Brosens, who co-founded the Taconic hedge fund.

Most recently Anthony Noto, who in his role as global co-head of technology banking at Goldman led stock market listings for companies such as Twitter, joined the Coatue hedge fund.

Apart from Goldman, alumni from several other former bank proprietary traders have succeeded in creating some of the world’s largest hedge funds. The British-born Alan Howard, co-founder of Brevan Howard, worked as a fixed-income trader at various banks before building Brevan into managing about $40bn.

However, all of these former prop traders launched before the financial crisis, when investors in hedge funds were more willing to back new managers.

Investors argue that launching a hedge fund in the 1990s was even easier, as there was less competition for good trades and capital.

“It was much easier to launch back in the 1990s, when there were more market inefficiencies,” says Troy Gayeski of SkyBridge Capital, a fund of hedge funds. “Now there isn’t nearly as much low-hanging fruit in the majority of strategies as there was then.”

I discussed this article in my last comment on whether a stock market correction is overdue, stating the following:

These are tough markets and I warned all you Soros wannabes to forget about starting a hedge fund. I don't care if you are a "star" prop trader at Goldman, you're going to get killed in these markets. Stick with Goldman, at least there you can make millions front-running your pension fund clients.

I sent that article to a few people. One of them was Francois Trahan, another former colleague from BCA Research and one of the best strategists on Wall Street (now at Cornerstone Macro). Francois closed his hedge fund for personal reasons but he also shared this with me: "....one my three reasons for winding down was my piece from early May on the new normal ... a world where PEs go up is a shitty one for hedge funds. Nobody wants 2/20 and single digit returns when the S&P500 goes up 30% in a year."

Another hedge fund manager shared this with me:

I also think that once a trader moves from the confines of a prop desk, with its near infinite supply of low risk capital, to a place where they have to draw on capital that likely includes their entire net worth, that they assess risk/return in a different way. Also, when you have to start factoring in things you never really had to deal with when trading at the bank - commissions, margin limitations imposed on you by your prime desk, etc.

Also, it takes a lot of time to either replicate or match the trading systems that they had at the bank. I know at our firm, it took the one partner (who handles the trading platform) months to build everything and integrate with third-party systems. I know he wasn't really happy till a couple of years after they opened up and to this day he spends a considerable amount of time tweaking and refining it. So if these guys are true traders, rather than more cerebral research types (who trade once in blue moon), and they don't have a technical background, it can be very difficult to be the same trader you were at the bank.

Also, once the market closes you have start your second job as small business owner. That doesn't help thing at all.

Bottom line, as I wrote in my comment on the Tiger fund burning bright, most hedge funds stink and there are too many bozos who think they can run a hedge fund that are going to get their heads handed to them.

I read the comments at the end of the Financial Times article and one of them really stuck out:

As a consultant who assists start up hedge funds, I have seen that many struggle not for any specific reason, but for a combination of reasons. Most have never had management or board level responsibilities so actually "running" a business is a new skill to acquire and they no longer have the infrastructure of their investment bank (no operations department, no IT department, no premises department, no HR, no compliance or legal department, no training department, no finance department) to assist in running the business. That is a big wake up call, that their success was dependent on a lot of people that they never knew about, saw or cared about.

While they can outsource some of these activities once they start out on their own, they will still remain responsible for things that always just happened for them that they don't really understand and that is a pretty big learning curve, even for a master of universe. The petty admin of record keeping and getting agreements signed is hard if you are doing with one or two other portfolio managers or traders who have never done it either.

At the same time, they are trying to raise capital and get decent performance, because if you don't have decent performance in the first year or two - you are dead in the water.

Having a successful hedge fund after being a prop trader is not as easy as it looks, or as people think it will be.

David Blitzer had his eye on Addy Loudiadis’s business at Goldman Sachs Group Inc. for years.

By the middle of 2013, the Blackstone Group LP (BX) dealmaker had his shot. Pressured by regulators to boost capital under new rules, the bank started looking for investors to take pieces of Rothesay Life Ltd., the insurer that Loudiadis heads in London. Blitzer, whose private-equity firm historically has to control companies it buys, was fine taking a minority stake in a Goldman cash cow. In October, he struck a $297 million deal to buy 28.5 percent of Rothesay, with Singapore’s sovereign fund taking an equal share.

Blitzer has spent the past two years engineering unorthodox deals like Rothesay that no one else within Blackstone could do. The 44-year old New Jersey native runs Tactical Opportunities Group, a $5.6 billion unit with the mandate to make investments that fall between the cracks of the firm’s other businesses. The group has bought oil tankers, developed Brazilian shopping malls, and created a finance unit for U.S. landlords, capitalizing as banks are forced to shrink, and cutting deals that were the domain of Wall Street before its retreat from proprietary investing.

“An awful lot of what Tac Ops does was either done by the big banks on their proprietary trading desks or by hedge funds in their illiquid side pockets,” Tony James, Blackstone’s president, said in an interview last month. “Both those sorts of capital have been eliminated and unless they come back, there will be tons of opportunities.”

Beating Targets

Since Blackstone’s billionaire founder Steve Schwarzman drafted Blitzer in 2011 for the newly created role, his group has evaluated more than 500 investments for the world’s largest alternative asset manager, a behemoth overseeing $272 billion across credit, hedge funds, real estate and private equity. In just over two years, the 30-person unit has exceeded fundraising targets and returns with annual gains near 20 percent. It could soon grow to $15 billion, said James.

Blitzer can thank New Jersey’s pension fund for his role. He’d returned from an almost decade-long stint running Blackstone’s European private-equity arm in 2011, a business he had started in 2002, and was leading efforts to strike partnerships with its largest investors. Blitzer was also formulating a special-situations group that could capitalize on more of the opportunities that Blackstone sees through its web of businesses.

New Scale

Around the same time, New Jersey’s head of private equity, Christine Pastore, had approached Blackstone to ask for a discount on fees in exchange for handing over a big chunk of money. New Jersey had invested more than $1 billion in Blackstone funds, including with credit arm GSO Capital Partners LP, and wanted to see if it could lower the 1.5 percent management fee and 20 percent charged on profits. The discussion turned to investments that don’t fit into private-equity mandates. Tactical Opportunities was born.

Christopher McDonough, director at New Jersey’s $87 billion investment division, said it differs from special situation funds, which usually target specific opportunities such as distressed debt or real estate, by its size and scope.

“A lot of the time special situations funds focus on one particular aspect of the market,” said McDonough. “We haven’t seen anything of this scale.”

The structure is different from private-equity and also hedge funds, which have the latitude to buy exotic or wide-ranging assets. Blackstone will invest over a period of three years, compared with the five to six years for a buyout fund. Unlike a hedge fund, the money can be locked up for more than 10 years and profits from deals can be recycled back into new opportunities.

Winning Investors

The New Jersey deal also includes lower fees, with Blackstone taking a 15 percent cut of the profit, less than the 20 percent charged by most private-equity firms.

Blackstone agreed to the terms after New Jersey committed $750 million, and more than $1 billion additionally to other private-equity funds and accounts. Its allocations to Blackstone over the preceding 12 months totaled $2.5 billion, the most in any year by a single investor.

Some of the largest institutional clients followed investing with Blitzer’s group, including the California Public Employees’ Retirement System, Oregon Public Employees Retirement Fund and New York State Common Retirement Fund, which collectively control about $500 billion in assets.

“We are very well suited as a firm to having this pool of capital that plays across the spectrum and can attack opportunities in the marketplace and do it very quickly,” said Blitzer.

Pied Piper

James said Blitzer, with his “pied piper” personality, was a natural to head the effort. He’d joined Blackstone from Wharton Business School’s undergraduate program in 1991, six years after Schwarzman and Peter G. Peterson founded the firm to mainly buy companies with borrowed money.

During his time at the firm, Blitzer has helped Blackstone invest in United Biscuits, Allied Waste Industries Inc. and the company that makes soft drink Orangina. Along the way, he’s personally bought stakes in the Philadelphia 76ers basketball team and last year the New Jersey Devils hockey club.

“When you start a new business with no money, no clients and no team, you need a leader, a personality who can bring in employees, clients and companies,” said James.

Rising Stars

Blitzer tapped London-based Chad Pike, 43, Vice Chairman of Blackstone Europe and a former co-head of real estate, to help advise the unit, while Christopher James, 38, who’d worked on the firm’s 2007 initial public offering, took the role of chief operating officer. Blitzer also recruited some of Blackstone’s rising stars, including Jasvinder Khaira, a 33-year-old graduate of the University of California at Berkeley who sports purple and orange turbans. Khaira, like Blitzer, had played multiple roles in Blackstone, including working at GSO, within private equity, and on the IPO.

Blitzer wasted no time striking his first deal for Tactical Opportunities. Hunting for undervalued assets, he explored collateralized loan obligations, packages of leveraged loans that are sliced into securities of varying risk. He said he contacted Bennett Goodman, the head of GSO, to ask about the riskiest portions that offer the highest returns. Goodman backed his thesis that investors were avoiding the investments in the wake of the financial crisis even as they performed well.

Blitzer Hunting

Blitzer went on the hunt, starting with deals overseen by GSO. He found a piece of a CLO called Inwood Park that was put together in 2007 and owned by Lehman Brothers Holdings Inc.’s estate, which needed to sell assets. GSO, as manager of the CLO, helped explain the structure, and Goodman, like Blackstone’s other group heads, sits on the investment committee for Blitzer’s division. In February 2012, Blackstone invested $38 million, paying about 70 cents on the dollar. It’s already returned most of the money through distributions and as of March 31 has a gross internal rate of return of 24 percent.

One of Blitzer’s advantages over hedge funds and other investors chasing trades is that he’s able to tap into ideas from across the firm. Its real-estate business, run by Jon Gray, is the world’s largest, overseeing $81 billion in assets. The private-equity unit headed by Joseph Baratta that buys companies has $66 billion; Blackstone’s hedge-fund business, run by Tom Hill, oversees $58 billion and the credit arm manages $66 billion.

“We’re trying to mine that expertise across the firm,” said Blitzer.

‘Best Minds’

His investment group meets every Monday at noon in the Blackstone boardroom on the 43rd floor of its Park Avenue, Midtown office. For up to two hours, Schwarzman, James and other senior members of the firm screen ideas -- lucrative investments that fall outside the core mandate of each group. Teams from across the company are incentivized to pass on ideas since they get a share of the profits, said James.

“It’s the one activity in the firm when the best minds across Blackstone work together,” he said. “It’s thrilling in that sense.”

Gray’s real estate group, for instance, had looked at taking a control position in One Market Plaza in San Francisco, a two-tower complex near the city’s waterfront that it had sold to Morgan Stanley in 2007. The seller, Paramount Group, would only give up a 49 percent stake, so Gray passed the idea to Blitzer, who cut the deal in April.

Blitzer’s largest single investment for Tactical Opportunities has been Rothesay.

Rothesay’s Growth

Goldman Sachs started the business in 2007 to take on retirement obligations. It was headed by Loudiadis, who had joined Goldman Sachs’s European derivatives marketing group in 1994 from JPMorgan Chase & Co., was named partner in 2000 and had risen to be one of the bank’s top sales executives.

Rothesay promises to pay pensions if retirees live beyond a certain age. The firm receives a portion of the pension plan’s assets and tries to hedge the risk they take on with derivatives. In 2013, the business had pretax profit of 184.4 million pounds ($310 million) and was responsible for pensions at companies including British Airways Plc.

Blitzer had followed Rothesay when he worked in London and considered investing in a rival. He said he talked to Goldman Sachs executives including Loudiadis and made sure they knew Blackstone was interested if they decided to sell.

Schwarzman Target

By June of 2013 Rothesay had $9.66 billion of assets when more stringent capital rules imposed under new rules known as Basel III made holding Rothesay more expensive for the bank. By the end of the year, Blackstone and GIC Pte, the sovereign fund, bought a majority stake.

Blackstone “demonstrated their ability to combine creativity, flexibility and broad financial market expertise to analyse and execute on a complex opportunity,” Loudiadis said in a statement.

One reason for James’s excitement about the Tactical Opportunities business is drawing together the various strands and senior leaders of Blackstone. Another is the ability to keep raising money outside of traditional private equity. Schwarzman said last June he could imagine Blackstone growing to be a $500 billion investment firm.

The target isn’t as outlandish as it sounds. Blackstone has raised $132 billion in capital in the last three years, according to Luke Montgomery, an analyst at Sanford C. Bernstein & Co. in New York. Much of this has gone to newer products like those offered by Blitzer’s business.

‘Blackstone’s Edges’

’’Innovation is one of Blackstone’s edges,’’ Montgomery said.

Helped by the rise in assets and gains in the value of its funds, Blackstone shares have jumped 56 percent in the past year, compared with 19 percent for the Standard & Poor’s 500 Index.

Most Tac Ops investments have been made as banks pulled out of businesses in the wake of the 2008 financial crisis and amid new capital requirements such as Basel III. Wall Street has also had to scale back trading because of the Volcker Rule, a centerpiece of the 2010 Dodd-Frank Act named for former Federal Reserve Chairman Paul Volcker, which seeks to stop banks with federally insured deposits from making trades that could threaten their stability.

Blitzer sees more opportunities from increased regulation, before the current financing vacuum will eventually disappear. His unit will then have to adjust, for instance by investing in public securities, he said, taking Blackstone further from its core business.

“The risk going in is that it was unproven,” said New Jersey’s McDonough. “Time will tell ultimately, but we are pleased about how the portfolio has come together.”

The Dallas-based private-equity firm expects to raise about $7 billion for Lone Star Fund IX, according to the minutes of a March meeting of the New Mexico Educational Retirement Board, or NMERB. Grayken’s contribution will be the most he’s invested in one of his firm’s funds and will top the $330 million he placed with a separate property fund last year.

Grayken, 57, is putting chunks of his own fortune on the line as he scours the globe for distressed assets in the wake of the financial crisis. The investments may lure outsiders to follow him and put money in Lone Star’s funds, the latest of which is focusing on non-commercial real estate loans and “asset rich” financial companies.

“We always like to see a substantial investment by the general partner of any fund,” said Bob Jacksha, Santa Fe-based chief investment officer of the NMERB, which manages about $10.7 billion of teachers’ pensions in New Mexico. “It helps promote a healthy alignment of interest.”

Jed Repko, a spokesman for Lone Star, declined to comment.

The NMERB agreed to invest $100 million in Lone Star Fund IX, according to the minutes. Other investors include the Oregon state pension fund, which will put in $300 million, according to an April 30 statement.

Money Raised

The Lone Star IX fund has raised $5.3 billion so far, according to a filing last month with the Securities and Exchanges Commission. The total amount raised so far is closer to $5.7 billion, Dow Jones reported last month, citing a person familiar with the matter.

“The strategy is to take advantage of the regulatory requirements in the banking sector and the deleveraging in the U.S. and Europe,” according to the NMERB minutes. “They feel this will continue to provide investment opportunities over the next several years.”

Lone Star will spend 40 percent of the cash raised on assets in the U.S., 50 percent in Europe and 10 percent in Japan, according to the NMERB minutes. The company’s investments since the financial crisis include Irish property debt and German financial firms.

The deal, which one of the people said may close within a month, would the largest property transaction in Spain since the country's real-estate burst six years ago and illustrates foreign investors' renewed appetite for assets in the financially stressed euro-zone countries in Europe.

Under the terms of the proposed deal, known under the code name Project Octopus, Lone Star would acquire the majority of the loans in the portfolio, while J.P. Morgan would acquire a minority and provide the financing for the deal, one person said.

Oktree Capital Group LLC (OAK), the world’s biggest distressed-debt investor, cut the $3 billion goal on its next control investing fund by about 40 percent as it struggles to find deals amid an economic recovery, according to three people with knowledge of the matter.

Oaktree told prospective clients it reduced the target to about $1.8 billion, said the people, who asked not to be identified because the information is private. The Los Angeles-based firm plans to shorten its investment period on Oaktree Principal Fund VI LP to three years from five, the people said.

Given the lack of traditional distressed opportunities, Oaktree is spending more time on European nonperforming loans, shipping, commercial real estate and energy, said Ronald Beck, a managing director at the firm, on a panel at the SuperReturn U.S. conference in Boston this week. He pointed to anemic default rates and high-yield bonds trading above par.

“You have to be very sector-specific,” Beck said.

Alyssa Linn, a spokeswoman at Sard Verbinnen & Co., declined to comment on behalf of Oaktree.

Opportunities for distressed funds are getting scarce as the Federal Reserve has held interest rates near zero and global corporate defaults remain low.Global corporate defaults fell to 66 last year from a peak of 266 in 2009, according to data from Moody’s Investors Service. A Bank of America Merrill Lynch index of U.S. high-yield bonds shows the debt trading at an average of 105.72 cents on the dollar as of yesterday, almost double the low from late 2008.

Slower Pace

“Financing is readily available and there’s little corporate distress,” John Frank, managing principal of the firm, said in a November earnings call with analysts. “Against this backdrop and in light of generally elevated asset prices, we continued our harvesting of profitable investments across our strategies.”

Oaktree, which started marketing the fund more than a year ago, in 2013 pushed back fundraising because its 2009 pool was deploying capital slower than expected. That fund was about 79 percent invested at the end of March, according to the firm’s first-quarter earnings report.

Fund Performance

Oaktree was originally seeking a similar-size fund to its 2009 and 2006 pools, which gathered $2.8 billion and $3.3 billion, respectively. Those funds were producing net internal rates of return of 8.5 percent and 8.2 percent as of March 31, according to the filing. That compares with returns of 17 percent and 7.7 percent, respectively, for all distressed private-equity funds in those vintage years, according to London-based research firm Preqin Ltd.

Oaktree’s fund, while global, will focus mainly on investments in the U.S., a person briefed on the matter said in February 2013. It will seek to buy equity or debt in distressed or stressed businesses with an eye toward eventually taking control of the companies.

Howard Marks founded Oaktree in 1995 with Bruce Karsh and five other partners from TCW Group Inc. The firm, which managed $86.2 billion in assets at the end of March, has raised funds devoted to non-control distressed, real estate, corporate debt and mezzanine investing.

Oaktree shares fell 1.2 percent to $50.58 at 3:04 p.m in New York, extending the drop this year to 14 percent.

Pierre Andurand was so comfortable with his $8 billion crude­ oil position that he spent the first half of his day doing a hard­ core workout with his personal trainer, casually reading the news on a Bloomberg computer terminal, and munching on lean pro­tein and toast at his London town house. It was May 5, 2011, Osama bin Laden had just been killed, and political instability in the Middle East seemed guaranteed to raise energy prices.

Andurand made the short walk to his hedge-fund office at midday. Brent crude-oil futures, the commodity market based on petroleum drilled in Europe’s North Sea that he followed most closely, had been hovering in the low $120s that morning, which annoyed him. He’d been betting for weeks that oil would trade higher, but prices had not obliged. Still, with the U.S. markets having only recently opened for the day and the amount of trad­ ing still a bit light, he kept a previously scheduled meeting with the author of a book series called Market Wizards in a conference room downstairs from his trading desk.

An hour or so into the meeting, Andurand got an urgent e-mail from one of his traders, who had returned from a coffee break to find the Brent market down $2.50. That was a big move for a single afternoon in London, let alone for a fraction of an hour. The trader was baffled.

Andurand wasn’t worried. The oil market was a volatile beast, he knew, and such fluctuations weren’t unprecedented. He’d always played them to his advantage, even awakening one time from surgery to find that Brent had risen $10, just as he’d predicted. He kept chatting with the writer, telling him about his philosophy on trading and how he’d applied it at his hedge fund, BlueGold Capital Management, which had been celebrated for having predicted both the high point and the low point of the crude-oil market in 2008. It was a call that had established the firm as one of the most successful commodity hedge funds of all time.

E-mails from upstairs began flooding in. The Brent drop had widened another fraction of a dollar, then another dollar. Andurand’s team was scouring the trader chat rooms and the Internet for information that would explain the sell-off—a production hike by OPEC? A release of the U.S. Strategic Petroleum Reserve?—but there was none to be found. Meanwhile, BlueGold was losing hundreds of millions of dollars. Andurand couldn’t focus. “Why are you looking at your BlackBerry?” the writer finally asked him.

Andurand ended the meeting and rushed upstairs. His two young traders, Neel Patel and Sam Simkin, were sitting at their computers, looking anxious. Brent futures had fallen several dollars in an hour, and their downward spiral was weighing on other parts of the market too. It was a level of distress the thirty-four- year-old Andurand, who had been trading energy products daily for more than a decade, had rarely seen. He called a few other traders to ask what was happening. He instant-messaged a few more. Nobody had a clue.

Whatever it was, it was bad for BlueGold. Andurand and his partners had used complex trades to build a position three times as large on paper as the $2.4 billion in assets they were managing, and it was set to maximize profits as crude oil prices rose. But if crude fell sharply, as it did that day, it could have been disastrous for the hedge fund.

Andurand turned to his traders. “Sell a few hundred million worth!” he said. “See how the market takes it.”

Clicking their mouse buttons furiously to finalize trades on their computer screens, Patel and Simkin began selling off futures on Brent crude as well as its U.S. counterpart, the West Texas Intermediate, or WTI, oil contract, which was pegged to physical crude oil stored in Oklahoma. Although crude was al- ways subject to its own regional supply and demand issues, jitters about the trajectory of prices tended to play out publicly in the futures markets, where hedge funds like BlueGold made bets on whether prices would stay low or high in the months and years to come.

Unloading a multibillion-dollar set of trades was extremely difficult to do without losing additional money in the process. On a calm day, sale orders comprising large numbers of contracts— each of which was linked to one thousand barrels of actual, phys- ical petroleum—could tip other traders off to the idea that somebody had a lot to sell and prompt them to sell oil contracts themselves. The result was an even further price drop. On a rough day, a large sale could prove an even stronger depressant on prices.

BlueGold’s initial sales on May 5 seemed to worsen the mar- kets. Brent continued falling, and the fund’s traders perceived an added drop whenever they pressed the sell button. A few hours into the rout, Brent was down $6, then $7, with little sign of settling.

But Andurand couldn’t afford to stop. He told the traders to wait twenty minutes before making additional sales, hoping that would let the market calm a bit. It was chaos in their office. Land lines and mobile phones were ringing. Competitors and friends wanted updates and gossip. Was BlueGold collapsing? they asked. Reporters had the same question. Everyone knew of Andurand’s appetite for enormous bets—and his reputation for relaxed risk management.

Brent went down, down, another dollar, another fifty cents, another dollar. BlueGold continued selling. By 7:30 that evening in London, as the U.S. markets dwindled to a close, Brent had fallen almost $10.40 per contract, a historic move.

Andurand, finally able to pause, was in a state of shock. Blue-Gold had managed to sell off $3 billion worth of positions, far more than he had expected they could under such duress. But the firm’s losses for the day were a half billion dollars, and it still had $5 billion invested in the markets, betting that crude-oil would rise.

Andurand’s day that May was the sort of experience that would humble any good trader. But in the world of commodity trading, where a relatively small circle of powerful players take enormous risks gambling on the future price of physical raw materials like oil, corn, and copper, huge market moves and the resultant gains and losses are incredibly common.

“Commodity” is an overused word that in colloquial terms applies to things so widely available—toilet paper, milk, dry cleaning— that they are bought and sold almost solely on the basis of price. In the context of the global markets, physical commodities serve a crucial purpose, however: they are the basic building blocks of agriculture, industry, and commerce. The reason Brent crude oil or the widely grown grain known as number two yellow corn are called commodities—a term that brings to mind things that are easily found and not overly valuable—is that their structural, chemical makeup is the same no matter where in the North Sea they are drilled or in what field they are harvested. Like toilet paper and dry cleaning, those commodities also trade on the basis of price. But price in their case is an outgrowth of a long list of what traders call “fundamentals”: the cost of actually getting the commodity out of the earth, the cost of moving it from its source to a buyer, how many people want to buy it at a given time, how plentiful it is in other locations, and at what price, at that particular time.

Commodities may sound like an esoteric market, but everyone has heard of at least some of them. Gasoline and crude oil are important ones, and copper, which is used in the wiring of iPhones and air conditioners and maintains a minor presence on the U.S. penny (which at this point is mostly zinc), is another. Corn, wheat, and cotton are consumed or worn by almost everyone. Other commodities, such as the element cerium, referred to as a “rare- earth” commodity because of its elusiveness, are obscure—although cerium too is put to work in mundane products like cigarette lighters and movie-projection bulbs.

The practice of gaming out commodity price changes through financial bets—the subject of this book—is believed to be quite old. More than three thousand years ago, Sumerian farmers promised a portion of their harvests in exchange for silver up front. Those agreements, known to modern traders as “forwards,” were memorialized in the first written language, a body of symbols known as cuneiform.

The trading of commodities based on future deliveries persisted for centuries, from ancient Rome to the Italian merchant cities to the Dutch traders who exchanged tulips in the 1630s. Commodity trading came to the U.S. with the British colonists, and was formalized by the opening of the Chicago Board of Trade in 1848, spurring a century and a half of more sophisticated virtual trading by a group of more dedicated practitioners. Eventually, commodity trading became its own dedicated niche. Farmers uncertain of the next year’s crop wanted to ensure that they had a reliable amount of income, even in a bad year, and companies dependent on a certain metal for manufacturing wanted to lock in lower prices in advance to guard against a huge price spike that could erase their profit margins. Over time, additional commodity exchanges opened in the cities that most needed them, and entire companies grew up around the need simply to hedge commodities.

During the 2000s, however, commodity trading became the new fad. Volume and volatility in the commodity contract markets exploded, propelled by a massive influx of both everyday and professional investors. In the “listed” markets, where contracts traded at places like the New York Mercantile Exchange and the Intercontinental Exchange in Atlanta, volume shot from roughly 500 mil- lion contracts per year in 2002 to nearly 2 billion contracts in 2008.

Meanwhile, in the over-the-counter market for commodity contracts, where an array of exotic financial products connected to physical commodities was traded party-to-party by phone and computer (in other words, off the exchange), the total value on paper of the trades outstanding spiked from about $800 billion to more than $13 trillion over roughly the same period. Suddenly, commodity contracts, once a rounding error in the world of tradable products, were all the rage.

Nonetheless, commodity investing was small compared to stocks, bonds, and currencies. Until the mid-2000s, most investors had never seriously considered adding commodities to their individual portfolios, which tended to favor simple, easily traded things like stocks and U.S. Treasury bonds. But something happened to commodities in the 2000s to change their minds: a huge increase in prices and an especially convincing sales job by Wall Street.

Between the early 2000s and the middle of 2008, before the U.S. financial crisis hit, the contracts tracked by the Goldman Sachs Commodity Index, known as the GSCI for short—the commodity equivalent of the Standard & Poor’s 500 Index—nearly tripled in price. (S&P, in fact, bought the index and added its own name to the title in 2007.) Crude oil futures rose three and a half times their earlier levels. Corn futures also tripled. Even gold, an odd- ball commodity because it often performs better when the stock markets fall—and in this case stocks were on fire—nearly doubled.

It was a period of easy money, and the benefits were felt all around, from state pension funds that had added commodities to their investments in order to mitigate their exposure to other, unrelated markets, to individual investors, who had dipped into commodities as a way to make money off of skyrocketing oil prices even though their gasoline was so much more expensive at the pump. Salesmen for the GSCI and other commodity indexes ar- gued that their products were an important way to diversify in- vestment portfolios. An array of new securities that traded like stocks but tracked precious metals like gold and silver had made commodity investing easier for regular people than ever before, and the commodity market’s inexorable upward movement meant that they’d be crazy not to buy in.

“Wall Street did a nice job of marketing the value of having the diversification of commodities in your portfolio,” says Jeff Scott, chief investment officer of the $74 billion financial firm Wurts & Associates. “I don’t mean that sarcastically. And there is value to having certain commodities in your portfolio. Unfortunately, the return composition changed.” In other words, at a certain point the money wagon stopped rolling along.

Until 2008, there were plenty of reasons to like commodities, most important of which was the torrid pace of demand in India and China. Those economies, which were driving up the price of raw materials around the world, were widely seen as the harbingers of what the buzzier banking analysts referred to as a new “supercycle,” a period of sustained world growth the likes of which had not been seen since World War II. There was also a prevalent theory known as “Peak Oil” suggesting that the world’s petroleum supplies were well on their way to being tapped out—a situation that would make crude oil, the engine of so many economies, frighteningly scarce. Both hypotheses augured a continuing climb in the price of oil.

But during the second half of 2008, the belief in higher com- modity prices vanished. Like stocks and bonds, commodities were roiled by the financial crisis in the U.S. The main commodity index plummeted, and crude-oil contracts sank to a fraction of their record high of $147. Underlying their sudden drops amid volatile times in the market was a broader story line: the whole commodity craze had by then begun to fizzle.

Throughout the bubble in commodities, a core group of traders were siphoning much of the profit. They were industry veter- ans who, like Pierre Andurand, used a combination of strategy and heft to play the markets to their benefit. Along the way, their bets that commodity prices would rise had the ability to move markets upward, and their bets that prices would fall, the opposite. For the most part, they weren’t manipulating prices by hook- ing up with fellow traders to orchestrate group decisions, nor were they buying physical commodities to constrict supplies while collecting money by betting that the futures prices would go up, a classic commodity swindle known as cornering. But their intimate knowledge of nuanced industries, their access to closely held in- formation, and their enormous resources gave them tremendous advantages that few others had. And even when they bet wrong, they were still so rich and well connected that they could usually return the next day and begin to make their money back.

It was an industry of optimism, peopled by wealthy, focused traders who were not afraid of an occasional setback. Some had absentee fathers whose gaps they longed to fill with power and money, some were simply more comfortable with risk than their counterparts. After all, commodities were an area in which the market swings in a given day could be exponentially greater in size than the typical moves in stock or bond markets.

“When you trade commodities, you realize really quickly that markets can do anything,” explained Gary Cohn during an inter- view in Goldman’s sleek New York corporate offices one day in 2012. “So I love when I sit there with guys who say, ‘that would be a three-standard-deviation move,’ ” that is, a shift in market prices that was three times as great as the typical one would be—as if that notion should come as a shock to the listener, he added: “In commodities, we have three standard-deviation moves in a day.”

Commodity players can appear pampered, even lazy. Maybe they spend half the summer in Provence or Nantucket, working remotely from a Bloomberg terminal in their home office while their kids are minded by a live-in nanny. They might piddle away a serious investor meeting talking martial arts, move a long- scheduled international appointment just days in advance, refuse to take a view on the markets, or be too busy grouse-hunting in Norway to answer a couple of questions about the crude-oil business. All of the above happened with people interviewed for this book. But when it comes to trading raw materials, they are a shrewd and indomitable lot, and, at least for the moment, the contracts they trade are still so loosely regulated that the correct combination of money and skill creates irresistible opportunity. That’s why I am only half-joking when I call them the secret club that runs the world.

In BlueGold’s prime, it had several hundred competitors in the hedge-fund business, each of varying size. Commodity hedge funds, typically based in London, Greenwich, or Houston, picked one or more raw materials they understood well, then made a business of trading in the related contract markets. Their inves- tors, usually a combination of larger money-management firms and wealthy individuals, presented them with billions of dollars to trade. There were many winners, but John Arnold, a onetime Enron trader who went into business for himself after it folded, did the best of all; his natural-gas-focused hedge fund, Centaurus Energy, generated 317 percent returns in 2006. Several years later, Arnold retired, a billionaire at the age of thirty-eight. He became a philanthropist.

Prodigies like Arnold were the superstars of the industry, com- manding respect as a result of the enormous sums of money they’d made. Andurand, who generated 209 percent returns in 2008, was in there too. But few hedge-fund traders were quite that accomplished. The rest of the commodity-trading hierarchy was topped by the large, multinational brokers involved in every single aspect of commodity harvesting and trading, from extract- ing the coal out of Colombian mines to hiring massive cargo ships to move them to Singapore while hedging the future price of coal as it was transported. Those companies, based largely outside of the U.S., had a long and sordid history of doing backroom deals with shady politicians, flouting international trade and human- rights laws, and engaging in tax dodges, pollution, even, allegedly, child labor. The big players in the industry were companies like Glencore and Trafigura, and their founding father was the Amer- ican fugitive Marc Rich. Other parts of the commodity business feared their aggressive approach to business, given that they transacted with parties with whom the majority of the business world feared to work.

But their scope and sheer manpower helped them understand tiny regional discrepancies in the price of oil and other goods, allowing them to source commodities more cheaply and sell them at a premium. That process generated tens of billions in profits. “This is off the record,” or at least it has to be anonymous, one industry analyst told me, before describing one of the companies, because he didn’t want the subject of his comments “to be blowing up my car.” Many investors and even other traders had reservations about the international trading houses. But the comprehensive approach taken by Glencore and others, helped by a creative use of corporate regulatory havens, had given them elite status in certain commodity markets and made their execu- tives exceedingly wealthy.

Most hedge-fund traders sat somewhere in the middle of the totem pole. In the larger scheme of commodity trading, they were essentially money changers, pooling other people’s cash to try to outmaneuver the markets, placing bets on where prices would go, and skimming profits off the top of whatever they made when they were right—generally 20 percent of a year’s earnings and about 2 percent of the money investors gave them. A Frenchman who had socialist influences growing up, Andurand considered the physical oil business to be dirty and distasteful, and told me at one point he would never consider taking delivery of an actual barrel of crude. He was just a trader, and although he had an £11 million house near Harrods in London, a customized Bugatti sports car, and a gorgeous Russian wife, he would never attain the sort of riches and power that his counterparts in the corporate commodity logistics business would. He was a mere millionaire, not a billionaire.

Still, Andurand had something others lacked: fearlessness. He traded billions of dollars’ worth of oil contracts in the markets daily, exposing himself to potential losses that many traders couldn’t stomach. Commodity hedge-fund traders talked often about their daddy issues and other insecurities and how they had learned to compartmentalize their financial woes without bringing them home at night. “My wife couldn’t tell you if I had a good day or a bad day—ever,” one Greenwich-based oil trader told me late in 2011. Andurand shared that thinking; he preferred to spend tens of thousands of euros on a bespoke wedding gown for his fiancée than to acknowledge his setbacks to her directly.

The international banks that dabbled in commodities were lower in the pecking order. In better days, Goldman Sachs and Morgan Stanley took in more than $3 billion apiece in revenue from buying and selling oil, gasoline, copper, and other commodities. They arranged elaborate hedging strategies for airlines de- pendent on cheap jet fuel, charging fees for their advice along the way, and they lent capital to hedge-fund traders, pocketing inter- est and fees in return. Sometimes they profited from trading directly with those clients, buying a commodity the client was selling, for instance, and making money unexpectedly when markets moved against that client. But the real money was made in trading for the house—turning their commodity traders into mini-Andurands with purses provided by the bank’s shareholders. In 2008, for instance, two of the best-paid employees at the Swiss firm Credit Suisse were a pair of commodity traders who took home a combined $35 million after betting correctly on the crude markets. Their role was effectively eradicated in 2010 when a new law in the U.S. barred bank employees from trading for the house, prompting them and many of their counterparts to flee to less regulated parts of the industry. But the banks continued nos- ing around the regulatory margin, looking for ways to optimize their commodity-trading chops, and the Credit Suisse traders simply quit the bank and started their own oil-focused hedge fund.

Lying miserably at the bottom of the commodity-trading power structure were the individuals and corporations that depended on physical commodities—the Coca-Colas, Starbucks, Delta Air Lines, and small farmers of the world. Those actors were paralyz- ingly dependent on aluminum, sugar, coffee, and jet fuel for sur- vival, but were, almost without exception, unable to keep up with the commodity traders at banks and hedge funds. Conservative- minded by nature, and loath to use the exotic financial products or fast-moving trading strategies that professional commodity traders employed, they lacked the expertise to game the markets and felt it wasn’t their job to try, anyway. After all, they were sell- ing lattes and airline seats, not risky commodity contracts that required multithousand-dollar down payments. Still, with the prices of many commodities climbing, the companies couldn’t ac- commodate price shocks, so they often wound up hiring banks to hedge their vulnerability to volatile product markets. The result could include added fees, bad quarters—even potential bank- ruptcy, if large demands from banks or other trading counter- parts for extra cash or collateral became too much to bear.

And if their limited knowledge and power were not enough of an obstacle, these companies and people were also damaged by sleaze in the brokerage business. Twice in the aftermath of 2008, middleman firms that lent money to commodity-contract buyers and sellers to make trades and then finalized them on exchanges failed due to the mishandling of funds, wiping out customer money in the process. One of them, MF Global, was run by Jon Corzine, a former head of Goldman Sachs in the 1990s and later the governor of New Jersey, who at MF used small investor money to pay debts from a side bet on European bonds that had gone bad. The case against him is still cycling through the courts, and it took more than two years for MF Global’s customers to be made whole.

The astonishing wealth of commodity trading’s inner circle was created in near-total obscurity. Because it operated within either closely held companies that didn’t trade on public exchanges or deep within large banks and corporations, where commodity prof- its and losses weren’t disclosed separately, the commodity-trading power elite has enjoyed utter anonymity. But if the individual par- ticipants in the boom went unnoticed, their impact did not. The commodity market’s sudden growth in volume, and the parallel surge in commodity prices, along with the entrance of public in- vestors such as the California Public Employees’ Retirement Sys- tem, raised serious questions about whether traders were jacking up the prices paid for commodities by average citizens.

In the United States, where so many people depend on car travel, fuel was an especially charged issue. During the commodity price spikes of 2008, the resultant $4-per-gallon price of gasoline sparked an outcry in the U.S., where members of Congress held forty hearings on the topic in the first half of that year alone. Motorists, trucking companies, and other fuel buyers blamed commodity speculators for driving up prices, and they wanted the government to rein things in. Under intense public pressure, Congress and the Commodity Futures Trading Commission vowed to scrutinize the speculators, who their own records showed were accounting for a much larger portion of the markets. But the brewing financial crisis and an ongoing political struggle between those in Washington who believed speculators affected commodity prices and those who didn’t made the CFTC slow to act.

Overseas and in the States, the cost of food was another red flag. Food prices had risen during the market boom of the mid-2000s, but the concurrent inflation of home prices and the availability of cheap credit had blunted the impact on consumer spending. In the years after 2008, the price of staple grains like corn, wheat, and soybeans hit all-time highs, making food products costlier, even unaffordable. Some analysts believed that grain prices were caus- ing revolution in already-stressed places such as Egypt, which played a pivotal role in the 2011 uprising known as the Arab Spring. And while unpredictable weather, poor crop yields, and a rise in demand were certainly influences, some academics also argued that commodity indexes like the GSCI were to blame, saying that the structure of those investments, which was to bet over and over again that prices would rise, actually caused such rises to happen in the physical and futures market.

They had a point, as an academic paper published in 2010 later proved. But the clear evidence of causation was still hard to find; even when a connection appeared obvious, the support for the theory tended to be largely anecdotal. Andurand estimates that during that fateful day in May 2011, BlueGold moved the Brent futures market down an additional $2 or $3—exacerbating by up to 33 per- cent what was already a huge, $10 down spiral in the crude market. Negative headlines about a lawsuit implicating the hedge-fund manager John Paulson, a large holder of the physically backed gold security known as the GLD, appeared to force gold futures down nearly 2 percent on a single day in 2010—a considerable move in a very large market that is difficult for any single party to affect. The idea that there is a connection in both cases is powerful, and likely accurate. But because the impact of market sentiment is impossible to document, we’ll never completely know.

What is clear is that the last decade in commodity trading had a unique impact, both on the market itself and the public’s perception of commodities as a compelling investment. The abundance of new speculators, the meteoric growth of the GSCI and other, similar investment vehicles, and the general ebullience about the supercycle and its implicit effect on raw materials all made the market’s shifts more dramatic. That volatility created kings in the trading world’s empowered class, and drove other people and companies into financial ruin. The commodities bubble of the 2000s is a snapshot of one of the most extraordinary periods in American finance, providing an object lesson on the role of markets, regulators, and how the money world can sometimes lose its connection to the real one.

At first glance, the Canada Pension Plan looks like a model for a government-created retirement fund. The portfolio is growing, returns have looked strong and the plan is now among the 10 largest of its kind in the world.

But as it approaches $220-billion in assets, the CPP’s investment arm, the Canada Pension Plan Investment Board, is taking on more risk than ever. The CPPIB has moved into a host of far-flung private investments such as Chinese real estate, high-yield debt, speculative energy plays and even a deal with the organization that runs Formula One car racing. Sources say it has also faced an internal struggle over investment strategy that has contributed to the departure of several key executives.

As the fund moves farther away from safe holdings, like government bonds and blue-chip stocks, the ramifications could be significant for 18 million Canadians who depend on the CPP for retirement benefits. In the past four years, the CPPIB has rapidly expanded its private investment portfolio from $30-billion in 2010 to $88.5-billion today. And earning exceptional returns on these investments can be challenging.

“In my 15 years as a professional investor, this is by far the most difficult market” for private assets, CPPIB chief executive officer Mark Wiseman said in an interview.

In a sign the new strategy isn’t paying off just yet, the CPPIB has failed to beat its own internal benchmarks two years in a row, falling short by $350-million – and in four of the past six years, amounting to $1.9-billion worth of total underperformance.

Much like a mutual fund, CPPIB’s success cannot be judged on annual returns alone. The pension fund must also be assessed on its ability to beat the market. Almost any fund manager can earn 10 per cent when the market is up 15 per cent, but real value, or alpha, as it is known on Bay Street, comes from going above and beyond. Because the market is so hard to beat, surpassing it by even the smallest of margins is touted as a success.

Even if the underperformance seems small for such a large fund, failing to consistently beat the benchmark can have far-reaching implications. It would undermine the shift toward more high-risk assets and it could hold back overall returns. And considering that the CPP is expected to grow to $500-billion by 2030, any misstep on the investment strategy could be costly.

Such a scenario can be confusing. To the average person, the fund’s annual performance looks impressive. The CPPIB has roughly doubled the size of the fund in the past 10 years to $219-billion and its 16.5-per-cent return last year suggests the portfolio is humming. The fund has also become a major player on the world stage, opening offices in four countries and participating in several foreign transactions, and CPPIB executives are regularly invited to elite gatherings such as the World Economic Forum in Davos, Switzerland (click on image below).

But the CPPIB has undergone a substantial transformation. A decade ago, executives lobbied hard to shift away from solely investing in passive investments, such as federal and provincial bonds that that pay low, safe returns. The goal: To take on riskier but potentially higher-paying strategies, such as investing in private companies and real estate. Ottawa ultimately gave CPPIB the green light, but required that the fund find ways to determine if the extra risk was worth it.

To help track its performance under the new strategy, the CPPIB created a “reference portfolio” – a low-cost, basic basket of global public market investments it could otherwise invest in. Each year, CPPIB’s returns are compared with this portfolio. When the returns fall short, it means Canadians would have been better off avoiding the riskier investments, the same way a retail investor might fare better by investing in an exchange-traded fund that tracks the simple S&P/TSX composite index instead of picking and choosing between companies.

The CPPIB must now prove that taking on the extra risk was worth it in the long run. And it has to do that just as the environment for these kinds of investments has become much more competitive as many other pension funds, private equity firms and sovereign wealth funds seek to do the same thing.

All this extra attention on private equity has put more pressure on the CPPIB’s far larger public investments arm, which buys and sells publicly-traded stocks and bonds as well commodities, currencies and interest rates. Returns here have to be good to compensate for any shortfall on the private side. The trouble is, this division, which comprises 60 per cent of the fund’s assets, hit a series of road bumps in recent years, such as infighting over investment strategy.

To start righting the ship, CPPIB launched a major strategic review last year, tackling everything from organizational structure to compensation. After some soul-searching, the pension fund is out to prove to Canadians that they will be adequately compensated for the extra risk added to their retirement funds.

Investment strategy strife

To truly appreciate the current conundrum, it helps to have a good grasp on the past.

The Canada Pension Plan has existed since the mid-1960s, but the program was revamped in 1997 when federal and provincial governments realized its demographic assumptions were outdated. To correct course, politicians forced Canadians to put more of their paycheques into the plan, sending the value of funds under management soaring. The government also created the CPPIB to start dabbling in investments beyond government bonds.

Almost a decade later, the CPP was overhauled again when management adopted a much more aggressive strategy to earn even higher returns. In the years since, CPPIB has invested in assets such as Sydney office towers and it has also completed a host of high-profile deals such as buying U.S. reinsurer Wilton Re for $1.8-billion (U.S.), forming a $250-million joint venture with China Vanke in Shanghai to invest in Chinese residential real estate and acquiring a portfolio of Saskatchewan farmland for $128-million (Canadian).

But it was deep in the board’s public markets division, which manages a $131-billion portfolio, where problems first surfaced a few years ago.

Because the public markets division is so large, it employs myriad investing strategies. Such diversity can sound like a good idea, but its practical implementation doesn’t always pan out. “The problem with the public markets group,” said a former employee, “is that they’re in so many different strategies that it’s very difficult for all the stars to align so that every group is making money.”

With so many strategies at play, it can be hard to pinpoint those that have worked and those that don’t. But in its simplest form: if one makes $3-million, another loses $4-million, and a third returns $1-million, the net effect is no gain.

There has also been a deep divide between the public markets group’s two dominant investing themes – quantitative versus fundamental analysis.

Many fund veterans, including recently departed chief investment strategist Don Raymond, were steadfast quantitative investors, which means they deployed money based on things like probability distributions and standard deviations. A quantitative portfolio manager may arrange an investment mix based on certain assets’ correlations to one another.

As CPPIB’s portfolio expanded, however, its fundamental investing team – which conducts research to forecast future cash flows and pores over corporate financial statements – grew bigger and very quickly housed a large group of people who had a different view of the market. These folks did not care much about what the statistics said.

In an interview, Mr. Wiseman acknowledged it was a marriage that could not work. “It’s like getting [people] who speak two different languages and asking them to go write a novel,” he said. “It just becomes really, really difficult.”

Other units within the public markets division also had to be overhauled after they each underperformed their benchmarks by hundreds of millions of dollars, according to two different sources familiar with the fund. CPPIB would not verify the amounts, saying it only reports results at a very high level.

Mr. Wiseman acknowledged problems in two particular units: the global corporate securities group, or GCS, which primarily played with long and short positions, and the global tactical asset allocation team, or GTAA, which invests based on macroeconomic themes, such as a euro zone recovery or an emerging-markets slump. The first group needed to fine tune its strategy, he said, while the second suffered from bad leadership.

Compensation issues

Another problem was determining annual compensation for long-term investment strategies.

Because CPPIB has such a lengthy investment horizon – 75 years in some cases –both GCS and GTAA tried to use it to their advantage, sometimes placing trades that required them to hold securities for two to five years. (Most money managers in the private sector have a time horizon of less than two years.) At CPPIB, a portfolio manager might purchase Spanish securities in the middle of the European debt crisis, assuming the euro zone will eventually get its act together, even if it takes three or four years to reap the benefits.

The problem is that the securities’ values could fall farther in the meantime. If so, the annual mark on the investment would show a loss, and that affects group compensation for the given year, often leading to infighting. “A losing trade is an orphan,” one portfolio manager said. ‘No one wants it.”

Such a struggle isn’t unique to CPPIB, but it was something the pension fund had to learn the hard way. “All pension plans get into the habit of hiding in the long term,” said veteran pension consultant Malcolm Hamilton, now a fellow at the C.D. Howe Institute. “You can’t think like that. Unfortunately, you have to act in the short term, you have to pay in the short term.”

While all of this was playing out, CPPIB started losing some top talent. Mr. Wiseman said the fund’s total employee turnover ratio has held relatively steady near 9 or 10 per cent annually, but he acknowledged some venerable names have left, including Mr. Raymond; Sterling Gunn, a former vice-president of quantitative research; and Jean-François L’Her, the former head of investment research for the fund’s Total Portfolio Management team – a departure that led to crying on the trading floor, according to someone there that day.

Asked what his No. 1 concern was at the moment, Mr. Wiseman emphasized talent retention. “I’m worried: Are we going to be able to keep those people engaged and have them continue to be employed and working for us?” he said.

To help convince them to stay, CPPIB is considering restructuring compensation. CPPIB typically pays salaries based on four-year rolling windows, which differs from most funds and firms on Bay Street, and that means new hires got bonuses based on previous years’ results. Going forward, newer employees won’t have as much of their pay tied to the fund’s performance before they arrived.

The troubled units, GCS and GTAA, also have new leaders, and in some cases, have retooled their strategies – something Mr. Wiseman said showed CPPIB’s long-term dedication. “If we were a hedge fund, we would have fired the whole team,” he said. “We still believe in the fundamental tenets of those two strategies. We still believe we can get it right.”

Burying the bad news

As the public markets arm retools, the CPPIB’s private equity division is dealing with a different, but equally challenging, scenario.

Whenever the board’s managers are asked about the fund’s private equity capabilities, they are quick to tout its inherent advantages. As a publicly funded plan, the CPPIB has certainty of assets, meaning it does not have to worry about investors redeeming their money at the first sight of something going wrong. Canadians cannot get their savings out until they retire.

Like many funds, the CPPIB has a tendency to celebrate its private equity successes – such as the recent sale of Gates Corp., the automotive parts manufacturing division of Britain’s Tomkins PLC. The pension fund teamed up with Onex to buy Tomkins for $5-billion in 2010 and the partners have since sold eight of the conglomerate’s holdings for gross proceeds of $7.9-billion.

However, struggling investments are rarely highlighted. For example, the fund invested $250-million in oil sands player Laricina Energy Ltd. in 2010 at $30 per private share; in March, the CPPIB coughed up $150-million more for a debt financing that came with warrants -- which can serve as a proxy for Laricina’s private share price – that allow the CPPIB to buy new shares between $15 to $20 apiece.

“Whenever CPPIB has a success, they are quick to discuss it publicly. The same goes for new investments,” said Mark McQueen, who runs Wellington Financial, a private firm that specializes in venture capital. But when you ask about struggling investments, “CPPIB says they’re not material. They want to have it both ways, and the board is complicit in management’s tendency to bury the bad news.”

There is also the age-old issue of risk versus reward. Private assets can generate major returns, but they also come with drawbacks. “One of the big advantages of being in public markets is you have liquidity. You can exit when you want,” said Jim Keohane, CEO of the Healthcare of Ontario Pension Plan, which manages $52-billion. The same isn’t true of private assets.

Pressed about these realities, Mr. Wiseman acknowledged some missteps. “We’ve made bad investments; we’ve lost all our money,” he said, adding that it is just the nature of private equity. “If we’re not doing that, we’re not taking enough risk.”

He also acknowledged that private equity isn’t a sure bet – especially not in this competitive market when assets are sometimes purchased at big premiums. “It’s really hard to get right. It’s a tough, competitive business.” Jaw-dropping returns are getting harder to come by now that university endowment funds and sovereign wealth funds have all moved into this terrain. “This industry has matured. It’s always harder to get superior returns when there’s a lot of money chasing deals,” Mr. Wiseman said.

Private assets also pose a valuation problem – they are incredibly hard to value until they are sold. Because there are only so many power and water utilities up for sale at one time, it can take time to find comparable transactions. In financial circles, then, the valuation process is sometimes called “marking to myth,” and the problem is so widespread that Keith Ambachtsheer, a renowned pension expert who runs the Rotman International Centre for Pension Management at the University of Toronto, is devoting much of his research to analyzing the issue.

Back to the glory days

While it can seem like CPPIB’s task is daunting, the reality is far from it. The country’s largest pension fund is still pumping out positive returns, and it is complying with its most crucial guideline.

Every three years, Canada’s chief actuary calculates the returns CPPIB must generate to meet its long-term pension obligations. The last time the review was conducted, it showed the fund must generate a 4-per-cent real rate of return each year – or 4 per cent after adjusting for inflation. Over the past 10 years CPPIB’s annual real rate of return is 5.1 per cent.

As for the internal benchmark, CPPIB has proven it can beat it. Early on the fund generated a lot of alpha, and those gains have contributed to total positive “value-add” of $3-billion since CPPIB adopted its more aggressive approach and created the reference portfolio in 2006. Now management must prove that it can get back to the glory days.

Mr. Wiseman stressed there is no need to worry. Because 40 per cent of CPPIB’s portfolio is invested in private assets, he argued that the fund is at an inherent disadvantage when public stock and bond markets are hot, like they are right now, because private assets take much longer to reprice. “Just keeping up to the reference portfolio in a bull market is unbelievably good,” he said.

In the private asset portfolio, Mr. Wiseman said CPPIB has the luxury of being “steadfastly patient.” Because the fund doesn’t have to return money to investors every five to seven years, as private funds do, it can wait for good opportunities.

And overall CPPIB also has some wiggle room. The fund benefits from net inflows until 2023, meaning its members’ contributions amount to more than its annual payouts until then.

However, the net inflows can serve as a double-edged sword. Whereas Ontario Teachers’ Pension Plan can’t afford to make investment mistakes because it currently pays out more than it brings in every year, CPPIB can arguably hide behind its sizable contributions. The pension plan also has less stakeholder engagement than rival funds. OTPP, for instance, holds quarterly meetings with the Ontario Teachers’ Federation, according to Rhonda Kimberly-Young, the union’s secretary-treasurer.

“We really rely on the integrity of the people on the board and we rely on the competence and vigilance and transparency of the people who are on the staff to do a good job, [because] they don’t have a stakeholder looking over their shoulder,” said Mr. Hamilton of the C.D. Howe Institute.

Mr. Wiseman shrugs off such worries, arguing that the board is vigilant. Just because missteps happened does not mean management has had, or will have, a free ride. “Not making a mistake means you’re not building your business, you’re not taking enough risk,” he said.

But he also understands the severity of the situation, and pledged to prevent the same drama from unfolding again. “Making the same mistake twice? That’s unconscionable,” he said.

Even if CPP’s future is much smoother, there still is no guarantee that the active management strategy will pay off, something other massive pension funds are wrestling with. While Singapore’s GIC sovereign wealth fund has adopted a similar approach, Norway’s $850-billion wealth fund is debating whether it should move farther away from passive investments.

“It’s human nature for people not to invest passively,” Mr. Hamilton said. “They all want to try to do better [than the market].” The problem is that the time frame required to assess the merits of an active approach can take decades – time during which billions of dollars can be made or wasted. “At this point, it really is an experiment,” he said.

• Except for bonds, these results are very strong across the board. If you look at the table above, you will see exceptional returns in both public and private markets except for bonds which were basically flat in fiscal 2014.
• Almost $10 billion of the gain came from foreign exchange as the Canadian dollar slid in FY 2014 (I warned all of you to short Canada back in December). And it could have been better if CPPIB didn't hedge F/X. Footnote #4 in the table above explicitly states that the total fund return in fiscal 2014 includes a loss of $543 million from currency hedging activities and a $1 billion gain from absolute return strategies which are not attributed to any asset class.
• CPPIB should follow AIMCo and others and report net returns in their headlines. Their press release, however, does state the following: "In fiscal 2014, the CPP Fund’s strong total portfolio return of 16.5% closely corresponded to the CPP Reference Portfolio with $514 million in gross dollar value-added (DVA) above the CPP Reference Portfolio’s return. Despite the strong CPP Reference Portfolio return, we outperformed the benchmark due to strong income and valuation gains from our privately-held assets.Net of all operating costs, the investment portfolio essentially matched the CPP Reference Portfolio’s return, producing negative $62 million in dollar value-added."
• The press release, however, emphasizes long-term results: "Given our long-term view and risk/return accountability framework, we track cumulative value-added returns since the April 1, 2006 inception of the CPP Reference Portfolio. Cumulative gross value-added over the past eight years considerably outperformed the benchmark totalling $5.5 billion. Over this period cumulative costs to operate CPPIB were $2.5 billion, resulting in net dollar value-added of $3.0 billion."
• I realize CPPIB is running a mammoth operation and is being "built for scale" but operating costs matter and they include fees being doled out to external public and private managers. This is why I'm a stickler for transparency on all costs, fees and foreign exchange fees. At the end of the day, whether you are running a pension fund, hedge fund, mutual fund, or private equity fund, what matters is the internal rate of return (IRR) net of all fees and costs, including foreign exchange transactions.
• Mark Wiseman is a very smart and nice guy. I've spoken to him on several occasions and he knows his stuff. He's absolutely right, in markets where public equities roar, CPPIB will typically under-perform its Reference Portfolio but in a bear market for stocks, it will typically outperform its Reference Portfolio. Why? Because private market investments are not marked-to-market, so the valuation lag will boost CPPIB's return in markets where public equities decline. Over the long-run, the shift in private markets should offer considerable added value over the Reference Portfolio which is made up of stocks and bonds.
• But while I understand the diversification benefits of shifting a considerable chunk of CPPIB's assets into private markets, this shift presents a whole host of operational and investment risks which need to taken into account. My biggest fear is that too many pensions and sovereign wealth funds are chasing big deals around the world, enriching private equity and real estate gurus, and bidding up the price of assets. Lest we all forget the wise words of Tom Barrack, the king of real estate who cashed out right before the financial crisis in 2005, stating back then: "There's too much money chasing too few good deals, with too much debt and too few brains."
•  Shifting more and more assets into private markets has become the new religion at Canadian public pension funds. It goes back to the days of Claude Lamoureux, Ontario Teachers' former  CEO, who started this trend, made the requisite governance changes and started hiring and compensating people properly to attract and retain talented individuals who know what they're doing in private markets. But I agree with Jim Keohane, CEO of HOOPP, a lot of pensions are taking on too much illiquidity risk, and they will get crushed when the next crisis hits.
• Of course, CPPIB and PSP investments have a huge liquidity advantage over their counterparts in that their cash flow is positive for many more years, which means they can take on a lot of liquidity risk, especially when markets tank.
• But right now, the environment isn't conducive to making  a lot of deals in private markets which is why Mark Wiseman and André Bourbonnais, CPPIB's senior vice-president of private investments, are going to sit tight and be very selective with the deals they enter. CPPIB's size is more of a hindrance in this environment because they need to get into bigger and bigger deals which are full of risks when other players are bidding up prices to extreme valuations.
• As far as India, China and other BRICs, there are tremendous opportunities but huge risks in these countries. Hot money flows wreak havoc in their public markets and if you don't pick your partners carefully, good luck making money investing in their private markets.
• In terms of compensation, I note that both Mark Wiseman and Mr. Bourbonnais both made almost the same amount in fiscal 2014 ($3.6 million and $3.5 million). I contrast this to PSP's hefty payouts for fiscal 2013 where Gordon Fyfe, PSP's CEO, made considerably more than other senior executives (all part of PSP's tricky balancing act). This shows me that CPPIB's compensation, while generous, is a lot fairer than that of PSP which has the same fiscal year. PSP is outperforming CPPIB over a four-year period but still, the difference in comp is ridiculous considering the outperformance (value added over a four year period) isn't that much better and the fact is that PSP is based in Montreal which is way cheaper than Toronto in terms of cost of living (I have to give credit to Gordon, however, he sure knows how to ensure he and his senior managers get paid extremely well. He's a master at charming his board of directors).
• Finally, one area where CPPIB is killing PSP Investments is in plain old communication (you can even follow CPPIB on Twitter now). I embedded four articles from Canadian and U.S. sources in this comment (there are more). The pathetic coverage of PSP's results isn't just because its results come out in July when Parliament approves the annual report, it's because PSP's public relations and website stink when it comes to communication. Again, that's all Gordon's doing, he doesn't like being discussed in the media, keeps everything hush, and basically thinks the annual report suffices.

Japan's government is readying to unfetter its huge public pension fund, freeing managers to dump low-yield sovereign bonds and go in search of higher, but riskier returns, in a move that could see cash flood global markets.

The nation's pension programme, into which almost all citizens pay, is supported by the world's largest investment fund, worth a staggering US$1.26 trillion - equivalent to one-quarter of the country's entire economy.

It towers over its nearest competitor - the US$700 billion belonging to Norway - and is multiples of the US$173 billion holdings of Temasek, a Singapore investment company.

But, unlike some other more adventurous vehicles, the Government Pension Investment Fund (GPIF) keeps by far the majority of its cash in super-safe - and super low return - Japanese government bonds.

The government’s hopes that Quebec’s municipalities and unionized workers could come to a speedy mutual agreement in their pension dispute appeared in peril Thursday.

No sooner had Quebec Municipal Affairs Minister Pierre Moreau tabled a fresh version of the previous government’s pension bill in the National Assembly and called for talks, the coalition of unionized workers rejected it bluntly.

“This is not a bill, it’s a declaration of war,” Marc Ranger, spokesperson for the Coalition syndicale pour le libre négociation, told reporters.

He went further, calling the new constraints for the two sides to reach an agreement a kind of “holdup,” and accused Moreau of double-crossing the unions to please Quebec’s mayors seeking a way to reduce their labour costs.

Ranger said now that the government has shown its hand, his members are on a war footing.

The tone was totally different from Moreau who, at an earlier news conference, said the government is taking no sides in the dispute.

Bill 3 is designed to help Quebec municipalities and workers manage massive pension plan deficits. Although initially that deficit was estimated to be $5 billion, Moreau Thursday revised that downward to $3.9 billion.

“We can no longer shovel it forward or hand off the bill to the citizens of the cities, many of whom have no pension plans themselves.”

The bill uses the same formula the Parti Québécois proposed; splitting the deficit 50-50 between workers and cities.

The bill proposes freezing the automatic indexation of pensions for workers already retired. That would affect 20,000 out of 50,000 retired workers and yield $1 billion a year in new money.

The bill sets out a one-year term for talks between the parties starting at the latest Feb. 1, 2015.

It allows for one three-month extension — which can be renewed once — before an arbitrator steps in. That person would have six months to impose a deal that would be final.

But Ranger said the government is treating every pension the same way when only some of them are in the red.

And he argued some of the deficit problems are already solving themselves without having to “put the axe” to collective agreements.

The only group making favourable noises about the proposal was the Quebec Federation of Municipalities, which called the government’s bill a well-balanced solution.

“By having the two sides share equally in the costs of past and future deficits of pension plans, by allowing the freezing of indexation on current retirees and by taking into account the overall remuneration, the government is proposing a measured approach that favours intergenerational equity,” said federation president Richard Lehoux.

The federation approves of the negotiation timetable, which it said would ensure a solution to the pension issue within two years.

Montreal Mayor Denis Coderre, Quebec City Mayor Régis Labeaume and the Union of Quebec Municipalities said they would not comment until Monday.

Montreal Mayor Denis Coderre and the Quebec Union of Municipalities have thrown their support behind a provincial bill designed to help municipalities and their workers deal with huge pension plan deficits.

Coderre also appealed to city workers to remain calm during forthcoming negotiations on pension reform. On Thursday, 80 Montreal firefighters retired immediately fearing that their pensions would be reduced following negotiations between the city and their union.

The new Liberal government introduced Bill 3 to try and help municipalities across the province deal with pension deficits estimated at $3.9 billion.

The bill proposes that the deficit be split 50-50 between workers and cities. In many cases, cities cover 70 per cent of the cost of pensions with workers covering 30 per cent.

The bill also calls for past deficits to be covered by current workers and municipalities, a major sticking point for the unions, which say they are not to blame for the past mismanagement of pension funds and should not be forced to pay for them.

Coderre said the bill was a reality check and said cities need to respect the ability of the taxpayers to fund public pensions now and in the future.

“There are some people who don’t have a pension and they’re still paying for it (municipal pensions),” he said.

The bill also proposes freezing the automatic indexation of pensions for workers already retired.

Last year, municipal employees in cities with populations greater than 25,000 received 37.9 per cent more in salaries and benefits than counterparts in the public sector, Westmount Mayor Peter Trent said, citing provincial statistics. “In my view, this cannot continue,” he said at a news conference in Montreal.

The pension funds took a huge financial hit after the 2008 economic downtown and many cities failed to keep up with contributions over the years.

The bill sets out a one-year term for talks between the parties starting at the latest Feb. 1, 2015. If both sides can’t reach a deal, an arbitrator will step in and would have six months to impose a deal.

Suzanne Roy, president of the Quebec Union of Municipalities, called the bill a major benefit for all citizens. She urged municipal workers not to get too worked up about changes and promised that discussions with unions will be cordial.

“We want a climate of collaboration with the employees,” she said.

... I basically think everyone is full of it when it comes to pensions: the federal government which has yet to enhance the CPP for all Canadians; public sector unions with severe entitlement issues who have yet to embrace the concept of risk sharing; and Canada's public pension plutocrats getting paid like star hockey players for managing billions from captive clients (what a joke!).

There are many other things the federal government could have done right after the crisis to cushion the blow to private sector workers. For example, the current RRIF rules penalize people working well past the age of 65, which is absolutely insane. Many people who work past 65 were forced to take money out of their RRIF at the worst possible time while public sector workers retired with their guaranteed pensions. It's a complete travesty and Finance Canada has yet to implement any changes.

Now more than ever, we need is to get our collective heads out of our asses, sit down and implement policies that bolster our retirement system and economy for the long-run. The benefits of defined-benefit plans are misunderstood and grossly underestimated. I'm glad Ontario is going it alone but the best solution is still to enhance the CPP for all Canadians.

Someone asked me what I thought of Quebec's budget 2014 which was revealed yesterday. Quebec's public finances are a total mess. In many respects, the explosion of our debt is eerily similar to what happened in Greece except we have a much better economy. Nonetheless, the era of austerity has just begun and Quebec needs to do a lot more to cut waste, stimulate its economy and tackle its pension deficits.

Agreed. Quebec needs its own version of OMERS but it needs to be a separate entity. Capital is too concentrated in Quebec already for CDP to be the recipient of all of it. Too big to fail related moral hazard should apply to pension funds as well it does to banks.

Current city pension plans are for the most part too small to attract qualified individuals to manage them so the reality is that they have little to no investment staff and management is delegated by the board to outside consultants who themselves select external managers. A lot of economies of scale could be accomplished if all these funds didn't act independently.

Denmark's biggest commercial pension fund is clinging on to its inflation-linked bonds in case markets suddenly turn and prices surge.

“You’ve never paid less for linkers than you do now; the pricing is at historic lows,” Poul Kobberup, head of fixed-income investment at the Copenhagen-based fund, said in a phone interview. “No one knows what the market will look like half a year from now. Linkers may well prove to be the most attractive asset class out there and the best way to guard against sudden rises in rates.”

PFA wants bonds designed to hedge against inflation even amid warnings that much of the developed world is sinking into a disinflationary rut. The fund, which is also trying to build up its real estate portfolio, says it doesn’t want to risk getting caught in a bottleneck should more investors start buying inflation protection once markets turn.

“We continue to have a very traditional allocation,” Kobberup said. The fund wants linkers and real estate assets to make up as much as 20 percent of its total portfolio, he said.

Denmark’s inflation linked bond due 2023 has lost investors 0.5 percent since it was issued in May 2012. Nominal bonds with seven to 10 years left before they mature delivered their owners a 5.1 percent return over the same period, according to data compiled by Bloomberg.

Tackling Lowflation

A report last week showed Danish consumer prices fell 0.1 percent in May from a month earlier, while annual inflation was just 0.5 percent. In the euro area, inflation is less than half the European Central Bank’s target of close to, but below, 2 percent. In neighboring Sweden prices slid an annual 0.2 percent in May.

Since International Monetary Fund Managing Director Christine Lagarde in April coined the term “lowflation,” evidence of disinflation and even deflation has spread through much of the rich world. At the same time, many of the economies dealing with below-target consumer prices are witnessing record-high prices in their housing markets.

The developments prompted some of the Nordic region’s biggest investors, Denmark’s ATP Pension fund, which oversees $125 billion in assets, and PensionDanmark, which manages $28 billion, to reduce their holdings of linkers.

PFA has seen its stash of inflation-linked bonds fall, though only as a consequence of shrinking supply, Kobberup said. It lost 4.7 percent on its linker portfolio last year versus a 0.5 percent loss on its nominal krone bond holdings. The fund held 23.3 billion kroner in debt that tracks consumer prices at the end of 2013, according to its annual report. That’s a 15 percent decline from the beginning of the same year.

“We’ll always have a part of the portfolio in linkers,” Kobberup said.

Denmark’s central bank said it sees no threat from deflation as an accelerating rebound has brought the Scandinavian economy back to pre-crisis levels.

Danmarks Nationalbank raised its forecast for gross domestic product growth to 1.5 percent in 2014, 1.8 percent in 2015 and 2.0 percent in 2016, up 0.1 percentage point in all three years, according to a statement today. Inflation will be 0.6 percent this year and accelerate to 1.8 percent in 2016, the Copenhagen-based bank predicted.

“Although wage increases are modest, the low inflation at present is not a sign of deflationary pressures in the Danish economy,” Governor Lars Rohde said in the statement.

The bank, which uses monetary policy to peg the krone to the euro, this month opted not to follow the European Central Bank back into negative territory. Policy makers raised the deposit rate in April, exiting negative rates after almost two years. The ECB this month cut its deposit rate to below zero for the first time as ECB President Mario Draghi unveiled a round of measures to help fight the threat of deflation.

The Danish bank said that excluding a decline in the extraction of raw materials, GDP is back at pre-crisis levels.

“Overall, private sector demand is expected to grow steadily over the coming years, while public sector demand is assumed to rise at a more subdued pace,” the bank said.

Linker Yield

The bank is monitoring the declining unemployment, which it says is at the same level for some professions as when the economy was “overheating” in 2006.

The yield on Denmark’s inflation linked bond due 2023 rose the most in a week to 0.136, according to data compiled by Bloomberg. Unlike nominal bonds, linkers are designed to protect the value of investors’ fixed income from being eroded by inflation.

“Interest rates are close to zero and the housing market has self-reinforcing mechanisms,” Rohde said “Closer monitoring of developments in the housing and labor markets is therefore required.”

Whiffs of inflation have gotten everyone nervous that the Fed will rein in their bond purchases at a more aggressive rate and even start raising rates in 2015. I say "bullocks!". Stocks are getting slammed hard in what is a clear overreaction to the inflation data.

If you want to know where inflation is really heading as well as short-term rates, just have a look at the 10-year U.S. Treasuries where yields keep falling, even after the strong inflation reports. The 10-year yield now stands at 2.5%, which is a six-month low.

Why is the stock market overreacting to inflation data while the bond market is clearly unimpressed? Because stock market participants are collectively stupid and when it comes to discerning economic trends, the bond market gets it right.

There is no inflation. Nothing has changed since I wrote my outlook 2014. Sure, the big unwind has clobbered every momo playing high beta stocks, but there is still plenty of liquidity in these markets to drive risk assets much higher. In fact, I wouldn't be surprised to see biotechs (IBB and XBI), small caps (IWM) and technology shares (QQQ) rally very hard in the second half of the year.

Folks, there is no inflation. If anything, the biggest risk remains that we're heading toward a protracted period of debt deflation, which will expose many naked swimmers. Look at what is going on in the eurozone where anemic growth is leading to dangerously low inflation. Gold prices and shares will surge higher once the ECB gets cracking on quantitative easing.

But the problem isn't just in Europe. Even in the U.S., where an economic recovery is slowly taking hold, there is a serious threat of deflation. I was talking to a buddy of mine this morning. He told me that "cheap money for hedge funds and pension funds" is starting to be counterproductive. He added: "credit remains very restrictive for the masses which is why inflation will remain subdued for years to come."

I agree, while the 1% are the ones that profit from all the cheap money, the masses are being crushed under piles of debt. There is a private debt crisis and a jobs crisis going on which is why I take all these upticks in inflation with a shaker, not a grain of salt. I do my groceries too and have seen my grocery bills surge over the last year but that is a transient thing, which is why economists typically look at inflation trends ex food & energy.

Bottom line is there is too much debt out there and until you see a significant drop in the long-term unemployment, and a commensurate and sustained rise in wages, you can forget all about inflation. And if there is a crisis in China, you will see lower import prices which will reinforce deflationary headwinds. This is why I think all the talk of Fed tapering is way overdone. In fact, I expect the Fed to step up its bond purchases if an emerging market crisis unfolds.

1. The emerging market crisis escalates further;
2. The Eurozone crisis re-ignites;
3. The disinflationary trend intensifies and potentially turns into deflation;
4. The economic recovery currently underway proves unsustainable; and/or
5. Flow of funds provides more support for bonds than anticipated

Pierre Andurand has lost more dollars than he made for clients even. His IRR is probably negative. He had a very good first 18 months but it's only after that that assets piled in. There is fundamentally no difference between him and Brian Hunter who sank Amaranth. These guys go from punt to punt. If it works, they win. If it doesn't, investors lose.

I don't understand why many large pensions which I'm sure you know invested so much money with him right at the peak. They stuck with him even after becoming aware of his lavish wedding and flamboyant purchases. They lost almost 40% before deciding to pull the trigger.

As for Jennifer Fan, she went to Arrowhawk which I believe was set up by one of the original founders of FrontPoint. She had a good first year but then Arrowhawk folded when its seed client redeemed. Fan managed to hold to the assets in the commodity fund and set up Arbalet. She quickly raised a few hundred millions but I wasn't convinced. People who invested with her only did it to meet their commodity allocation target as many other funds were folding. She had no information advantage. The strategy was just based on quantitative screens with a good risk management process bolted on it. I felt the best to expect from her was 0.

Commodities hedge funds have something that appeal to investors which I don't understand. I don't think diversification benefits are overstated. I think it's expected return that is overstated. Fewer than 5 of them have been running more than $250M for more than 5-years. The survival rate is very low. Yet investors remain excited about every new launch. Jennifer Fan was another one. She lasted less than 18 months. She is now with Millenium. In fact the lack of quality supply in that hedge fund segment may explain why Andurand was given another life line.

The proliferation of more clever passive commodities exposure that take advantage of contango and backwardation on an opportunistic basis killed the golden goose. This is why commodities hedge funds were arbed away in 2008-09.

In fact, one of the most respected commodities Fund of Funds (a good representation of a real-life experience by an investor in the space) has shut down last week. They were in a 4-yr drawdown that was approaching 25% (Schroder's Opus Commodities). The only one that's left in the space is Pinnacle Natural Resources FoF. I think they're good but they can't replace their best managers if they close to capacity or retire and just like many others, have made more money pre-2008 when they had no assets. Since 2010, they haven't cracked the mid single-digit return and they're barely outperforming T-bills on a 5-yr rolling basis.

To me these are undeniable proof that it doesn't work. The only way I'd invest in a commodities hedge fund is at the GP level to get carried interest and only if I feel the main guy has a good marketing strategy because I don't think a fund investment will be profitable. This is a segment where the very best struggle. I'd rather focus on segments where even the fools thrive although these segments are rare.

If investors believe passive commodities 2.0 are a good way to beat the GSCI and DJ-UBS first generation indices, they can't believe at the same time that commodities have a chance because commodities hedge fund have made their money doing what passive commodities 2.0 products are doing.

I noticed your article of June 13th about Kate Kelly’s book and Pierre Andurand. I would like to highlight that there are a number of factual errors in the book, particularly relating to position size and descriptions. However, of even greater concern to me is the postscript that was published to your article following a conversation with one of your readers as this contains significant inaccuracies and unfounded allegations about Pierre Andurand and BlueGold.

I would like to make it clear that nobody “piled in” at the top of BlueGold. In percentage terms, BlueGold had an annualised return of 34% even after the last year’s loss, and in dollar terms the return was in excess of $1B. Further, after BlueGold shut down, all investors were offered their high watermark in the new fund, so the shutdown was not in any way an attempt to escape losses or “get a new lifeline”. (So far the new fund has returned over 32% net for these legacy investors and not charged any performance fees. We believe we have always acted honourably and fairly to our investors and will keep doing so going forward).

Brian Hunter of Amaranth lost about 300% of his AUM in his last year, so this is in no way comparable to BlueGold and Pierre. (Pierre’s return since 2004 is over 2000% cumulative, 45% annualized, and his biggest loss was 34.8% in 2011 which is now being largely recovered)

I hope you may see that based on these facts, the postscript information is shown to contain poorly considered comparisons and comments. Although the postscript may represent simply a “throwaway” comment these incorrect assertions are obviously damaging to Pierre’s reputation so we are hoping that you may remove it, or at least post my comment so that both sides of the argument are represented for your readers.

I stand corrected. You can remove my original comment. There were exaggerations.

They're right. I double checked and there were more inflows at the beginning and later at the end than what had been represented to me. It's only dollars invested in 2011 that experienced negative IRR. Between Dec-10 and Apr-11, they had perhaps $300M in net inflows or roughly 15% of the assets in the main fund. And that's when the high water mark was hit. That $300M or so, if it stayed until the liquidation was announced, was down 40%. 2008 and 2009 dollars invested definitely enjoyed super IRR. Unclear about 2010. I have no access to audited track record prior to that so my comments only applied to the BlueGold track record.

Kudos for granting the high water mark for investors who re-underwrote Pierre.

As for the comment concerning the parallel between BlueGold and the Amaranth of the later days, it is more a function of where both managers were on the risk appetite spectrum judging from the volatility of their monthly returns and the breadth of their investible universe. They were both in the 5th percentile. And that tends to be toxic.

[Andurand] spent the next few months preparing to launch his new hedge fund. Depending how well the fund-raising went, he was willing to put up to $100 million of his own money into the business, but he hoped some of his old investors would support the new venture. To help attract them, he had offered to forgo his own cut of the new fund's profits until they made back any money they lost at BlueGold -- a move known in the hedge-fund business as transferring the high-water mark. It was a tough standard to meet, but money managers at Citadel, the large Chicago fund group, had recently done it, and Andurand figured he could too.

On March 28 2011, Delta Air Lines delivered a plea to Washington. Traders with no business in the oil market were pushing up the price of the 4bn gallons of jet fuel Delta burnt each year. The Commodity Futures Trading Commission needed to stamp down on the speculators, the carrier argued in a letter, or risk “concrete detrimental consequences for the real economy”.

The company was a classic “commercial hedger”, in the parlance of commodities markets. It used futures to lock in fuel prices at places such as the New York Mercantile Exchange. At the time, oil was spiking for the second time in four years and airlines blamed financial investors herding on to the Nymex.

Delta’s antipathy towards speculators was soon to change, as Kate Kelly reveals in The Secret Club that Runs the World. In April 2011 Delta hired Jon Ruggles, a cocksure veteran energy trader, as vice-president of fuel. Facing a shortfall in an employee bonus pool, managers authorised Ruggles to pursue a “purely speculative trade” in heating oil that would make Delta $100m.

The airline’s bet confounds the policy debate that has raged around commodity markets since oil, metal and grain started streaking higher about a decade ago. Washington and Brussels want to reduce speculators’ influence in futures markets, convinced they can distort prices for basic materials. But if hedgers also use futures to speculate, how will regulators know whom to curb?

Kelly, a reporter at CNBC, explains complex trading strategies through lively stories about Ruggles and a handful of other high-flying western commodities trading personalities from New York to London to Zug. They include Pierre Andurand and Jennifer Fan, both hedge fund managers, and Alex Beard, global head of oil at Glencore, the giant commodities trading house. While few names will be secret to readers of the financial press, Kelly digs up vivid details of their behaviour during times of extreme market stress.

We learn how Beard “put on a massive speculative bet” that oil prices would fall in 2008 – as they did, decisively. We are told how Gary Cohn – now president of Goldman Sachs – built “enormous caches” of aluminium in the early 1990s that drove up prices, foreshadowing Goldman’s controversial entry into metals warehousing. Traders seem to make as much money when prices fall as when they rise, often via arcane structures with names such as “cap-swap double-down extendable”. This complexity underscores the challenge for regulators such as the CFTC, which meets next week to discuss speculation limits.

At times, The Secret Club feels a bit breathless. Traders are cast as “shrewd and indomitable” representatives of a world in which “a relatively small circle of powerful players take enormous risks gambling on the future price of physical raw materials like oil, corn, and copper”. Some of the details Kelly seizes on to bring her subjects to life – a penchant for designer jeans, say, or for grouse hunting – could seem unremarkable in another context.

The author can also be glib on why commodities markets rallied until mid-2008, crashed and then rallied back, in some cases to fresh records. “The commodities bubble of the 2000s is a snapshot of one of the most extraordinary periods in American finance, providing an object lesson on the role of markets, regulators, and how the money world can sometimes lose its connection to the real one,” she writes in chapter one. More than 200 pages later, this lesson is unclear. The roles of hedge funds and commodity index investors receive more attention than obvious factors such as the doubling of Chinese demand for oil over that decade.

In the three years since Kelly began reporting The Secret Club, commodity markets have become rather boring. Banks are pruning operations. Specialist hedge funds have closed. Volatility is depressed.

Meanwhile, the world is still guzzling more commodities. As the energy and metals trading house Trafigura argues in its annual report, the outlook “has not changed in any very significant way from the one that prevailed before the financial bubble burst in 2008”. Kelly’s engaging review of the previous decade may also serve as a guide to future tumult.

How do you build the world's largest hedge fund? Bridgewater Associates founder Ray Dalio says he did it by creating a culture of "radical truth and radical transparency." Mr. Dalio's perhaps radical belief is that "everything is a machine"—including organizations and even the individual people within them. At his firm's Westport, Conn., headquarters, we are discussing the human machines at Bridgewater and the equally fascinating machine known as the U.S. economy.

As for the people at his firm, the idea is to encourage everyone to accept unvarnished criticism as a treasured opportunity to learn and to solve problems. This is intended to allow constant refinement of business processes—also known as machines within the firm—from how Bridgewater buys office furniture to how it evaluates the world oil market.

But human machines don't always welcome complete candor. And at Bridgewater they have to get used to internal software that conducts a non-stop evaluation of their performance based on daily entries from colleagues and even rates their credibility on particular issues. This doesn't mean the software makes all decisions. When the system recently reported that the company's head receptionist was underperforming, executives decided that it was a case of the software not being calibrated to effectively measure her work.

If an employee is willing to accept this unique culture, the company promises a rigorous search for the truth with a minimum of politics and subjective decision-making. Mr. Dalio says that anybody in the company can get up in front of a crowd and say that something doesn't make sense. At other firms, he says, "most people keep that to themselves." But at Bridgewater "you have a right and an obligation to say I think this is terrible and explore whether or not that's true." He adds that there's no reason it should not happen at other organizations but that it doesn't happen "because of that emotional ego barrier."

For most new Bridgewater employees, "it's a little bit like entering the Navy SEALs," says Mr. Dalio. "There's a period—usually about 18 months—of sort of adaptation to this. And some make it and some don't make it. And so we call it 'getting to the other side.'" He adds that "the other side looks like: They can't work anywhere else and the reason they can't work anywhere else is they don't know what anybody's thinking anywhere else. They don't have an ability to speak their mind anywhere else. They don't have the guardrails of their weaknesses. Everybody's got weaknesses. They can't candidly address weaknesses.

"We describe it as: there's the upper-level you and the lower-level you. The human brain is part thoughtful man," he explains, "and part animal. And you have to drag yourself. And we see the struggle as between the upper-level them and the lower-level them." In other words the brain wants honest feedback but the emotions aren't always ready to handle it. "It's not a struggle between us and them typically. It's a struggle between what do they want" and "what happens in their emotional reactions to that."

He believes that the Bridgewater culture has been critical to the growth of the firm, because in financial markets "if you can't have independent thinking" and "you can't know what your weaknesses are, and sort those things out, you're not going to be successful."

How does he implement this culture? "I tape everything so everybody can listen to every conversation, except if there's a very personal matter" or "if we're going to execute a trade or something proprietary." Otherwise "everything is taped so everybody can see it and we go through a process of valuing critical feedback to try to together discover what the patterns are" and how improvements can be made.

Created in Mr. Dalio's New York City apartment in 1975, Bridgewater now manages $160 billion in assets. A "global macro" investor that focuses on understanding national economies, the firm has a history of reporting market-beating returns to clients—and even made money during the financial crisis—but posted disappointing results in 2012 and 2013. Bridgewater appears to trade less with some of Wall Street's giant banks than some large funds do, but Mr. Dalio says that it's not a policy of his firm to avoid Wall Street. "We just go wherever the transaction costs are cheapest."

Just as he sees individuals and business processes as machines, Mr. Dalio also sees an economy the same way. And that "means that there are cause-effect relationships" and this allows one to understand that "most things happen over and over and over again." Mr. Dalio says that, "In order to really understand the machine I believe that I have to have timeless and universal rules" across all time and all countries.

The emphasis on transparency within the company doesn't mean that Mr. Dalio is seeking media attention. "No, I hate it," he says. But he has consented to this interview, and has published papers and a video online at EconomicPrinciples.org, because he wants everyone, including Washington policy makers, to look at the economy in a new way—to understand the machine.

"Because I've watched repeatedly so many misunderstandings [that] have bad consequences. And I think that rather than trying to discuss what should be done that we have to start with the basics of saying: how do things work?" He adds, "If we can agree on how it works, then that's a foundation for what should be done and also what will prevent problems. So an example of that would be printing money. Is printing money inflationary? Well let's just go back to basics and look at that question."

While people debate whether the Federal Reserve's money creation will or will not cause inflation, Mr. Dalio says it's first necessary to get a clear view of the monetary machine. Stated simply, he says, all purchases in the economy must come from money or credit. He therefore sees a role for central banks in helping to prevent a steep downturn when the availability of credit plunges during a financial crisis. "The printing of money offsets the contraction in credit," he says, "and relieves the liquidity problem."

The Fed has been creating a lot of money since the crisis. Mr. Dalio says his team at Bridgewater has studied 67 historical periods of deleveraging, when countries or economies had to reduce debts after a credit boom. He pronounces the current U.S phenomenon "a beautiful deleveraging"—with the Fed adding money to the economy to maintain overall spending. And as people in the economy extend more credit, he says, the Fed should in turn reduce its money printing.

Still, he says, "I worry about the effectiveness of monetary policy in the next downturn." That's because the first tool the Fed can use to goose the economy is to lower interest rates. But since rates were already very low during the crisis, the Fed decided to employ a second tool: creating money as it purchased Treasury and mortgage bonds through a program known as quantitative easing. But such purchases are less effective than lowering rates, says Mr. Dalio, because while interest rates directly affect nearly everyone as they buy houses and cars and shop with credit cards, the people who own financial assets and who benefit from QE don't necessarily buy more things as a result. QE works best when not much money is in the system and asset prices are low. With lots of money now in the system and the prices of financial assets having soared since the depths of the crisis, such policies will likely be less effective.

"There will have to be a monetary policy number three," says Mr. Dalio. "This is an issue I haven't yet figured out." He adds that "every cyclical peak and trough in interest rates was lower than the one before it since 1980." One therefore wonders what firepower the Fed will have if it is again called upon to prop up the economy. "We'll probably find a way to manage through that," he says. But for now we are in "neither boom nor bust" and Mr. Dalio doesn't expect much volatility over the next few years.

A lot of readers will no doubt think that we need activity in other parts of the American economic machine, rather than just Fed money printing, to return to robust growth. Mr. Dalio makes it his business to study national economies around the world and of course he has a machine to evaluate them.

Surveying the rise and fall of economies over time, Mr. Dalio and his colleagues have developed a model intended to predict national economic growth rates over 10 years. The model is based 35% on the country's level of indebtedness and 65% on competitiveness and "by that I mean what you get for what you pay," he says. The single "most important factor is what it costs to have an educated person."

For this reason, Mr. Dalio can see significant unrealized potential in Russia because of its very low level of indebtedness, which means "they have the power to buy," and due to its highly educated and cheap labor force. But culture matters, too. Another key to growth "is the notion of self-sufficiency," he says. "Economies in which a greater percentage of the population feels the rewards and penalties of their actions tends to grow faster than those that don't."

In Russia, he notes, "there's no inventiveness, there's no entrepreneurship, there's no small business development." International indexes note high corruption and limited property rights. Mr. Dalio sums up the results for economic growth when few people have ownership opportunities: "Nobody ever washes a rental car."

Such factors are why he still sees a bright future for the U.S., even with lots of debt and moderately expensive educated workers. The U.S. has "a very high rate of innovation," and technology development "in my opinion is going to produce and is in the early stages of producing productivity miracles." He compares America's "connectivity revolution" to Gutenberg's invention of the printing press, and he also notes that the U.S. is becoming energy self-sufficient. "Plus we have rule of law, we have property rights."

One area where the U.S. "could make a lot of progress" is in improving public education. "That's a high-potential area," he adds. It's unclear whether anyone can understand the machine known as the U.S. public-school system, but it's safe to say that it doesn't operate much like Bridgewater.

As for the U.S. economy as a whole—as well as all the people within this great machine—Mr. Dalio offers a simple rule to help avoid the next credit crisis: Don't allow debts to grow faster than income.

Some of the biggest investors on Wall Street are losing money with wrong-way bets in markets around the globe, a surprising black eye amid a rise in stock and bond prices.

Hedge-fund managers including Paul Tudor Jones, Louis Bacon and Alan Howard are among those who have misread broad economic and financial trends. Some have lost money as Japanese stocks fell, while others have been upended by the surprising resilience of U.S. bonds.

An unusual period of calm has exacerbated problems for many trading strategies dependent on volatile markets. The losses by these so-called macro investors are contributing to a trading slowdown hurting the largest investment banks.

The flagship fund at $15 billion Moore Capital Management LP, led by star investor Mr. Bacon, was down 5% this year through the end of May, the firm has told clients. Mr. Jones's flagship fund at $13 billion Tudor Investment Corp. is down 4.4% this year, according to a person familiar with the firm.

By comparison, the S&P 500 index is up 5.4% this year, including price gains and dividends, and the Barclays U.S. Aggregate bond index, a standard measure for debt investments, is up 3.4%.

Funds operated by Mr. Howard's Brevan Howard Asset Management LLP, Fortress Investment Group, Caxton Associates LP, Discovery Capital Management LLC and Balestra Capital Ltd. also have posted losses, according to people familiar with their performance.

It is always difficult predicting broad trends, and the losses could quickly reverse. But hedge funds charge high fees with the expectation of impressive performance in any kind of market, and these investors built reputations with prescient market picks. Those running so-called macro funds generally bet on macroeconomic trends in global markets while investing in stocks, bonds, commodities and currencies.

"Macro investors have had a very, very hard time with the fact that bonds have done well and volatility is so limited," said Matt Litwin, director of research at Greycourt & Co., a Pittsburgh-based investment firm that invests $9 billion in hedge funds and other firms but has been reducing some of its investments with macro hedge funds. "There are a lot of losers."

Many funds piled into Japanese shares last year when they began rallying. But the Nikkei Stock Average is down 7.1% since reaching a high in January, amid doubts about the sustainability of Japan's economic recovery. Fortress, a $63 billion firm, has acknowledged to investors in its Fortress Macro fund that it was hurt by both this year's run-up in U.S. Treasury prices and weakness in the Nikkei. The Fortress Macro fund was down more than 3% this year as of June 6.

Brevan Howard Capital Management's roughly $28 billion flagship fund was down 3.8% through June 6, according to an investor in that fund, with interest-rate and bullish Nikkei bets among its losers. Caxton Associates in New York, an $8 billion firm, has lost money every full month this year and was down more than 6% at the end of May, according to the firm's investor updates, partly due to bearish currency positions.

Kyle Bass's $2 billion Hayman Capital Management LP has lost money on wagers against some European countries, as well as a bet on further weakening of the Japanese yen, people familiar with the firm say. The Dallas-based firm's main fund suffered its steepest two-month drop in five years at the start of the year and fell more than 6% in the first quarter, these people say.

Woodbine Capital Advisors LP, a well-known fund run by Joshua Berkowitz, a former senior trader at Soros Fund Management, recently announced plans to stop managing outside money after disappointing returns.

Larger funds have a handicap in slow markets: They can be too big to trade in smaller markets that are seeing more volatility.

"You can't put $1 billion in coffee contracts and expect to get out quickly, so the big funds can't have these smaller plays in their portfolios," said Sam Diedrich of Pacific Alternative Asset Management Co., an Irvine, Calif., firm that invests in hedge funds.

The setbacks for macro investing—a style made famous by George Soros and others who anticipated past market turns—come after a rush of investors embraced this approach to trading, thanks to its impressive performance during the financial crisis.

Macro funds on average gained 4.8% in 2008, even as the S&P 500 fell 37%. Other investors saw how John Paulson, a onetime merger specialist, made $20 billion in profits at his firm, Paulson & Co., anticipating the 2008 meltdown, and they vowed to adopt macro strategies as well.

Today, there are 1,865 hedge funds focusing on macro investing, up from 1,233 in 2008, according to HFR Inc., which tracks the hedge-fund world. That growth is much faster than that of the overall hedge-fund business. Macro funds manage $508 billion, up from $279 billion in late 2008. But macro funds have had three years of disappointing returns.

The poor results are prompting investors to pull money from macro funds and are forcing some funds and other financial groups to scale back their trading. Large banks including Goldman Sachs Group Inc., GS -0.08% J.P. Morgan Chase& Co., Morgan Stanley and Barclays PLC execute many hedge funds' trades. Such banks tend to benefit from rising trading volumes and volatile markets.

Amid the recent quiet, many banks have posted soft results, and some have laid off traders. Goldman Sachs President Gary Cohn said last month that unusually slow markets had made it "difficult" for Wall Street firms. Morgan Stanley said this month it would cut jobs from its currency and rates-trading businesses in response to tepid investor activity.

Some worry that a lack of volatility will continue to haunt various markets, perhaps until the Federal Reserve signals higher interest rates are imminent following a long period with benchmark rates near zero.

"I actually find myself daydreaming about winning 'Dancing With the Stars' on some days in the office," Mr. Jones, of Tudor, joked at an investment conference this spring. "It's gotten to be very difficult, when you depend on price movement to make a living, and there is none."

Average daily bond trading has fallen to about $734 billion, the lowest level in more than a decade, according to the Securities Industry and Financial Markets Association. The CBOE Volatility Index, the most widely cited measure of investor expectations for daily stock-market swings, on June 6 slipped to 10.73, its lowest closing level since 2007, according to FactSet.

"These are very uninteresting times in the market," Jared Dillian, a former trader who now writes a newsletter, recently told his subscribers. "The goal is to not fall asleep."

• Publish your IRRs, net of all fees and costs, for each fund going back monthly to inception.
• Publish your turnover rate every year with an explanation if it rises.
• Publish your research and letters for everyone, not only your clients (What ever happened to Bridgewater's research piece "Selling Beta as Alpha'?)
• Last but not least, diversify your workplace and hire persons with disabilities. Don't worry, it will do wonders in counterbalancing the pervasive arrogance at your shops.

Corporate pension funds and university endowments in the U.S. have missed out on much of the rally for stocks since 2009, following a push to diversify into other investments that have had disappointing performances.

The institutions, ranging from large corporations such as General Motors Co. to big universities such as Harvard, have been shifting to hedge funds, private equity and venture capital. But while these alternative investments outpaced stocks during 2008's market meltdown and are seen as potentially less volatile, they have badly lagged behind the S&P 500 since 2009, a period in which U.S. stock indexes have more than doubled.

Diversifying away from stocks could work out since many of these institutions enjoy long investment horizons and won't need to spend the bulk of their assets until years in the future, if ever. At the same time, many alternative investments have topped stocks over the past decade. Investments in private equity, for example, nearly tripled the gains in stocks, according to Cambridge Associates LLC, which invests in these funds for clients.

Missing out on recent stock gains, though, adds to challenges facing pension funds, some of which don't have enough assets to meet future obligations. For universities dependent on endowment income, reducing stockholdings represents a lost opportunity in a time of stretched resources.

The recent poor showing has put a spotlight on pension funds and endowments that have turned away from stocks for more than a decade, including the period after the market's plunge, when stocks became inexpensive relative to their earnings.

"Alternative asset classes are expensive, especially if you have to live with the average fund instead of stellar funds," said Prof. William Goetzmann of the Yale School of Management. Hedge funds and private-equity firms generally charge investors much higher fees than mutual funds and other traditional investments, including management fees of as much as 2% of assets and a take of any returns.

Harvard University, with the world's largest endowment at $32.7 billion, had an average annual return of 10.5% over the past three years through June 2013, according to the school, well below returns of 18.45% for the S&P 500, including dividends, over that same period. Yale University, with an endowment of $20.8 billion, and Stanford University, $21.9 billion, had returns of 12.8% and 11.5%, respectively, over that same period, the schools said.

Over the past 10 years, the schools fared better, generating gains of 9.4%, 11% and 10%, respectively, above the 7.3% return of the S&P 500. Spokesmen for the schools declined to comment.

The U.S. companies with the largest defined-benefit pension plans in 2013 posted an average return of 9.9%, according to a survey of 100 large firms by Milliman, which provides actuarial products and services. The S&P 500 returned 32% in 2013, including dividends.

The average college endowment had 16% of its investment portfolio in U.S. stocks as of the end of June 2013, the most recent academic year, according to a poll of 835 schools conducted by Commonfund, an organization that helps invest money for colleges. That is down from 23% in 2008 and 32% a decade ago. The 18% allocation to foreign stocks didn't change in that period. Schools in the poll, which collectively manage nearly $450 billion, had 53% of their funds in alternative strategies, up from 33% in 2003.

The average allocation of corporate pension funds to stocks was 43% at the end of last year, down from 61% at the end of 2003, according to J.P. Morgan Chase & Co. The average public pension fund had 52% of its portfolio in stocks at the end of 2013, down from 61% at the end of 2003, J.P. Morgan said.

While stockholdings have shrunk, alternative investments made up 25% of the portfolios of public pension funds, up from 10% a decade ago. Corporate funds had 21% of their money in alternative investments, up from 11% at the end of 2003, J.P. Morgan said. Hedge funds and private-equity firms can use a range of strategies, including betting against stocks and buying and selling companies.

The shifts haven't worked out lately. Since the start of 2009, when the market began rallying, the S&P 500 has climbed 137%, including dividends, to record levels. By contrast, the average hedge fund is up 48%, according to research firm HFR Inc., while the average hedge fund that is focused on stocks has risen 57%. Over that same time, private-equity funds have climbed 109% on average, while venture-capital funds rose 81%, according to Cambridge Associates.

Among large U.S. companies with small allocations to stocks in their pensions, shareholdings ranged from 5.2% at NCR Corp. to 14% at Prudential Financial Inc. and TRW Automotive Holdings Corp. to 15% at Ford Motor Co. F to 18% at General Motors to 19% at Citigroup Inc., as of the end of fiscal 2013, according to Milliman and data provided by the companies.

A Prudential spokesman said the company establishes "guidelines that match our obligations with assets in the plan." A Citigroup spokesman said its plan is "largely invested in assets other than equities in part because it has been closed to new participants for several years and has adopted an approach that is consistent with plan closure."

A GM spokesman cited language in the company's annual report that the asset mixes of GM's pension fund aim to improve its funded positions while trying to reduce the plan's risks. Spokesmen for NCR, Ford, and TRW declined to comment.

Some pension funds have elected to have big bondholdings instead of shares or alternative investments. CBS Inc., which had 26% of its pension fund in stock as of last year, largely invests in bonds, according to a CBS spokesman.

Some institutions aim to achieve a certain return above inflation and find steady returns from alternative-investment vehicles make it easier to plan future spending. Alternative investments generally do a better job competing with stocks when the risk of the various investments is taken into consideration.

The long-term results of alternative investments are somewhat better. Over the past 10 years, the S&P 500 has climbed 114%, including dividends. That bests the 75% gain of the average hedge fund, according to HFR, and the 68% return of the average stock-focused fund. But private-equity funds topped stocks, rising 304% on average over that period, while venture-capital funds climbed 153%, according to Cambridge Associates.

"It's in the long term that these strategies hit their stride, particularly private equity," said Andrea Auerbach, head of Cambridge's global private investment research.

Placing money with hedge funds once was viewed as risky; today, a mix of stocks, bonds and cash is seen as more dangerous, industry members said, partly because alternative investments held up better during the financial crisis and are seen as more dependable investments.

Some argue that the shift stems at least partly from an effort to ape the strategy of David Swensen, who has long led the endowment of Yale University and was among the first to shift big chunks of its investments to hedge funds and similar vehicles.

A 2012 paper written by Mr. Goetzmann and another professor at the Yale School of Management, Sharon Oster, argues that university endowments often invest in hedge funds simply to catch up with their closest competitors, rather than to achieve top returns, a shift the professors call "herding behavior" and "trend chasing."

Harvard's endowment had an allocation of 33% to global stocks and stock-focused hedge funds, but just 11% to U.S. shares, as of the fiscal year ended last June. Yale had 15.7% in global stocks and Stanford had a target stock allocation of 25%.

Those shifting to alternative investments more recently could be "too late to the game," said Scott Malpass, chief investment officer at the University of Notre Dame, which has had more than 50% of its $9.2 billion endowment in alternative investments for more than a decade.

Betting on hedge funds and private equity "can be a knee-jerk reaction to the crisis," he said.

Alberta Investment Management Corp (AIMCo), the C$80 billion ($73.7 billion) provincial pension manager, is steering clear of investments tied to existing roads, bridges and transmission lines as their growing popularity squeezes returns.

AIMCo Chief Executive Leo de Bever said on Monday the company is pushing into late-stage venture capital and newly constructed infrastructure as it looks for above-market returns for the pension and provincial government funds it manages.

Investment in land or transmission lines "has become commonplace," de Bever told reporters. "The returns on it have started to diminish."

De Bever was one of the early pioneers of investing pension funds in infrastructure. While a senior vice-president at Ontario Teachers' Pension Plan in the 1990s, de Bever bought a 25 percent stake in AltaLink, which controls half of Alberta's electricity-transmission network. Warren Buffet's Berkshire Hathaway Energy acquired the company from SNC-Lavalin Group Inc last month for C$3.2 billion, a price that kept pension funds out of the bidding.

"The price gives ... about a 5 percent return on equity," de Bever said. "To me, that's a little skinny. These assets are trading at very, very high prices."

Rather than look to existing assets to provide the long-term payouts needed by pension funds, de Bever said AIMCo is looking to play a role in funding new infrastructure construction in fast-growing areas like Fort McMurray, Alberta, a booming city of 77,000 in the heart of Canada's oil sands. As well, it is looking at providing late-stage venture capital for energy-technology companies.

"We have to get more innovative in different areas," he said at a press conference. "We have to stretch ourselves and stretching ... means going for the more difficult assets."

De Bever points to AIMCo's investment in bankrupt Australian timberlands controlled by Great Southern Plantations as an example of the fund manager's search for unconventional assets offering above-market returns.

"It was a huge mess and everybody else looked at it and said it's going to take a long time to sort it out so why would we get involved?" he said. "Us being long-term investors said 'Hey this is a perfect opportunity because if we can straighten this out and we can buy it cheaply then presumably the return is going to come'."

AIMCo is looking to its unconventional investments to replace low-return assets like bonds whose prices are threatened by rising interest rates.

De Bever, 66, plans to retire from the fund manager once an executive search for his replacement is complete.

In the face of Detroit’s tumultuous bankruptcy proceedings, in which multiple parties are quarreling to protect their interests, the city and its unions have quietly negotiated a scaled-back pension plan that could serve as a model for other troubled governments.

One of the most closely watched issues of the case is whether a government pension plan can be legally cut in bankruptcy. Detroit, saddled with a pension system it cannot afford, has introduced a new plan with the cooperation of its unions, which have been among the most vocal opponents of cutbacks.

While both retired and active workers now participate in the same city pension system, the new plan is intended only for Detroit’s active workers, who will shift to it on July 1. Retirees will keep 73 percent to 100 percent of their current base pensions under the city’s proposal to exit bankruptcy.

The new plan is called a hybrid, which means the workers will keep some of their current plan’s most valuable features but will give up others. Trading down to a less generous pension plan is often said to be a legal nonstarter for government workers, so if Detroit succeeds, its hybrid could become a model for other distressed governments from Maine to California. Countless elected officials — from Rahm Emanuel, the Democratic mayor of Chicago, to Chris Christie, the Republican governor of New Jersey — are caught between ballooning pension obligations, angry local taxpayers who don’t want to pay for them and labor lawyers who say it’s impossible to cut back.

“We have a festering sore here,” Christopher M. Klein, the judge in the bankruptcy case of Stockton, Calif., said at a hearing in May, referring to that city’s surging pension costs. “We’ve got to get in there and excise it.”

Detroit’s current pension system simply costs too much relative to its battered tax base, and the watchword for Detroit this summer is feasibility. For the city to emerge from bankruptcy, its emergency manager, Kevyn D. Orr, must convince Steven W. Rhodes, the judge overseeing Detroit’s bankruptcy case, that his long-term financial plan is feasible. The matter is to be decided at a trial to start in August.

There would be little hope of persuading Judge Rhodes if Detroit’s workers were still covered by the existing pension plan and struggling local taxpayers were still liable for the relentlessly mounting obligations. For many years, the current plan allowed city workers to earn benefits that others in Detroit could only dream about — full pensions at 55, longevity bonuses, annual cost-of-living increases, an extra “13th check” in December and bankable sick leave that could be converted to cash, among others. In recent years, the resulting pensions have been greater than the per capita income of the residents who were expected to pay for them.

On June 30, Mr. Orr will freeze that pension plan, meaning that the city’s current workers will not accrue any further benefits on those terms.

Starting the next day, in the new hybrid plan, they will still earn so-called defined-benefit pensions — a specified monthly payment based on tenure, age and earnings history — something their unions consider critical. But they will also start to bear most of the new plan’s investment risk. That means Detroit’s taxpayers — who pay a city income tax in addition to property and sales taxes — will no longer face cash calls every time the plan’s investments drop in value. Officials hope that making the workers backstop the investments will discourage overreliance on high-risk strategies.

This unusual combination of features gives both the city and the unions an opportunity to declare victory and provides Mr. Orr with ammunition for the coming feasibility trial.

But it also flies in the face of a legal principle known as the vested-rights doctrine, which holds that the pension formula in force on the day a public worker goes on the job cannot be reduced for the full duration of employment. No such legal protection exists for workers in the private sector, whose pension plans can be frozen at any time. But in the public sector, the vested-rights doctrine is an article of faith, zealously defended, and it helps explain why a bankrupt city like Stockton is proposing to saddle its other creditors with big losses but not touch the pension plan.

The vested-rights doctrine is especially powerful in California, growing out of court decisions dating back to 1947. Unions in San Jose recently used it to keep the city from making its workers contribute more toward their pensions. Employees of four California counties argued in court last year that they had a vested right to pad their pensions by counting things like unused vacation time in their benefit calculations, despite laws prohibiting the practice. In March, Judge David B. Flinn of Contra Costa County Superior Court ruled that there was no such thing as a vested right to an illegal benefit — but the ruling applies only to current workers. Retirees are still receiving the padded pensions.

California’s state pension system, Calpers, is a powerful proponent of the vested-rights doctrine, and many state and local governments follow its lead.

In Detroit’s bankruptcy, however, the vested-rights doctrine does not appear to be an issue. The Michigan law for distressed cities gives emergency managers like Mr. Orr the power to set the terms of public employment. That means he can legally freeze Detroit’s existing pension plans and establish new ones for city workers, said Bill Nowling, a spokesman for Mr. Orr.

“He is not making any benefit cuts,” Mr. Nowling added.

For Detroit’s retirees, it’s a different matter. They are not being asked to give up benefits they had hoped to earn in the future; they are being told they must give up benefits they have already earned. Michigan’s constitution forbids this, so Mr. Orr is using the Chapter 9 municipal bankruptcy process, in which federal law applies. A bitter battle is already taking shape.

By the time the fate of the retirees has been decided, Detroit’s workers will already be earning hybrid benefits. To shift the investment risk their way, Detroit has set up a series of eight “levers” to pull if the plan’s investments falter. They include setting up a reserve fund that must be used to cover losses, raising the workers’ required contributions, lowering retirees’ cost-of-living increases and making workers build up their benefits more slowly.

Should investments not produce the expected returns — in a protracted bear market, for example — leaving too little money to meet all obligations, officials will be required to pull as many levers as it takes to get the plan back to the 100 percent funded level within five years. Only if all eight levers are pulled and the plan is still not responding adequately can Detroit’s taxpayers be called on to rescue it.

To measure the level of funding, the plan will assume a 6.75 percent rate of return. That still allows for a substantial amount of risk, although it is less than the 7.9 percent assumption the city was using when it declared bankruptcy. Officials of the American Federation of State, County and Municipal Employees, which led the negotiations, did not respond to calls seeking comment. The union is one of 48 that represent Detroit’s municipal workers.

Even as they were negotiating the hybrid pension plan, Detroit’s unions were still appealing a ruling last December by Judge Rhodes that pensions could be cut under federal bankruptcy law, despite protective language in Michigan’s constitution. The unions are required to drop the appeal if they vote for Detroit’s plan of adjustment. From California, Calpers has asked to serve as a “friend of the court” in the appeal, saying Judge Rhodes’s decision “raises issues that are of critical importance to Calpers and its 1.7 million members.”

Calpers’s brief argues that Judge Rhodes ruled improperly and asks the United States Court of Appeals for the Sixth Circuit to vacate his finding that state laws protecting pensions are not binding in bankruptcy cases. Although California’s laws have no force in a federal case in Michigan, Calpers expressed concern that rulings concerning Detroit’s bankruptcy might recast the legal landscape in California.

“Such a precedent can be, and has been, misconstrued for the broad proposition that all pensions are subject to impairment in Chapter 9,” the Calpers brief said.

There is nothing that pisses me off more than a bunch of incompetent goofballs in Ottawa and idiots at right-wing think tanks spreading malicious lies on defined-benefit pensions and why we shouldn't enhance the CPP for all Canadians.

But I also got a bone to pick with all these public sector unions who think gold plated pensions are their god given right. Think again. There is nothing written in stone that guarantees you a nice pension for life. Just ask the civil servants in Greece and Detroit what happens when the money runs out.

I worked at various jobs in the public and private sector. There are lazy, incompetent fools in both the private and public sector. It used to drive me nuts when I had some senior civil servant bureaucrat telling me they are counting the days to retire so they can collect their pension.

Let me be clear on something. I am all for defined-benefit pensions across the public and private sector but I am also for major reform including raising the retirement age and risk sharing.

Importantly, if it were up to me, I'd raise the retirement age to 70 because people are living a lot longer and I would pass laws where pension plan benefits are indexed to markets. I would also ensure much more transparency and better governance at all our pension plans, including our much touted large Canadian public pension funds where compensation is running amok.

The government of Quebec and municipalities have no choice but to slay this pension dragon once and for all. I personally think they should amalgamate all these small and medium sized public pensions and create a new pension with world class governance. They could give the money to the Caisse but that organization is big enough and I think we can use another major public pension fund in Quebec with new blood (not the same old Caisse faces which everyone is tired of).

A specter is haunting Europe -- the specter of deflation. Countries throughout the European Union have been struggling for the past several years with stagnant or falling prices. In Hungary, inflation has fallen to its lowest level since 1974. In Bulgaria, Cyprus, Greece, Ireland, and Latvia, consumer prices fell on a year-over-year basis in 2013. Over the same period, consumer prices remained static in Portugal and Spain, and they rose by the statistically insignificant rate of 0.5 percent in Denmark, Lithuania, Slovakia, and Sweden. Aggregate inflation in the EU has declined to a five-year low of 0.5 percent, well below the target of two percent set by the European Central Bank (ECB).

As long as incomes remain stable, deflation has a positive impact on consumers’ purchasing power; they can buy more goods and services as prices fall. Their savings also increase in value as prices decline, unless banks begin to charge negative interest rates -- basically, a fee for holding money.But deflation can be devastating for citizens with loans: as the value of their money remains stagnant or even decreases, they must continue to meet their debt obligations, the nominal value of which does not change. At the same time, whatever assets they have pledged as loan collateral decline in price, prompting lenders to demand further security against default. Deflation is also bad news for individuals and companies who do business across borders. Imports may become more expensive, and exports can generate lower revenues. Deflation also threatens citizens and companies with loans and other credit facilities.

For evidence of the ill effects of deflation, look to Japan in the 1990s, which closely resembles Europe today. There, too, the financial sector struggled under a large burden of bad loans. Like Europe, Japan also faced an aging population that consumed less. Another disquieting similarity is that the ECB, like its Japanese counterpart, seems unwilling to dramatically counteract these ominous monetary trends. The ECB has some reasons for its reticence -- but they aren't good enough.

MISSED OPPORTUNITIES

The ECB has already missed its best opportunity to effectively ease Europe’s money supply to counteract deflation. Two years ago, inflation in Europe dipped below the central bank’s two-percent target, and the European economy was at the lowest point of its four-year downturn. But the ECB was strongly influenced by Germany’s Bundesbank, which has historically been much more concerned about inflation than deflation. Now that the economy has started to revive and inflation has likely reached its lowest point, monetary expansion would not have much of a positive impact, at least not for Europe's leading economies.

For Europe's smaller economies, monetary expansion might still facilitate a recovery. If the ECB adopted a quantitative easing program involving the direct purchase of national bonds and collateralized loans, Spain, which has a huge stock of such debt, might come out ahead. But the implementation of such a strategy would be far more challenging in Europe than in the United States or Japan because of structural problems within Europe’s banking sector. Financial institutions within Europe’s fragmented banking sector still hold savings within the confines of their national borders.

It is also unclear whether quantitative easing is likely to have a significant impact across Europe right now. In the United States, quantitative easing seemed to help the most during and immediately after the financial crisis, because it brought stability to asset prices and to the financial sector generally. Beyond immediate damage control, though, quantative easing has had a relatively small effect in the United States. Japan’s recent policy of quantitative easing, which was much more ambitious than that of the United States had its greatest impact last year, stimulating GDP growth, at least temporarily, and boosting inflation to 1.5 percent per year, its highest level in years. Yet despite these achievements, quantitative easing has not been sufficient to bring an end to Japan’s long-term stagnation.

The ECB, furthermore, has already pursued a type of quantitative easing, which might have accomplished all the EU can hope to achieve through such policies. The ECB’s most effective measure to date was its program of long-term refinancing operations, which greatly improved the liquidity of the banking sectors in Europe’s smaller economies while decreasing the risk associated with their government bonds. For these effects alone, the policy was a success. But it had only a minor impact on inflation and GDP growth. Further rounds of quantitative easing, then, would likely lead to effects similar to those in the United States and Japan. It might contribute a few percentage points to GDP growth and the inflation rate, but it would not have any lasting effects on Europe’s economic recovery.

BETTER LATE THAN NEVER

Nonetheless, further quantitative easing by the ECB would be worth the effort. First, for Europe's weakest economies, an increase in economic growth by even a few tenths of one percent would make a tremendous difference. Second, further quantitative easing would allow the ECB to refine its use of extraordinary monetary measures. It could identify which assets are the most effective to buy and at what quantity. If the ECB is ever called on again for quantitative easing, that information would prove to be very useful.

But the ECB should be cautious. Unlike the U.S. Federal Reserve, the ECB does not have the legal authority to buy broad asset types, such as federal bonds and mortgage-backed securities. Instead, it would likely have to focus on more defined instruments, such as corporate bonds. And that would raise the political pressure on the central bank to choose assets based on political expediency, rather than sound financial and economic reasoning.

Moreover, European governments will have a hard time rallying citizens around deflationary policies. Over the last two decades or more, Europeans have been told by their governments that inflation leads to negative consequences, such as rising prices, the devaluation of savings, and a slowdown in social and economic development. Now, governments will have to convince them that, rather than fight inflation, the EU should hope for it.

EXTRAORDINARY MEASURES

The ECB continually emphasizes the differences between Japan and the eurozone. Yet it shouldn't deny the very clear similarities. Demographically, Europe and Japan both have aging populations that are consuming less, which produces slower economic growth. Europe and Japan are both heavily indebted as well, which increases the negative effects of deflation.

Although the ECB did not mention deflation in its 2013 economic report, current conditions make it a real possibility. European countries, especially the Baltic States, already see the reduction of wages and prices as an unavoidable form of internal devaluation necessary to correct economic imbalances with other EU countries. Meanwhile, Europe’s banking sector remains fragile. Once inflation reaches zero percent -- which may happen soon -- the ECB would be forced to acknowledge the risk of deflation. By then, however, it may be too late.

That's why the ECB must take steps now to counter the possibility of deflation. It should start by putting downward pressure on interest rates until they fall slightly below zero. This would encourage consumers to spend rather than save their money, which would lead to higher economic growth and lower unemployment. The ECB should also continue purchasing government bonds under the Securities Markets Programme (SMP), without “sterilizing” those purchases by removing an equal amount from banks of those countries. But since these measures alone will not reverse the slide toward deflation, the ECB should also proceed directly to another round of quantitative easing.

Speaking at the ECB's inaugural Forum on Central Banking, Krugman suggested the eurozone could sleep walk into Japan-style deflation.

It would be easy to convince oneself there is no problem, Prof Krugman said, adding: "There is not that explosive downward dynamics in the euro area, or in the United States.

"But then there has never been explosive downward dynamics in Japan either, and yet we do think that Japan has had a persistent deflation problem."

Opening the ECB's Sintra Forum, billed as the European version of the Federal Reserve's renowned Jackson Hole conference, Mr Draghi warned on Monday that there was a risk of disinflationary expectations taking hold.

I must admit, I'm a high beta junkie and love trading stocks that move. Bonds just don't do it for me, never did. In fact, I don't understand why anyone would invest in bonds given the historic low rates we're seeing. Nonetheless, I think the bond panic of 2013 was way overdone and given the risks of deflation, investors would be wise to invest in high quality bonds and carefully choose high dividend stocks of companies with low debt and strong cash flows (the backup in yields is presenting good opportunities on some interest rate sensitive sectors, like utilities and REITs).

Gold won't shine again until ECB moves: In my last comment on hot stocks of 2013 and 2014, I discussed why gold shares (GLD) are way oversold and it's a good time to start accumulating at these levels. And as I stated in my comment from tapering to deflation, the ECB will have to crank up its quantitative easing, and when it does, gold shares will rally hard.

But be careful with gold. Just like other commodity shares, you'll see plenty of false breakouts due mostly to short covering. These counter-trend rallies are great to trade but don't be fooled, gold will not take off until the ECB starts cranking up its quantitative easing (short the euro, it's overvalued).

When will the ECB move? I don't know but I will tell you this, there will be another Greek haircut and it may come sooner than you think now that Greece has achieved a primary surplus by ramming through troika's insanely deflationary policies. Periphery Europe remains a huge concern for the global recovery and there is no doubt in my mind the ECB will have to crank up its quantitative easing. This is bearish for the euro but bullish for gold.

Some U.S. public pensions, which lack savings for $1.4 trillion of promises to retired government workers, will record wider gaps in fiscal years starting after July 1 because of changes in accounting rules.

Pensions in Illinois, Kentucky, Pennsylvania and other states will see funded levels decline, in some cases by more than half, as they comply with new Governmental Accounting Standards Board rules that for the first time will require future pension costs to be included on balance sheets and change how they must calculate their underfunding.

The new rules won’t affect the amount that states and municipalities actually owe, though they could prompt them to address their underfunding, said Dean Mead, research manager at the Norwalk, Connecticut-based board known as GASB, which makes accounting rules used by most governments. The changes may force some states to cut borrowing or spending.

“It could affect their policy decisions,” Mead said in a telephone interview. “It’s their choice how to react to the new numbers.”

Under the new rules, governments will have to calculate an estimate of how much they owe for future pension liabilities and put that on their balance sheets. Under current rules they put estimates in footnotes on financial statements. Some plans predicted to run out of money will have to lower investment return assumptions used in calculating their future costs, making their liability seem larger.

Funding Adjustments

“They may not want to discuss these numbers,” said Keith Brainard, the Georgetown, Texas-based research director with the National Association of State Retirement Administrators in Washington. “Because of these new numbers, some policy makers will make funding adjustments so they won’t look so bad.”

Teachers Retirement System of the State of Illinois could see its funded level decline to 17.5 percent from 48.4 percent under the changes, according to 2012 estimates from the Center for Retirement Research at Boston College.

Illinois Teachers doesn’t agree with the estimates, said spokesman Dave Urbanek. The only effect of the new GASB rules will be that the fund will have to report a new number. Though the pension has earned 9 percent on average in the past 30 years, the state has never fully funded the plan since it was created in 1939, he said.

“We will have a full range of unfunded liabilities that people can pick from,” said Urbanek. “The bottom line is that we have a problem.”

Fixes Made

Funding for the Kentucky Employee Retirement System would decline to 23.7 percent from 40.3 percent, according to the Boston College estimates.

Executive Director William Thielen said by e-mail that he wasn’t aware that the changes would affect the funding ratio. The rules will require the fund to use new reporting terms and “include significantly more information” in financial reports, he said.

Some municipalities have taken action to try to increase funding ahead of the new rules taking effect: Alaska moved $3 billion from its rainy day fund to shore up pensions. California passed legislation to close a $74 billion gap in the California State Teachers’ Retirement System.

The new numbers may not affect debt costs in the $3.7 trillion municipal bond market because of limited supply and small differences in yields between issuers, said Richard Ciccarone, president of Merritt Research Services in Chicago. Still, borrowers that don’t address shortfalls may eventually be penalized, he said.

“Over time, as the pension crisis continues, you’re going to see spreads widening,” Ciccarone said.

Two of Canada’s largest pension funds are raising their stakes in the U.S. office-building market in a bet on a strong recovery of the world’s largest economy.

Ivanhoé Cambridge, the real estate arm of the Caisse de dépôt et placement du Québec, is boosting its presence in high-end U.S. office properties with the $150-million (U.S.) acquisition of a 49-per-cent stake in a midtown Manhattan property, in partnership with Callahan Capital Properties. The deal is a joint venture with affiliates of Beacon Capital Partners.

In a separate announcement Thursday, the Canada Pension Plan Investment Board (CPPIB) said it plans to invest $108-million to increase its stake in a Manhattan office property and signalled it is looking for more U.S. office real estate in key markets.

Ivanhoé Cambridge’s investment is in 330 Hudson, a 467,000-square-foot, 16-storey Class A building in the Hudson Square section of Midtown South.

CPPIB said it is increasing its stake in One Park Avenue to 45 per cent through a joint venture with Vornado Realty Trust. CPPIB previously held an indirect interest of about 11 per cent through its investment in the Vornado Capital Partners Parallel LP fund. The property is valued at $560-million, including the assumption of $250-million of debt, CPPIB said in a statement.

The Caisse, CPPIB and other Canadian pension funds are “betting on the U.S. recovery. They think employment gains are going to continue,” said independent pension fund analyst Leo Kolivakis.

“It’s fine to bet on the U.S. recovery but it can falter. There is still a lot of uncertainty in the global economy,” said Mr. Kolivakis, who writes the Pension Pulse blog.

The Ivanhoé Cambridge investment in 330 Hudson follows on an $850-million deal last year to buy a majority stake in a 45-storey office tower on Manhattan’s “Corporate Row.”

Also last year, the Caisse placed $360-million in a twin office building complex in Chicago.

“330 Hudson is a leading example of the creative work environment that is increasingly desirable to the growing technology and media industries in Hudson Square, which is one of New York’s most promising urban live/work neighbourhoods,” Ivanhoé Cambridge executive vice-president for U.S. investments Adam Adamakakis said. “We hope to capitalize on more opportunities in key U.S. markets soon.”

“We are delighted with the addition of 330 Hudson to the Ivanhoé Cambridge/Callahan portfolio as it exemplifies our strategy to build a high-quality office platform concentrated in top markets around the world,” said Tim Callahan, chief executive officer of Callahan Capital Properties.

Ivanhoé Cambridge and Callahan have invested more than $2.1-billion in U.S. office platforms in five acquisitions. The Caisse’s real estate division has been bulking up on office buildings, shopping centres and residential units and moving out of hotels, which are viewed as riskier real estate.

Last month, Quebec’s giant pension asset manager put up for sale two iconic hotels, Toronto’s Royal York and the Hotel Vancouver.

CPPIB, which manages a fund pool of more than $219.1-billion (Canadian), said its U.S. office strategy is to acquire high-quality assets in major cities.

“We look forward to further expanding our relationship with Vornado as we continue to build our office portfolio in the U.S.,” Peter Ballon, CPPIB head of real estate investments in the Americas, said in a statement.

Even as U.S. employment pushes past its pre-recession levels, employers are remaining frugal when it comes to office space.

Employers have only reoccupied about 52% of the 142 million square feet that went vacant amid the economic downturn, with occupancy in the second quarter growing by 2.8 million square feet, according to numbers set for release Tuesday from real-estate-data firm Reis Inc. (REIS).

The office vacancy rate remained unchanged in the second quarter at 16.8%, still near its post-recession peak of 17.6% in 2010 and well above the 12.5% rate in 2007.

Meanwhile, rents sought by landlords have grown 7.2% since 2010 and 0.7% in the second quarter to an average annual rent of $29.49 a square foot, according to the Reis report, which tracks 79 metropolitan areas. Rents typically rise with modest growth, even if vacancy is relatively high.

There are several factors behind the sluggish performance.

The office market tends to expand slowly in the years immediately following an economic downturn because companies remain skittish about costs. They often wait until their head count swells considerably before adding new space (click on image below).

"There's a certain amount of underutilized space that needs to be taken up first," said Ryan Severino, an economist at Reis.

But during this economic cycle, companies have been more reluctant than usual to expand, which many in the sector believe reflects a trend by companies to pack a greater number of employees into tighter spaces. This is partly a cost-savings measure but it is also a strategy some companies are using to encourage workers to collaborate.

Seyfarth Shaw LLP, a Chicago-based law firm, announced in April it was moving to the Willis Tower, where it would occupy 195,000 square feet, from a nearby building where it occupies 300,000 feet, despite employing a steady number of lawyers. The firm plans to shrink workspaces, cut back space devoted to a law library, and, in a rarity for the legalprofession, it is considering taking some lawyers out of private offices and placing them in cubicles, particularly those who work part-time,said Peter Miller, a managing partner at Seyfarth.

"We have an obligation to our clients to reduce our overhead and be more efficient," Mr. Miller said, adding it will save "multiple millions per year."

Making life harder for landlords is that an industry with substantial job growth—the technology sector—is known for having among the most densely-packed office space.

Personal-finance website NerdWallet just signed a lease for 46,000 square feet in San Francisco's South of Market neighborhood. It expects to eventually fit a workforce of about 360 employees in the space. That is nearly twice the density of some banks, and not even the top executives will have private offices.

"You want to be in a little bit more of a creative environment," said Chief Operating Officer Dan Yoo. "We'll be in bench seating with everyone else."

Of course, unlike in much of the country, landlords in the area are doing just fine. The San Jose area—which includes Silicon Valley—and the San Francisco area led the nation in rent growth, with rents increasing 6.4% and 5.1%, respectively, over the past 12 months to an average of $26.66 and $37.84 a square foot, according to Reis.

"We're going through almost four years of a solid run in San Francisco," said Victor Coleman, chief executive of Hudson Pacific Properties Inc. The landlord hosts companies including digital-payments firm Square Inc. and Uber Technologies Inc., which recently signed a large expansion.

Most markets saw some rent growth over the past year, with only three—New Haven, Conn., Buffalo, N.Y., and Milwaukee—registering small declines.

Swooping into sectors left cratered by the global financial crisis, hedge funds have found that the surest bets in recent years are in mortgages and other asset-backed securities.

Greg Richter, who co-manages the $950 million Candlewood Structured Credit Fund, says the reason lies in the mix of return and risk in securitized debt, Bloomberg Markets magazine will report in its July/August issue.

“Some of it’s the opportunity, the beta,” Richter says.

The asset-backed-securities market as a whole offers yields of about 8 percent, he says. Much of the rest of the fixed-income world is providing less return.

Results from the Bloomberg Active Indices for Funds, which aggregate return and risk data by strategy, back up his point.

The top-performing hedge-fund strategy from January 2011 through May 2014 was investing in mortgage-backed securities, with a total asset-weighted return of 54 percent. Mortgage-backed was followed by the asset-backed category, with a gain of 46 percent. That’s not all: The two strategies registered the smallest monthly losses, the lowest proportions of down periods and the highest Sharpe ratios, which measure risk-adjusted performance.

The Candlewood Structured Credit Fund, which Richter oversees with co-manager Brian Herr, returned a cumulative 80 percent over the period. Its only down month since its inception in January 2011 was June 2013, when the fund recorded a 1.6 percent dip, according to company data.

Credit Suisse Roots

New York–based Candlewood Investment Group LP traces its roots to a credit hedge fund started within Credit Suisse Group AG. The fund was spun out in 2010 and now oversees $2.8 billion in assets. Of that total, about $1.5 billion is invested in two structured-credit funds managed by Richter and Herr. The rest is focused on event-driven and distressed corporate credit strategies, including the Candlewood Special Situations Fund.

Candlewood’s structured-credit investments are spread across a dozen niches of the market, including bonds backed by aircraft operating leases, student debt, subprime mortgages and collateralized debt obligations, Richter says.

“We’re constantly searching for what we believe to be undervalued CUSIPs,” he says, referring to the identification numbers assigned to bonds. The managers look to resell what they find to buyers who value the bonds differently, on average turning over more than 20 percent of the fund’s portfolio each month.

“We’ve got a lot of trading DNA,” Richter says.

Returns Persist

Relatively high returns persist in the securitized market because, for one thing, many bonds have low credit ratings.

“What we have is a lot of triple-C- and D-rated securities because the rating agencies are still trying to rate the return of principal at par,” Richter says. “It keeps a lot of the deep-pocketed investment-grade buyers out of our market and allows us to trade at still-attractive yields.”

Candlewood has no illusion that it will receive 100 cents on the dollar for the bonds it buys.

“We’re buying these securities at 50; we want to get 70 back,” Richter says.

The labyrinth of the securitized-debt market is a barrier to entry for competitors.

“There’s so much information, so much innovation, so much structural complexity, so many different credit enhancements that have been used in these different sectors,” he says.

Another obstacle is sourcing bonds, according to Herr.

“If you haven’t historically been involved in some of these markets, it gets tougher to leap in,” he says.

The upshot, Richter says, is that in contrast to the corporate bond market, “there are mispriced cash flows left and right.”

Largest Holdings

The fund’s largest holdings as of April were in nonagency, subprime mortgage-backed securities, which accounted for 29 percent of its portfolio. The next-biggest sectors were aircraft-related debt, at 14 percent, and commercial mortgage-backed securities, also at 14 percent.

Each subsector has its peculiarities, Herr says. One holding is aircraft bonds issued before the Sept. 11, 2001, attacks on the World Trade Center and Pentagon. Airlines often don’t own the planes they use, choosing instead to lease them from special-purpose vehicles that buy them with funds raised in bond sales. In the wake of Sept. 11, such bonds plunged to as low as 75 cents on the dollar as lease rates were cut by a third.

“A lot of planes were parked in the desert,” Richter says. “The deals in essence blew up in 2002 and 2003.”

Aircraft Valuation

Another complication for the securities is how the valuation of an aircraft changes as it ages.

“Oil prices are one of the things that can really move the value of these planes because the older ones tend not to be as fuel-efficient as the newer ones,” Richter says.

Airplanes can also throw off cash when they go out of service and get sold off for parts, he says. Aircraft bonds and other asset-backed securities differ from corporate junk bonds in that way, Richter says.

“They are amortizing, self-liquidating securities,” he says. By contrast, getting paid back on a junk bond often depends on refinancing. A high-yield issuer needs to remain leveraged to function, Richter says.

“Our deals naturally delever; the payments from the underlying loans or leases are captured in the trust to pay down debt,” he says. “They don’t need a capital markets event to pay you back.”

In response to rising default rates on subprime U.S. auto loans, bond investors are deciding the best thing to do is pile into securities backed by the debt.

In the market where auto loans to people with spotty credit are bundled into bonds, the difference in yield between the lowest-rated securities and the safest has narrowed to the least since August 2007, according to Wells Fargo & Co. data. Demand for the bonds is translating into cheap funding for lenders, allowing them to make even more loans though payments more than 60 days late are on the increase.

Investors are turning to riskier debt to boost returns as stimulus measures from central banks around the world suppress interest rates. The European Central Bank last week became the first to take one of its main rates below zero, underscoring the lengths to which policy makers are willing to go to jumpstart growth more than five years after the worst financial crisis since the Great Depression.

“People have to reach further and further,” said David Schawel, a money manager at Square 1 Bank in Durham, North Carolina. “The objective now is to reach a certain yield target instead of feeling good about the underlying credit.”

Yields on subprime auto-loan bonds rated BBB have fallen to within 65 basis points of those ranked AAA, down from 124 basis points a year ago, Wells Fargo data show. A basis point is 0.01 percentage point.

Market Revival

Issuance of securities backed by the debt has reached $10 billion this year, up 5 percent from the pace in 2013 through May 30, according to Wells Fargo. Total sales of $17.6 billion last year were more than double the $8 billion sold in 2010, when securitized-debt markets started to revive after all but shutting down amid the 2008 financial crisis.

Aided by low interest rates, the U.S. auto industry has been one of the bright spots of the economic recovery. Vehicle sales rose 11 percent to 1.61 million in May, bringing the annualized pace to 16.8 million, the most since February 2007, according to researcher Autodata Corp.

The economy contracted at a 1 percent annualized rate from January through March, the first decline in three years. An unexpected drop in spending on health-care services means gross domestic product probably shrank even more in the first quarter, according analysts at JPMorgan Chase & Co. and Pierpont Securities LLC.

Investors are increasingly willing to look at smaller, less-established firms in the subprime auto segment to boost returns, Wells Fargo analyst John McElravey said in a telephone interview.

27% Interest

Tidewater Motor Credit, a Virginia Beach, Virginia-based lender, sold $145 million of bonds last week that are backed by 7,438 loans carrying interest rates ranging from 9.45 percent to 26.55 percent, deal documents show. The transaction marks the first asset-backed bond offering for the company since 2012, according to data compiled by Bloomberg.

GM Financial Inc., the subprime lender acquired by General Motors Co. (GM) in 2010, boosted its asset-backed bond sale by $200 million earlier this month to $1.4 billion in its largest such offering since 2007, according to data compiled by Bloomberg.

Bond investors were paid a yield of 120 basis points more than the benchmark swap rate to buy the bonds rated BBB and maturing in four years in the June 3 sale. That compares with a spread of 175 basis points on similar debt sold in November.

Blackstone Acquisition

The subprime auto segment has ballooned since contracting following the financial crisis. Private-equity firms, attracted by the high margins, have flocked to the business during the past three years. New York-based Blackstone Group LP (BX) acquired Irving, Texas-based subprime lender Exeter Finance Corp. in 2011, the same year that Perella Weinberg partnered with CarFinance Capital LLC.

The influx of new players to the business has fueled concern that companies are lowering underwriting standards to win business.

“Subprime auto lending from banks, captive finance companies and credit unions continues to increase and is pressuring more traditional subprime lenders to lend to ever-weaker borrowers to maintain lending volumes,” Moody’s Investors Service analysts led by Peter McNally wrote in a January report.

The percentage of subprime auto loans that are more than 60 days late rose to 2.75 percent in March from 2.24 percent a year prior, Standard & Poor’s said in a report last month, citing the latest available statistics. The delinquency rate on loans to the most creditworthy borrowers was about flat at 0.28 percent.

Lender Pushback

Defaults on the debt are climbing as the segment reaches an “inflection point” with borrowers falling behind and loan terms easing, S&P analyst Amy Martin said in an interview in March.

Losses on the debt, though still within expectations, jumped to 4.45 percent in March from 3.88 percent a year earlier, according to S&P.

Some lenders are pushing back against deteriorating underwriting standards, becoming less willing to extend loans to increasingly risky borrowers, according to Moody’s. Borrower credit scores for used car loans improved in the fourth quarter of 2013 for the first time since 2010, the rating company said in an April report.

Lengthening loan terms and rising debt burdens relative to the value of a vehicle show that lenders are still taking on more risk, the Moody’s analysts led by McNally wrote in the report.

Yield Gap

Top-ranked securities linked to the debt are yielding 45 basis points more than the benchmark rate, compared with 36 a year ago, according to Wells Fargo. Bonds rated BBB, two steps up from non-investment grade status, are 110 basis points more than swaps, down from 160, the data show.

New-loan volumes are likely to remain high in the subprime auto segment at least through 2015 even as some lenders pull back, according to Moody’s.

“Since lenders will still continue to vie for borrowers, we don’t expect a major slowdown in subprime lending,” the Moody’s analysts said. “Competition will continue to pressure the credit quality of new originations as lenders fight for business.”

How does it feel to have a trillion dollars burning a hole in your pocket?

Ask the private-equity industry. It has been so successful in raising money from investors recently that it can't spend it fast enough.

The amount of money raised by private-equity firms but not yet invested—known as dry powder—hit a record high of $1.073 trillion globally at the end of 2013, according to data provider Preqin, an increase of $130 billion from 2012. The total has continued to grow this year, reaching $1.141 trillion globally as of the start of June.

"Private equity has been the best-performing asset class for many institutional investors over the long term," says Hugh MacArthur, head of global private equity at consulting firm Bain & Co. "In a world where many other investments, like credit-based investments, offer a very low yield, they're saying they need to continue to pursue those returns, so they're putting more money into private equity."

The influx of capital is good news for the private-equity industry, but it may not be such good news for investors. Some analysts fear that private-equity firms will struggle to invest such a large amount, resulting either in money remaining uninvested for years or in fund managers overpaying for deals, both of which could affect investor returns.

Reinvesting Profits

For now, that's not deterring investors. They committed $431 billion to private-equity funds in 2013, the highest amount since the financial crisis that started in 2007, according to Preqin. And that is set to continue, as 90% of investors surveyed by Preqin in December said they intend to invest either the same amount or more in private equity this year compared with last year, and 92% said they would maintain or increase their private-equity allocation over the longer term.

One factor in those plans, says Bain's Mr. MacArthur, is that investors are reaping substantial profits from older private-equity funds.

Frustrated Shoppers

The problem for private-equity firms is that the same strong stock market that has allowed them to collect big profits in the past couple of years on their earlier investments is making it harder to find good investments now.

"A lot of the private-equity sponsors I speak with are really frustrated at finding opportunities at a price they're interested in," says Lee Duran, partner and private-equity practice leader at consulting firm BDO USA LLP.

Sectors like software as a service and health care are particularly popular among investors right now, says BDO's Mr. Duran, meaning valuations for companies with strong profits and good growth prospects can be very high.

In December, BDO asked more than 100 U.S. private-equity executives what their most significant challenge would be in the coming year, and the most common response was pricing, cited by 39% of respondents, up from 15% in a similar survey a year earlier. Second on the list was identification of quality targets, cited by 34% of respondents, up from 28% in the previous survey.

Despite these challenges, deal activity has remained strong, with $171 billion in private-equity-backed buyout deals in North America in 2013, up 10% from 2012, according to Preqin.

Money Is Still Welcome

The bottom line for investors: Private-equity firms may struggle to find compelling investment opportunities in such a strong market, and this could make it harder for them to achieve the level of returns that investors have come to expect.

It appears unlikely, though, that the private-equity industry will start turning away investors.

It would be very unusual for funds not to be able to find any suitable opportunities and to return money to investors, Mr. MacArthur says. It's more likely that they'll simply take longer than usual to invest.

"I don't think we're massively out of balance right now, but it's something that bears watching over time," says Mr. MacArthur.

There is no doubt that private equity has been one of the best performing asset classes but I caution readers, there is a wide dispersion of returns among funds and top quartile funds typically outperform over long periods, so take past performance with a shaker of salt. If investors weren't in the right funds, they grossly underperformed the S&P 500.

Some analysts, however, are looking to leave Wall Street altogether.

Linda Lian, a former Morgan Stanley analyst, interviewed with private-equity firms last year. The process made her realize that she was not passionate about the business of buying companies and trying to revamp them. She recalled one interview in particular.

“I just remember speaking to one of the partners, and being interviewed by her, and realizing I didn’t want her life,” said Ms. Lian, 24, who graduated from Harvard in 2012. She now works in finance and business development for a mobile phone security company in San Francisco.

“Working at a private-equity fund was going to be like Banking 2.0,” she said. “Eventually, I just realized I simply didn’t want it.”

Of the recruiting process, she said, “it’s not really so much a process as a feeding frenzy, with banks, headhunters and private-equity funds all caring about their own interests.”

“When all this starts happening, you have no choice, really, not to engage with it,” she said. “If you don’t, there’s so much peer pressure around you, and you feel you’re missing out on opportunities.”

Since the financial crash of 2008, one of the biggest guessing games in the U.S. economy and markets has centered on interest rates — and when they would finally rise from the historic lows that followed the Great Recession.

But year after year, analysts who predicted a sustained rebound in rates have been foiled. The long stretch of rock-bottom rates has been great for many home buyers, corporate borrowers and stock markets. It has been murder on conservative savers, particularly older people with money in banks.

Now, with the U.S. economy showing resilience after a winter slump, the focus has again shifted to the question of when interest rates could begin to return to "normal" levels.

Yet many economists and investment pros believe that neither short-term nor long-term rates will go significantly higher, and stay there, in the next few years. More likely, they say, are modest increases that might even be quickly reversed.

The implications of another extended period of depressed rates would be huge for Americans' investing and saving strategies. It could continue to support stocks' bull market and home prices, for example.

But pension funds hoping for higher bond yields to fund promised retiree benefits would be stymied. And there would be more frustration for savers who now have nearly $10 trillion sitting in short-term bank accounts and money market mutual funds, earning almost nothing.

At the heart of the debate, of course, is the Federal Reserve. The nation's central bank controls short-term rates and has held them near zero since the end of 2008 to support the financial system and economy.

In a report Fed policymakers issued after their June meeting, they made clear that they expected to finally begin lifting their benchmark rate in 2015, if the economy continues to expand and unemployment continues to decline.

Even so, 12 of the 16 members of the policy committee expected the Fed's rate to be no higher than 1.5% by the end of 2015 — a full 18 months from now.

Asked for their rate prediction for the end of 2016, the majority of the Fed panel expected 2.5% or less. And because the Fed's rate influences all other interest costs, that would suggest still-low rates across the board.

To put the 2.5% forecast in context, the Fed's key rate was more than double that, at 5.25%, in September 2007, one year before the financial system meltdown.

The Fed's caution fits with a theme that has been heavily debated on Wall Street since 2008: the idea that the U.S. economy, badly scarred by the Great Recession, has become stuck in a slow-growth mode that could last many years.

Lawrence Summers, president emeritus of Harvard University and President Obama's economic advisor in 2009-10, has warned of "secular stagnation," the risk of the U.S. falling into a Japan-style funk marked by weak consumer spending, anemic economic growth, minimal inflation and low interest rates.

Summers' scenario is a more dire version of the "new normal" that investment giant Pimco in Newport Beach described beginning in 2009. The firm, led by bond guru Bill Gross, foresaw a long period of struggle for the debt-saddled global economy instead of the usual rapid post-recession rebound in growth.

Pimco was mostly on target. The U.S. economy grew at an average annual rate of just 2.3% from 2010 through 2013, compared with an annual average of 3.7% from the 1950s through the 1990s (click on image below).

Now, Pimco and Gross have coined a fresh term for what they see ahead: the "New Neutral," a reference to the Fed interest rate level appropriate for the economy's pace and the level of inflation. They see the Fed's rate no higher than 2% through the end of the decade.

"The New Neutral ... suggests things are just gonna be this way for at least the next three to five years, and likely much more," Gross says.

Another huge money manager, Prudential Investment Management, also is warning clients against counting on a return to interest rates that were considered normal seven years ago — let alone to the double-digit rates of the inflation-wracked 1970s.

"People who are looking for higher inflation and higher interest rates are fighting the last war," said Robert Tipp, Prudential's chief investment strategist for fixed income in Newark, N.J.

Rather than a historical oddity, the current low-rate environment is closer to the long-term norm, Tipp said. The 10-year U.S. Treasury note yield, a benchmark for other long-term interest rates including mortgage rates, has mostly bounced between 1.5% and 4% since 2008 (click on image below).

That also was the usual range for the T-note yield from the late 1880s through the early 1960s, a period that included economic booms and busts, according to data compiled by Yale University Professor Robert Shiller.

Even if Fed policymakers begin raising their key rate next year, they will be wary of any new wobble in the economy, Tipp said. "If they see any sign of a slowdown, they'll stop," he said.

That could mean wider intervals between rate hikes, because this economic recovery has had a stop-and-go pattern since it began in mid-2009.

Scott Minerd, chief investment officer at money manager Guggenheim Partners in Santa Monica, also believes the Fed will be "hypersensitive" to economic conditions as it tightens credit. After the economy's crash in 2008-09, "they are frightened that it could ever happen again," he said.

What's more, the Fed's counterparts, the European Central Bank and the Bank of Japan, have shown no signs of retreating from their own campaigns to keep interest rates depressed. Their benchmark short-term rates are even closer to zero than the Fed's rate. And the ECB last week said it was ready to launch new programs to pump money into the struggling Eurozone economy, where the jobless rate is 11.6%, nearly double the U.S. rate of 6.1%.

"The world has become addicted to low interest rates," Minerd said.

But central banks directly control only short-term rates. Long-term rates, such as on bonds, are influenced by the banks but are set by investor demand — from giant pension funds to small savers hunting for steady income.

This year, once again, investors have been following the central banks' lead by driving bond yields lower. Yields fall when investors are aggressive buyers of bonds because strong demand allows bond issuers to lower the interest rates they offer.

The 10-year T-note has fallen from 3% at the start of 2014 to 2.64% now. That slide took many Wall Street pros by surprise because it came even as the Fed has cut back on its own bond purchases.

In December 2012, the Fed began buying $85 billion a month in Treasury and mortgage bonds, its third round of bond purchases since 2008. The goal of the programs, known as quantitative easing, was to help push long-term interest rates lower to boost the economy. But beginning late last year, the Fed began reducing its purchases by $10 billion a month.

Investors, however, have more than taken up the slack left by the Fed.

Robust investor demand for bonds in part stems from the developed world's aging populations, who are increasingly hungry for interest income and relative safety of principal, analysts say. The long-term drag on the global economy and on interest rates from graying demographics is a favored theme of Jeffrey Gundlach, who oversees $50 billion at DoubleLine Capital in Los Angeles and who foresees a long period of subdued interest rates.

In the aftermath of the financial crisis, shell-shocked investors pumped an unprecedented net $1 trillion into U.S. bond mutual funds from 2009 through 2012, while they were net sellers of stock funds, according to the Investment Company Institute.

In 2013, bond funds saw a net outflow of $80 billion as some investors cashed out. But in the first five months of this year, the inflows resumed, totaling a net $40 billion.

Despite the potential economic and demographic downward pressure on interest rates in the next few years, those forces could easily be overridden by another: inflation. If prices for goods and services were to rise sharply and stay elevated, bond investors could quickly drive longer-term interest rates up dramatically. They would have to, or they'd risk locking in interest returns that would be badly eroded by inflation.

Since 2009, investors have had little to fear from inflation, which has remained mostly below a 2% annual rate by any of several key gauges.

Measured by the Fed's favored inflation gauge, the so-called personal consumption expenditures core deflator, annualized inflation fell to a rate of just 1.1% in January and February. That set off alarm bells that the economy could face the opposite threat: deflation, meaning a broad decline in prices fueled by dismally weak growth.

In the last few months, however, the Fed's inflation gauge has rebounded, reaching an annual rate of 1.5% in May. The better-known consumer price index also has accelerated, reaching 2.1% in May, a 19-month high (click on image below).

Asked at a June news conference whether markets should be concerned about the sudden pickup in inflation, Fed Chairwoman Janet L. Yellen said the increase was partly "noise," though she didn't elaborate. She also pointed out that, at 2%, inflation was just reaching the Fed's long-run target rate.

Still, some analysts say the surprise could be that inflation continues to rise this year, in part because of pressure from higher energy costs. "We think you'll see stronger inflation readings in the near term," said Rick Rieder, co-head of Americas fixed income at money manager BlackRock Inc. in New York.

The result, he said, may be that the Fed moves to raise short-term rates "sooner than many market watchers expect."

But in the longer term, many big investors see inflation remaining low for one overarching reason: "To see a pickup in inflation you have to see it in wages. It just isn't there," said Ethan Harris, co-head of global economics research at Bank of America Merrill Lynch in New York.

Growth in average hourly earnings of U.S. workers has crashed from an annual rate of 3% to 3.5% before the Great Recession to around 2% since 2009, Bureau of Labor Statistics data show. That's a function of continuing high U.S. unemployment and the glut of labor overseas. Many workers have no ability to press for significant wage increases.

Even though the U.S. economy added a net 288,000 jobs in June — exceeding expectations — annualized wage growth held at 2%. Historically, it has taken rising wages to fuel a sustained increase in prices — because otherwise, hefty price hikes can't stick. "To get a wage-price spiral, you'd need to have a different global economic landscape," said Prudential's Tipp.

Guggenheim's Minerd agrees that the world economy is unlikely to face entrenched inflation any time soon. But if central banks eventually get the stronger economy they're aiming for with the tidal wave of money they've unleashed since 2008, higher prices should follow, he said.

"Inflation isn't a problem for this decade," he said. "But it will be a problem for the next decade."

Any tapering in the Fed’s $85 billion-a-month asset-purchasing program will hurt economies in Europe and Asia, where the focus remains on loose monetary policy, Stephen L. Jen and Joana Freire of London-based hedge fund SLJ Macro Partners LLP wrote in a June 10 report. This decoupling would particularly strike emerging markets, which previously served as magnets for capital as the Fed kept monetary policy looser than their central banks did.

Now think about what will happen if we get a crisis in emerging markets because the Fed starts tapering. It will only reinforce global deflationary headwinds, which is exactly the opposite of what the Fed and other central banks want.

For this and other reasons I've outlined above, I just do not see the Fed tapering any time soon. If they do, they will spark another global financial crisis at a time when the world is still dealing with the effects of the last crisis. Moreover, the spectre of deflation lingers, posing a real threat to the global financial system and to pensions preparing for inflation.

As far as tapering, maybe the Fed took a look at the work of Frances Coppola and decided that QE wasn't stoking inflation expectations, it was actually pushing them down. So they decided to begin tapering hoping inflation expectations will rise. But if rates begin rising too fast, debt-laden consumers will be crushed, virtually ensuring a viral bout of debt deflation.

“There’s always a lot of pressure, especially at peaks, to get fully invested,” he said. “That’s what I think is the problem with our industry. We’re so short-sighted at times. When prices are high, the pressure to buy is the greatest. It really should be the opposite.”

Mr. Cinnamond isn’t predicting an imminent pullback. He said he doesn’t have a current market outlook and stocks “could easily keep going higher and higher.”

“The pressure to get invested is constant, but we’re very disciplined in our valuation process,” he said. “It’s just impossible for us to justify these prices.”